Bankruptcy in Brazil

Course:

• Corporate Finance

Professor:

• Thomas Brull

EMBA E# 9: April 16th 2005

Andre Schussel

Edward Walker

Flávio Kakimoto

José Outeiro

Marcelo Rigoni

Bankruptcy – The Beginnings

• In medieval Italy, when a businessman did not pay his debts, it was the practice to destroy his trading bench. From the Italian for broken bench, "banca rotta," comes the term bankruptcy.

Bankruptcy – Early Years•Prior to 20th century, bankruptcy laws favoured the creditor and were very harsh toward the bankrupt.

•The first laws were passed in England in 1542, under Henry VIII. A bankrupt individual was considered a criminal and was subject to criminal punishment.

•In the U.S., early bankruptcy laws were temporary responses to bad economic conditions such as the Civil War and Great Depression.

Bankruptcy – Modern Laws• Modern bankruptcy laws in the U.S. emphasize rehabilitating (reorganizing) debtors in distress. • From WW II through the 1970s, bankruptcy was not a major issue. There were no notable business failures in U.S.

•The Bankruptcy Reform Act was passed in the U.S. in 1978. This act revamped bankruptcy practices.

• In general, the Reform Act of 1978 made it easier for both businesses and individuals to file a bankruptcy and to reorganize.

Bankruptcy – The Breakdown in US

• Chapter 7 - "straight bankruptcy" allows the debtor to "wipe the slate clean" and start all over. Who have no hope of ever repaying their creditors.

• Chapter 11 - allows business to continue normal business activities while reorganizing its finances.

•Chapter 13 - is the reorganization of an individual consumer's debt with a new payment schedule. The debtor reaffirms to pay all or a part of their debt

Bankruptcy – Some Global Facts

• Since the 1980s there have been record numbers of bankruptcies. Ten of the largest bankruptcies ever were filed between March 2001 and July 2002. 5% of US GDP!

•Companies included: WorldCom ($107 billion), Enron ($63 bn), Texaco ($36 bn), Kmart, United Airlines, Conseco.

• One-third of companies that file will emerge successfully from bankruptcy.

• Only about 7 percent of companies emerge from bankruptcy and go on to become a thriving concern.

• Código Comercial (Lei 556 de 1850)• Regulamentos 757 (processual) e 738 (falimentar)• Código Comercial Francês• Decreto n-917/1890• Lei n- 859/1902• Lei n- 2024/1908• Lei n- 5746/1929• Decreto Lei 7661/1945

– More rigid Laws and more liberal Laws.

Brazilian History

The ISSUE in Brazil today

• Companies need money (investment) in order to grow.

• Who lends this money to the companies? Banks and Financial Institutions.

• The ISSUE: companies goes BANKRUPT…and the Bank never sees the money again!

• Banks need to have confidence that they will receive the money + interest, otherwise…

The ISSUE in Brazil today…..… they will charge a High Interest Rate to compensate for the HIGH RISK.

The higher the risk, the higher the Required Rate of Return.

This is called the Banks Spread.

• In practical terms, the current Brazilian Law structure makes it very difficult for the creditor to retrieve their money and for the debtor to recover their business. There is no “win-win” solution.

• Experts comment that the current law is similar to a “revenge law”, because the creditor will usually break the debtor in court, but will never get their money back…

The ISSUE in Brazil today

The New Law

• New law 11.101/ 2005 and Complementary Law 118/2005.

• Introduces the concept of corporate recovery (80% of insolvent companies in Brazil fail to recover from their financial difficulties).

• Presidential sanction on February 9, 2005 the law will become effective on June 19, 2005.

Objectives of the New Law

• Reduce loan interests rates, given the reduced risk under the new law.

• New law is modeled on foreign bankruptcy laws, especially the Chapter 11 filing in the USA Bankruptcy Code, aiming to support the restructuring of companies that are economically viable.

• Greater speed in addressing bankruptcy cases.

