The New Brazilian Bankruptcy Law – Some Practical Concerns
Written By Timothy John Smith1 and Carlos Derraik
Derraik Advogados
Associado a - Associated with
Squire, Sanders & Dempsey L.L.P.
Rio de Janeiro, RJ, Brazil
tismith@ssd.com
cderraik@ssd.com

Introduction
The proposed Brazilian Bankruptcy law as proposed by the House of Representatives was extensively amended by the Senate. The Senate revisions are currently being considered in the House of Representatives, which has appointed a commission to recommend changes to the Senate version.

The following comments are based on some of the more important provisions that appear likely to be included in the final law. However, it is impossible to determine which provisions will actually be included in the law as ultimately adopted.

General
The proposed Brazilian Bankruptcy Law would represent a radical change from the current law. It much more closely resembles the U.S. Bankruptcy Code than the bankruptcy laws adopted by most other civil law countries — especially with respect to the reorganization aspects.

The proposed bankruptcy law is founded on an underlying shift in philosophy that aims to provide the opportunity to rehabilitate financially troubled companies. As in the United States, it provides for a reorganization process (“recuperação” in Portuguese) with creditor involvement and for a type of “automatic stay” that prohibits creditors from commencing or continuing to collect claims against the debtor. This is important because currently in Brazil creditors of financially troubled companies aggressively pursue enforcement of their claims – often to the detriment of other creditors and the debtor. (It is important to note, however, that under the Senate version the automatic stay would not apply to tax creditors in reorganization proceedings. This could present a real danger for secured creditors because tax claims in Brazil can be very substantial and the tax claimants will be able to pursue their claims while other creditors are stayed even against collateral of a secured creditor.)

Despite the change in philosophy and the extent of the proposed changes, U.S. creditors should be aware that there are a number of provisions that are very different from the provisions under the U.S. Bankruptcy Code. These differences have an important impact on their credit analysis with respect to Brazilian companies.

Foreign Exchange Concerns
A very basic concern under the proposed Brazilian Bankruptcy Law is that any claim in a foreign currency is converted into Brazilian Reais in the event of a liquidation proceeding. (In the Senate version this conversion would also be made in a reorganization proceeding for purposes of determining voting rights.) The conversion is made at the exchange rate in effect on the date the liquidation order is made by the court. This can drastically change the economic relation between the parties because in a contract between a Brazilian entity and a foreign entity obligations can be specified and paid in a foreign currency. Because the Brazilian Real is subject to dramatic foreign exchange rate fluctuations and there has been consistent high inflation in Brazil, the denomination and payment of obligations in U.S. dollars provided a very important risk management structure for creditors. The risk management structure will be thrown out the window in the event of a liquidation proceeding. Under the proposed Brazilian Bankruptcy Law, this risk is automatically re-imposed on the creditor in the event of a liquidation proceeding. In addition, all this will be happening at a time when the creditworthiness of the Brazilian debtor is in its worse state.

Secured Creditor Treatment
The proposed bankruptcy law aims at improving the priority classification of secured creditors holding a valid voluntary security interest in identified property. However, it still does not equate with the position enjoyed by secured lenders in the United States. Notably absent in the law are any procedures for conditioning the debtor’s use of the secured creditor’s collateral on the debtor providing “adequate protection” of the secured creditor’s interest in the collateral. In other words, under the proposed bankruptcy law the debtor is not required to establish that the secured creditor’s position will not deteriorate during the reorganization process.

In addition, under the existing Brazilian law, a secured creditor’s claim is only satisfied from its collateral after all labor claims have been paid, and in certain cases all tax claims. Under the House version of the proposed bankruptcy law, the secured portion of a secured lender’s claim (the amount up to the value of its interest in the collateral) constitutes a second priority claim (labor claims would have a first priority) that will share, on a pro-rata basis, with other secured lenders and any tax claims. The Senate version would further improve the secured creditors’ classification in a liquidation proceeding by classifying the secured claims prior to tax claims. However, under the current Senate version, in a reorganization proceeding the secured claims, as a practical matter, may still be effectively subordinated to tax claims because the automatic stay does not apply to tax creditors. Thus, the tax authorities will be able to pursue the collection of their claims while the secured creditors are stayed — and under the Tax Code, the tax authorities have a preference over all creditors, including secured creditors in reorganization proceedings. This will continue to be the case under the proposed Tax Code provisions relating to the proposed bankruptcy law.

