Bankruptcy Reform Coming to Brazil
The Brazilian Congress is putting the final touches on the Business Restructuring and Insolvency Bill No. 4376/93 and the National Tax Code Supplementary Law Bill No. 72/03 (collectively, the "Bankruptcy Amendments"). Luiz Inácio Lula da Silva, the President of Brazil and a strong proponent of the legislation, is expected to sign the Bankruptcy Amendments into law. The proposed reforms represent a sweeping overhaul of Brazil's existing bankruptcy laws and send a clear signal that Brazil, the world's ninth largest economy, is engaged in a historic transition to a creditor-oriented economy. In this article, we briefly summarize key aspects of Brazil's existing bankruptcy laws and the Bankruptcy Amendments.
Brazilian Bankruptcy Law
Governed by Decree-Law No. 7661 of June 21, 1945 (Brazilian Bankruptcy Law), the focus of the Brazilian Bankruptcy Law for almost 60 years has been the permanent liquidation of companies incapable of fulfilling their debt obligations. During the past decade, there has been widespread criticism of the Brazilian Bankruptcy Law. The reforms are aimed at addressing several of the law's fundamental weaknesses that impede bankruptcy reorganizations and hinder economic development in Brazil.
First, the current Brazilian Bankruptcy Law provides limited safeguards for secured creditors. Unlike the layers of protections afforded to holders of secured claims in the United States under the Bankruptcy Code (e.g., §§361, 363(c), 506 and 1109), the Brazilian Bankruptcy Law often prevents secured creditors from enforcing pre-petition guarantees or redeeming collateral. The primary source of this problem is the current priority scheme for claims. Under the Brazilian Bankruptcy Law, secured claims are placed lower in priority than two classes of potentially unlimited claims: labor claims (first priority) and tax claims (second priority). Because labor claims and tax claims are frequently enormous in Brazil, there are generally few assets remaining in a debtor's estate to satisfy secured claims. Consequently, Brazilian lenders have incurred tremendous losses due to loan defaults in bankruptcy. In part to offset such losses, Brazilian banks charge some of the highest lending rates in the world.
Also, the Brazilian Bankruptcy Law creates no meaningful role for unsecured creditors in the reorganization process. The existing law does not permit the appointment of official unsecured creditors' committees, nor does it provide a mechanism for creditor-approved reorganization plans. In addition, the Brazilian Bankruptcy Law contains numerous, archaic procedural mechanisms that complicate and delay the reorganization process. As a result, debtors linger in court-controlled bankruptcy proceedings for many years—some for more than a decade.
Furthermore, the Brazilian Bankruptcy Law fails to protect purchasers of assets in bankruptcy proceedings from successor liability. In other words, the existing law does not contain a provision comparable to §363 under the Bankruptcy Code, which generally authorizes the sale of a debtor's assets "free and clear" of all interests. Rather, investors purchasing assets through bankruptcy proceedings in Brazil are saddled with successor liability for a debtor's labor claims and tax claims. Because the actual amounts of such claims are not generally known or capable of accurate estimation at the time of a sale, investors avoid purchasing assets from debtors. Consequently, the existing bankruptcy laws preclude the development of an efficient market in Brazil for the sale of assets in bankruptcy.
Current Insolvency Proceedings
The Brazilian Bankruptcy Law authorizes several types of court-supervised bankruptcy proceedings. Two of the most common include (1) a bankruptcy liquidation (falência), which is analogous to a chapter 7 liquidation under the Bankruptcy Code, and (2) a debt rehabilitation (preventive concordata), which is similar to a chapter 11 reorganization. Both of these legal proceedings fall under the jurisdiction of the civil court located in the state where a company operates its principal place of business. In practice, the vast majority of insolvency proceedings under the Brazilian Bankruptcy Law have been bankruptcy liquidations.
In Brazil, a company is legally bankrupt when, without a justifiable reason, it fails to pay a liquidated debt when due as evidenced by an instrument that entitles a creditor to institute a legal action against a company to enforce payment. Also, a company is legally bankrupt merely by engaging in certain actions proscribed by Article 2 of the Brazilian Bankruptcy Law, such as liquidating the company hastily or contacting creditors to request cancellation of, or extension of the time to pay, an outstanding debt.
