In January 2003, Luiz Ignacio Lula da Silva, the candidate of the populist Worker's Party, became president of Brazil, South America's largest nation. His election caused widespread speculation of what measures the da Silva government would adopt to protect Brazil's ailing economy, including the implementation of protectionist trade and investment legislation, and how his campaign rhetoric would affect the country's relations with the International Monetary Fund. Three months into his presidency, Mr. da Silva appears to have opted for a mainstream approach. However, the Brazilian economy still suffers from the adverse affects of the past several years and the negative impact of the Argentine crisis. As a result, foreign creditors may find themselves embroiled in insolvency and bankruptcy proceedings filed by Brazilian debtors.
This article examines the procedural aspects of Brazilian insolvency and bankruptcy law, focusing on bankruptcy legislation.
I. GENERAL PROVISIONS
Insolvency and bankruptcy proceedings are predominantly governed by Decree Law 7661, originally promulgated in 1945, as amended by Law 7274 of December 10, 1984, Decree 2279 of 1985 and Law 8131 of December 1990 (hereinafter collectively referred to the "Bankruptcy Law").The Bankruptcy Law is supplemented by provisions of the Civil and the Commercial Codes.
Brazilian law prescribes that a debtor's assets generally guarantee payment of its debts, unless a particular creditor has been afforded a preference by law or contract. (Civil Code, Article 1556.)
The Bankruptcy Law distinguishes between bankruptcy and insolvency proceedings. Commercial bankruptcy is only available to business debtors, including sole proprietors. Bankruptcy proceedings involving non-commercial entities and individuals are regulated by the Civil Code and the Code of Civil Procedure.
Once bankruptcy proceedings are initiated, the bankruptcy court is afforded ancillary jurisdiction over all issues related to the assets in bankruptcy. All creditors must participate in such proceedings (Bankruptcy Law, Article 23). Although secured creditors are protected by security and mortgage interests, and as such are not directly affected by bankruptcy proceedings, it is noteworthy that Brazilian law greatly erodes such interests by affording other creditors priority over secured interests. (See, Section VI, supra.)
II. INSOLVENCY PROCEEDINGS
Insolvency proceedings allow the debtor to enter into a period of reorganization. Brazilian doctrine defines reorganization as a judicial indulgence granted to commercial debtors to partially discharge or postpone the payment of their obligations for purposes of avoiding or staying a potential bankruptcy.
The Bankruptcy Law contemplates two types of reorganization: "preventive" reorganization to avoid bankruptcy; and 2) "suspensive" reorganization to stay ongoing bankruptcy proceedings and to avoid the liquidation of the debtor.
A. Preventive Reorganization
The debtor is the only party that may request a preventive reorganization. The appropriate motion should be filed with the court of general jurisdiction where the debtor is located. In Brazil, there are no specific bankruptcy courts. If the debtor has various establishments, the motion should be filed where its principal place of business is located.
The motion must substantiate the debtor's state of insolvency. The debtor shall attach the following documents: (1) articles of incorporation or similar documents proving that the debtor has been in existence for over two years; (2) the entity's partnership agreement or current bylaws; (3) authenticated/audited balance sheets (not required for small companies, as defined by law); (4) proof that no protested documents exist-protests filed within the 30-day period prior to filing the motion are admissible; (5) proof that the debtor and its principals have not been convicted of fraud or other financial crimes proscribed by the Bankruptcy Law; (6) evidence that the debtor has not filed for preventive reorganization during the preceding five years; (7) verification that the debtor's assets are sufficient to satisfy at least 50 percent of its unsecured debts; (8) evidence that the debtor will be able to become a viable entity after conclusion of the reorganization; (9) an inventory of all assets; (10) a list of debts; (11) a list of creditors, indicating the addresses thereof and the nature and amount of the debts; and (12) a proposed payment schedule. (Bankruptcy Law,Articles 156 - 160.)
According to the Law, if the debtor fails to submit any of the required documents or fails to meet the criteria for filing for preventive reorganization, the judge shall declare the debtor in bankruptcy within a period of 24 hours. (Bankruptcy Law, Article 162.)
1. Effects of Preventive Reorganization
Once a motion for preventive reorganization is filed, the judge has 24 hours to decide the motion. The judge's order is not appealable. If the judge grants the reorganization, the order shall: (1) mandate publication of the order and a list of creditors in the Diario Oficial (the equivalent of the Federal Register). Secured creditors may be named in the list, but are not subject to the reorganization; (2) stay lawsuits and foreclosure actions against the debtor that are related to the debts subject to the reorganization; (3) stipulate the period within which creditors that are not named in the foregoing list must submit a claim and supporting documents. Such period is between 10 and 20 days as of the first publication of the order in the Diario Oficial; (4) appoint a commissioner; and (5) stipulate whether the insolvent debtor must post a "compliance" bond. (Bankruptcy Law,Article 161.)
If the debtor fails to satisfy the terms of the order, the judge will declare it in bankruptcy.
In addition to suspending the court and foreclosure actions against the debtor, the order granting the reorganization produces the following affects vis-a-vis the creditors:
* All non-preferred debts are accelerated and become immediately due and payable.
