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Investing in Distressed Assets in Brazil
November 2010
Investing in Distressed Situations in Brazil
• Brazilian Bankruptcy Law was enacted in 2005 and is inspired in the U.S. system.
• As the market continues to become more integrated and competitive, corporate restructuring has been playing an increasingly important role in Brazil in the last years.
• Investment in distressed situations in Brazil is, however, extremely undeveloped in comparison to the U.S. market. It is a market to be exploit.
• This presentation analyses the opportunities and strategies that investors (hedge funds, private equity firms, investment banks, pension funds etc) may adopt to acquire and trade in distressed assets in Brazil, as well the challenges and risks they must overcome to be successful.
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Investment in Distressed Situations Modalities
1. Purchasing financial claims, equity or assets of a distressed entity:
a) Purchasing currently outstanding debt claims for the purpose of:
• influence the terms of the reorganization plan; or
• convert the debt into a major equity stake in order to take control of the distressed entity
b) Purchasing voting stock (and other securities) or assets
2. Providing new debt or equity financing to a distressed entity (v.g., DIP or Exit Finance). In many situations this new funding may lead to financial gains or the acquisition of corporate control (convert credit in to equity).
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Brazilian Bankruptcy System(Law No. 11,101, of February 9, 2005)
• Brazilian restructuring models:
1. Out-of-court restructuring (Acordos Privados) (Section 167)
• Out-of-court settlements between debtor and creditors
2. Extrajudicial Reorganization (Recuperação Extrajudicial (Section 161)
• despite the title (extra judicial), it is a type of reorganization under court supervision
3. Judicial Reorganization (Recuperação Judicial) (Section 47):
• reorganization proceeding under court protection and supervision
4. Liquidation (Falência) (Section 75):
• Court liquidation proceeding
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Purchase of Currently Outstanding Debt Claims
• Brazilian Bankruptcy Law does not explicitly govern trading in distressed claims
• As a general principal in Brazilian Law, the assignment of credits is allowed and may be undertaken without the original debtor’s approval. In this case, the purchaser (investor) will enjoy the same rights, guarantees, privileges and disabilities held by the original claimholder
• Therefore, it is a possible strategy to purchase debt claims for the purpose of influencing the reorganization plan, or with the expectation that these debts are converted into significant amount of voting stock
• Quorum for the approval of a reorganization plan:
• Extrajudicial reorganization: more than 3/5 of each class of creditors
• Judicial reorganization: as a general rule, the 3 classes subject to the reorganization proceeding (labor, secured and unsecured) must approve the plan by the majority of the votes (labor – majority of individuals; other classes – majority of individuals and majority in credit amount attending the creditors’ assembly)
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Purchase of Equity (or other securities)
• Brazilian Bankruptcy Law does not govern as well the acquisition of equity or other type of securities issued by a distressed entity. As a general rule, these transactions are legal and valid.
• Most of Brazilian companies that in the last years filed for bankruptcy protection (extrajudicial reorganization or judicial reorganization) are privately held and have a controlling shareholder. Thus, the purchase of a significant amount of voting shares depends fundamentally on the prior approval of the controlling shareholder.
• Creditors may pressure the controlling shareholder to accept a change of control (their bargaining power derives from the fact that creditors may be in a position to reject the reorganization plan). For this reason, it may be extremely important that investors coordinate their actions with other creditors in order to secure a blocking position as to the approval of the plan which may enable them to take control of the debtor or to force changes in the management of the company.
• On the other hand, investors and debtor may adopt a joint strategy aiming to impose on creditors the terms of a reorganization plan that reduce creditor’s participation in the company’s value.
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Purchase of Debtor’s Assets
• Investor should consider two risks:
• Succession on debtor’s obligations and liabilities (mainly, labor and tax)
• Sale may be challenged in court by creditors seeking do declare it null and void
• With respect to this issues Brazilian Bankruptcy Law provides different rules depending on the modality of restructuring
1. Our of court restructuring:
a) Brazilian Bankruptcy Law provides that certain acts performed within a prescribed period of time preceding the court's decision to liquidate the insolvent entity (usually 90 days) may be revoked (Section (130) or considered per se void (Sections 129). Even though some acts may be performed out of the suspect period they may be challenged on the grounds of creditors fraud (Civil Code, Section 158 and 159) or creditor’s lawsuit fraud (Civil Proceeding Code, Section 593, II)
b) Purchaser of debtor’s assets may be liable for its debts, mainly tax and labor (succession in labor and tax obligations).
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Purchase of Debtor’s Assets
2. Extrajudicial reorganization
• Lack of a specific regulation for investments
• Settlements are subjected to the general rules applied to transactions executed outside a restructuring proceedings. Investors also should consider the two risks mentioned above: a) succession on debtor’s obligations and liabilities; and b) the purchase of assets may be considered null and void.
3. Judicial Reorganization
• assets are free and clear of successor liability claims, including tax and labor liabilities (Section 60). This protection applies if:
a) the sale is provided in the reorganization plan approved by creditors and ratified by the Bankruptcy Court;
b) the sale does not involve all the debtor’s assets, but part of them integrated in a operational unity (unidade isolada);
c) the sale is supervised by the Court – in most of the cases, a competitive auction is adopted.
