42 July/August 2007 ABI Journal

Written by:Otto Eduardo Fonseca LoboMotta, Fernandes Rocha Advogados; Brazil

Paulo Penalva SantosMotta, Fernandes Rocha Advogados; Brazil

Rick B. AntonoffPillsbury Winthrop Shaw Pittman LLPNew York

Contributing Editor:Josefina Fernandez McEvoyK&L Gates LLP; Los Angelesjosefina.mcevoy@klgates.com

Brazil’s new insolvency law—LawNo. 11.101 of Feb. 9, 2005 (NewBrazilian Bankruptcy Law or

NBRL)—which became effective June 9,2005, is designed to stimulate therehabilitation of business enterprises, aslong as minimum thresholds of viabilityand efficiency are met. The mainobjectives of the New BrazilianBankruptcy Law are:

1. The protection ofhonest debtors,through a proceed-ing that governs therehabilitation of thecompany, known asthe recovery pro-cedure (akin toU.S. chapter 11),with emphasis onn e g o t i a t i o n

between creditors and debtor so that,under its management, the enterpriseis able to continue as a productiveunit of the national economy;2. The acceleration of the liquidationprocedure (akin to U.S. chapter 7) ofa debtor that fails to meet therequirements of the recoveryprocedure;3. The adoption of protectiveprocedures (akin to the automaticstay) such as temporary moratoriumfor recovery proceedings;4. The appointment of a disinterested,independent administrator and/or acommittee to oversee (but notreplace) the debtor’s management ina recovery proceeding;5. The reformulation of the judiciary’srole in the recovery procedure as asupervisor of the negotiationsbetween creditors and debtor;

6. The reclassification of priorities ofclaims and credits; and7. The establishment of a summaryrecovery proceeding for smallerorganizations.

One of the first majortests of the NewBrazilian BankruptcyLaw was the judicialrecovery case ofVarig, S.A. (nowknown as S.A.(Viacao Aerea Rio-Grandense)) and itsaffiliates Rio-SulLinhas Aereas S.A.

and Nordeste Linhas Aereas S.A.(collectively, Varig).

The Varig case is oneof the first recoveryproceedings of aBrazilian airline com-pany. Prior Brazilianlaw disallowed re-covery proceedingsof a commercialairline based on therationale that it wouldnot be safe for the

general public to the extent that aircraftmaintenance could be affected by thefinancial instability suffered by an airlinein recovery. Article 198 of the NBRLdisallows recovery proceedings ofcompanies for which the previousinsolvency law did not authorize aconcordata, an insolvency proceedingsimilar to the current judicial recoveryunder NBRL. Nevertheless, Article 199of the New Brazilian Bankruptcy Law

specifically extends to airlines the rightto request judicial recovery.

The Varig case isalso one of the firstlarge cross-bordercases of a Braziliancompany with anancillary case in theUnited States underformer §304 of theU.S. BankruptcyCode (the Code).1

The relief availableto a debtor under former §304 was,essentially, a preliminary injunctionprotecting the foreign debtor’s assets inthe United States and prohibiting U.S.creditors, and others subject to U.S. courtjurisdiction, from taking action againstthe foreign debtor outside of the foreigninsolvency proceeding. In Varig’s case,the debtor sought U.S. court protectionprincipally to enjoin aircraft and enginelessors and financers from repossessingtheir equipment, notwithstanding thatVarig was already months in arrears tothese creditors in amounts that in theaggregate were in the tens of millions ofdollars.

Initial Assessment of the NewBrazilian Bankruptcy Law

This first major test of the NewBrazilian Bankruptcy Law—the judicialrecovery of Varig and its affiliates—demonstrates that the law may not havegone far enough to create as effective arecovery system as was intended.

The first real difficulties encounteredby the lawyers working on Varig’sjudicial recovery in Brazil were thelimited duration of the automatic stay ofpost-petition claims and the very shortdeadline for the insolvent company to

Varig Airlines: Flying the Friendly Skies of Brazil’sNew Bankruptcy Law with Help from Old §304

Latin America Update

About the Authors

Otto Lobo and Paulo Santos arepartners with Motta, Fernandes RochaAdvogatos in Brazil, attorneys for Varig.Rick Antonoff is a partner with PillsburyWinthrop Shaw Pittman LLP in NewYork, attorneys for Varig. JosefinaMcEvoy is a partner with K&L Gates inLos Angeles and ABI’s Vice President-International.

