Swapping an axe for a scalpel
Brazil’s 2005 bankruptcy law provided the country’s legal community with an expanded tool kit to help the country’s leading companies to avoid bankruptcy. Joe Rowley takes a look at some of the creative ways the law is being used to help companies restructure their debts and survive, and finds out what more could be done to make the law fit for purpose.
Only the most eagle-eyed readers of Valor Econômico would have noticed the small advertisement in a recent edition of Brazil’s leading business and financial publication. Nestled in the top corner of the front page of the business section, it promoted the services of a small, São Paulo-based investment boutique. Although more understated than some of the flashier notices in the newspaper, what made the advert unusual was the particular service offered to potential customers. Despite the company providing clients with assistance in areas ranging from mergers and acquisitions to structured financing, the advice on offer related to judicial recovery.
With Brazil mired in its worst recession since the 1930s, few would question the commercial rationale of the boutique promoting bankruptcy and insolvency expertise over skills more normally associated with healthier, economic times. Over the last two years, a potent mix of economic, political and industry-specific factors has led to a surge of companies in severe financial distress. Stubbornly low oil and gas and mineral prices have battered Brazil’s commodity dependent economy. Worsening the situation is a historic corruption investigation into Petrobras, which has made the state-owned oil giant the world’s most indebted company and pushed dozens of companies along its long supply chain into bankruptcy. “Until the investigation into Petrobras, most people didn’t realise to what extent the Brazilian market was dependent on its investment policies,” reflects Soares Bumachar Chagas Barros Advogados partner Laura Bumachar.
Meanwhile, political uncertainty surrounding the impeachment of Brazil’s sitting president, Dilma Rousseff (who is now suspended from office for 180 days), and spiralling unemployment have led consumer confidence to plummet; cutting demand for many companies’ products and services precisely at a time when the Brazilian real’s 40 per cent decline against the US dollar has made their dollar-denominated debt unmanageable. “The current crisis is even affecting the good companies,” says Felsberg Advogados partner Thomas Felsberg. “When there was liquidity in the market, good companies took on debt in foreign currency, but all of a sudden the exchange rate doubled, their debt doubled and banks in Brazil shut down access to credit in most sectors of the economy. When this happens, and when recession means demand is low, it is a perfect storm.”
A broad crisis
No sector in Brazil has been left completely unscathed by the country’s declining economic health, but few have been harder hit than the sugar and ethanol industry. After years of heavy investment in the early 2000s, which saw cane output increase by 10 per cent per year, many companies were overleveraged when the onset of the global financial crisis in 2008 reduced demand for ethanol fuel. Government efforts to dampen inflation by cutting taxes on petrol and diesel, which drove down the price of ethanol, coupled with reductions in credit lines provided by Brazil’s development bank and bad harvests, further exacerbated the situation.
When global sugar prices fell to a six-and-a-half-year low last year, companies found their debt burden had become unmanageable. Efforts by the government to reinvigorate the sector came too late. In 2015, a record number of sugar mills filed for bankruptcy protection, according to Valor Econômico. In total, almost one-quarter of all sugar and ethanol companies in Brazil are currently undergoing some form of restructuring, according to Felsberg.
Other companies in the energy sector are suffering. In February, industrial valve manufacturer Lupatech filed its second Chapter 15 bankruptcy protection in almost as many years, driven by the “drastic” drop in oil prices and the financial difficulties of its main client Petrobras, whose debt obligations have soared to US$128 billion. Efforts to meet the growing costs of the Car Wash investigation led Petrobras to slash investment and launch fire sales of billions of dollars-worth of assets, pushing several other companies into bankruptcy. In April last year, Grupo Schahin filed for bankruptcy protection for 28 of its subsidiaries, a month after Portuguese steel manufacturer Amal.
