May 14, 2009 Brazilian-American Chamber of Commerce Creditors’ Rights in Brazil after PEC-12...

May 14, 2009

Brazilian-American Chamber of Commerce

Creditors’ Rights in Brazil after PEC-12

“Default Threat in the Precatorio Market”

José Virgílio Enei

Table of Contents

I. Introduction – General Terms

II. Analysis - PEC-12 – The Proposed Default

III. The Precatório Market

IV. PEC 12 and its Impacts on Precatório Investors

V. Alternatives to PEC 12

I. Introduction – General Terms

II.II. Analysis - PEC-12 – The Proposed DefaultAnalysis - PEC-12 – The Proposed Default

III.III. The Precatório MarketThe Precatório Market

IV.IV. PEC 12 and its Impacts on Precatório InvestorsPEC 12 and its Impacts on Precatório Investors

V.V. Alternatives to PEC 12Alternatives to PEC 12

1. Introduction – General Terms

Precatório

Courts of Origin

Federal Precatórios are issued by Federal Courts, after a final and non-appealable judgment against the Federal Government is achieved in connection with a certain lawsuit

State or Municipal Precatórios are issued by State Courts

Types

“Precatórios Alimentares” (Alimony): are those resulting from claims regarding

salaries, wages, retirement payments and indemnification (torts)

“Precatórios Não-Alimentares” or “Ordinary Precatórios”: are those resulting from

any other claims, including contractual, tax and real estate expropriation matters

Ordinary Precatórios may be payable in up to 10 installments (if resulting from a claim

brought to the Brazilian courts prior to 2000) or in a single payment

“Precatórios” are negotiable debt instruments issued by judicial courts in Brazil that represent monetary non-appealable judgments against Brazilian governmental entities (mainly the Federal Government; the States or the Municipalities)

Prior to the actual issuance of the Precatório but after a decision on the merits against the Government, Plaintiff has credit rights (to be converted into Precatorios) that it may negotiate with third parties (with higher discounts)

1.1. General Overview

Theoretical Sequence in a Lawsuit Resulting in the Issuance of a Precatório


Filing of an Original Lawsuit

Compensation for damages and losses caused by direct or indirect (through governmental entity) actions from the Government

Unappealable and FinalDecision

on the merits

In case of appeal in a first level court decision, a second level decision is required (sometimes a third level is required up to the Supreme/Superior Courts – STF/STJ)

Award Calculation

Required to calculate the amount of the award. Usually involves the issuance of an expert report and needs ratification

in court (can be appealed by both parties)

Enforcement Claim

After a final decision is rendered in the award calculation phase, plaintiff can request the inclusion of the amount for payment in the annual budget

Precatório

Even after issuance, the possibility of a final appeal (rescisória) remains after 2 years

Step 1 Step 2 Step 3 Step 4 Step 5 Payment

Single installment for Alimony Precatórios and in 10 installments for non-alimony according to article 78 of the ADCT (1)

____________________

(1) Precatórios issued until June 30 of a determined year (y) must be paid (1st installment, in case it is a non alimony one) until December 31 of the subsequent year (y+1). Precatórios issued in the second semester of a determined year must be paid until December 31 of the year following the subsequent year (y+2).

1.2. Illustration of Precatorio Timeline

After issuance of an ofício requisitório, a precatório will be issued.

Step 6

RescissoryClaim (2-year

Period)

1.3. Typical Payment Terms of a Precatorio

Interest and

Monetary Adjustment

Issues related to Interests over Precatórios

Federal Constitution establishes that Precatórios must be updated by (a) legal interests (which are determined by the final decision or by the law) and (b) monetary adjustment

Federal and each State Court have determined their own understanding of the constitutional provision. Therefore, each Precatório has a methodology of calculation

Examples

Federal Precatórios: IPCA-E (~4.5% per year) + 6% per year

State of São Paulo: INPC (~4.5% per year) + 6% per year

Municipality of São Paulo: INPC (~4.5% per year) + 6% per year (up to 2003) + 12% per year (after 2003)

General Rule: Brazilian Constitution establishes that interests shall only apply after December 31st of the year the Precatório is included in the budget

Installments: A discussion has been raised by Public Debtors in the Courts on the methodology of interests on the installments of Precatórios: (a) interests shall apply after the due date of the first installment up to the final payment or (b) interests shall apply only after the expiration of each defaulted installment