1 Section 304 was repealed as part of the BAPCPA. It has been replaced

by new chapter 15 (Ancillary and other Cross-Border Cases). The issues

that arose in the Varig ancillary case in the United States that are

discussed in this article would have arisen under chapter 15 as well,

although the procedural framework and the more explicit provisions of

chapter 15 might well have yielded different outcomes. Those

differences, however, are beyond the scope of this article.

2 Publication of the decision to admit the processing of recovery

procedures occurs within days after the company files a petition. In

Varig’s case, for example, the decision was published five days after the

petition was filed.

Otto Eduardo Fonseca

Lobo

Paulo Penalva Santos

Rick B. Antonoff

Josefina F. McEvoy

ABI Journal July/August 2007 43

present its recovery plan. These tighttimeframes are particularly pertinent inthe case of a large and complex companysuch as Varig. Unlike other insolvencysystems where debtors have years topresent a recovery plan (even thoughother parties in interest may also have theright to do so), the debtor under theNBRL has only 60 days after thepublication of the decision admitting theprocessing of the recovery procedure2 topresent its recovery plan and only a six-month automatic, nonextendable staybefore creditors may begin enforcingrights and exercising remedies withrespect to post-petition claims.

In the United States, Varig’s lawyerswere immediately faced with aircraft andequipment lessors and financers (aircraftcreditors) that are accustomed to thespecial protections afforded to suchparties under §1110 of the Code—namely, the right either to be paid currentor to obtain possession of their aircraftand equipment. A basic tenet of ancillarycases under §304 was that the U.S. courtwould only grant comity to a foreignproceeding if, among other things, (a) therights afforded to U.S. creditors are notprejudiced and (b) the priority of claimsis “substantially in accordance with” theCode. Because the NBRL had nocorollary to §1110 at the time Varig filed,the aircraft creditors argued right awaythat the U.S. court should not recognizethe judicial recovery in Brazil because,among other reasons, the NBRL did notafford these creditors the special positionthey hold under U.S. law.

In addition, to be eligible for judicialrecovery relief under the NBRL, thedebtor must present tax good-standingcertificates. This is no easy requirementto fulfill, as most companies that file fora judicial recovery relief have pending taxclaims, from and against the government,that are in litigation, thus hindering thedebtor’s ability to obtain the tax certificateand, in some cases, preventing it.

Furthermore, the new Brazilianbankruptcy law has a deadline of one yearfor labor creditors to receive payment oftheir claims, and it is still undeterminedwhether this deadline can be extendedthrough collective bargaining agreements.

Although a comprehensive com-parison of Brazilian and U.S. bankruptcylaws and practice could be presentedagainst the backdrop of the Varig case,this article is narrower: How the rights ofaircraft creditors were treated in theabsence of special protections underBrazilian law and whether the NBRL

provides debtors with the ability to sellassets free and clear of the claims andinterests of creditors.

FactsBy 2005, Varig, the largest Brazilian

and Latin American airline with flights toall major cities of Brazil and severalworld capitals, had been in financialturmoil for several years. On June 9,2005, the NBRL became effective. OnJune 17, 2005, Varig filed for judicialrecovery under the NBRL to takeadvantage of the several new mechanismsunder the law that make it easier fordebtors and creditors to negotiatereorganization plans, backed by thebankruptcy court. On that date, theBrazilian court issued an interim order—a medida liminar—similar to a temporaryrestraining order in the United Statesspecifically to prevent aircraft creditorsfrom seizing or interfering with Varig’suse of aircraft and equipment needed tooperate its airline business. Also on thatdate, Varig commenced the ancillary casein the U.S. Bankruptcy Court for theSouthern District of New York under§304 of the Code, and obtained ex partefrom the U.S. court a temporaryrestraining order to enforce the Braziliancourt’s interim order in the United States.

On June 22, 2005, the 8ª VaraEmpresarial do Rio de Janeiro (8thCorporations Court of Rio de Janeiro,herein Brazilian Bankruptcy Court)granted the processing of the JudicialRecovery relief requested by Varig. OnJune 27, 2005, after notice and a hearingat which many of the aircraft creditorsappeared in opposition, the U.S. courtissued a preliminary injunction tocontinue the relief obtained in thetemporary restraining order and tobroaden it to other types of creditors.

In July 2006, creditors in Brazilvoted to approve Varig’s in-courtrecovery plan, which contemplated asale of the airline’s name, operatingassets and business pursuant to article 60of the NBRL after a competitive biddingprocess. Following two auctions, theBrazilian Bankruptcy Court determinedthat the prevailing bidder was VarigLogistica S.A., a former Varig subsidiarythat was sold during the recoveryproceedings. Following the satisfactionof certain conditions to the sale, theBrazilian Bankruptcy Court declared thesale complete on Dec. 15, 2006.