While bankruptcy laws in many civil law countries preferred treatment to tax and labor claim exists, many of them at least impose a limit on the amount of the tax claims that can be paid from a secured creditor’s collateral. There is no such limit in the proposed bankruptcy law (except in the Senate version with respect to labor claims). This is a real concern because in Brazil numerous taxes are imposed on a business, and the rates are very high. (Note that the total taxes imposed on a business are often in the range of 40 percent of its gross revenues).

In the United States the only claims that normally are imposed on the secured lender’s collateral, are tax claims that are specifically imposed on the particular asset (e.g. real property taxes). In the United States, the debtor’s payment of these taxes is easy to monitor, and the amounts of the tax are relatively limited. However, in Brazil a secured creditor can be lulled into a false sense of security based on its collateral, only to find that in the event of a bankruptcy its secured position has been largely eroded due to substantial unsatisfied tax and labor claims.

It is very interesting to note that under the Senate version, a secured creditor is better off in a liquidation proceeding, because unlike in the case of a reorganization, the labor claims that will prime its interest are capped and the tax claims are subordinated to the secured claims. In other words, the Senate version actually provides incentives for secured creditors to oppose a plan of reorganization and to liquidate the debtor. This is the exact opposite of the stated philosophy underlying the proposed bankruptcy law – that is, encouraging the reorganization of companies and providing an opportunity for them to avoid liquidation.

Creditor Voting Rights and “Cram-down”
The proposed bankruptcy law provides for creditor involvement and voting in the reorganization process. (Under the current law, the judge makes decisions regarding the treatment of claims and the debtor in the bankruptcy process without any voting rights by creditors).

The proposed Bankruptcy law also introduces “cram-down” provisions under which a judge can approve a plan of reorganization (a) if the plan is accepted by creditors representing over half of the value of the total claims, (b) at least 50 percent of the claims in at least two of the three mandatory classes of creditors (e.g., labor claimants, secured [and preferred creditors in the house version] and ordinary creditors [and preferred creditors in the Senate version]) accept the plan and (c) if at least 33 percent of the of the claims in the non-accepting class voted in favor of the plan.

The introduction of these “cram-down” provisions helps balance the negotiating and approval process between the debtor, the various creditors and the court. Previously, most of the power resided in the courts and creditors moved quickly and aggressively to enforce their individual claims against financially troubled companies. The voting and cram-down provisions provide a framework for developing a more balanced and fair plan, because the bargaining power is allocated between the various interested parties, and neither the debtor, nor the court, nor any single class of creditors can control the process.

Diligence and Timing of Claims
Under the proposed bankruptcy law creditors must be very diligent in monitoring their claims. Unlike in the United States, there is no requirement for a debtor to give direct notice of a bankruptcy filing to its creditors. The only notice required is publication in newspapers of general circulation. A creditor has only 15 days after publication to verify the proper listing of its claim by the debtor and to file an objection – otherwise they risk losing their voting rights and their distribution rights. This means that U.S.-based creditors will likely need to rely on local representatives in Brazil to monitor the activities of any of their debtors in order to insure that they will be able to enforce their rights and receive distributions on their claims in the bankruptcy proceedings.

Effect on Credit in Brazil
It appears that the proposed bankruptcy law will be a definite improvement over the existing legislation, especially from the viewpoint of secured creditors. However, the changes may still leave secured creditors short of the point that they can be relatively certain that they will be able to realize the value of their collateral in a reorganization proceeding in Brazil. For this reason, unless the version of the law ultimately adopted provides clear protections to the secured creditors, it is unlikely to have a noticeable effect on the availability and cost of credit facilities in Brazil.

We witnessed the same phenomenon in Central and Eastern Europe in the 90s, when legislators and commentators were opining that similar changes in the bankruptcy laws and mortgage laws would result in a substantial increase in the availability of, and the improvement of the terms in, available credit facilities. The proposed bankruptcy law has some definite improvements. However, creditors today are sophisticated and need to have a degree of certainty that is lacking in the proposed bankruptcy law in order for there to be a substantial effect on the availability and cost of credit in Brazil. In addition, creditors (especially foreign creditors) are likely to wait until there have been sufficient proceedings actually conducted by the courts, and a reliable track record has been established on the treatment of creditor claims under the proposed bankruptcy law before they will modify their credit risk analysis based on the provision of the proposed bankruptcy law.

1 Managing partner of SSD in Brazil, resident in Rio de Janeiro.
Back to text

OTHER STORIES
IN THIS ISSUE:

Fairchild Summary

Thailand Amends its Bankruptcy Laws

Basic Provisions of German Insolvency Law

Basic Provisions of United Kingdom Insolvency Law

Introduction to the United Kingdom's Enterprise Act 2002