* Interest continues to accrue on approved and verified debts. Nevertheless, with respect to credits that are accelerated as a result of the reorganization, interest begins to accrue as of the date the credit instrument expires to prevent a windfall by awarding interest on the debt prior to the date the debt actually becomes payable.
* Preventive reorganizations do not constitute a legal cause to abrogate a contract. The Bankruptcy Law provides that "contracts shall remain subject to the common law rules". (Bankruptcy Law,Article 165.)
The Bankruptcy Law allows the debtor to retain possession and control of its assets during a preventive reorganization as well as to continue to operate, subject to the oversight of the court-appointed commissioner (Bankruptcy Law,Article 167). Doctrine and jurisprudence encourages an insolvent company to continue normal operations to avoid further diminishing the value of the company and its assets, especially if the entity is largely service or sales oriented. Continued operations also minimize the negative impact on the business' employees.
The commissioner acts as a deputy of the court and is responsible for overseeing the acts of the debtor during the reorganization. The commissioner is typically one of the major, but not necessarily largest, creditors, and must be domiciled in the jurisdiction of the court and be of recognized moral and financial integrity.
The duties of the commissioner are set forth in Article 169 of the Bankruptcy Law. Unlike the bankruptcy trustee, who ultimately manages the assets of the bankrupt entity, the commissioner only audits the debtor's conduct. However, the commissioner has the ability to approve certain acts. For instance, Article 167 provides that the sale of real property and the granting of mortgages by the debtor are subject to the approval of the commissioner as well as authorization by the judge.
The commissioner shall also verify that the debtor satisfies his obligations during the reorganization, examines the debtor's books and other documents, audits the debtor's assets and liabilities, requests any information he deems pertinent from interested parties, appoints a financial expert to review the accounting records related to the reorganization, and analyzes any claims filed by the creditors, issues an opinion related to such claims. In the event of an unsuccessful reorganization, he also determines whether the reorganizing entity meets the criteria specified by the Bankruptcy Law for requesting bankruptcy.
The Law stipulates the limitations placed on the commissioner from participating in the reorganization, the criteria for substituting the commissioner and the fees he shall receive. (Bankruptcy Law, Articles 170, 171.)
The Bankruptcy Law provides that the debtor who requests a preventive reorganization shall allow its creditors or the duly appointed accountants thereof to examine its books, and financial and commercial documents within the time period stipulated by the court. (Bankruptcy Law,Article 172.) Similarly, the creditors participating in the reorganization must disclose to the remaining creditors, the judge and the commissioner all facts related to the transactions they have conducted with the debtor and to allow any interested party to review the books and documents related thereto.
2. Filing a Claim/Verification of Debts
The unsecured creditors named by the debtor in the motion for preventive reorganization are deemed subject to the reorganization and are automatically included in the official list of creditors. Any interested party, including the insolvent debtor and the Public Ministry, may oppose the claim or the participation of any creditor within 20 days of the issuance of the court's initial order. (Bankruptcy Law, Article 173.) In the event a debt is challenged or opposed, the commissioner shall review the documents supporting the creditor's claim and determine whether the claim is valid. His decision is subject to approval by the court.
Creditors that are not included in the initial list submitted by the debtor must file their claims for verification. The verification period is 90 days. After reviewing all new claims, the commissioner shall compile a list of general creditors to be approved by the judge.Again, any interested party may challenge the list. Once approved, the judge shall order publication of the list in the Diario Oficial. (Ibid.)
3. Payment Schedule
The payment schedule submitted by the debtor must propose to pay all unsecured creditors at least 50 percent of their underlying debt immediately; or an increased percentage over time-60 percent over 6 months, 75 percent over 12 months, 90 percent over 18 months, or 100 percent over 24 months. In the event the debtor proposes payments over 18 or 24 months, it must pay 40 percent of all unsecured debt during the first year of the schedule. (Bankruptcy Law,Article 156.)
Within five days of the verification of the debts and the publication of the general list of creditors, the commissioner shall file a report analyzing the debtor's financial status, its ability to comply with the payment schedule, contrasting its conduct prior to and after filing for preventive reorganization, and recommending whether the judge should approve the payment schedule. (Bankruptcy Law, Article 169(X).) Once the commissioner submits his report, the debtor has 24 hours to submit evidence that it has paid all of its tax obligations. If not, the judge shall automatically declare the debtor in bankruptcy.
If the debtor has paid its taxes, the judge shall order the publication, within five days, of a notice in the Diario Oficial indicating that creditors may file their objections to the payment schedule proposed by the debtor. If no objections are filed or if the court deems such objections groundless, the judge shall grant the reorganization. If the court rules that the creditors' objections are well founded, he shall declare the debtor in bankruptcy. If not, the judge will approve the schedule and order the debtor to comply with the terms thereof.
In this regard, it is important to note that unlike the laws of other civil law countries, Brazilian bankruptcy legislation does not provide for a general creditors' meeting to vote upon the payment plan submitted by the debtor. Although any creditor can oppose the settlement terms or any creditor included in the general list, the judge ultimately decides whether the settlement, as proposed by the debtor, should proceed.