Construction companies have also felt the sting. In January, UTC became the first implicated in the investigation to agree an out-of-court restructuring with its creditors, a month after OAS was forced to agree a deal with creditors. Grupo Galvão, which filed for bankruptcy in 2015, is one of 23 companies blacklisted by Petrobras for paying bribes to win lucrative contracts. Camargo Corrêa, one of the first construction companies whose top executives were convicted of corruption and money laundering, has been selling assets in order to pay fines totalling hundreds of millions of dollars.
Requests for bankruptcy protection more than doubled in the first quarter of this year compared to the same period last year. “In the last two years, what happened was the crisis stopped being concentrated in one or two sectors,” explains Renato Mange Advogados Associados partner Eduardo Foz Mange. “It began in the ethanol industry, and then the auto parts industry, but now it is in all sectors.”
Opening the toolbox
Brazil’s 2005 bankruptcy law may provide lawyers with a versatile tool to help them resolve the growing number of complex cases arriving on their desk, but the level of indebtedness and multiple political and economic factors that have to be taken into account is putting the legislation to its greatest test. Despite this, most agree it is a marked improvement on the previous law passed 60 years earlier, which gave companies experiencing financial difficulty two options: liquidation or preventative restructuring (concordata preventativa), which would impose a haircut on its creditors and provide the company with a debt moratorium. “The former law was not concerned with preserving the value of the ongoing business, but was more of a way of paying the creditors and selling the assets,” says Luciana Celidonio, a partner at Tauil & Chequer Advogados in association with Mayer Brown.
Laura Bumachar, Thomas Felsberg, Eduardo Foz Mange, Luciana Celidonio and Fernando Lobo
Closely modelled on the US bankruptcy code, Brazil’s updated law allows debtors to choose from three alternatives: judicial reorganisation, namely a court-supervised proceeding similar to the US’ Chapter 11; extrajudicial reorganisation, an out-of-court proceeding involving a pre-packaged bankruptcy; or liquidation. To make it easier for companies in the midst of restructuring to raise new financing, it also increases the security available for foreign and domestic investors. Debtor-in-possession (DIP) financing, which was a largely unknown feature of bankruptcy cases in Brazil, now has absolute priority over other debt should the company liquidate. To enable companies to raise financing through the sale of assets, so-called independent productive units (known as UPIs), such as a factory or a business line, can be made exempt from the liabilities.
The concept of UPIs received its greatest test not long after the law was introduced with the restructuring of Varig. The case saw Brazil’s oldest airline spin-off its most important assets, including aircraft, landing slots and its trademark, into a new subsidiary, which was subsequently sold to rival Gol. Varig’s creditors, which included tens of thousands of employees and retirees, petitioned the Supreme Court to make Gol accountable for their labour and indemnification claims, but the Supreme Court ruled that the subsidiary was an operating unit and not the whole company, freeing Gol from any liabilities. “This was the first major case under the new law, but the law is now very clear in its treatment of UPIs,” says De Luca, Derenusson, Schuttoff e Azevedo Advogados (DDSA) partner Luis Azevedo.
A work in progress
Brazil’s legal community may have spoken with one voice in welcoming the reforms to the country’s bankruptcy and insolvency code a decade ago, but most agree that further amendments to the law will be required to ensure that it can effectively and efficiently serve all stakeholders involved in Brazil’s many bankruptcy proceedings today. The lack of definitional clarity of some concepts in the law, exclusion of certain participants from the negotiation process and absence of strict guarantees for foreign investors, are among the features singled out by lawyers as urgently in need of reform.
A major weakness in the law is the priority it gives to equity holders over creditors. In contrast to bankruptcy codes in jurisdictions such as the US, under Brazilian law equity holders are the only parties with the authority to present a restructuring plan to the debtor company. Although creditors may present an alternative plan to the judge in the hope of influencing the outcome, their lack of formal inclusion in the process means that the debtor has little obligation to take into account their views. “Equity holders still have a gigantic role in the process in Brazil,” notes Pinheiro Guimarães – Advogados partner Eduardo Mattar. “The process is very equity controlled, debtor friendly and very harmful to creditors.”