If a company meets this legal definition of a bankrupt entity, it must initiate a voluntary bankruptcy liquidation within 30 days and seek an order of the court declaring itself bankrupt. Alternatively, any interested party may commence an involuntary bankruptcy liquidation against the company (e.g., a creditor whose alleged debt has not been paid by the company). Once a bankruptcy liquidation proceeding has been commenced, a company may avoid the court's immediate declaration of bankruptcy in one of several ways, including (1) producing evidence showing valid defenses to payment of the alleged debt, (2) depositing cash equal to the amount of the alleged debt with the court within 24 hours or (3) initiating a preventive concordata before being served process of the bankruptcy liquidation.
If a court declares a company bankrupt, the management of the debtor is taken over by a court-appointed trustee (síndico) whose primary duty is to liquidate it. The síndico's powers include those typical of a chapter 7 trustee under the Code, such as collecting and selling assets, making distributions to creditors and dissolving the company.
Preventive ConcordataA preventive concordata is the primary court-supervised proceeding for reorganizing an insolvent company in Brazil. In its simplest form, a preventive concordata grants a discharge of a percentage of unsecured claims held against a debtor. However, other claims (e.g., secured claims) are excluded from a preventive concordata, and there is no automatic stay preventing these other creditors from attempting to collect their claims.
During a preventive concordata, a debtor remains in possession of its assets and continues to conduct its business. However, a debtor is supervised throughout the proceeding by a court-appointed receiver (comissário) possessing significant oversight powers, and a debtor faces significant restrictions with respect to the permissible range of reorganization strategies it may pursue. In addition, a court may convert a preventive concordata to a bankruptcy liquidation for cause if a debtor fails to fulfill its statutory obligations.
To obtain the partial discharge of unsecured claims provided by the preventive concordata, a debtor must pay the class of unsecured creditors a statutorily prescribed percentage of such claims within a 24-month period. The Brazilian Bankruptcy Law requires a debtor to treat holders of unsecured claims equally by paying the exact same percentage to every claimant in the class. Also, the percentage varies depending on the date the debtor actually makes payment, and it ranges from 50 percent (if payment is immediately made) to 100 percent of the amount of unsecured claims (if claims are satisfied at the end of the 24-month period). In the case of a preventive concordata lasting between 18-24 months, a debtor must pay between 90 to 100 percent of the amount of unsecured claims and has the added burden of discharging at least 40 percent of the unsecured debt within the first year.
Amendments Focus on Reorganization over Liquidation
One of the primary objectives of the Bankruptcy Amendments is to stimulate entrepreneurial rehabilitation through reorganization and prevent a company facing financial hardship from liquidating. The rationale underlying the Bankruptcy Amendments' emphasis on rehabilitation is a widespread belief in Brazil that a successful reorganization is preferable to liquidation because a functioning and profitable company will be in a better position to repay creditors, continue to employ its workforce, pay taxes and provide dividends to its shareholders.
In order to fulfill this goal, the Bankruptcy Amendments replace the preventive concordata with two new bankruptcy procedures, including an out-of-court reorganization (recuperação extrajudicial) and a judicial reorganization (recuperação judicial). Both of these bankruptcy procedures authorize debtors to pursue a wide range of reorganization strategies typically taken by chapter 11 debtors under the Bankruptcy Code, such as debt restructuring, selling assets, overhauling the corporate structure or arranging for a spin-off, merger or consolidation of a debtor's business operations. In addition to the greater flexibility afforded debtors, the new bankruptcy procedures create a central role for creditors in the reorganization process because they are based on creditor-approved reorganization plans.
Another important innovation of the Bankruptcy Amendments is the introduction of a type of cramdown that will permit confirmation of a reorganization plan over the objection of dissenting creditors and bind all of a debtor's creditors to the terms of an otherwise confirmed reorganization plan. Additionally, the Bankruptcy Amendments establish a form of priority in favor of post-petition creditors. Similar to a chapter 11 proceeding under U.S. law, the reforms accord post-petition creditors priority over pre-petition creditors for the value of post-petition loans, goods or services provided to a debtor-in-possession (DIP). In particular, it is expected that the grant of priority for post-petition loans made by lenders to debtors will help to create a market for DIP lending in Brazil.
An out-of-court reorganization is analogous to a "pre-packaged plan" under the U.S. Code. If a financially distressed company elects to pursue an out-of-court reorganization, it will privately negotiate the terms of the plan with its major creditors. Subsequently, the company must obtain approval of the plan from creditors holding at least 60 percent of the claims in each class or group of creditors subject to the plan and initiate a legal proceeding to obtain the plan's confirmation by the court. However, if confirmation is denied by the court (e.g., the debtor fails to obtain the minimum number of votes from creditors), a debtor may petition for a new out-of-court reorganization or propose a judicial reorganization.