4. Compliance With Payment Schedule; Termination of Preventive Reorganization
A unique element of the Brazilian insolvency regime is that, to avoid bankruptcy and to demonstrate its ability to comply with the schedule it filed with the court, the debtor must begin to deposit with the court cash to pay debts that become due. In addition, within 30 days of filing for preventive reorganization, the debtors must begin depositing monies with the court that shall be used to satisfy the payment schedule, as ultimately approved. The judge determines the amounts to be deposited. (Bankruptcy Law,Article 175.)
Once the court approves the schedule, the debtor has a period of 30 days to pay court costs and the commissioner's fees.
Once the terms of the payment schedule have been satisfied and all related fees have been paid, the debtor may move the court to publish a notice that the reorganization has been completed. The judge can terminate a reorganization, preventive or suspensive, if the debtor: (1) fails to comply with the payment schedule or any other obligation agreed upon; (2) pays one unsecured creditor to the prejudice of the remaining creditors; (3) abandons its place of business; (4) sells its assets for little or no consideration; (5) fails to continue its commercial activities; (6) incurs unjustified or superfluous expenditures; or (6) engages in any criminal or fraudulent activity. (Bankruptcy Law,Article 150.) Any creditor may file for termination of the reorganization on the foregoing grounds (Article 151). The debtor may avoid termination by paying all debts due and payable. (Ibid.)
5. Effect on Secured Creditors
Preventive reorganizations do not affect secured creditors. Reorganization only affects unsecured creditors. Article 147 of the Bankruptcy Law clearly indicates that, "Approved reorganizations bind all unsecured creditors, both commercial and civil, resident in the country or abroad, in absentia or that have obtained attachments."
Secured creditors are not required to submit their claims during the reorganization process. They retain their right to avail themselves of any action at common law against the reorganizing debtor.
B. Suspensive Reorganization
As indicated above, "suspensive" reorganizations are available to commercial entities that have been declared in bankruptcy for purposes of avoiding the liquidation of the entity. Brazilian doctrine imposes two basic prerequisites to file for this type of reorganization: the debtor must be in bankruptcy; and the bankruptcy trustee shall not have filed any lawsuits against the entity, the partners or directors/officers for fraud or other financial crimes.
The Bankruptcy Law contains relatively few provisions specifically regulating suspensive reorganizations: only eight articles. (Articles 177 - 185.)
Only the debtor may file a motion for suspensive reorganization. The motion must be filed within five days of the date the bankruptcy trustee is required to submit his initial report to the court. (Articles 63(XIX) and 178.)
In the case of a commercial entity, the decision to file a motion for suspensive reorganization must be approved by: (1) all the partners who are jointly and severally responsible for the debts of the entity; (2) all the partners of a joint venture entity; or by the shareholders of a corporation. (Bankruptcy Law,Article 179.) In the event a sole proprietor files for suspensive reorganization, his unsecured creditors must join in the motion. (Article 180.)
As with the preventive reorganization, the debtor shall propose a settlement and payment plan. The plan must provide for the immediate payment of: at least 35 percent of the debt due unsecured creditors; or 50 percent of such unsecured debt over a period of two years. In the latter instance, a minimum of 40 percent of all unsecured debt must be paid within the first year. (Article 177.)
If the motion does not comply with the prerequisites and conditions set forth in the Law, the judge shall deny the request, and the bankruptcy proceeding shall continue.
If the legal requirements are satisfied, the judge shall grant the motion filed by the debtor. Once granted, the debtor shall regain possession and control of its assets, as well as the right to dispose of them freely, except for the right to sell or mortgage real property. Transactions involving real property must be authorized by the court.
Once the motion for reorganization is granted, the period for making the proffered payment begins to run.
Unlike preventive organizations, debtors in suspensive reorganizations are required to pay all underlying debts, including secured debts, labor-related debts and taxes. Thereafter, the debtor must pay the unsecured creditors pursuant to the terms of the reorganization plan. After all such payments are made, the debtor may request that the judge rule that the reorganization has been completed.
If the debtor fails to comply with the payment schedule or any other obligation it may have assumed during the reorganization proceedings, the judge will terminate the reorganization, and bankruptcy proceedings will resume. The judge may also terminate the reorganization for any of the reasons discussed above for preventive reorganizations.
Brazilian doctrine defines bankruptcy as a collective process for demanding payment during which the assets of a business debtor are sold pursuant to a court order, and the proceeds of such sale are distributed proportionally to the creditors.
There are two essential requirements to filing bankruptcy. First, the debtor in question must be a commercial entity. Sole proprietors and partnerships especially created to transact business are deemed commercial debtors. (Commercial Code, Articles 1, 4 and 16.) All corporations, regardless of their purpose, are considered commercial entities. (Law 6404, December 15, 1976, Article 2.)
The Bankruptcy Law, however, is not applicable to certain entities that manage public resources or that promote social interests. These entities may be subject to intervention or liquidation by an administrative body. Moreover, the Bankruptcy Law is not applicable to insurance companies (Decree Law 73 of November 21, 1966, Article 26), cooperatives (Law 5764, Article 75) or financial institutions (Law 6024 of 1974).