On March 19, 2007, the U.S.Bankruptcy Court issued a permanent

continued on page 72

72 July/August 2007 ABI Journal

injunction pursuant to §§304 and 105(a)of the Code, permanently enjoiningactions in violation of the Brazilianrecovery plan.

Treatment of Aircraft Lessorsand Financers under the NewBrazilian Bankruptcy Law

One of the principal purposes forfiling Varig’s ancillary case in the UnitedStates was to extend the protective ordersof the Brazilian court and render themenforceable in the United States againstproperty and creditors subject to U.S.court jurisdiction. This was particularlycritical in Varig’s case, because nearly allof the aircraft creditors were located in theUnited States and could have repossessedtheir equipment at any of the three U.S.airports where Varig landed (Los Angeles,Miami and New York) or at other airportsoutside of Brazil that arguably are beyondthe reach of the Brazilian court.

Indeed, some aircraft creditors hadalready threatened to take enforcementactions against Varig’s aircraft in theUnited States. Varig demonstrated to theU.S. court that any such enforcementaction would have immediately andirreparably damaged Varig’s airlinebusiness and jeopardized the continuationof Varig’s efforts in the judicial recoveryproceeding in Brazil. As noted above, theU.S. court granted Varig temporary andpreliminary injunctive relief to allow thejudicial recovery case to proceed withoutinterference from the aircraft creditors.

The Contingency Return PlanHowever, several months into Varig’s

judicial recovery proceeding in Brazil andits ancillary case in the United States,Varig was unable to remain current onpayments to the aircraft creditors. Itbecame increasingly more difficult toresist the aircraft creditors’ argument thatbecause the NBRL did not treat theirclaims in accordance with the priorityprovided by the Code, the U.S. courtshould order Varig immediately to returnaircraft and engines.

At the same time, there was intensediscussion in the Brazilian proceedingregarding the effects of the judicialrecovery in Brazil and the suspension ofthe payment of the debts from the aircraftlease agreements for 180 days. Severalrepossession suits were filed by aircraftcreditors in numerous civil courts inBrazil separate and apart from the judicialrecovery proceeding.

At the time Varig commenced itsjudicial recovery proceeding in Brazil,there was a loophole in the law that waspromptly amended after the filing (hencethe amendment was not effective in thejudicial recovery of Varig). As originallydrafted and enacted, Sole Paragraph ofArticle 199 of the NBRL identified“mercantile” leases as being outside thejudicial recovery procedure, so that thenondebtor party to such a lease (i.e., acapital or finance lease) could exercisedefault remedies notwithstanding the

suspension of actions under the NBRL.3

Nevertheless, as with any other type oflease, the aircraft lease agreements arestill subject to the rule of first part of §3ºof Article 49 of the NBRL, providing thatany assets that are leased cannot berepossessed from the debtor if it isessential to the economic activity of thecompany in judicial recovery.

In the absence of a Brazilian corollaryto Code §1110 in the Varig case andmindful of the real possibility that Varigcould run out of money and be forced intoliquidation, the U.S. court devised analternative solution—the so-calledcontingency return plan, which requiredVarig to prepare a comprehensiveschedule showing the location of eachaircraft and engine and their respectiveparts and documentation, and granting tothe aircraft creditors a priority claim fordamages incurred by them as a result ofmissing parts and missing or incompletedocumentation. The U.S. court alsodirected Varig to seek to have thecontingency return plan (including thepriority claim) approved by the Braziliancourt. The Brazilian court did approve theplan, giving the aircraft creditors someform of special protection.

How Article 60 of the NewBrazilian Bankruptcy LawPromotes Asset Sales Freeand Clear of Claims

On July 20, 2006, a judicial auctionwas held in the Brazilian proceeding under

Latin America Update: Varig Airlinesfrom page 43

3 Article 199 was amended to provide that lease agreements (including

aircraft lease agreements) are not subject to the judicial recovery,

according to the first part of §3º of Article 49.