Rates: After enactment of Civil Code in 2003, several theories have been raised in Courts: (a) 6% p.a up to final payment; (b) 12% p.a. up to final payment; (c) 6% p.a. up to 2003 and 12% p.a. thereafter; (d) SELIC up to final payment; and (e) 6% p.a. up to 2003 and SELIC thereafter



ChronologicalOrder

Breach of Chronological

Order

Federal Constitution establishes that Precatórios must be paid according to the chronological order of issuance (first come, first serve basis)

This is an unchangeable and fundamental constitutional principle that guarantees to the precatório holders that the Public Debtors shall not priorize any other precatório issued (isonomy)

If the Public Debtor breaches the chronological order, then the holder of the precatórios not paid shall be able to file a seizure claim to withdraw money from the bank accounts held by the Public Debtors

Applicable to alimony and all ordinary Precatórios (either or not divided into installments)

Jurisprudence in certain States (e.g. São Paulo) is predominantly favorable to the seizure in such hypothesis of breach of chronological order

Alimony and Ordinary

Chronological Orders

Alimony and Ordinary Precatórios are paid in different chronological orders

Federal Constitution establishes that alimony precatórios shall have a priority order over the ordinary ones

In practice, due to seizure remedy, alimony precatórios are paid in a slower fashion than the installments of ordinary precatórios

1.3. Typical Payment Terms of a Precatorio (cont.)


FEDERAL CONSTITUTION ESTABLISHES 3 WAYS TO MONETIZE PRECATÓRIOS

Holders of precatórios not subject to seizure remedy (alimony and ordinary precatórios not submitted to installments regime). Estimate of payment depends on the Public Debtors capability.

Examples: Federal Precatórios are paid regularly; Municipality of São Paulo currently pays alimony Precatórios issued in 1998 etc.

Payment by the Debtor

Seizure of Assets

Seizure is allowed in two alternatives: (a) breach of chronological order and (b) default of any of the 10 installments of non-alimony Precatórios submitted to installment regime

Favorable decisions in the State Courts of São Paulo and Superior Courts

Tax Compensation

Federal Constitution provisions allowed tax compensation with past due installments of ordinary precatórios only. Legal grounds contained in the Civil Code may allow tax compensation with all Precatórios (including alimony).

Precatório holders have used them as collateral in tax claims filed by the Government.

Jurisprudence still being consolidated in Higher Courts.

1.4. Current Alternatives/Remedies for Precatorios

Date: 1988 (at the promulgation of the Constitution)

Target precatórios: all the outstanding non-alimony precatórios were submitted to the rule (Municipal, State and Federal levels)

Payment: 8 annual installments (beginning on 07/01/89)

Interest index: 6.0% p.a. (discussion whether interest should be included or just monetary adjustment should apply)

Seizure remedy and tax compensation: no seizure remedy or tax compensation were allowed

Assignment: no provision on the assignment of the credits (Higher Courts authorized it, though)

Public debtors were allowed to annually issue public notes to bear the payment, which were not factored in as global indebtedness

Great majority of states and municipalities did not comply with the rules and never paid amounts owed

Art. 33 – Transitory Constitutional Provisions Act1st Moratorium

Art. 78 - Transitory Constitutional Provisions Act2nd Moratorium

Date: 2000 (Amendment to the Constitution n.30)

Target: all outstanding non-alimony precatórios derived from lawsuits filed before Dec/99 were submitted to the rule (Municipal, State and Federal)

Payment: 10 annual installments (first maturity on 12/31/01)

Interest index: discussion on the use of 6.0% p.a., 12.0%p.a. or SELIC (the latter without monetary adjustment)

Seizure remedy: granted to precatórios holders in case of default or late payment by Public Debtors

Tax compensation: possibility to compensate the unpaid installments with tax obligations

Assignment: expressly allowed

Again, great majority of states and municipalities did not comply with the rules and never paid amounts owed (except through seizure proceedings, limited to few states and municipalities)

1.5. Previous Mandatory Reschedulements

1. Introduction –General Terms

I.I. Introduction – General TermsIntroduction – General Terms

II. Analysis - PEC-12 – The Proposed Default


IV.IV. PEC 12 and its impacts on Precatório InvestorsPEC 12 and its impacts on Precatório Investors