The option to pursue an out-of-court reorganization (i.e., a pre-packaged plan) is viewed by many Brazilian bankruptcy professionals as one of the major innovations of the reforms. In contrast to the existing law in which debtors are often mired in court-controlled bankruptcy proceedings for years, an out-of-court reorganization provides a speedy and cost-effective strategy for debtors to gain creditor confidence for a proposed business plan and emerge quickly from bankruptcy.
Judicial Reorganization Permitted
Another innovation introduced by the Bankruptcy Amendments is judicial reorganization. If a financially distressed company elects to pursue a judicial reorganization, it must initially demonstrate to the court that it is a good-faith debtor with a profitable business core around which to reorganize. If the court determines that rehabilitation is feasible, a debtor is required to submit a proposed reorganization plan to the court. If the proposed plan is unopposed by any creditor, the court must confirm it.
However, if the proposed plan is opposed by any single creditor, the court will call a general meeting of creditors for the purpose of ascertaining creditor approval. Creditors attending the general creditors' meeting will be divided into one of three classes, depending on the nature of their claims: labor claims (Class 1), secured claims (in rem) (Class 2) and all other claims (e.g., unsecured claims) (Class 3). A plan will be approved if votes in its favor are obtained from creditors attending the general creditors' meeting representing (1) a majority in number of labor claims (Class 1) and (2) 50 percent in amount of the claims for each of the classes of secured claims (Class 2) and all other claims (Class 3).
Even if a proposed plan is rejected by one of the three classes, a debtor may nonetheless obtain the necessary creditor approval by obtaining votes in its favor from creditors attending the general creditors' meeting representing (1) a simple majority in number of the combined creditors in all three classes and (2) 50 percent of claims in the two classes approving the plan (in number for Class 1 or in amount for Class 2 and Class 3) and (3) 33 percent of the claims in the rejecting class (in number for Class 1 or in amount for Class 2 and Class 3). If creditor approval is obtained for a proposed plan, the court must confirm it. On the other hand, if a proposed plan is rejected by creditors and the debtor is unable to gain creditor approval by modifying it, the court must convert the case to a bankruptcy liquidation.
Treatment of Claims Adjusted
Similar to the U.S. Code, the Brazilian Bankruptcy Law sets forth a legally fixed order of priority for claims under which some types of claims have priority over others and distributions are shared pro rata by claimants in a particular class. As described above, however, the Brazilian Bankruptcy Law provides few protections for secured creditors because secured claims are ranked third in priority after labor claims (first priority) and tax claims (second priority).
The Bankruptcy Amendments add protections for secured creditors in two ways. First, the reforms provide that creditors holding secured claims will be moved up to second priority after labor claims, thereby placing secured claims higher in priority than tax claims. Also, the Bankruptcy Amendments introduce a cap on the priority accorded labor claims (first priority). For each employee, the cap is equivalent to Brazil's monthly minimum wage for 150 months. At current exchange rates, the amount of the cap is approximately $13,700 per employee. As a result of these revisions, there is a greater likelihood that assets will be available to satisfy the claims of secured creditors.
Eliminating Successor Liability
The Bankruptcy Amendments create additional protections for investors. Significantly, the Bankruptcy Amendments revise Brazil's tax laws to eliminate successor liability with respect to certain categories of claims. In particular, purchasers of assets in insolvency proceedings will no longer inherit legal responsibility to pay the debtor's obligations for (1) labor claims, tax claims and social security claims under a bankruptcy proceeding and (2) tax claims and social security claims under judicial reorganizations. As such, it is anticipated that sales of assets through insolvency proceedings will become a viable rehabilitation strategy for debtors and that the value of such assets will rise due to their newfound marketability, thereby increasing the possibility that debtors will be able to sell assets in bankruptcy and obtain funds to make meaningful payments to creditors.
New Law Is Cause for Optimism
The Bankruptcy Amendments are designed with an eye toward providing greater flexibility for debtors, protecting the rights of creditors, fostering investments in financially distressed companies and reducing the country's sky-high lending rates. By refocusing Brazil's bankruptcy laws from liquidation to reorganization, Brazilian bankruptcy professionals are optimistic that the Bankruptcy Amendments will attract significant investments in debtors and foster economic development in Brazil.
1 Mr. Jarvinen is an associate at Kronish Lieb Weiner & Hellman LLP. Views expressed in this article are those of the authors and not necessarily those of Kronish Lieb Weiner & Hellman LLP or Pinheiro Neto Advogados. Return to article