Luiz Fernando Valente de Paiva and Andre Moraes Marques provide an overview of in-court and out-of-court restructuring proceedings in Brazil, and suggest amends to legislation which may further improve the regulation of insolvency cases.
1. What trends, in terms of activity levels, affected industries or investor focus, have you seen in the restructuring and insolvency market in your jurisdiction over the last 12 months?
During 2015, Brazil’s gross domestic product probably decreased by approximately 3% (against a 0.1% growth in 2014). The worsening of the recessive perspective of the Brazilian economy has caused a reduction of liquidity in the market, an increase in the costs of financings, a devaluation of the Real against the dollar, and an increase in production costs.
The recession of the Brazilian economy has ultimately undermined the financial capacity of Brazilian companies and led to an increase in corporate rates of default in 2015, as well as to the highest number of filings for judicial reorganisation proceedings in one year (2015) since 2006, shortly after the Brazilian Bankruptcy Law was enacted (2005).
According to research conducted by Serasa Experian, in 2015, 1,287 companies filed for judicial reorganisation. This represents an increase of 55.4% in requests for judicial reorganisation compared to 2014, which saw the filing of 828 requests (against 874 in 2013). Therefore, there is a significant rise in the number of companies resorting to the judicial reorganisation proceeding to restructure debts and operations.
The same research reveals that the number of requests for bankruptcy liquidation (a proceeding similar to a Chapter 7 liquidation proceeding) filed in 2015 was 7.3% higher than the number of such filings in 2014, which confirms that Brazilian companies have been struggling with liquidity problems. Among the industries most affected by the current recession, we highlight the oil and gas, sugar and ethanol, construction, shipping and automotive industries.
2. What is the market view on prospects for the coming year?
The prospects for the Brazilian economy in 2016 are also discouraging. The current forecast of the gross domestic product shows another decrease of around 3% (similar to 2015). Therefore, we also expect that Brazil’s continued recession will adversely affect many companies in 2016. It is likely that corporate rates of default will continue growing and the number of filings of judicial reorganisation proceedings and bankruptcy liquidation will also increase or at least stabilise. Those sectors already under stress in 2015 are likely to continue to struggle in 2016 and other sectors involved in the production of commodities (such as oil and iron ore) may also suffer in 2016.
The outcome of the political crisis that Brazil is currently experiencing seems crucial for a recovery of the economy. If the government is able to cut the deficit, enhance control over public spending, significantly reduce the two-digit inflation and pass the political reforms which are essential for the development of the economy, 2016 may, to some extent, be better than 2015.
3. What are the key tools available in your juris-diction to achieve a corporate restructuring – are they primarily formal, court-driven processes, or are informal out-of-court restructurings possible? Do you feel that the tools you have available are effective in terms of providing speedy, fair and predictable outcomes?
The Brazilian Bankruptcy Law (Law No 11.101 – “BBL”) came into force on June 9, 2005. The BBL has had a pivotal role on business reorganisations in Brazil. It is uncontroversial that the BBL is a lot more efficient than the outdated, 1940s statute which was replaced by the BBL. The public policy underlying the adoption of the BBL represented an essential paradigm shift under Brazilian law towards financially-distressed companies. The prior statute emphasised bankruptcy liquidation proceedings and placed several legal hurdles in the path of corporate debtors that wished to reorganise. In contrast, the BBL provides financially-distressed, but economically viable, business entities the opportunity to restructure their operations through market-based restructuring strategies negotiated with the respective creditors.
The BBL created, among other features, two new legal proceedings enabling viable companies to overcome financial difficulties and protect themselves against actions taken by creditors. Both can be used in a restructuring and ultimately allow debtors to obtain court confirmation of reorganisation plans negotiated directly with their creditors that can involve the cram down under certain circumstances.
The first is the judicial reorganisation (recuperação judicial), which is similar to the Chapter 11 reorganisation proceeding of the United States Bankruptcy Code. The second is the out-of-court reorganisation (recuperação extrajudicial), which is similar to a prepackaged reorganisation under the United States Bankruptcy Code. Only the debtor has standing to file for such reorganisation proceedings. As a rule, in both proceedings the debtor and its managers remain in charge of the business.
Upon filing, and provided all relevant supporting documentation is in good order, the court will grant the processing of the judicial reorganisation. After such order, the debtor will be granted with an automatic stay of all collection actions, enforcement and foreclosure proceedings based on claims which are affected by the judicial reorganisation proceeding. A court-appointed trustee is designated to supervise the judicial reorganisation proceeding but does not have any management powers.
The debtor must submit a plan of reorganisation within 60 (sixty) calendar-days counted from the publication of the order granting the processing of the judicial reorganisation. Following the presentation of the plan of reorganisation, creditors will have up to 30 (thirty) days to file their respective objections against the plan. If the plan is objected by at least one creditor, the court shall call a general meeting of creditors to deliberate and vote on the plan of reorganisation.