Proposal: PEC 12 was originally proposed in March 2006 by the Senator Renan Calheiros (PMDB-AL), which was shortly after replaced by Senator Cesar Borges (PR-BA), then followed by Senator Valdir Raupp (PMDB-RO)

Discussions and Amendments: since first conceived, the PEC 12 provisions have suffered major amendments and revisions

Financial Crisis: Most recently, the subject attracted an increased pressure from states and municipalities as a result of financial crisis and sharp deterioration of public accounts

Political Pressure: In the end of March/09 Senator Raupp was replaced by Senator Kátia Abreu (DEM-TO), from the same party of SP mayor Gilberto Kassab and an ally of SP governor José Serra, two of the most interested and engaged politicians in the PEC discussion

Approval: On April 1, 2009 PEC was approved in two shifts at the Senate’s Commission of Constitutionality (“CCJ”) and Senate’s full body (“Plenário”)

BACKGROUND AND GENERAL INFORMATION CURRENT STATUS

Current Status: PEC 12 shall be voted by the the House of Representatives (“Câmara dos Deputados”), where a 60% majority in 2 shifts is also required for final approval of the PEC 12

Committee. Eduardo Cunha (PMDB-RJ) has been appointed by the Representatives to analyze the constitutionality of PEC 12.

Estimate: Voting session could take place as early as in the first semester of 2009, depending on interests alignment among political parties

Amendments: In case further amendments are proposed by the representatives, the PEC would have to be re-approved at the Senate level

Social Claims: The society, associations (e.g. Brazilian Bar) and precatório holders have manifested their repudiation to PEC 12 and a social claim has been raised

Political Environment: Presidential and state governors elections in 2010 increase political pressure over the PEC, which might end up being used as a trade currency

2. Analysis - PEC-12 – The Proposed Default

2.1. Background and current status

Effectiveness: Immediate effectiveness, encompassing all outstanding precatórios and derived lawsuits (alimony, ordinary, installments etc)

Special Regimes: States and municipalities have 2 alternatives to pay precatório debts (“Special Regimes”):

– (A) Mandatory annual deposits of amounts equivalent to certain fixed percentages of current revenues according to relative precatório indebtedness at the time of the approval of the PEC (please refer to the next slide for further detail)

– (B) Linear yearly amortizations in order to zero the inventory in up to 15 years

Seizure remedy: Seizure route limited to breach of mandatory payments established in (A) or (B)

Tax compensation: Possibility of tax compensation limited to original holders of the precatório (assignees can’t benefit from this aspect, thus impairing current “liquidity” of the market for that purpose)

MAIN CHANGES AND CHARACTERISTICS OF THE PROPOSED NEW REGIME

MAIN CHANGES AND CHARACTERISTICS OF THE PROPOSED NEW REGIME

Offset by Public Debtors: Public debtors are allowed to offset precatório payments with tax liabilities from original holders of the precatório, regardless of potential assignments occurred since issuance

Percentages: Caveat for possibility of review of %s determined in (A) through a law (“Lei Complementar”), thus avoiding the requirement for a new PEC in case public entities decide to change the mechanisms again

Adjustment Rates: Precatórios, including the federal ones, shall be adjusted by official rates applicable over savings deposit accounts (TR of ~ 1.5% + 6.0% p.a., non-compounded), as opposed to inflation rates (~ 4.5%) + interest rates (6% or 12%), which are currently in force

– The Public State charges SELIC (~10%) for tax credits not paid by citizens and companies doing business in Brazil


2.2 Principal Aspects

Payment Mechanism Proposed by the PEC 12 – Alternative A

60% of remainder(reverse auction)

1st Priority Creditors

(over 60-yrs holders)

40% of remainder

(size order)

Annual Current

Revenues

Amount Allocated

to Pay Precatórios

States:0.6% to 2.0% (1)

Munic.:0.6% to 1.5% (1)

