Published on Tuesday, 9 August 2016
What are the most common types of private equity transactions in your jurisdiction?
Private-equity transactions in Ecuador have traditionally centered on the financing of infrastructure and development projects, particularly in the oil sector given the prevalence of high oil prices through 2014. Secondarily, they have consisted of growth capital, and of strategic buyouts whereby founding shareholders have cashed out. Lastly, we have seen some seed capital, particularly in the real estate sector. Leveraged or management buyouts, acquisition capital, and capital for turnarounds have been rare in the Ecuadorean market.
What types of investors are most active (and what jurisdictions are they most commonly from) in the private equity market of your jurisdiction?
Private equity investors in the Ecuadorian market have typically been strategic, i.e., local or foreign companies that invest to expand or complement their operations, or more typically, to undertake or develop a particular project. The most active investors in the Ecuadorean market have been oil or oil-related companies, as well as foreign multinationals, especially from Asia, funding strategic development projects. Private equity investments by portfolio or investment companies has been more limited. Local pension funds have been relatively active as they have sought to diversify their portfolios. Legal restrictions have foreclosed private-equity investments by financial institutions outside of the financial industry. The government has attempted to encourage investments in the mining sector, thus far, with little success.
What historically have been the main target industries and what trends were noticeable throughout 2015? What trends do you expect to see in the next 18 months?
Historically, the most attractive industry for investments has been the oil industry, due to the high oil prices that prevailed through 2014. Ecuador has also seen strategic private equity investments in the manufacturing and retail sectors, and to some extent in real estate projects.
Most private-equity investment in the next 18 months will be driven by the government’s tight fiscal situation, which has generated momentum for the sale of government assets, notably equity participations in state-run companies. Already, several potential equity sales in companies in the media, telecommunications and other industries have been announced.
Much of the private equity investment in the next 18 months is also likely to be shaped significantly by the Public-Private-Partnerships law that was recently adopted by the Ecuadorean legislature. This law is in large part intended to address the recent liquidity shortage that is besetting the country, by attracting private capital towards sectors and projects that the government deems strategic for the country’s on-going development. These sectors include hydrocarbon extraction and refining, petrochemicals, mining, electricity generation and transmission.
Please describe the main features, size and activity levels of local private equity funds. Are there any regulatory or market restrictions or incentives to the development of any such local funds? Have any begun to participate significantly in transactions out of their local jurisdiction?
Local private equity funds have increased activity in recent years. However, foreign institutions are still the most prominent. We have not seen much activity by local funds outside of Ecuador. Ecuador has revamped its financial legal framework, providing certain tax advantages such as a corporate income tax exemption on the distribution of dividends and exemptions on any tax levies assessed on the granting and registration of any guarantees created to secure investments. Fund managers, which are corporations created solely for that purpose with fiduciary duty to the investors, can only be created with the authorisation of the Superintendence of Companies. The main governing body of the fund manager is the investment committee.
Are there any private equity funds listed in your jurisdiction? Are there any special regulations or requirements applicable to the listing and public offering of securities by such funds or any reform initiatives that are under discussion?
Any fund that wishes to make a public offer or place securities on the stock market or any alternative market must register with the Public Registry of the Securities Market and obtain a risk rating. Currently there are 23 private equity funds listed in the Public Registry of the Securities Market. All funds that assume a corporate form must also be registered with the Mercantile Registry and obtain the approval of the Superintendence of Companies, Securities and Insurance.
The financial sector’s framework was completely overhauled in 2014, when the Monetary and Financial Organic Code was enacted, substituting all then existing regulations. Central to this overhaul was the creation of the Monetary and Financial Policy and Regulation Board. The Board has powers to issue resolutions complementing the Code. No other major reforms have been adopted.
What are the main issues in connection with the liability of fund managers?
Fund managers owe fiduciary duties to their investors. Furthermore, funds have certain investment restrictions that vary depending on the type of investment and the fund’s level of equity capital. Managers are jointly liable with the fund for a violation of the law. Potential liability ranges from civil liability to criminal charges.