If the plan is rejected by the general meeting of creditors, the court should, as a rule, convert the judicial reorganisation into a bankruptcy liquidation proceeding. On the other hand, if the plan of reorganisation is approved during the general meeting of creditors and no illegalities are found in the plan, the court will eventually confirm the plan, which will discharge and novate all pre-petition claims subject to the plan and ultimately give the debtor a fresh start. After the confirmation order, the debtor will remain under judicial reorganisation for a supervision period of 2 (two) years, after which the judicial reorganisation proceeding will be terminated.
Out-of-court reorganisation is a less complex and a faster proceeding if compared to a judicial reorganisation. In the out-of-court reorganisation, all of the time required for the negotiation and approval of the plan is spent before the filing before the court (as in a prepackaged reorganisation). The debtor may propose and negotiate an out-of-court reorganisation plan with one or more classes of creditors (e.g., creditors holding unsecured claims) or with one or more groups of creditors holding claims entitled to similar treatment of claims (holders of debentures of one specific issuance). If negotiations are successful and the debtor meets the minimum legal requirements – especially with respect to the minimum thresholds for approval of the plan – it may file for an out-of-court reorganisation requesting court confirmation of a previously approved plan before a court.
After the filing of the out-of-court reorganisation proceeding, the creditors will be able to present objections to the plan. If the plan is confirmed by the court, all pre-petition obligations affected and comprised by the out-of-court reorganisation plan will be discharged and novated pursuant to the terms of the plan. If the plan is not confirmed by the court, the out-of-court reorganisation will not be converted into bankruptcy liquidation and is allowed to decide whether or not to present a new out-of-court reorganisation plan, file for judicial reorganisation, or pursue an out-of-court restructuring.
Despite bringing a more efficient blueprint to protect corporate debtors and balancing the rights of debtors and creditors, the BBL does not set forth adequate mechanisms to mobilise creditors or foster the coordination of various groups with aligned interests. As a result, it is very difficult to engage, out-of-court and within the required time, the required number of creditors to meet the minimum required threshold to allow the filing of an out-of-court reorganisation.
4. In terms of intercreditor dynamics, where does the balance of power lie as between shareholders and creditors, and as between senior lenders and junior/mezzanine lenders? In particular, how do valuation disputes between different stakeholders tend to play out?
Our comments to this question will focus on the judicial reorganisation proceeding, because it is much more commonly used than the out-of-court reorganisation proceeding. The legislator of the BBL thought that there would be a balance of power between the debtor and creditors subject to the judicial reorganisation plan. On the one hand, the debtor has exclusivity with respect to the plan and, thus, may refuse to include in the plan the amendments requested by the creditors. On the other hand, the creditors have the ability to reject the judicial reorganisation plan presented by the debtor and, consequently, push it into bankruptcy liquidation. From a practical perspective, however, the debtor seems to have maintained exclusive control over the judicial reorganisation process. The debtor knows that the consequences of a bankruptcy liquidation are also detrimental to the creditors because it entails a destruction of value to all stakeholders. As a result, creditors are reluctant to reject the reorganisation plan and end up giving debtors and their controlling shareholders a substantial power with respect to the rejection of the amendments to the plan requested by the creditors.
With respect to the relationship between the creditors subject to the effects of the judicial reorganisation, it is worth clarifying that such creditors are divided into 4 (four) classes, as follows: (i) holders of labour-related claims or occupational accident claims (Labour Class); (ii) holders of secured claims, up to the amount of the respective collateral (Secured Class); (iii) holders of unsecured claims, with special priority claim, general priority claim or subordinated claim (General Class); and (iv) small and micro companies (Small Companies Class). Therefore, the existence of a creditor with greater power or even a veto power depends essentially on the size of the claim of each creditor in the respective classes.
It is worth pointing out that there are some claims which are not impaired by the filing of a judicial reorganisation proceeding (safe harbors), including tax claims, claims secured by fiduciary sale agreements (a type of collateral), claims deriving from financial leasing, and claims deriving from advance on export exchange contracts (ACCs). In addition to the claims excluded from the judicial reorganisation, in an out-of-court reorganisation, labour claims are also excluded.
5. Have there been any changes in the capital structures of companies based in your jurisdiction over recent years caused by the retreat of banks from loan origination? In particular, have you found that capital structures now increasingly comprise debt governed by different laws (such as New York law governed high yield bonds)? If so, how do you expect these changes to impact on restructurings in the future?
Even though under the current recession of the Brazilian economy local banks are more reluctant to lend, in our experience such banks have not significantly retreated from loan origination. Therefore, in the majority of the reorganisation proceedings, local banks still have a predominant role as creditors vis-à-vis foreign lenders and bondholders. Notwithstanding such reality, holders of New York law governed high yield bonds have played a predominant role in some high-profile judicial reorganisation cases. In those cases, the involvement of the bondholders brought positive innovations to the restructuring practice, such as plan support agreements. Depending on the effects of the current recession on local banks, the capital structures may increasingly comprise debt governed by different laws, especially New York law governed high yield bonds.