Payment Breakdown

Priority to individuals older than 60 years

30 minimum wages per person for municipal precatórios

40 minimum wages per person for state precatórios

Should drain majority of earmarked resources during first 2-3 years

Auctions to be regulated by the CVM (Brazilian SEC) and/or the Central Bank

Auctions according to proposed haircut by the precatório holders

Possible caps on amortized amounts per single precatório owner

Payment of precatórios according to their size

Smaller precatórios will be paid first, at face value

____________________(1) Brackets in accordance with relative precatório indebtedness as a % of current annual revenues at the time of the approval of the PEC: + States: < 10% = 0.6% | 10% - 15% = 0.8% | 15% - 35% = 1.5% | > 35% = 2.0% + Municipalities: < 10% = 0.6% | 10% - 15% = 0.8% | 15% - 35% = 1.0% | > 35% = 1.5%


2.3 Summary of the Special Regimes

HISTORICAL FIGURES AND MAIN ASSUMPTIONS


KEY TAKEAWAYS – THE EVIDENCE OF THE LACK OF PLANNING

Municipality of SP

– 1.5% applicable earmarked does not even pay for the accruals on existing inventory (assuming new accrual rates)

– Net redemptions would begin only in 2022, due to the 7.5% Compounded Annual Growth Rate assumed

– Full amortization would take over 25 years assuming 50% average discounts in the auctionsState of São Paulo

– Healthy financial condition does not justify implementation of a new moratorium, as the state has been paying over 2.0% of the RCL in recent years

– Full redemption of the inventory in ~ 10 years

(R$ bn)

Historical Data Assumptions

Public Debtor

2008 Net Current Revenues

(RCL)RCL CAGR2004 - 2008

Inventory of Precatórios

(I) I / RCL

Applicable PEC-12

% of RCL

Theoretical 2008 Earmarked Proceeds

2008 Actual Precatório Payments

Average Auction

Discount

New Precatórios Issued p.a.

RCL Future CAGR

State of Rio de Janeiro 26.7 6.1% 2.3 8.8% 0.60% 0.16 N.A. 50.0% 0.275 2.0%

State of São Paulo 83.2 13.3% 16.3 19.6% 1.50% 1.25 1.78 50.0% 0.350 6.5%

Municipality of São Paulo 20.6 13.4% 9.6 46.6% 1.50% 0.31 0.42 50.0% 0.300 7.5%

Source: Public entities' treasuries and certain estimates.

2.4 Financial Analysis – São Paulo and Rio de Janeiro

PEC 12 may be challenged in the Supreme Court, as it may be deemed as unconstitutional in accordance with the following arguments:

UNCONSTITUTIONALITY OF THE PEC 12

Vested Rights. PEC 12 would violate vested rights (“direito adquirido”) of the precatórios’ holders as they have the right to be submitted to the rules established at the date of the relevant issuance, not subject to retroactive effects

Unchangeable and Final Decisions. PEC 12 would violate final judicial decisions (“res judicata”), which may not be changed by any further amendment to the federal Constitution (ultimately this may be deemed as a violation of the separation of powers and autonomy of the judiciary system)

Legal Uncertainty. PEC 12 is the third substantial change to the rules applied to the payment of Precatórios since promulgation of the Federal Constitution (1988), which would be deemed as violation of the principle of legal certainty (“segurança jurídica”)

Chronological Order. The auctioning process established in PEC 12 may be deemed as disrespecting a basic constitutional rule regarding public debts, which guarantees preference for creditors in accordance with the order of presentation of the relevant Precatórios (first come, first serve basis), which may be construed as an individual guarantee against the State, being considered as an unchangeable clause (“cláusula pétrea”)

Confiscation by the State: PEC 12 shall institute an expropriation of rights without fair indemnification, as it shall (a) reduce the interests and monetary adjustment of Precatórios; (b) extend for an indefinite time the payment of past due Precatórios; (c) exclude certain remedies and guarantees (such as seizure and tax compensation); (d) restrict the ability and free will of the holders to negotiate and assign their credits and (e) oblige and impose to the holders a forced discount to participate into the auctions where there is only one bidder (the own debtor of the credits)

2.5. Conclusion from a Legal Perspective


PEC 12 seems to be infeasible and inconsistent from a practical point of view:

INFEASIBILITY OF THE PEC 12

2.6. Conclusions from a Practical Perspective


Deadline. Payment through alternative A has no determined deadline, allowing for extremely long terms coupled with low adjustment rates, amounting to a default in all aspects. Simple projections and simulations indicate infeasibility of the proposal, with expected terms in excess of 30 yearsOriginal Creditors Liabilities. Offsetting of tax liabilities against original creditors dramatically impairs liquidity of the market, avoiding future assignments and raising several issues regarding those already performedFurther Changes in the Rules. Possibility of future changes on the rules through Lei Complementar creates an unstable political environment, with reduced predictability, representing a possible incentive for public entities to breach existing contracts, originating new precatórios Pending regulation. Enforceability of auction mechanism depends on complex and sensitive rules to be implemented by the CVM and/or the Central Bank, which may demand several discussions and take considerable timeFederal Precatórios. Inclusion of federal precatórios disrespects original purpose of the PEC (poor financial condition of States/Municipalities), creating a dangerous precedent for future discussionsMonetary Adjustments. New accruals according to savings deposit rates bring massive losses to creditors and are totally decoupled from rates applied with public entities as creditorsFormation of the Prices in the Auctions. Holders of old, sizeable precatórios will have to match ask prices from holders of recently issued precatórios if they want to monetize their assets in a more timely fashionFuture Outcomes in Contractual Area. Private companies engaged in public services would have severe losses arising from future precatórios to be issued. Risk in contracting with Public Entities (and the direct and indirect costs to the Government in connection therewith) shall increase



III. The Precatório Market



3. The Precatorio Market

Background

FIDCs

The precatorio market has been a field mainly practiced by lawyers involved in the lawsuits, as clients constantly offered their portion to be purchased for a huge discount.

More recently, banks and companies have envisaged business opportunities in precatórios, either holding them up to maturity or using them for tax compensation.

Players focused in Federal Precatórios, but certain players have also acquired State and Municipal Precatórios (specially from SP)

Current Main Players

Banks

Investment funds (FIDCs), including onshore and offshore investors

Companies using for tax compensation (i.e. VAT and income tax)

Tax and accounting benefits

Subordination mechanism

Bankruptcy remote structure (securitization type of transaction)

Liquidity of the quotas

Others

3.1. General Overview

3.1. General Overview (cont.)

Legal Grounds

Homologation and Judicial

Communication

Art. 78 of the ADCT (included in the Federal Constitution in 2000) has expressly allowed the assignment of the Ordinary Precatórios (alimony was not mentioned). Section 42, I and 567, II of the Civil Procedure Code allows the assignment of any judicial credit

Precedents in Higher Courts

Partial Assignment was allowed

Due Diligence

Purchasers were encouraged to carry out an in-depth due diligence into the financial and legal status of the Seller and over the Precatório

Main Goal: To avoid risk of fraud against creditors and any procedural flaw that could impair the payment of the Precatórios

Players (a) requested judicial homologation of the assignment and (b) communicated to the Public Debtors

Payments are made direclty to the judicial account and holder of the peractório is able to withdraw the proceeds directly in Court

Sellers granted an irrevocable power-of-attorney to allow the Purchaser to act in their name in Court if necessary


3.2. Illustration of a Typical Transaction

Public Debtors

FIDC

Seller

Judicial Account

Investors

Negotiation of thePrecatório

Issuance of quotas

$

Payment of Precatório

$

$Communication and Homlogationof the Assignment

1. Purchaser and Seller negotiate the Precatório

2. Purchaser sets up a FIDC and pay in quotas

3. FIDC acquires the Precatório from Seller (subordination mechanism may be instituted, as Seller may sell a portion and grant the remaining portion of the Precatório and receive subordinated quotas)

4. FIDC requires homologation of the assignment and communicates transfer of the Precatório

5. Public debtor pays the Precatório6. FIDC withdraws the money directly

in Court7. If payment is not made, then FIDC

shall file a seizure claim.

Trading Steps

11

22

44

55

33

Sale of the Precatório

$

66





IV. PEC 12 and its impacts on Precatório Investors


4. PEC-12 and its Impacts on Precatorio Investors

Major Impacts

Investors shall have their rights violated, such as vested rights, chronological order, confiscation, violation of the final judicial decisions etc.