Second, the Bankruptcy Law requires that the debtor be unable to satisfy a liquid obligation, evidenced by an instrument and contracted by the debtor that may result in an action to collect. (Bankruptcy Law, Article 1.)
As used in the Bankruptcy Law, an instrument is a document. Brazilian law contemplates that every collection must be based on a judicial or non-judicial instrument that grants a right to collection or payment. Examples of such judicial instruments include a judgment in a civil case and a final, non-appealable arbitral award. Non-judicial instruments include letters of exchange, approved or duplicate invoices and checks.
A. Indicia of Bankruptcy
The inability to pay a debt is considered the clearest indication of a state of insolvency. Doctrine and jurisprudence provide that the failure to make a single payment that is due, regardless of whether the debtor has the assets to make such payment, is indicative of insolvency. However, to be in default a debtor must fail to comply with an extra-judicial demand for payment submitted by the creditor. (Bankruptcy Law.Article 10.)
The Code of Civil Procedure, which supplements the Bankruptcy Law, indicates that a debtor is presumed to be insolvent at law when "the debts exceed the value of the debtor's assets" (Article 748). Unless evidence to the contrary is submitted, the Code further presumes that a debtor is insolvent when all its assets have been attached or when it attempts to hide assets, avoid attachments or defraud creditors (Article 750). As discussed above, the debtor may also declare insolvency, by filing a motion for a preventive reorganization (Article 759).
In addition to the failure of the debtor to pay a liquid debt that is due and payable, arising from an instrument that justifies the collection thereof, Article 1 of the Bankruptcy Law requires that the debtor cannot have a defense justifying nonpayment. Generally, "just legal causes for nonpayment" include the fact that the obligation was not contracted, that the debt was forgiven or that payment was previously made.
Insolvency may also be demonstrated by undertaking the certain "acts of bankruptcy". (Bankruptcy Law,Article 2.)The following are considered acts of bankruptcy: (1) upon receiving a demand for payment, a debtor fails to make payment or to file a bond sufficient to cover such payment; (2) the debtor liquidated the entity prematurely or attempts to defraud its creditors; (3) the debtor calls a meeting of its creditors and proposes a reduction of debt or a deferral of payment; (4) the debtor conducts, or clearly attempts to conduct, fraudulent transactions, or attempts to sell all or a part of its assets to a third party, regardless of whether such third party is a creditor; (5) the debtor grants a security interest to an existing creditor that did not have such a security interest; or (6) the debtor absconds without designating a representative to manage its affairs or pay its creditors, abandons its place of business, hides or attempts to hide.
The Bankruptcy Law provides that a motion for an order declaring a debtor in bankruptcy may be filed by the debtor itself, a representative of the debtor, a creditor, or by the court sua sponte.
The bankruptcy order may result from the debtor's failure to satisfy the legal requirements for granting a preventive or suspensive reorganization, or from the debtor's failure to satisfy the conditions of a reorganization plan.
If the debtor only has one establishment, the motion for a declaration of bankruptcy shall be filed before a judge in such location. If the entity has multiple places of business, the motion shall be filed in the jurisdiction where the principal offices are located. (Bankruptcy Law,Article 7.)
Typically, a motion to declare a business in bankruptcy is filed by an unsecured creditor.A secured creditor may also file a bankruptcy motion, provided such creditor waives his underlying security interest, or if such creditor can prove that the security interest will not satisfy the debt in question. (Bankruptcy Law, Article 9(III)(b).) A secured creditor is required to prove the insufficiency of the security through expert testimony during a hearing prior to filing the motion. (Code of Civil Procedure, Articles 796, et seq.)
A creditor domiciled abroad may also move for bankruptcy, provided he posts a bond to cover court costs as well as any damages that may result in the event the motion is fraudulent or filed in bad faith. (Bankruptcy Law,Article 9(III)(c).)
The initial motion shall satisfy the formal requirements set forth in the Bankruptcy Law. If the debtor files the motion, it shall attach a balance sheet, an appraisal of all company assets, a list of creditors specifying the domiciles thereof, the amounts due each, the nature of the debt and the respective due dates. (Article 8.)
In the event a creditor or another party with standing files the motion, it shall attach a judicial instrument evidencing its right to collect a past due obligation, the instrument evidencing the debt, or the negotiable instrument in question with the corresponding protest. The motion shall also provide the address of the creditor, shall indicate whether the debt is secured, and whether the creditor has any of the debtor's property in its possession. (Article 11.)
Once a motion is filed by a creditor, it shall be reviewed by the judge to assure that it complies with all legal requirements. Thereafter, the judge shall serve the motion on the debtor. The debtor has a period of 24 hours to file any objections or defenses (Bankruptcy Law,Article 11). If the debtor's domicile is unknown, the process shall be served by edict, and the period for the debtor to file an answer is extended to three days.