What are the main remuneration schemes and related features for fund managers and have there been any recent shifts observable in the market? Are there any limitations or reforms under discussion regarding the same?
Please describe any legal considerations of particular importance in your jurisdiction in connection with executing leveraged buyouts and similar strategies.
In Ecuador, leveraged buyouts or similar strategies are not prohibited. However, Ecuadorian law does have restrictions on how much companies can borrow and at what rate for tax-deduction purposes. Failure to comply with these regulations will make the repayment of interest on any loan non-deductible for income-tax purposes.
If the leverage buyout is performed by a fund, please note that there are restrictions as to the percentage that each fund may invest in a single company. Funds may not invest more than 15 per cent of their equity in related companies of the managers or 30 per cent of their equity in non-listed companies. Funds also have restrictions on offering invested assets as collateral.
Lastly, there is a constitutional prohibition on financial institutions, its managers or shareholders, having a direct or indirect equity participation in non-financial companies.
What are the main organisational forms used in your jurisdiction to channel private equity investments? Has there been any change over time in the types of organisational forms used? What are the main formation requirements?
Private equity investments have been traditionally made using special purpose vehicles such as an Ecuadorian corporation or, in the case of real estate investments, a trust. These organisational forms have remained the same; however, the minimum capital required to raise the fund and the ratios of investment permitted for each fund are set and modified from time to time by the Monetary and Financial Policy and Regulation Board.
Corporations, funds and trusts must be incorporated by public deed. Corporations and funds must also be reviewed by the Superintendence of Companies and registered with the Public Registry of the Securities Market.
What are the most important legal issues arising in the operation and governance of local companies in your jurisdiction?
The legal representatives of a company is it chief officer under Ecuadorean law, and as such is personally liable for any actions taken on behalf of the company that do not comply with either the company’s articles of incorporation or the law. Such liability may not be limited through the Articles on Incorporation. Accordingly, any such limitation of liability in the Articles of Incorporation is deemed null and void. Shareholders may also be liable, up to their share participation, for the company’s outstanding debts in the event of its liquidation, especially for any breach of employment obligations, such as unpaid social security contributions or the company employees’ wages.
Ecuadorian law permits few restrictions on the free transferability of shares in a corporation. Thus, any pre-emptive rights, put or call options or other means of forced sale or acquisition are not subject to specific performance, and may only give rise to potential monetary damages. This has limited the use of shareholder agreements in Ecuadorian corporations.
Are there any issues to be considered in connection with the limitation of liability under the laws of your jurisdiction?
The law does not allow a company’s shareholders to limit the liability of its legal representative (the company’s chief officer) or to indemnify the legal representative for any liability he or she incurs in connection with his or her duties. Considering that corporations are the vehicle most often used by fund managers to channel their investments, these restrictions typically apply to them. Officer and shareholders of Ecuadorean companies may be held liable for some of the company’s obligations, such as the lack of payment of the company’s employee’s annual revenue share. Fund managers may also be subject to criminal or administrative liability if they breach their fiduciary duty and such liability may not be limited contractually or otherwise.
What are the most common minority protection rights, whether granted by operation of law or contractual agreement? Are there any special issues to be considered under the laws of your jurisdiction?
Ecuadorian law offer minority shareholders the following protection rights:
A company’s Articles of Incorporation may include additional contractual provisions to protect minority shareholders as long as they comply with the law. Shareholder agreements may also contain provisions to protect minorities, such as by granting them the right to appoint some of the company’s officers or directors. However, these measures are generally not subject to specific performance, and only give minorities the right to claim compensation for contractual damages.
What are the main exit strategies used by private equity investors in your jurisdiction? Are there any limitations to the availability, effectiveness or enforceability of exit arrangements that are commonly used in other jurisdictions? Have you seen a shift away from or towards certain exit strategies over the past year?
Ecuador does not have a robust capital market, nor a local stock exchange that offers a significant levels of liquidity. Accordingly, the most common type of exit strategy is the sale of equity to a third party, typically a strategic investor. That entails full or partial sales, with or without an auction, as well as corporate partnerships and joint ventures. IPOs, spin-offs or employee stock purchases are unusual.
