Juan Fernando Gaviria and Carolina Duque of Philippi Prietocarrizosa & Uría explain how Colombia is gearing up for new regulation and products that will make the jurisdiction more attractive and easier to operate in
Financial globalisation is particularly important for emerging markets and Colombia has not been indifferent to this reality. Foreign financial entities are increasingly looking to Colombia, not only for selling their products and services but also for making direct or portfolio investments. Similarly, Colombian investors are willing to explore foreign markets to diversify their risks. This situation, along with issuance of the Basel III guidelines and the fact that Colombia is seeking to be included in the OECD, has led the Colombian financial authorities to consider certain modifications to the regulations to facilitate and promote cross-border transactions. There are a number of new initiatives coming down the regulatory pipeline that will create opportunities for foreign financial entities interested in offering their products and services in Colombia (including the securities markets), investing directly or in Colombian portfolios, or structuring hybrid instruments for Colombian banks.(1)
Hybrid instruments
The Ministry of Finance (MoF) issued Decree 1648 on September 2 2014 (Decree 1648) to regulate the requirements that hybrid instruments must meet to qualify for tier 1 additional capital and tier 2 capital of financial institutions in Colombia, among other things. Decree 1648 aimed to follow the Basel III guidelines. However, it included a very broad and general regulation of these instruments that left more questions than certainties for potential Colombian issuers. As a consequence, the MoF is planning to issue a new decree (the Proposed Hybrid Instruments Decree) regulating in a more detailed manner hybrid instruments to be issued by Colombian financial institutions. The planed modifications to the Proposed Hybrid Instruments Decree include a number of new factors. As noted previously, hybrid instruments may qualify for tier 1 additional capital or for tier 2 capital. The requirements for these purposes are in essence the same when it comes to the full subscription and payment of the instruments, the deep subordination features that they must contain, the loss absorption mechanisms, and the fact that the issuer is prohibited from accepting differing prices in payment for the instrument. However, in addition to meeting the above-mentioned requirements, a hybrid instrument qualifying for Tier 1 additional capital must also meet the following requirements.
The instruments must be perpetual (in the case of Tier 2 capital instruments, they must be issued with a maturity of at least five years) and, therefore, they could only be redeemed early if the following three requirements arising from Basel III were met: (a) the issuer obtained the Colombian regulator's authorisation to that effect; (b) the instruments were substituted for others having the same or better features; and, (c) the issuer did not create expectations as to the repurchase of the hybrid instruments.
The prospectus, offering memorandum, or the relevant offering document must contain provisions allowing the issuer not to make payments of coupons under certain circumstances. However, the Proposed Hybrid Instruments Decree plans to allow the resetting of the interest rate of the coupon, if the issuer elects not to redeem the instrument early, following the provisions explained below.
In any event, the offering document must clearly state that the non-payment of coupons must not be regarded as a default or event of default by the issuer.
Finally, the Proposed Hybrid Instruments Decree does not allow the accumulation of coupon payments, once the financial strength of the issuer is recovered, as the case may be.
The Proposed Hybrid Instruments Decree regulates in detail the loss absorption mechanisms as follows.
As previously regulated by Decree 1648, the loss absorption mechanism may consist of the conversion of the hybrid instrument into shares or the early amortisation of the same. However, the Proposed Hybrid Instruments Decree confirms that the conversion must be into common or preferred shares, provided that those shares comply with the requirements for Tier 1 capital. In any event, the decree allows the issuer to determine in the offering documents the conversion methodology that it deems appropriate.
In cases of early amortisation, the Proposed Hybrid Instruments Decree allows total or partial amortisations permanently absorbing losses of the issuer. In other words, this decree, at the time of writing, does not allow future write-ups of the instruments, once the financial strength of the issuer is recovered.
As provided by Decree 1648, the Proposed Hybrid Instrument Decree reiterates that the loss absorption mechanism must restore the basic solvency ratio of the issuer to a minimum of 5.125% or to any other higher percentage defined by the issuer in the offering documents. These percentages are, thus, the automatic triggers for the loss absorption mechanism. However, the decree also confirms that the offering documents must clearly include provisions stating the Colombian regulator's trigger in this regard.
Finally, the Proposed Hybrid Instruments Decree allows the parent company of the issuer to include in its technical patrimony the hybrid instruments of its issuing subsidiary, if the offering document contains provisions to the effect that the loss absorption mechanisms are also triggered when the events mentioned in point 3 above are met by the parent company.
Foreign investment
Colombia has an exchange control regime that, although considered light in that it allows the free flow of currency into and outside Colombia, is formalistic in the extreme. In addition, it is not aligned with the suggestions and guidelines of the IMF and the OECD. Given the fact that Colombia expects to be formally admitted into the OECD in the near future, the MoF is planning to amend the foreign investment regulations, which include the exchange control regime, in order to closer comply with international standards.
One of the shortcomings of the foreign investment regime is the way in which direct investments (FDI) and portfolio investments are defined. Indeed, FDIs are simply defined as a list of operations commonly regarded as such and, in turn, portfolio investments are defined as investments in listed securities and local funds.
The problem with this kind of approach is twofold: for one thing, there are a number of operations that fall outside the list of operations that are considered FDI and, therefore, cannot be registered (and that registration is required to obtain remittance rights); and for another, the definitions do not capture the essence of FDIs.
According to the IMF and the OECD, FDI is defined as investments in which the investor takes control (or, at least, a large degree of influence) of the issuer, or when the investor aims at establishing a long-lasting strategic relationship with the issuer. In brief, the two approaches look after a permanent liaison of the investor in the target.