Another drawback is that financially distressed companies are required to file in the state in which they have their main operations. Only a handful of states, such as Rio de Janeiro and São Paulo, have specialised bankruptcy courts, so debtors that are required to file outside of Brazil’s main commercial or business hubs could find their restructuring plan evaluated by a judge without a working knowledge of Brazil’s bankruptcy law. “We still don’t have a significant number of decisions from the Superior Court of Justice [regarding] some gaps and other issues related to this law and we still face a very uncertain scenario when we advise our clients, especially in M&A transactions and financing matters,” explains Leonardo Morato, a partner at Tauil & Chequer. “We know that the São Paulo State Court rules some matters in a different way from the Rio de Janeiro State Court, so we are still in a stage when you cannot predict how a court will rule.”
This situation is further complicated by the absence of a clear definition of what constitutes a company’s main operation. Pointing to one ongoing case he is working on, Galdino, Coelho, Mendes, Advogados partner Flavio Galdino explains that a “negative conflict of jurisdictions” between courts in Minas Gerais and Goiás about where his client’s main business centre is located, has already progressed to the country’s highest court and led to delays of eight months and counting. “The problem is there is no definition at all about what constitutes a company’s ‘main business centre’,” he explains. “Is it where the company has its headquarters? Where the majority of the workers are? Where it gets most of its revenues? Where it pays the most taxes?”
Even without disputes over jurisdiction, companies will find progress through Brazil’s court system a slow and costly experience. Despite the legislation outlining a strict 180-day window for the creditors to vote on a reorganisation plan after the judge’s approval, the reality is that the timetable can become sidetracked by challenges from creditors. Research by Goldman Sachs of filings before the OGX case found that 70 per cent of all cases lasted at least two years. For example, the restructuring of Parmalat’s Brazilian subsidiary, which was the first major case to test the new bankruptcy law, took more than five years to be resolved despite its plan being approved within the 180-day window. Figures compiled by the World Bank show that it takes an average of four years from filing until the resolution of distressed assets; a time frame that has remained unchanged in the decade since Brazil passed the new insolvency law. By contrast, insolvency procedures in the US take one-and-a-half years to process, while Mexico processes claims in under two years. A great majority of companies entering the process will not emerge from judicial restructuring as a single corporate entity. “Thousands of restructuring cases take off, but only hundreds land,” notes Souza, Cescon, Barrieu & Flesch Advogados partner Alexandre Barreto.
Time is money
Companies already under significant financial stress can ill-afford a costly delay. To help speed up the process, the debtor could opt for an extrajudicial recovery, which allows the debtor to negotiate with creditors out of court and submit a pre-approved or pre-packaged plan, which can speed up the process and reduce costs. The debtor need only reach an agreement with 60 per cent of its creditors for the plan to become binding. It’s appealing to creditors as it reduces the risk of the basis of its claim being challenged in court.
However, pre-packaged bankruptcies remain rare in Brazil. According to Felsberg, until last year there were only 32 cases of out-of-court restructuring compared to several thousand for traditional restructuring. One reason is that the threshold for obtaining approval in a judicial recovery is a simple majority of the claims that vote in each class (aided by cramdown rules requiring creditors to accept the terms if the threshold is not met), rather than a minimum of 60 per cent of all affected claims in an extrajudicial recovery (without cramdown rules), meaning it is easier for the debtor to cajole creditors to reach the threshold, according to Pinheiro Guimarães’ Mattar.
A second reason for their relative unpopularity is cultural. “The problem is that in these restructurings there is first a phase of posturing, where people want to show how tough they are,” says Felsberg, which can slow down the process and increase costs. Indeed, while pre-packs include a drag-along right, it does not protect the company from individual claims for assets or money, which would require the debtor to file for protection in court anyway. “Sometimes in the middle of negotiations a bank, or a more aggressive creditor, will try to get assets granted as collateral,” says DDSA’s Fernando Lobo. “This means it would be difficult for a debtor to continue with negotiations and they would have to file for protection for this claim.”