1. Answer and Defenses
Within the period established by law, the debtor may:
* acknowledge and pay the debt, together with interest thereon and the costs incurred by the creditor to file the motion for bankruptcy;
* answer and file a bond. In this case, the bond constitutes an additional guarantee pending a determination of the veracity or existence of the underlying debt; or
* contest the motion.
The Bankruptcy Law recognizes the following defenses: the debt instrument is a forgery; the debt or corresponding instrument has expired or become void; the debt was paid after the debtor filed a protest, but prior to the filing of the motion for declaration of bankruptcy; the debtor requested a preventive reorganization prior to the filing of the motion; a bond sufficient to satisfy the debt was filed with the court; or any other basis sufficient to cancel or suspend the debtor's obligation to pay the debt. (Bankruptcy Law,Article 4).
Doctrine indicates that the foregoing defenses are not exclusive.
Pending a ruling on the motion for bankruptcy, the Bankruptcy Law allows the attachment of the debtor's books, assets and correspondence as precautionary measures, as well as an injunction against the sale of assets. (Article 12.)
2. Order Declaring Bankruptcy
Article 14 of the Bankruptcy Law stipulates that the order declaring bankruptcy shall: (1) indicate the name of the debtor, the location of its principal place of business, the nature of the business, the names of the partners/shareholders and the addresses thereof, the names of the directors, managers and liquidators in the case of partnerships and corporations; (2) prescribe, if possible, the legal time period for the bankruptcy, designating the date on which bankruptcy began, which date may not be extended more than 60 days as of the date of the first complaint for lack of payment or the date of the motion for preventive reorganization; (3) appoint a trustee; (4) establish the period for the creditors to file claims and documents supporting such claims; and (5) dictate measures to protect the assets, including ordering the preventive incarceration of the bankrupt party or the representatives of the bankrupt entity.
The order shall be published in the Diario Oficial.
3. Order Denying Motion
If the court finds the answer filed by the debtor to have merit, the judge may deny the creditor's motion. In such case, the court shall determine whether the creditor filed the motion fraudulently or in bad faith. If so, the creditor shall pay court fees and costs.
C. Period of Scrutiny and Legal Period
Between the moment a business becomes de facto insolvent and the time it is adjudged bankrupt, the acts of the debtor are subject to scrutiny for potential fraud. As such, these acts may be investigated and declared void vis-a-vis the creditors.
Under Brazilian law, these periods are referred to as the "period of scrutiny" and the "legal period". The period of scrutiny is the period between the date the debtor becomes insolvent and the date the bankruptcy order issues. The legal period is the 60-day period prior to: the first complaint for nonpayment; a motion based on the so-called "acts of bankruptcy"; or a motion for preventive reorganization.
1. Transactions Voidable by Law
According to the Bankruptcy Law, any acts that adversely affects creditor rights are valid between the original contracting parties, but they are void vis-a-vis the bankruptcy estate. Article 52 of the Bankruptcy Law stipulates that certain transactions are void as a result of the debtor's insolvency, regardless of whether the contracting party was aware of such state or whether the debtor's intent was to defraud the remaining creditors.
Such acts include: (1) the anticipatory payment of debts within the legal period; (2) the payment, within the legal period, of debts that are due and payable in any manner that is not specifically permitted by the instrument evidencing the debt; (3) the granting of security interests after a debt is contracted-security interests granted at the time a debt is incurred remain valid; (4) the transfer of assets worth at least 1,000 reales within two years of the date of the order imposing bankruptcy; and (5) the rejection of any right of inheritance within two years of the date of the bankruptcy order.
D. Effects of the Bankruptcy Order
The bankruptcy order results in the following effects.
1. Personal Effects
The bankrupt businessman or the directors/officers of an entity in bankruptcy may not leave the jurisdiction.The businessman or a duly appointed corporate/partnership representative must appear at all bankruptcy related hearings. Moreover, the party in bankruptcy must file all statements required by the court, within a period of up to 60 days or be subject to contempt. (Bankruptcy Law, Articles 34, 35.)
The trustee shall receive and review the correspondence of the bankrupt entity. The party in bankruptcy is only entitled to receive correspondence of a personal nature, not related to the bankruptcy estate.
2. Assets Comprising the Bankruptcy Estate and Transfer of Control
Brazilian law stipulates that all the assets and rights of the bankrupt entity, whether acquired for consideration or otherwise, form part of the bankruptcy estate. (Bankruptcy Law,Article 39.)The bankrupt entity loses the right to control or manage such assets. (Article 40.) However, it retains ownership rights thereto.
The bankrupt entity is not deemed to be in receivership, it merely loses the right to manage and sell the assets that comprise the bankruptcy estate. It can continue to engage in civil acts, but it is restricted from transacting any business related to the ownership of assets. If the debtor sells an asset or grants a security interest to an asset, the transaction is void per se.(Ibid.)The restriction on alienation extends to the assets belonging to the partners and limited partners of the bankrupt entity.
Once the bankruptcy order is issued, the trustee assumes possession of the bankruptcy estate, including the rights, actions, books and documents of the bankrupt entity, wherever situated, for purposes of collecting assets to satisfy outstanding debts.