Ecuadorean law prohibits limitations on the free transferability of a company’s shares. That limits the availability and effectiveness of common exit arrangements found in shareholder agreements, such as tag-along and drag-along rights, put and call options, rights of first refusal and rights of first offer. Specific performance would thus not be available for enforcement of such rights, leaving only potential monetary damages.
There is no discernible trend away from third-party sales as the preferred exit strategy
What are the key legal issues to be considered when appointing or replacing directors and officers?
The main issue to consider is the exposure to liability that directors and the officer that serves as the company’s legal representative are jointly liable with the company with obligations it assumes, such labour liabilities. Furthermore, the company may not indemnify its directors and officers, or otherwise contractually limit their exposure, for such liabilities.
A lesser issue to consider is that the director or officer that serves as the company’s legal representative must be domiciled in Ecuador.
Appointments are formalised when the director or officer accepts his or her designation in writing. In the case of the general manager and president, or a director who is the legal representative of the company (if designated as such by the articles of incorporation), the appointment must be registered with the Commercial Registry to be valid and enforceable against all third parties.
Please describe the most significant issues commonly considered under the laws of your jurisdiction in connection with purchase and shareholders’ agreements.
Purchase agreements in Ecuador face many of the same issues that purchase agreements in other jurisdictions face, such as indemnities, earn-outs, escrow arrangements and the scope of representations and warranties. One issue that gains more importance in Ecuador due to a cumbersome judicial system is the mechanism to resolve disputes. Often the parties opt for arbitration, and if one of the parties is foreign, typically international arbitration. In this regard, note that the arbitration clause in any transaction involving a public entity, such as a publicly-owned company, must be approved by Ecuador’s Attorney General.
Other issues that may be particular to Ecuador are tax issues. One important factor to consider is that in Ecuador the target company itself is liable for capital gains taxes that the seller fails to pay. Another tax issue is that payments of the purchase price to an Ecuadorean seller that are made abroad would be subject to the 5% tax on foreign remittances, even if the funds never enter Ecuador. For tax purposes, Ecuadorean law always looks at the ultimate beneficial individual owner of the shares.
Lastly, the companies that are often most attractive to private-equity investors tend to operate in regulated industries, which typically raise the prospect of complicated regulatory approvals. This is the case, for example, in for hydrocarbons, mining and telecommunications.
As to shareholder agreements, the most salient issue is the enforceability of limitations on the transfer of shares, which Ecuadorian law generally prohibits. Thus, any such limitations in shareholders’ agreements will not be subject to specific performance, and most likely only give rise to monetary damages. These limitation extends to the transfer of economic rights and obligations tied to the underlying shares, such as the right to claim retained dividends and the obligation to contribute in any pending capital increase.
Finally, in the case of limited liability companies, note that quotas or participations can only be transferred with the partners’ unanimous authorisation. The transfer must be made through a public deed, which must be registered before the Mercantile Registry. A copy of the registered deed must be filed before the Superintendence of Companies and this entity will register the transfer.
Please describe the main issues related to dispute resolutions under purchase, shareholders’ and other principal private equity agreements. What are the most common dispute resolution mechanisms selected in these agreements?
Ecuadorean courts offer what is generally perceived as a slow and cumbersome dispute resolution mechanism. Accordingly, arbitration, either local or international, is the preferred choice for this type of transactions. In the event of agreements with mixed-economy companies (i.e., companies that are partially owned by public institutions) or with public companies, any local or international arbitration clauses will require the prior authorisation of the State Attorney General in order to be enforceable. The Ecuadorian government favours international arbitration clauses with the forum in a Latin American country and that are governed by UNCITRAL rules.
What are the most common funding structures? Are there any significant issues commonly confronted in implementing such structures?