•Avoid unnecessary shut-off of productive entities.

•When a company is not viable, a expedited asset transfer is taken to avoid depreciation.

Main Characteristics

• The new law isn’t applicable to financial institutions or public owned companies.

• Credits are to be verified by an official administrator nominated by a judge (this administrator is responsible for information, reports, evaluation of the recovery plan, and so on).

Main Characteristics

• Committee of Creditors composed by representatives from the following interest groups: employees, real guarantee creditors and other creditors.

• Committee of Creditors are required to monitor judicial administrator's performance, analyze complaints and approve the recovery plan.

Main Characteristics

• Main executives remain within the company during the recovery plan implementation.

• Legal responsibility lies with the company partners and main executives.

• Tax authorities allowed to enact specific rules granting special tax payment schedules for companies under judicial recovery.

The Path to Bankruptcy

TroubledCompany

ExtraJudicial

Judicial

Bankruptcy

Recovery Plan• Extra-judicial: allows the debtor to undertake friendly negotiations with most important creditors.

•No interference from the Judge. •No mandatory order for payments.

• Judicial: following the law. Recovery plan, approved by the Committee of Creditors.

•Innovation: no liabilities succession if judicial liquidation process ( similar to US Chapter 7 ).

•Allow selling part of the “business”.

•Supervised for 2 years. Issues, court can declares bankruptcy.

Bankruptcy

• Debtor can request own bankruptcy if don’t see conditions for recovery.

• Company’s assets and rights will be evaluated as fast as possible to avoid depreciation.

• Employees can use labor credits in order to purchase the company.

• Bankrupted company can be acquired by another company without obligation for previous fiscal and labor debts.

•Bankruptcy can only be requested if debt is higher than 40 minimum wages.

Complementary Law 118/article 185-A

• Permit a judge to freeze a debtor’s asset.

•Before law 118/Article 185-A, debts were not secured with assets and court had to search and lien ( penhor ) debtor assets.

Comparison New vs. Old Law

• The New Law ensures that creditors (Banks and Financial Institutions) have a higher priority to recover the money.

• Under the old law, creditors appeared 4th in the payment priority order. Usually, they will never receive the money they invested.

• Now creditors are second in the payment priority order with Fiscal Debts. Distribution of money to the employees has been limited.

• This is very important because it allows creditors to invest with more certainty and therefore with a lower interest rate - spread (we hope!).

Credit Priority Order

Old law 7,661/1945 New law 11,101/2005

Taxes (Fiscal Debt) Employees (up to a maximum of 150 minimum wages)

Pension Programs (Fiscal Debt) Creditors (Banks and Financial Institutions) and Fiscal Debts

Employees (no limits) Other Creditors

Creditors (Banks and Financial Institutions)Other Creditors

Old law 7,661/1945 New law 11,101/2005

Purchase of a bankrupted company implied responsibility for previous fiscal and labor liabilities.

Possibility for acquisition of portions of the company without succession of fiscal or labor liabilities.

Any creditor can file for debtor’s bankruptcy independent of payment values.

A party may only file for debtor’s bankruptcy if the credit against the debtor is at least equivalent to 40 Brazilian minimum wages

Comparison New vs. Old Law

Conclusions

• The New Law has been modernized - Brazil has advanced towards a more stable and reliable economy – the law is good!

• Investors will now have more confidence in lending money to companies and therefore should reduce the Interest Rate (spread).

• However, concerns still exist……

Some Concerning Points

• Most Brazilian states (São Paulo included) do not have legal specialized systems in bankruptcy legislation. Thus, it is not clear yet how Judges will behave.

• Mexico has recently adopted a very similar Law and is facing huge difficulties to implement it, given structural problems in the Judiciary system (Brazil has a similar judiciary system).

• In most WTO countries, creditors payments are located first in the credit priority payment order after bankruptcy is established. In Brazil, creditors appear second together with fiscal debts.

Therefore, only time will tell if the New Law will really work or not………..

Final Thought