The judge chooses the trustee from the largest creditors of the bankrupt entity. However, the trustee does not have to be the biggest creditor, and the judge is free to choose from any civil, commercial, privileged, secured creditor or unsecured creditor. (Bankruptcy Law,Article 60.)
The trustee must be an individual because the position is subject to civil and criminal penalties. If a legal entity is chosen, the legal representative of such entity acts as the trustee. The trustee must reside in the jurisdiction in which the bankruptcy proceedings are initiated and shall have a reputation for moral and financial integrity. In the event three separate trustees appointed from among the creditors recuse themselves, the judge is free to appoint a non-creditor trustee.
If the bankrupt entity moves for, and is granted a suspensive reorganization, it recoups the right to control and manage the estate.
3. Debt Acceleration
Bankruptcy affects all the debts of the entity in question. As such, all installment credits are deemed due and payable and included in the process. Debts subject to a condition precedent are not accelerated. These shall only be included in the proceedings if the underlying condition is satisfied. (Bankruptcy Law,Article 25.)
4. Staying Lawsuits, Executory Actions and Accrual of Interest
All lawsuits and foreclosure actions pending against the bankrupt entity are stayed. Similarly, bankruptcy stays the accrual of interest (Bankruptcy Law,Article 24.)
5. Tolling Statutes of Limitation
During the bankruptcy proceedings, statutes of limitations related to the debts of the bankrupt entity shall be tolled. (Bankruptcy Law,Article 47.)
6. Contracts Entered Into By the Bankrupt Entity
The general rule is that an order declaring bankruptcy does not affect bilateral contracts that are in full force and effect. Thus, if the non-bankrupt party has performed under the contract in question, the trustee must similarly perform. If the trustee fails to perform, the other contractual party may file a motion to force the trustee to state, within five days, whether it intends to do so. If the trustee responds that it will not perform, the opposing party acquires the right to file an ordinary action against the bankrupt entity and shall be afforded the same rights as an unsecured creditor. (Bankruptcy Law,Article 43.)
Debts may also be satisfied by an offset. According to Article 46 of the Bankruptcy Law, debts incurred prior to declaring bankruptcy may be offset without judicial intervention, provided evidence of such offset is filed with the court to allow the judge to acknowledge the payment.
The federal Supreme Court has ruled that a debt that is not yet due and payable may be offset during the bankruptcy proceeding. This is particularly important in the case of banks whose debtors declare bankruptcy and who have assets deposited with such creditor banks.
E. Verification of Claims
Once the bankruptcy order issues, the creditors must file their claims. The order adjudging bankruptcy shall prescribe, among other things, the period within which the creditors shall file their claims and supporting documents. This period may vary from 10 to 20 days as of the first publication of the order in the Diario Oficial. (Bankruptcy Law,Article 80.) In addition to publishing the order, the trustee shall send notices to the creditors by first class mail, return receipt requested. If the creditor is not located in the jurisdiction, such notice may be served by telegram or telefax. (Article 81.)
The presiding judge shall review such claims and determine whether they are admissible.
The only entities not subject to this requirement are the taxing authorities, the National Institute for Social Prevention Administration and Social Assistance and certain parastatals. In addition, labor credits need not be claimed; the court can verify such credits on the basis of the debtor's books and records.
The trustee or any creditor, whether preferred, ordinary, secured or unsecured, may challenge any claim filed against the debtor. (Bankruptcy Law,Articles 87, 88.)
F. Priority and Classification of Claims
Unless preferences have been established, all creditors have equal right to the assets of a common debtor. (Civil Code, Article 1556.) In accordance with Article 1557, debts afforded a preference include privileged debts, security interests and mortgages. The Civil Code stipulates that such preferences are fully enforceable in a bankruptcy proceeding.
Brazilian law establishes the following classification of preferences to be applied in bankruptcy proceedings: (a) labor credits; (b) tax and similar credits; (c) claims related to costs to preserve the debtor's assets; (d) claims based on the debts submitted in bankruptcy; (e) mortgage debts; (f) debts with special preferences; (g) debts with general preferences; (h) unsecured debts; (i) subordinated debts; and (j) shareholder debts. (Bankruptcy Law,Article 102.)
1. Labor Credits
Currently, Brazilian law affords labor credits full protection during bankruptcy proceedings, giving them preference for their entire value over all other claims. Law 6449 stipulates that during bankruptcy proceedings, all amounts due employees as compensation are deemed privileged claims.As of the effective date of such law, Brazilian jurisprudence has recognized that labor claims, in their full amount, are considered privileged.
Decision 219 of the Supreme Court of Brazil grants similar preference to claims derived from services rendered to the bankruptcy estate, including trustee fees.
2. Tax and Similar Credits
Beginning with Decree Law 960 of 1938, the Treasury has been afforded a privileged position: it is not required to participate in any reorganization to claim taxes due, and it does not have to submit a claim during the course of a bankruptcy proceeding.
Article 188 of the law that establishes the National Taxing System specifies that taxes due or payable are afforded preference over any other debt during bankruptcy proceedings. Similarly situated are claims by parastatals, and social services authorized by law that are organized or directed by private entities and partially funded with public funds, such as the Social Service of Industry and the Social Service of Commerce.