None of these elements are taken into consideration in the definitions of FDI or portfolio investments, hence leading to confusion (and sometimes sanctions) when investors register their foreign investments with local authorities. One example of this situation would be an investment in listed companies with a long-lasting outlook: foreign investors tend to register these investments as FDIs. However, in a document recently issued by the MoF, these investments were considered portfolio investments, given the definition mentioned above.
As the government is aware of this situation, the MoF intends to amend the prevailing foreign investment regime by following the 'substance' approach of the IMF and the OECD. Furthermore, although in the existing draft decree the list of operations remains as the approach for defining FDIs, at least the substantial test mentioned above is also included, providing much more certainty to investors and local advisors.
Other areas of concern around the rigid formalism of our foreign investment regime include: the fact that there are different ways to register different kinds of operations (which also creates confusion); the strict timelines in which the registration must be accomplished; and, the capacity of the local exchange control authorities for reviewing the existence of the underlying operations that give rise to the foreign investment.
The new approach of the MoF in these respects involves simplifying the registration procedures, limiting the authority of the governmental agencies in reviewing the existence of the underlying operations (exchanging this process with an affidavit from the investor), and abolishing the time limits for carrying out the registration. This should lead to fewer breaches of the prevailing regulations by foreign investors and, hence, result in fewer administrative investigations that might lead to sanctions for the investors.
Promotion of foreign financial products and services
To recognise the evolution of the local and international stock markets and to protect non-sophisticated local investors, by the end of 2014, the MoF proposed modifying Decree 2555 of 2010 in respect of the promotion of foreign products and services in Colombia (the Proposed Off-shore Services Decree).
The aim of the Proposed Off-shore Services Decree is to establish a clear difference between the types of clients approached by foreign financial institutions. Indeed, if the foreign financial institution plans to engage in promotional activities aimed at institutional or sophisticated investors, the MoF is proposing reducing the regulatory burdens for the promotion of foreign financial products and services. By the same token, the Proposed Offshore Services Decree also aims at de-regulating the requirements for foreign reinsurance companies wishing to promote their business in Colombia, by requiring them to incorporate a representation office without the need for any previous authorisation from the SFC, on the basis that they are dealing with insurance companies that are deemed to be sophisticated entities. The mere registration of the representation office with the SFC will suffice.
To prevent non-sophisticated Colombian investors from misunderstanding foreign products and services and the risks associated with them, the Proposed Offshore Services Decree plans to include strict advisory duties for local officers of foreign financial institutions engaged in promotional activities. To this effect, the Proposed Offshore Services Decree, following the Markets in Financial Instruments Directive issued by the European Parliament and the Council of the European Union, requires marketing personnel of foreign financial institutions to make recommendations and disclose warnings to the client. This is to help ensure that the client understands the offered product or service and its applicable regulations thus enabling the client to make an informed decision.
The Proposed Offshore Services Decree also requires that officers engaged in promotional activities evaluate the individual conditions and risk-tolerance of the client. Furthermore, if the professional rendering the advice considers that the client's profile is not adequate for the risk it is taking in connection with a foreign stock market product, that professional is required to disclose his/her opinion in writing.
Finally, the Proposed Offshore Services Decree assigns a very important role to local stockbrokers as being the only agents in Colombia for foreign financial entities. In fact, if a foreign financial institution needs to promote its capital market services in Colombia, the Proposed Offshore Services Decree requires it to either incorporate a representative office or enter into correspondent agreements solely with stockbrokers. These agreements may also be entered into with financial corporations.
However, the main component of the Proposed Offshore Services Decree is that only stockbrokers will be allowed to trade, on behalf of Colombian investors, with foreign securities in the primary or secondary markets and with securities and shares issued by offshore investment funds. For this purpose, the decree establishes a series of rules to protect this type of investment from unnecessary risks.
With this regulatory pipeline in mind, it is clear that the Colombian government is looking to incorporate international standards into the financial regulatory framework, not only to promote cross-border transactions but also to maintain prudential regulation. It seems that the reduction of certain procedural burdens and the creation of incentives to trade with international financial products are a response to a business necessity at a time when the combination of the devaluation of the Colombian peso and the drop in the price of crude oil is certainly impacting our economy.
[1] Yeyati, Eduardo L. and Williams, Tomas. 2011. Financial globalization in emerging economies: Much ado about nothing?. © World Bank. http://elibrary.worldbank.org/doi/book/10.1596/1813-9450-5624 License: Creative Commons Attribution CC BY 3.0
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Juan Fernando Gaviria
Philippi Prietocarrizosa & Uría
Bogota
About the author
Juan Fernando has advised lenders and borrowers, including the Colombian government and state-owned companies, in the areas of corporate finance, asset finance, and project finance, among others. He has participated in the financing and restructuring of several power generation and cogeneration projects connected to these transactions. Juan Fernando has also participated in various infrastructure projects and local and international mergers and acquisitions, including the acquisition of local companies through worldwide acquisitions, and has advised both creditors and debtors in several bankruptcy and reorganisation proceedings.
Carolina Duque
Philippi Prietocarrizosa & Uría
Bogota
About the author
Carolina has extensive knowledge in financial regulation. She is an expert in structuring bank loans (including corporate and structured loans ) and has participated in the issuance of notes and ADRs by local financial institutions on the international market (Regulation S and 144A). Additionally, she has specialised in project finance, where she has had a cross-practice. Indeed, she has structured private tender processes to award infrastructure projects (BOOM), has drafted and negotiated contracts related to infrastructure projects (including EPC, O&M, and off -takes, ) and has implemented guarantee schemes with or without limited recourse against the sponsors.