Renato Maggio, Luis Azevedo, Eduardo Mattar, Leonardo Morato and Flavio Galdino
Whether choosing an in-court or out-of-court procedure, new money can be crucial in ensuring the company remains solvent. DIP financing, which is provided to companies in the midst of restructuring and is normally considered senior to other types of debt, is one option, but Machado, Meyer, Sendacz e Opice Advogados partner Renato Maggio argues that the instrument has a “very different situation and spectrum in Brazil than it does in the US”. For example, although the law prioritises the repayment of DIP financing in the case of liquidation, certain distinctions between DIP lenders, such as super-priority status, are relatively unknown compared to other jurisdictions, which may dissuade certain creditors from providing funding
Another factor limiting the availability of DIP financing in Brazil is that the pool of possible lenders is relatively small. Regulations that would provide greater security to local banks in providing DIP loans are still being developed, according to Maggio, meaning that private equity funds or foreign investors are often the only options left for companies looking to obtain addition funding. “Brazilian banks are not protected on this type of work…so the candidates for making a DIP financing in Brazil are often vulture funds or strategic investors,” he says.
External factors also have a substantial impact on the availability of DIP financing. Ironically, it can sometimes be the same factor that contributed to the financial difficulties of the debtor in the first place. Two of Brazil’s most high-profile DIP financing cases illustrate the risks. In 2009, meatpacker Independencia was forced to file for bankruptcy months after receiving a 250 million reais loan from Brazil’s development bank after the deepening global financial crisis slashed global demand for beef. After having its plan approved, the company raised additional DIP financing, but defaulted soon afterwards, sparking a lengthy court battle with various creditors over collateral attached to the DIP loans that is yet to be fully resolved. More recently, another DIP financing by oil company OGX hit financial difficulties when the global oil price fell sharply, which dissuaded a second group of creditors from converting their debt into equity. This led to allegations that the debtor did not afford equal treatment to all creditors and sparked litigation over collateral attached to the funds. “DIP loans haven’t been very frequent in Brazil because the same uncertainties that make it uncertain to invest in Brazil also harm the DIP loan market,” says Pinheiro Guimarães’ Mattar. “In the vast majority of cases, DIP lenders lost money and I don’t think this will change until local courts apply the law in a reliable way.”
Perhaps the greatest challenge for the country’s legal professionals is changing the perception of bankruptcy and insolvency within the Brazilian market. A legacy of the previous concordata system, where the majority filings resulted in liquidation, is that many debtors and creditors continue to view filing for bankruptcy protection as a measure of last resort.
Rather than seeking to tackle the company’s debt burden early on, when the chances of making a recovery are highest, most debtors wait until the last possible moment, when the company’s financial situation may be terminal. “Often, you don’t want to assume that you are facing a crisis,” explains Tauil & Chequer’s Celidonio. “In Brazil, it’s very hard to recover from bankruptcy, it’s not like in the US where if you become bankrupt you start all over again. Here it’s something more terminal.”
With Brazil’s continuing political and economic malaise expected to increase the number of clients under financial stress, lawyers say the biggest priority will be ensuring the legislation and court system is suitably equipped to meet the demand. While no one would criticise a small investment boutique for selling its prowess in judicial recovery on the pages of Brazil’s business dailies, bankruptcy is never a positive outcome for either the company or the wider economy. While Brazil’s economic doldrums may have resulted in a boom in demand for restructuring work, a long-term aim should be to amend the legislation and educate the country’s judiciary to increase the survival rate of companies in severe financial distress. “The law has to be amended and many things should be added and adjusted, but more than that, the courts should be restructured and educated with basic economic rationale to make the processes more efficient,” opines Mattar. “Making the system more reliable, faster and especially more law abiding… will help make credit cheaper, more accessible and foster economic growth.”