3. Workman's Compensation
The Bankruptcy Law provides that workman's compensation claims shall be paid before remaining claims. Brazilian doctrine has attempted to reconcile the absolute preference afforded labor claims with the preference created for workman's compensation.The labor courts have concluded that workman's compensation claims shall be paid after labor and tax claims.
4. Claims Related to Costs of Preserving the Estate
Such costs are incurred for the benefit of all creditors to preserve the assets of the bankrupt entity.These include: property taxes; business or corporate taxes; costs related to the bankruptcy proceedings; costs for preserving the assets; and the fees charged by experts, accountants and the trustee.
5. Credits Related to the Debts of the Bankruptcy Estate
These debts, derived from transactions conducted by the trustee, are given equal footing with those related to preserving the estate.
6. Secured Debts
Historically, Brazilian legislation accorded secured debts absolute priority.The Brazilian Civil Code provides that in the case of debts guaranteed by a security interest, antichresis or mortgage, the property given as a security remains subject and related to the payment of the obligation and that the secured debt has preference over any personal debt. (Civil Code,Articles 755, 1560).
Such absolute preference was in force until the promulgation of the current Bankruptcy Law in 1945.The original text of the existing Bankruptcy Law afforded debts incurred to preserve the estate and debts incurred by the trustee the highest preference. In 1960, Law No. 3726 established a priority for labor credits, further reducing the standing of secured debts. Finally, Article 184 of the National Tax Code, Law No. 5172 of 1966, definitively ranked secured debts after labor credits, tax credits, debts to preserve the estate and debts incurred by the estate.
Secured debts also encompass relatively new instruments that permit security interests and mortgages to be transferred in the same manner as exchange instruments. An example of such instruments is bonds guaranteed by a mortgage, created by Decree Law No. 70 of 1966.
7. With Special Privileges
Debts with special privileges are associated with specific assets and are created by law.
These debts are referred to in Articles 470, 471 and 474 of the Commercial Code (related to maritime debts such as supplying provisions for boats, port fees, rescue, etc.) and Article 102 of the Bankruptcy Law (rents for the commercial space of the bankrupt entity).
8. Unsecured Debts
Unsecured debts do not enjoy any preference.They are not included in any of the foregoing categories and are payable after such debts have been satisfied. (Bankruptcy Law,Article 104).
9. Subordinated Debts
Subordinated debts are paid after unsecured debts.These are debts related to subordinated obligations that are essentially tantamount to capital. (Corporations Law,Article 58.4).
10. Shareholders of Bankrupt Entities
The final classification is comprised of the shareholders of bankrupt entities. Shareholders are subdivided into preferred shareholders, and general shareholders or holders of usufruct rights. These are entitled to any assets remaining after all other creditor classes have been paid.
Within 48 hours of filing his report, the trustee shall publish a notice in the Diario Oficial that he will begin the process of liquidating the debtor's assets. In the event the debtor files for suspensive reorganization and is denied, the notice shall be published 48 hours after such denial. (Bankruptcy Law, Article 114.) The assets may be sold in their entirety or separately. (Article 116.)
The assets shall be sold at public auction, subject to a 10-day notice for personal property and a 20-day notice for real property. A representative of the Public Ministry must be present at the auction, otherwise any sale may be declared void. (Article 117.) The successful bidder must make a down payment of at least 20 percent of the purchase price and must pay the remainder within three days of the auction. If he fails to do so, the trustee may proceed to re-sell the asset in question.
The trustee may also choose to sell the assets pursuant to closed bids. If he elects this option, he must publish a notice both in the Diario Oficial and in a newspaper of major circulation during the course of 30 days. Bids shall be delivered to a notary public and opened by the judge.The trustee shall then evaluate the bids and make a recommendation to the court. Within three days of receipt of the trustee's recommendations, the judge shall award the bid. The creditors may oppose the court's decision at the time they receive notification of the underlying decision. (Article 119.)
Creditors holding more than 25 percent of the total debt may file a motion with the court requesting a creditors' meeting to determine the exact terms and manner in which the assets shall be sold. Such motion shall not affect the sale of any assets previously undertaken by the trustee. (Article 122.) Decisions taken at the meeting shall be by majority vote, based on the monetary value of the underlying debt represented therein.
In addition, creditors representing two-thirds of the total debt may elect options other than liquidation, such as the incorporation of a new company to continue the debtor's business or the transfer of the assets to a specific third party, or may impose conditions of sale, such as the setting of minimum prices. (Bankruptcy Law, Article 123.) In the event the creditors decide to form a company, the creditors who voted against the decision shall be paid in cash, based on an appraisal of the assets, after deducting the debts attributable to the bankruptcy estate.
IV. SECURITY INTERESTS
A. Security Interests
Article 755 of the Brazilian Civil Code stipulates that the property given to guarantee debts secured by a security interest, antichresis or mortgage is inextricably linked to the payment of the underlying debt. Notwithstanding, however, the priority of secured credits under Brazilian law is secondary to labor, tax and public interest credits as well as the debts incurred by the estate.