6. Is there significant activity on the part of distressed debt funds in your jurisdiction? How successful have they been in entering the market, and how much has market practice (or law) evolved in response? If funds have not successfully entered the market, can you identify reasons why?
In our view, distressed debt funds still have a limited participation in the Brazilian restructuring market. One of the possible reasons why the involvement of distressed debt funds is still below the potential of the Brazilian market is that the BBL has been enacted for a little over 10 years and only now investors are having more clarity and certainty with respect to how several issues related to the BBL are being interpreted by the Brazilian courts. In addition, even though the restructuring framework has developed a lot after the enactment of the BBL, there are several improvements that still need to be implemented in the BBL to make it more attractive to distressed debt funds.
7. Are there any unusual features of your insolvency or restructuring law that an external investor should be aware of (such as equitable subordination, or substantive consolidation)?
Yes. For instance, there is no specific legal provision in the BBL regarding substantive consolidation. Even though the first judicial reorganisation proceeding was filed by a group of companies and featured a substantive consolidation, only in the last two years the discussions regarding substantial consolidation have become more common and relevant. Over such period it has become more common for companies of the same group to file joint requests for judicial reorganisation and request substantive consolidation (even in cases where the companies have completely different activities) so that the group of companies can present one single judicial reorganisation plan and hold only one general meeting of creditors, where the creditors are treated as if they were creditors of one single consolidated entity. In our experience, substantive consolidation has been recognised in the majority of cases where it was requested. Courts usually take into consideration if the companies are (i) interdependent and act as if they were part of an economic group with one single coordinated purpose (e.g., personal guarantees provided in favour of other companies, intercompany loans, synergy between business units for the performance of the group’s activities), and/or (ii) under the same control or management (same board members, managers or executives, one single cash account, etc.). This matter, however, is far from being considered settled and should be addressed in future legislative reforms in order to grant additional certainty to all stakeholders.
In addition, external investors should be aware that shareholders of companies under judicial or out-of-court judicial reorganisations are not wiped out against their will, even if the enterprise value of the company or the value of the assets of the company is lower than the amount of claims held by the creditors. As a rule, the shareholders of the company will still hold the same amount of equity they originally held. Only in exceptional circumstances do reorganisation plans contemplate a debt to equity conversion. In such cases, the consent of the majority of the shareholders is required. For this and for other reasons (e.g., exclusivity of the debtor to file a reorganisation plan), the controlling shareholders of the debtor still play a central role in reorganisation proceedings in Brazil.
8. Are there any proposals for reform of the legal framework that governs insolvency and restructurings in your jurisdiction?
Even though there are proposals for reform of the BBL, there is no indication that one of the existing proposals will be approved at this juncture.
9. If it was up to you, what changes would you make?
One change we would be to subject all creditors to the effects of the judicial reorganisation, respecting, however, the legal privileges and protections granted to each individual creditor. With this amendment, the BBL would create a balance among the creditors and, on the one hand, would avoid one single creditor having the ability to prevent the restructuring approved by all other creditors and, on the other hand, would allow other creditors to impose on a creditor with certain privileges and protections greater sacrifices than those currently imposed by law or by the other creditors in the same position.
In addition, the BBL should also be amended to establish the parameters and the minimum requirements for the granting of a debtor in possession (DIP) financing. The BBL should also grant the DIP lender absolute priority of payment in case the reorganisation efforts fail and the debtor goes into bankruptcy liquidation. The DIP lender should also have the assurance that the privilege of its claim will not be affected in case the decision granting the processing or the decision confirming the judicial reorganisation plan is reversed.
Another amendment would involve allowing the creditors to file a competing judicial reorganisation plan that could be reviewed and resolved by all of the creditors. The debtor would be required to comply with a competing plan approved by the creditors, including if such plan sets forth the removal or dilution of the shareholders. The BBL should also afford a special protection to creditors that decide to convert debt into equity, so that such creditors are not adversely affected by any of the liabilities of the company (except in case of fraud).
Another subject that requires improvement is the treatment of tax claims of companies that resort to reorganisation proceedings. An alternative in order to discourage companies from accumulating excessive tax liabilities would be to set maximum thresholds of tax debt, above which a company would no longer have the ability to file for judicial or out-of-court reorganisation proceedings (thus, assuming that under such circumstances the company would no longer be considered economically viable). On the other hand, the debtor that files for judicial or out-of-court reorganisation should be granted the opportunity to reschedule its tax liabilities through adequate tax rescheduling programmes that would impose on the tax authorities sacrifices which are similar to those made by the other creditors.
Finally, at least two changes could be implemented to accelerate the processing of the judicial reorganisation. First, the BBL could set forth an expedited processing of the judicial where a general meeting of creditors would not be held in cases where the debtor has already obtained the required majorities to approve a plan. In addition, the company and creditors should be authorised by the BBL to resort to alternative methods to resolve disputes, such as mediation and conciliation. This amendment would foster and improve the quality of the settlement agreements entered into by the relevant stakeholders.