Foreign financing has recently increased in Ecuador due to the economic crisis that the country is currently facing, which has resulted in a shortage of liquidity. The most common funding structures are capital increases, private placements of debt securities and secured loans. Foreign financing from international credit facilities and multilateral entities such as the Andean Development Corporation (CAF), the World Bank or the International Finance Corporation (IFC) has increased in the past few years.
Ecuador currently assesses a 5% tax on transfers of funds to jurisdictions outside of Ecuador – the so-called Foreign Remittance Tax or ISD by its Spanish acronym. As an incentive for foreign financing, the government has exempted from this tax loans by foreign financial institutions provided they meet the following conditions: (i) the financing must have a term for repayment of one year or more; (ii) the interest rate may not surpass the maximum reference rate set by the Monetary and Financial Policy and Regulation Board; and (iii) the loan’s proceeds must be used for productive activities in Ecuador, as set out in the Production, Commerce and Investment Organic Code. If a related party carries out the financing, then the debt may not exceed 300 per cent of the debtor’s equity. Additionally, if the foreign loan meets these conditions, interest payable on the loan will also be deductible for income-tax purposes.
Is there a domestic financing market for private equity deals? Has there been a shift in the sources of funding over the past few years? Where do you expect to see financing come from in the next 18 months?
Domestic financing has not been as active as in other parts of the region. The local capital market offers only limited liquidity, and financial institutions have strict regulations as to how much indebtedness they can incur and may not make equity investments in sectors other than finance.
We have seen, however, a surge in foreign financing and multilateral financing as these entities have started to allocate more funds to Ecuador due to the fall in activity in some of the region’s largest markets and scarcity of local liquidity. We believe that foreign financing will increase during the following months as local companies actively seek leverage or equity to confront the current economic downturn.
What are the principal accounting considerations that arise in private equity transactions? Are there any contemplated or ongoing shifts in regulatory accounting standards in your jurisdiction?
In 2011, Ecuador adopted the International Financial Reporting Standards (IFRS). These regulations establish the methods for keeping proper accounting of investments, which can be based on market value, the net cost method, the equity method and the fair value method. The Organic Law on the Domestic Tax System states that for tax purposes, the deductible cost of equity investments can be determined in accordance to either: (i) its nominal value; (ii) its purchase value; or (iii) its net book value.
Currently there are no changes contemplated in Ecuadorian regulatory accounting standards.
Are there any disclosure, registration or licensing requirements affecting private equity funds investments currently in effect or under consideration by regulators?
Funds must be registered with the Public Registry of the Securities Market. Fund managers must also comply with reporting obligations to the Ecuadorian Market Value Commission and the Superintendence of Companies, such as disclosure of their annual accounts and investment ratios.
Please describe any restrictions, requirements or protections applicable to foreign investors in connection with private equity investments.
Ecuador has attempted to provide a legal frameworks aimed at attracting foreign investment. As such, in 2010 the Production, Commerce and Investment Organic Code (COPCI) was enacted. The COPCI includes a set of tax advantages for any investments in economically depressed areas, such as: (i) five-year exemptions on payment of corporate income tax and on the advance of the corporate income tax payment; (ii) currency remittance tax exemptions on the repayment of foreign loans; and (iii) deferred payment plans for the payment of foreign-trade taxes. COPCI has also included international law principles such as: (i) fair and equitable treatment of investors; (ii) prohibition on adopting discriminatory measures; and (iii) prohibition on unlawful expropriations.
The most relevant factor that COPCI has included is access to an investment agreement with the Ecuadorian government, which will formalise all of the aforementioned benefits, and enables the inclusion of an international arbitration clause for dispute resolution. The investment agreements permits the inclusion of a tax-stability clause (with some limits) for investment projects in mining or projects that surpass US$100 million. Note, however, that inclusion of the tax stability clause results in an increase of the corporate income tax assessed on non-mining projects from 22% to 25% as an offset.
For foreign funds wishing to invest in Ecuador, the law states that they must do so through a local fund manager. The foreign fund must have a representation agreement with the local manager. In this case the local manager will have joint fiduciary duty with the fund. The investment ratios are the same as for local funds.