B. Application of Insolvency Proceedings to Security Interests
A preventive reorganization is not applicable to secured creditors, whether the debt is guaranteed by a security interest or a mortgage.
As such, the preventive reorganization only affects unsecured creditors. Article 147 of the Bankruptcy Law provides that, "[once a motion for] reorganization is granted, all unsecured creditors, both commercial and civil, resident in the country or abroad, with or without a lien, are subject to such proceeding".
During a preventive reorganization, secured creditors are not even required to file a claim; rather, they may avail themselves of other remedies available under common law against the reorganizing debtor.
C. Application of Bankruptcy Proceedings to Security Interests
Secured creditors may not move for an order declaring a debtor in bankruptcy unless they waive the underlying security interest, or they can prove that the value of the asset is insufficient to satisfy the debt.
Bankruptcy severely affects security interests because such interests become subordinated to other debts, including labor and tax credits.
The near absolute priority afforded secured debts pursuant to the Civil Code and pre-1945 bankruptcy legislation has been greatly eroded. This prejudices the use of security interests in financing operations given that the goods used to secure debts may be used to satisfy other debts that did not exist on the date the security interest was created, thus losing the intrinsic value and effectiveness of the guarantee.
V. INTERNATIONAL BANKRUPTCY
The only reference applicable to international insolvency proceedings is found in Article 7 of the Bankruptcy Law that recognizes the concept of territoriality: "the Judge in the jurisdiction in which the debtor has its place of business or in which a foreign debtor has an establishment is competent to declare bankruptcy."
Doctrine maintains that local creditors may request the bankruptcy of a local debtor, and priority is given to domestic creditors. Foreign creditors shall be paid from any assets remaining after all domestic creditors have been paid in toto.
A creditor domiciled abroad may request that a debtor be declared bankrupt. Such right is guaranteed by the constitutional right of petition, which right is afforded foreign residents. The Bankruptcy Law, however, requires that foreign creditors who desire to participate in a bankruptcy proceeding guarantee costs and compensation for losses or damages in the event the petition for declaration of bankruptcy is fraudulent or in bad faith.
From the perspective of private international law, Brazil is a signatory of the Havana Convention of 1928, also known as the Bustamante Code. It has been ratified by, among others, Bolivia, Chile, Costa Rica, Cuba, Ecuador, El Salvador, Guatemala, Haiti, Honduras, Nicaragua, Panama, Peru, the Dominican Republic and Venezuela.
With regard to the international bankruptcy of banks, Brazilian law has held that a final foreign court order initiating bankruptcy proceedings against a foreign bank or banking institution is not applicable to existing branches of such bank in Brazil.
Local creditors may request a declaration of bankruptcy against a bank located in Brazil. In such event, the Supreme Court has ruled that local creditors have a preferential right over foreign creditors to payment from the bank's assets.
VI. OVERALL EVALUATION AND NEED FOR REFORM
A. Current Law
The principal comment made by Brazilian legal scholars with regard to existing insolvency/bankruptcy legislation is that the powers of the magistrate have increased, while the participation of the creditors has decreased. As such, the law favors the insolvent or bankrupt debtor.
Scholars comment that the 1945 law is inadequate to address Brazil's socioeconomic condition and status as South America's largest economy. Among the critiques levied are:
a. The courts do not order the necessary measures in a timely manner, and the judges lack technical knowledge.
b. The ultimate result of the bankruptcy proceeding is to liquidate the company and criminally sanction the businessman.
c. The lack of specialized bankruptcy courts leaves judges who are ignorant of financial and business administrative issues presiding over cases that can have a great impact on the economy.
d. The current legislation governing preventive reorganizations is based on purely formal elements that facilitate fraud and prejudices creditors.
e. The validity of the preventive reorganization is frequently questioned within the framework of new doctrine related to conserving the company.The principal criticism is that the debtor is the only party with standing to request reorganization; by the time a motion is filed, the debtor is already in an irreparable state that typically results in bankruptcy.
B. Proposed Reforms
As a result of a movement calling for bankruptcy law reform, a series of proposed reforms have been drafted.
The most significant project was submitted in 1993 for purposes of preparing pre-draft bill on insolvency and bankruptcy legislation.
The draft recognizes that the 1945 existing Bankruptcy Law should be amended substantially because it is antiquated. It suggests a widespread reform of the Law to promote the reorganization and continuance of business entities rather than the liquidation thereof. However, it fails to restore the priority of secured creditors.
To date, such bill has yet to be approved, nor is it likely to be in the near future.
Both legal scholars and the business community agree that Brazil's bankruptcy system needs to be amended. From the vantage of lenders, the fact that security interests are not given the ultimate priority normally expected constitutes a risk to be carefully analyzed and may affect a lender's willingness to enter the market.
By Francisco A. Laguna, JD
Francisco A. Laguna is the president of TransLegal, LLC, an Alexandria, Virginia-based multinational consulting firm that specializes in international law issues (www.translegalinc.com). For the text of any of the laws referred to in this article, e-mail firstname.lastname@example.org.…