Legal Uncertainty may cause a reduction into the current market of credits arising from Brazilian public entities

Violation of Constitutional

Rights

Internal Default

Judicial and Political risk increases perception of Brazilian risk for foreign investors

Federal Government accounting policies do not properly mention the debts related to Precatórios

Reputational Risk

Potential Adverse Effect to Brazil credit rating abroad

Investment Grade and other transparency policies shall be reviewed for all Brazilian internal public entities by rating agencies





V. Alternatives to PEC 12

5. Alternatives to PEC-12

ALTERNATIVES SHOULD MAINTAIN THE CHRONOLOGICAL ORDER AND DO NOT VIOLATE CONSOLIDATED CONSTITUTIONAL PRINCIPLES

PARTCIPATION OF FEDERAL GOVERNMENT IS A KEY POINT

Past-Due Tax Debts – “dívida atíva” and tax reschedulements (“parcelamentos”)

Legal Procedure allowing the payment of tax debts in an faster and administrative level (e.g. Minas Gerais State etc.)

Tax Compensation

Issuance of Debt

Instruments

Bonds/Notes issued by States and Municipalities backed by Federal Government

Proceeds from these bonds must be earmarked for payment of Precatórios

Stimulus to liquidity in the secondary market, allowing public financial entities (BNDES, CEF, Banco do Brasil, etc.) to distribute bonds originally underwritten to 3rd party investors - minimum default against CEF/ BB/ BNDES financings

Precatorio Funds

Mutually agreed reschedulements in exchange for stronger guarantees and more predictability

Precatorio funds could negotiage tenor extensions for Precatorios and be benefited by guarantees from the Federal Government; constitutional tax allocation and past-due tax debts

5.1. Potential Alternatives


5.2. Illustration of Precatorio Fund

Fund (e.g. FIDC) managed by a Federal Entity

Senior Investors

State XYZ(as Subordinated

Quotaholder)

Past-due or uncollected tax receivables or other assets to serveas liquidity cushion

$$

Original PrecatorioHolders

$$$

Sale of precatorios at mutually agreed discount

Internal and bilateral negotiation of tenor extensions/ reschedulements in consideration for stronger payment guarantees and predictability

Tax Debtors

$$

Principal + market interest (fixed rate)

$$

Residual return

Federal Government

Guarantee of Payment

State XYZ(as precatorio

debtor)

Positive Outcomes

No unilateral default, moratorium or breach of vested rights

Market oriented solution: precatorio holders would have an alternative for immediate monetization at reduced discounts, while institutional investors would have an alternative for long term investment (guaranteed by Federal Government) May extract value from past due taxes

May provide great relief to public debtors through negotiated tenor extension

More transparency in the public accounting, as the Fund shall be publicly managed by a Federal entity (Banco do Brasil, CEF etc.) and shall be supervised by Brazilian SEC


5.3. Illustration of Issuance of Public Bonds

Federal Entity

Senior Investors

$$

Original PrecatorioHolders

$$$

Payment of Precatórios

Assignment of the Precatorios Debt and internal renegotiation of the outstanding amount with the Federal Government

Long Term Secured Bonds

Federal Government

State XYZ(as precatorio

debtor)

Positive Outcomes

No unilateral default, moratorium or breach of vested rights

Precatorio holders shall be immediately paid

Federal Government would settle public internal accounting flaws

Market for the public bonds issued by Federal Entity

Federal Government has bargaining power to negotiate with States and Municipalities (i.e. freezing the allocation of tax revenues etc.)

Positive social and political impacts

Guaranteeof Payment

Law creatingthe FederalEntity

José Virgílio Lopes Enei

[email protected]

5511.3150-7041

w w w . m m s o . c o m . b r

São PauloTel.: (11) 3150-7000Fax: (11) [email protected]

BrasíliaTel.: (61) 2104-5550 Fax: (61) 2104-5580

[email protected]

Rio de JaneiroTel.: (21) 2253-9141Fax: (21) 2253-6143

[email protected]

SalvadorTel.: (71) 3339-1400Fax: (71) 3337-0441

[email protected]

NiteróiTel.: (21) 2199-9000Fax: (21) 2199-9016

[email protected]

Porto AlegreTel.: (51) 3325-8000Fax: (51) 3325-8028

[email protected]

Belo HorizonteTel.: (31) 3264-0630Fax: (31) [email protected]

New YorkTel.: 1 (212) 784-8802Fax: 1 (212) [email protected]

FortalezaTel.: (85) 3249-7000Fax: (85) 3262-0441

[email protected]

May 14, 2009 Brazilian-American Chamber of Commerce Creditors’ Rights in Brazil after PEC-12...

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