Written by: John Knapp
Cairncross & Hempelmann, PS
In June 2005, the new Brazilian Bankruptcy Law (the Law) became effective. The Law took its inspiration to some extent from chapter 11 of the Bankruptcy Code. Efforts under the previous, more rigid law (or concordata) to restructure business enterprises inevitably ended up in liquidation, which is what the Brazilian concept of bankruptcy (falência) tends to encompass. For maximum flexibility, the Law now provides for judicial reorganization, extrajudicial reorganization and liquidation. As of May 2007, 446 requests for judicial reorganization under the Law were filed in Brazil.
Given the chapter 11 link, U.S. judges and practitioners could be helpful resources in learning about the implementation of the Law and offering insights based on their experience. Toward that end, the Fifth Annual International Corporate Recovery Forum took place in São Paulo, Brazil, from Sept. 22 to 25, 2007. The Brazilian Institute of Management and Turnaround (Instituto Brasileiro de Gestão e Turnaround, or IBGT) and ABI organized the forum, with special collaboration of the São Paulo Tribunal of Justice, the São Paulo Magistrates Association and the National Conference of Bankruptcy Judges. United States and Brazilian judges, lawyers and other insolvency professionals participated in workshops designed not only to enhance the understanding of one another’s legal frameworks, but also for facilitating cross-border communications and cooperation. A Web cast of the conference is available at www.ibgt.com.br.
There have been many articles describing the basic features of the Law, and this article does not attempt to retread that ground. Rather, it will follow up on the success of the September forum and highlight issues that have arisen under the Law in the new judicial reorganization context and offer some observations on potential issues and solutions.
Limitation of Court Authority
A key matter that is not definitively resolved in the Law itself is the supremacy of the court assigned to handle the judicial reorganization over other courts of competing or perhaps shared jurisdiction. The debtor files a petition for judicial reorganization not in a comprehensive bankruptcy court, but in a court of more general jurisdiction, which is then responsible for granting the relief requested by the debtor and overseeing the reorganization process. For example, the judicial reorganization of Brazilian airline Varig was filed on June 17, 2005, in what is known as the 8th Corporations Court of Rio de Janeiro.
Under the Law, the court handing the judicial reorganization appears to have the power to grants sales of assets free and clear of claims. In Varig’s case, the creditors approved a plan that provided for such a sale. However, the sale was in jeopardy because another court, the Labor Court of Rio de Janeiro, froze Varig’s assets to pay Varig’s labor claims, notwithstanding the order authorizing sale. An appellate court resolved the issue in favor of the sale order, holding that the Law provides for sales free of successor liability, including for labor claims. See Otto Eduardo Fonseca Lobo and Paulo Penalva Santos, “Application of the New Brazilian Insolvency Law – Varig Airlines Case,” INSOL World (3d Quarter, 2007).
One potential fix for this jurisdictional problem would be for the Brazilian legislature to clarify the primacy and competency of the various courts. Based on experience with chapter 11, establishment of a special bankruptcy court and endowing it with jurisdiction to hear just about any matter related to the reorganization would clarify where a matter may be determined in the first instance. As in the United States, the bankruptcy court could always decide that a matter is more efficiently handled by another specialized court or a court more familiar with a particular dispute, but the centralization of the reorganization in a single court would improve the efficiency and finality of relief. Unfortunately, in the present political situation--where the Brazilian legislature and presidency are dominated by labor interests--the chances of making this change specifically to address employee claims in labor courts may be low.
Ambiguity in Limitation of Successor Liability
The question of successor liability in judicial reorganization is also unresolved.. The Law provides that there is to be no successor liability for labor or tax claims if the plan involves the sale of subsidiaries or “isolated productive units” of the debtor. However, as in Varig’s case, it is not easy to determine whether the sale falls within those limitations.
To some, it appears that the sale of Varig’s assets was a sale of the principal business itself, not just a part of it. This is reinforced by the fact that Varig substantially ceased operations after its assets were sold. Because the discharge of liabilities under the Law seems to be linked to the debtor’s remaining alive at least to some extent in judicial reorganization, Varig has engaged in “financial gymnastics,” such as continued collection of old accounts and rents from retained real property leases, to maintain the faintest of heartbeats. If the last remnants of Varig’s business completely fail, downstream buyers of Varig’s assets could face successor liability. Notwithstanding the appellate ruling described above, ultimate clarity on this point will likely reach Brazil’s federal supreme court. See Janaina Vilella & Zinia Baeta, “Successão de passivos deve gerar controvérsia,” Valor Econômico, Mar. 29, 2007.
The problem with the Law is that freedom from successor liability is linked to continued business operations of a bankrupt entity. This poses questions of practicality and encourages Varig-type financial gymnastics to nominally comply with the Law. Moreover, bidders may shun participating in auctions if there is a risk of unknown liabilities springing up at any time due to forces beyond their control affecting the old debtor.
A simple solution would be to modify the Law to provide that any sale of assets, whether of the enterprise in whole or in part, may be free of successor liability. Again, political realities involved in labor and tax claims may prevent this, which is probably why the Law is written as it is in the first place. Even the Bankruptcy Code does not go this far -- there are conditions attached to a sale free and clear, although the issue of successor liability there is driven by secured debt (which at one point bore some relationship to the value of the assets).
Limited Time to Present Plan of Reorganization
Another area of difficulty is the limited period of time in which a business may propose its reorganization plan. The plan must be filed within the first 60 days of the case and approved within the first 180 days, or the business will be liquidated. In the example of Varig, the debtor was actually able to comply with the 60-day period and timely obtain approval of its plan. It may have been impossible to formulate any plan for an international airline other than a quick sale under those circumstances.
Overall, the limited time available to develop a plan may serve to limit creativity in structuring a reorganization. According to a July 13, 2007, article in Brazil’s Valor Econômico, judicial reorganization plans proposed since the Law became effective have tended toward the conservative, perpetuating the practice under the concordata of payment of debts in installments while a moratorium is in effect. But the Law permits more than a simple repayment plan. Many restructuring options can be pursued: joint administration, special-purpose entities, employee ownership, issuance of convertible debentures, etc. Something more radical than delayed payment is generally needed to help the business recover from its financial troubles, depending on the complexity of the problem. However, some believe that creditors would be unlikely to approve such a creative plan and that management may feel that more radical restructuring would place their own positions at risk.
Perhaps the ability to seek an extension of this plan presentment and approval periods – of any additional length, particularly driven by the facts and circumstances of the case – would offer an opportunity to stabilize the business while attempting to resolve or negotiate complicated claims. Of course, under the Code, the previously potentially unlimited time to file and confirm a chapter 11 plan “for cause” has now been restricted to a maximum of 18 months and 20 months respectively. As Brazil experiments here, there is probably a period of time between 60 days and 18 months that would be reasonable.
The Law is still evolving, and Brazilian judges and practitioners are becoming more familiar with its terms and boundaries. For now, questions regarding the primacy of courts, scope of successor liability and terms of reorganization plans will develop on a case-by-case basis. ABI and IBGT joint conferences will be of great value in monitoring and shaping these developments.
John R. Knapp Jr. is a principal of the law firm of Cairncross & Hempelmann, P.S. in Seattle, (www.cairncross.com). Mr. Knapp is admitted to practice in Delaware, Washington and Idaho and speaks Portuguese. Special thanks to Eduardo Guimarães Wanderley of Veirano Advogados, Porto Alegre , Brazil, for research assistance.