Bankruptcy Reform Coming to Brazil

<p>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.

</p><h4>Brazilian Bankruptcy Law</h4>

<p>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.

</p><p>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 (<i>e.g.,</i> §§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.

</p><p>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.

</p><p>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.

</p><h4>Current Insolvency Proceedings</h4>

<p>The Brazilian Bankruptcy Law authorizes several types
of court-supervised bankruptcy proceedings. Two of the most common include
(1) a bankruptcy liquidation (<i>falência</i>), which is analogous to a chapter 7 liquidation under the
Bankruptcy Code, and (2) a debt rehabilitation (<i>preventive concordata</i>), 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.

</p><h4>Bankrupt—Legal Definition</h4>

<p>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.

</p><p>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 (<i>e.g.,</i> 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 <i>preventive concordata</i> before being served process of the bankruptcy liquidation.

</p><h4>Bankruptcy Liquidation</h4>

<p>If a court declares a company bankrupt, the
management of the debtor is taken over by a court-appointed trustee (<i>síndico</i>) whose primary
duty is to liquidate it. The <i>síndico</i>'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.

</p><h4>Preventive Concordata</h4>

A <i>preventive concordata</i> is the primary court-supervised proceeding for
reorganizing an insolvent company in Brazil. In its simplest form, a <i>preventive concordata</i> grants a
discharge of a percentage of unsecured claims held against a debtor.
However, other claims (<i>e.g.,</i> secured claims) are excluded from a <i>preventive
concordata,</i> and there is no automatic stay
preventing these other creditors from attempting to collect their claims.

<p>During a <i>preventive
concordata,</i> 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 (<i>comissário</i>) 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 <i>preventive
concordata</i> to a bankruptcy liquidation for
cause if a debtor fails to fulfill its statutory obligations.

</p><p>To obtain the partial discharge of unsecured claims
provided by the <i>preventive concordata,</i> 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 <i>preventive concordata</i> 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.

</p><h4>Amendments Focus on Reorganization over Liquidation</h4>

<p>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.

</p><p>In order to fulfill this goal, the Bankruptcy
Amendments replace the <i>preventive concordata</i> with two new bankruptcy procedures, including an
out-of-court reorganization (<i>recuperação
extrajudicial</i>) and a judicial reorganization (<i>recuperação judicial</i>). 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.

</p><p>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.

</p><h4>Out-of-court Reorganization</h4>

<p>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 (<i>e.g.,</i> 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.

</p><p>The option to pursue an out-of-court reorganization (<i>i.e.,</i> 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.

</p><h4>Judicial Reorganization Permitted</h4>

<p>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.

</p><p>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 (<i>in rem</i>)
(Class 2) and all other claims (<i>e.g.,</i> 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).

</p><p>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.

</p><h4>Treatment of Claims Adjusted</h4>

<p>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
<i>pro rata</i> 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).

</p><p>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.

</p><h4>Eliminating Successor Liability</h4>

<p>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.

</p><h4>New Law Is Cause for Optimism</h4>

<p>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.

</p><hr>
<h3>Footnotes</h3>

<p>^{<small><a name="1">1</a></small>} Mr.
Jarvinen is an associate at Kronish Lieb Weiner &amp; Hellman LLP. Views
expressed in this article are those of the authors and not necessarily
those of Kronish Lieb Weiner &amp; Hellman LLP or Pinheiro Neto Advogados. <a href="#1a">Return to article</a>

</p><p>^{<small><a name="2">2</a></small>} Mr. de
Paiva is a partner with Pinheiro Neto Advogados. Ms. Costa is an associate
with Pinheiro Neto Advogados. <a href="#2a">Return to article</a>