Challenging times ahead for Brazilian companies and investors

Brazil has been the single largest recipient of foreign direct investment in Latin America for some time due to its size (7^th largest economy and 2^nd biggest population in the western hemisphere), its wealth of natural resources, and relative political stability. Most investments in Brazil provide investors with an attractive return, but some do not. Brazil can present challenges for investors, especially those not familiar with the challenges of “custo brasil” (i.e., high cost of doing business in Brazil) or its unique business environment. Brazilian musician and composer Tom Jobim once said “Brazil is not for beginners” and this is especially true in business.  We often receive calls from foreign investors who face challenges in managing an underperforming investment in Brazil and don’t understand what can be done to fix the problem.

There are several options to assess when this happens.  Depending on the situation, it may be possible to improve profitability through out-of-court restructuring actions. In more challenging situations, the company may need to pursue an in-court restructuring process. Brazil has in-court restructuring options focused on returning a company to profitability, which are broadly similar to a US style chapter 11 process.

In more distressed situations, however, an investor may simply be focused on understanding the best way to exit the investment. Over the years we have worked with companies, equity investors, lenders and other stakeholders from the US, Europe, and Asia to help them assess how best to wind down the operations of an underperforming investment in Brazil. Often, these projects are initiated once a sales process has proven to be unsuccessful and the investor is interested in finding a graceful way to move on.

Wind-down options
Simply abandoning an investment in Brazil is not a realistic option given the possible liabilities that may exist for the investor or the parent company’s directors and officers. Typically, investors are looking at two options: an out-of-court process and an in-court process. 

Brazil has two main in-court restructuring/insolvency proceedings: one focused on returning a company to profitability called “recuperação judicial” (judicial reorganization) and another focused on terminating a company’s business activities, when the company is no longer economically viable, called “falência” (liquidation). While there are some important differences, a judicial reorganization is similar to a Chapter 11 process while an insolvency is similar to a Chapter 7 process.

For the purpose of this article, we will only emphasize the “falência” (liquidation) process, in which all assets from the company are collected and sold to settle creditor claims. This proceeding can be beneficial as it allows companies to wind down operations in an orderly and legally protected manner overseen by a judge and a Judicial Administrator. However, a falência process can be time consuming (although recent bankruptcy code amendments capped the asset sales process at six months). More importantly, it strips control from the shareholders and assigns it to the Judicial Administrator appointed by the Court. The Judicial Administrator is responsible for representing the liquidating company and managing the process of monetizing its assets and settling its claims. In some cases, existing ownership may need to inject additional funds to complete the falência process.

The out-of-court wind-down process in Brazil is often preferable as it allows the investor to remain in control and negotiate directly with the creditors. The investor can assess options and settle on a mix of strategic actions that allows it to minimize exit costs by pursuing ordinary course asset sales, managing severance costs, settling tax liabilities, protecting global vendor relationships, and avoiding the administrative costs of a “falência” (liquidation) process (including the fees of the Judicial Administrator). 

What to consider
When looking to wind down an investment in Brazil, there are several topics that need to be considered: 

• Labor: Terminating employee relationships can be time consuming and challenging with severance costs often exceeding expectations due to complex labor laws that have historically favored employees (with dedicated courts for labor claims) and strong unions covering ~10% of the workforce despite (although notably down from more than 15% in 2012).
• Taxes: Brazil’s tax system is consistently ranked as one of the least business-friendly tax regimes in the world due to its high-rates and complex code; most companies carry extensive tax liabilities on their books that will need to be resolved before a wind-down can be completed.
• Government: Local, state, and federal governments are active in regulating and incentivizing businesses to expand operations and follow established policies; when exiting an investment some incentives may be unwound and result in springing liabilities.
• Liability transfer: Selected liabilities (labor, tax, secured debt, etc.), if not settled prior to exiting, may transfer to directors and officers, shareholders, or related entities. Therefore, the full exposure needs to be understood and accounted for.
• Protect global relationships: Global relationships with vendors, customers, lenders, and others can be disrupted by winding down operations in Brazil if not thoughtfully planned and coordinated.
• Communication: Keeping key parts of the wind-down plan confidential can be hard given the typically close relationships amongst employees, consultants, and other professionals; we often see that rumors can quickly and negatively impact a wind-down process.

Each of these challenges needs to be understood and planned for as part of the upfront due diligence to assess wind-down options.

How to be effective
Our experience working with investors looking to exit underperforming investments in Brazil has taught us that the process is most effective when we follow the following generalized steps:

• Establish a project management office (PMO) to plan and execute wind-down activities while providing regular status reports to track progress.
• Create functional focus areas to address areas of concern (e.g., labor, tax, etc.), each with a taskforce of SMEs and clear responsibilities.
• Conduct deep due diligence to properly understand the full scope of liabilities (existing and contingent) as well as market value of assets (tangible and intangible) with the focus on the expected cash impact.
• Include external support from selected SMEs such as legal counsel for labor and tax issues, real estate advisors, etc.
• Develop recommendations with a robust and flexible exit plan that includes estimated costs, timeline and complexity to implement.
• Maintain confidentiality of process through a controlled communication site and established rules; also have a strong leak plan to identify, respond to, and manage possible leaks.
   

Conclusion
Foreign investors looking to exit investments in Brazil can take steps to do so in an effective and cost-efficient way by understanding and addressing the unique challenges that exist. Working closely with advisors to minimize liabilities and maximize recoveries, while mitigating the spillover effect to other operations, can allow the stakeholder to reset and effectively exit underperforming operations.

A special thank you to Liv Machado and Sofia Nielsen for their thoughtful contributions.