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Purchase of Debtor’s Assets
• sales may not be revoked (Section 131) based on suspect period (Section 129), fraud allegation (Section 130), fraud against creditors (Code Civil, Sections 158 and 159) and fraud against creditor’s lawsuit (Civil Proceeding Code, Section 593, II)
4. Liquidation (Bankruptcy)
• the purchase of assets (all or part of the bankrupt estate’s assets) is totally free and clear of past liabilities of all nature (Section 141, II).
• sales may not be revoked. Bankruptcy Law provides that sales of assets should be conducted through a Court supervised competitive auction proceeding, but Creditors’ Assembly may approve alternative plan of liquidation – quorum more than 2/3 of the total amount of credits present at the assembly.
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Providing New Finance(DIP and others)
• With respect to new finance, Brazilian Bankruptcy Law provides different rules depending on the modality of restructuring
1. Out of court restructuring:
a) lack of specific regulation
b) investors which provide the distressed entity with debt financing do not enjoy a priority claim in case of Liquidation.
2. Extrajudicial reorganization:
a) lack of specific regulation
b) investors which provide the distressed entity with debt financing do not enjoy a priority claim in case of Liquidation.
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Providing New Finance(DIP and others)
3. Judicial reorganization
a) superpriority claim (crédito extraconcursal): in case of Liquidation financial debts provided to the debtor are ranked above of pre-pretition credits (secured and unsecured).
b) it is required court authorization to obtain a security interest over debtor’s assets
4. Liquidation
• Debt financing provided to the bankrupt estate is considered extraconcursal.
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Providing New Finance(DIP and others)
• Understanding postpetition debt finance superpriority. The Brazilian Bankruptcy Law Order of Priority:
• A junior class will receive only after the senior classes receive the full amount of their credits.
• Certain creditors are not submitted to the priority rule, being allowed to foreclose on the assets granted as collateral to their credits. The most common creditors of this type are:
• Fiduciary ownership (chattel mortgage, fiduciary assignment of assets of receivables)
• ACC (credits related to exports)
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Providing New Finance(DIP and others)
• Priority order (summary)
1. Fiduciary ownership: • credits secured by alienação/cessão fiduciária are not subject to the judicial
reorganization. Therefore, creditor’s property rights vis-à-vis the relevant asset, as well as the relevant contractual provisions, are not affected thereby
2. ACC (forward foreign exchange agreements): • These credits, related to exports, are not subject to the recovery proceeding.
The creditor is entitled to request the restitution of the full amount prior to the payment of other creditors
3. Créditos Extraconcursais• DIP Finance, Judicial Reorganization and Bankruptcy proceedings fees and
expenses, among others
4. Labor claims• Limited to a maximum amount of 150 times the minimum Brazilian wage per
creditor - around USD 20,000.00)
5. Tax claims
6. Secured claims (v.g., pledges and mortgages)
7. Unsecured claims
8. Subordinated claims
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Final Analysis
• Out-of-court restructuring and Extrajudicial Reorganization do not provide specific regulation for investments. The most important opportunities and challenges are:
• Debt financing: seek to obtain an adequate collateral. Fiduciary ownership/assigment, when feasible, is the best alternative.
• Purchase agreements:
• if insolvency is an actual risk, it should be considered the possibility of having the contracts declared null and void by court (Section 129 and 130).
• the acquirer could be liable for debtor’s obligations, especially for labor and tax debts.
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Final Analysis
• Judicial Reorganization and Liquidation provide specific regulation for investments.
• The most important opportunities are:
• Judicial Reorganization provides substantial deviations from absolute priority rule, which means that investors may obtain a substantial part of the distressed entity’s value.
• Security interests, mainly fiduciary ownership, are enforceable and efficient mechanisms to enable recovery of the credit
• Investing in distressed assets is a market do be developed
• Brazilian Law provides that sales of assets in the context of a Reorganization or a Liquidation proceedings are free and clear of past liabilities
• No regulation or restriction as to the purchase or assignment of claims held against distressed entity
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Final Analysis
• The most important challenges are:
• DIP financing
• Despite DIP finance receives a priority claim, they are junior in comparison to fiduciary ownership and ACC. As fiduciary ownership has played an increasingly important role in Brazilian Financial Market (what could be considered an ex ante effect of the Brazilian Bankruptcy Law), the priority of DIP Finance could be meaningless in practical terms. For this reason, it is key that the investor obtains a security interest over the debtor’s assets, when providing the DIP.
• DIP Finance is ranked as crédito extraconcursal. There are several other credits, with different natures, classified at the same class. Since this class does not vote or play an active role in Judicial Reorganization, it is difficult to coordinate the interests of those different type of creditors in order to negotiate either a reorganization or a liquidation plan.
• Tax regulation
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Final Analysis
• Lack of transparency
• Brazilian Law and restructuring practice do not provide an efficient system to control the debtor’s management and to obtain accurate information about the business
• Lack of a developed secondary market for claims against debtors
• Inefficient Liquidation Proceeding or lack of experience in this field since the New Brazilian Bankruputcy Law was enacted in 2005. For this reason, creditors usually accepts reorganization plans significantly detrimental to their interests. It is common in Brazil that shareholders keep substantial amount of the distressed entity’s value after a restructuring proceeding (even in the case of judicial reorganization)
• Hold out and free-riders problems related to the fiduciary ownership and ACC’s superpriority claims.
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Contact Information
Eduardo Secchi Munhoz
Daniel Calhman de Miranda
Raphael Nehin Corrêa
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