Are there any government approvals required in connection with private equity investments in certain industries or any industry-specific regulatory schemes that can affect private equity investments? What are the main requirements to obtain such approvals? Have there been any observable trends recently in the posture of specific regulators or the regulatory environment generally in connection with the review or approval of such investments?
There are no specific requirements in connection with private equity investments. However, while the Ecuadorian government has encouraged investment in strategic sectors such as hydrocarbons, telecommunications, and non-renewable natural resources, among others, investments or acquisition of shares in these sectors will, in general, require prior authorisation by regulatory authorities.
Please describe any antitrust approvals or other competition law requirements that may apply connection with private equity investments into your jurisdiction?
The Organic Law of Regulation and Control of Power Market establishes a pre-merger control for any concentration or change of control of companies. Companies are obligated to notify the Superintendence of Market Power Control (SCPM) of their transactions and obtain its authorisation if any of the following conditions is met:
Are there any anti-money laundering or other similar financial regulations that should be considered when structuring a private equity transaction or setting up a vehicle?
Ecuador’s anti-money laundering regulations require all financial and insurance entities to keep comprehensive records of all their clients, including a legal certification of good standing of companies, the identity of the shareholders, share capital and incorporation information. Such records must be kept for a 10-year term after the commercial relationship has ended. Financial entities may not have encrypted or anonymous bank accounts.
Financial and insurance entities also owe the following reporting obligations to the Financial Analysis Unit: (i) report any monetary activity that as a whole or via various small transactions surpasses US$10,000 or its equivalent in other currencies; (ii) any suspicious monetary activity within two days of its occurrence; and (iii) monthly national or international transactions that exceed US$10,000.
These entities must also designate a compliance officer who will be in charge of reviewing the information and carrying out the reporting obligations. The officer must be registered with the Financial Analysis Unit.
Are there any exchange controls that typically affect how foreign private equity investments are structured in your jurisdiction?
Ecuador was dollarized in 1998 so it has no sovereign currency. Since Ecuador adopted the US dollar as its currency, there are no exchange controls as such, but there is a 5% tax on the outflow of currency abroad (ISD by its Spanish acronym), subject to exemptions (see question 17). The Monetary and Financial Policy and Regulation Board has the authority to direct, manage and publish monetary, credit, currency and financial policies, but at the moment there are no regulations establishing exchange controls as such.
What are the basic tax issues affecting private equity investments in your jurisdiction?
Since the revamp of the financial legal framework, the Ecuadorean government has adopted tax incentives for investment funds. Under the Monetary and Financial Organic Code, investment funds are considered corporations for tax purposes. However, distributions of dividends or revenues by investment funds are exempt from income tax. Investments funds are also exempt from other governmental fees, such fees on the registration of guarantees created by the fund and land registration fees.
The general income tax regime applicable to corporations is the following:
Additionally, any transfer of shares or capital rights is subject to capital gains tax, generally at a 22% rate, assessed on the difference between the shares’ sale price and their “patrimonial” value (akin to the book value). Capital gains tax is assessed on the seller of shares. However, if the seller fails to pay the tax, the company whose shares were sold must assume the obligation to pay the tax.
What impact are recent and projected changes in macroeconomic trends in your jurisdiction and abroad and your government’s reaction to these trends having on private equity activity in your jurisdiction? When did you start to see an impact?
Please describe any other regulations applicable to private equity funds and private equity investments not discussed in your answers to the above questions.
Please describe any other recent trends observed in your jurisdiction affecting how private equity transactions are conducted or how these investments are structured.
Please describe any other relevant legal considerations or new developments related to private equity investments in your jurisdiction not discussed in your answers to the above questions.
In response to the earthquake that struck Ecuador’s coastal region in April 2016, the government has enacted a provisional law increasing or creating certain taxes, such as the contribution of a day’s salary of each worker for relief purposes or a VAT rate increase from 12 per cent to 14 per cent. Although these measures are temporary, with most due to expire in one year, their adoption may hinder previously planned investments.