ABI Journal July/August 2007 73

the auspices of the Brazilian BankruptcyCourt. VARIG Logistica (a former Varigsubsidiary purchased during the judicialrecovery by an entity created with thebacking of U.S. private equity firmMatlinPatterson) emerged as the winningbidder. The sale to VARIG Logisticacomprised substantially all of the assets andoperations of Varig (referred to as the VarigProductive Unit or UPV), which is now anindependent unit, including the trademarkfor VARIG, S.A. VarigLog, S.A. formedthe company VRG Linhas Aereas S.A.(VRG) to hold and manage the UPV andto operate under the VARIG, S.A.trademark. The UPV also includes, but isnot limited to, VARIG’s and Rio Sul’sAirline Authorization Certificates(CHETA), which authorizes VARIG andRio Sul to operate their routes.

The sale did not include thetrademark or CHETA of Nordeste, which,under the plan, will remain assets of oldVarig. In addition, the sale excluded theold Varig’s real property assets, radiostations and the Varig Flight TrainingCenter, which will, in part, finance certainpayments to the old Varig’s creditorsrequired by the recovery plan.

On Dec. 15, 2006, the Brazilian courtissued a decision (the Dec. 15th decision)holding that pursuant to Article 60 of theNBRL, the sale to VRG was complete. Thesale of the UPV to VRG pursuant to Article60 of the NBRL was free and clear of anyliens, and VARIG Logistica, as purchaser,will not be a successor to any of Varig’sobligations, including any tax obligations.Furthermore, pursuant to Article 59 of theNBRL, the plan, as amended by therestated plan, constitutes a binding novationof all debts against the foreign debtorsarising prior to the commencement of theforeign proceedings. Like §363 of theCode, the effects of NBRL Article 60 areintended to allow and foster companies infinancial distress to continue in business

under new ownership, retain employeesand continue commercial relationships withvendors and customers.

In the Varig case, after the sale of theUPV to Varig Logistica, employees of theformer Varig asserted that the assets couldnot be sold free and clear of their laborclaims, and that the labor court was theproper forum to hear their argument.Varig argued that the court presiding inits judicial recovery should decidewhether the assets were sold free of orsubject to the labor claims. In support ofits position, Varig noted Article 3 of theNBRL, which adopts the principle of theuniversal judge of the judicial recoveryprocedure for all suits that may influencethe recovery plan (as did the previous law,Decree-Law 7.661 of 1045).

Jurisdiction of BrazilianCourts on Issues Related toSales Free and Clear of Claims

The rationale of the Universal Judgein Brazil was upheld by the BrazilianSuperior Court of Justice. On April 25,2007, Justice Ari Pargendler of theSuperior Court of Justice of Brazil decidedthat the Brazilian Bankruptcy Court hasjurisdiction to rule on issues related to therecovery plan, including a request madeby labor creditors in labor court to freezeamounts to pay for labor claims:

The judicial recovery is guided byother principles, but it seemsreasonable to conclude that itwould be jeopardized if the assetsof the company could be frozenby the labor courts.This was the rationale for Justice

Pargendler to rule on the motion ofconflict of jurisdiction that was filed bythe Public Attorney’s Office in theJudicial Recovery Procedure of Varig.

The issue arose when the labor courtin Rio de Janeiro ordered the freezing ofassets of Varig to pay labor claims against

the company while, at the same time, thebankruptcy court authorized the sale ofthe assets free and clear. The PublicAttorney’s Office filed a motion ofconflict of jurisdiction at the BrazilianSuperior Court of Justice.

Justice Pargendler based his rulingon the fact that Sole Paragraph ofArticle 60 and Article 141 of the NewBrazilian Bankruptcy Law both providethat this type of sale is free ofsuccession and so the bidder will not beresponsible for the liabilities of thedebtor, including debts for labor and taxclaims.

This is one of the very first judgmentsof the Brazilian Superior Court of Justiceon the jurisdiction of Brazilian courts torule on issues related to the NBRL.

Justice Pargendler’s Ruling:The Sale of an IndependentProductive Unit Is Free and Clear of Claims

The ruling also makes clear thatbankruptcy courts presiding in judicialrecovery proceedings fully understandthe issues related to a recovery planand, therefore, are the appropriateforum to hear and decide all mattersaffecting the plan.

Furthermore, the Brazilian SuperiorCourt ruling supports the proposition thatthe rehabilitation of a financiallydistressed company serves a socialfunction, since its objective is to make itviable for the company to overcome itseconomic social crises and consequentlymaintain itself as a source of jobs, as setforth in Article 47 of New BrazilianBankruptcy Law. What remains to beseen is whether the lower courts in Brazilwill also support this proposition insubsequent cases or instead try todistinguish the Varig case and allowseparate courts to render conflictingrulings. ■

Copyright 2007 American Bankruptcy Institute. Please contact ABI at (703) 739-0800 for reprint permission.