Regulators start cracking down on fraud with court-ordered debts

Investigations into the financial engineering devised by Banco Master have exposed a segment of the financial market that had operated beyond the reach of government supervisors. But the loopholes are beginning to close.

A resolution issued last month by the National Monetary Council (CMN) drew little attention, yet it appears to target several players in the scandal: Master, investment funds, the Hidden Carbon operation, court-ordered government debt payments, and the Judiciary.

The resolution covers Receivables Investment Funds (FIDCs), banning high-risk transactions and tightening the rules for valuing these funds, whose assets total R$35.2 billion.

FIDCs, a government official explains, are legitimate financing instruments that let those entitled to receive payments get their money in advance. A person or company that wins a lawsuit against the government, for example, can turn to one of these funds to avoid joining the government’s payment queue.

Over time, FIDCs began handling not only claims already in the enforcement stage, when a ruling has been issued and the amount determined, but also cases still in the ordinary proceedings stage, known as the fact-finding stage. In those cases, there is only an uncertain expectation of a legal right, with no definitive amount owed. When the claim is against the government, it is known as a pré-precatório, a potential future court-ordered government debt payment.

The resolution put a corrective brake on transactions involving pré-precatórios and other contingent claims held by FIDCs. It bars new contributions of such assets to the funds and sets transparency rules for their existing portfolios. A new resolution could provide more detailed guidance on how these assets should be valued, to prevent inflated prices.

Former banker Daniel Vorcaro’s interest in court-ordered government debt payments is tied to this mechanism. Master, the official explains, used FIDCs stuffed with inflated contingent claims to boost its balance sheet. Court rulings against the government could lend legitimacy to deals involving pré-precatórios.

The mechanism is not unique to Master, the official says. There is an “industry built around court-ordered debt payments” in which law firms with connections to judges collect multimillion-real fees.

Another issue that caught the government’s attention is that these transactions are structured through a tangle of funds holding stakes in other funds. Money circulates through these structures because ownership and source-of-funds checks are less stringent than at traditional banks.

“You have an investment and equity fund that invests in a special-purpose entity, which buys stakes in three more funds, including an FIDC and a FIP [private equity investment fund],” the official explains. “Someone puts in R$10 million, says they put in R$1 million, pays a bunch of people, and in the end sells the stake for R$9 million.” In this scenario, R$1 million was spent to “launder” R$10 million, the official says.

The CMN resolution was issued in September, on the same day the third phase of Operation Hidden Carbon (Operação Carbono Oculto) was launched, in response to findings from the investigations. Among the targets was a financial structure set up to acquire a fuel distributor by two businessmen who, according to São Paulo state prosecutors, are suspected of having ties to the PCC, Brazil’s largest criminal organization.

It was no coincidence that Supreme Court Justice Flávio Dino ordered the Finance Ministry to coordinate a group tasked with improving regulation of the securities market, particularly FIDCs.

The group has 90 days to submit a work plan to Dino. Its main task will be to review the Securities and Exchange Commission of Brazil (CVM) resolution governing investment funds. One possible outcome is a new rule imposing stricter requirements for setting up funds, which would make the strategy of creating multiple funds more expensive.

At the same time, the Finance Ministry is reviewing the supervisory framework for the financial system. Officials believe the current structure, with a separate agency for each type of product, leaves some areas subject to overlapping oversight and others off the radar. Under it, the Central Bank oversees credit, the CVM oversees securities markets, the Superintendence of Private Insurance (Susep) oversees insurance, and the National Superintendence for Supplementary Pensions oversees closed supplementary pension plans.

Until last year, the debate had been heading toward a model known as “twin peaks.” Instead of supervision organized by product, the system would be restructured around two agencies: one responsible for market conduct, the other for prudential and regulatory matters.

The proposal met resistance within the government. The discussion is now shifting toward prioritizing the sharing of data and information rather than necessarily changing the agencies themselves.

The challenge, the official says, is to improve supervision without stifling market development. The FIDC industry, for example, handles R$1 trillion in transactions, and the vast majority of participants operate properly, the official says.

The Master scandal and Operation Hidden Carbon show that this market needs closer scrutiny.