Brazil—A Complex Land of Opportunity
An overview of the challenge and promise this major developing economy holds for international ABL
Date july 2016
Featured in The Secured Lender
In June, Gordon Brothers announced that it entered the Brazilian market with the appointment of key Sao Paulo-based operational leaders and a strategic investment in a local appraisal business. Here, Rafael Klotz and Alfredo Finotti, who are spearheading the firm’s entrance, elaborate on the challenges and opportunities of the Brazilian ABL market, even amidst economic instability and the exit of many international players from the Brazilian business community.
Political turmoil, government corruption scandals, double-digit inflation, shrinking GDP, a Kafkian regulatory and tax environment and… a benchmark equity index that rose 23 percent from January to May 2016. That one sentence encapsulates the dichotomy of Brazil: complexity, risk and infinite opportunity. Brazil is the largest economy in Latin America, and the ninth largest economy in the world (ahead of Canada, Korea and Russia). It has vast agricultural and mineral resources and one of the largest unexplored offshore oilfields on the planet. While poverty in Brazil is high, the country also boasts a large, highly-educated workforce, with sophisticated legal, financial and cultural institutions. This notwithstanding, Brazil’s unemployment is higher than 11%. GDP shrunk by 5.9% in 2015, the worst annual performance since 1991. Its president has been temporarily suspended from office pending a final decision of an impeachment process. By some press reports, 60% of current members of the Senate have legal cases pending against them, with charges ranging from bribery to money laundering. The Wall Street Journal recently cited a World Bank report which ranks Brazil 174th in the world for ease of starting a business, behind Uganda and Djibouti.
Despite all of this, Brazil is a market that is hard to avoid for any firm engaged in international commerce. Its considerable market size, and, in relative terms, direct ocean routes to trading partners in the US and Europe, makes it an attractive target for many companies that need to expand globally. Even for US and European-based secured lenders with no direct business in the country, it is likely that at some point they will need to contend with valuable collateral located in or generated from (in the case of receivables or cash) Brazil. Excluding a borrower’s Brazilian operations and assets from the facility would be the easiest path to risk mitigation. However, an understanding of the cultural, regulatory and legal aspects of doing business in Brazil may enhance a lender’s willingness to include assets located in the country and, as a consequence, provide valuable liquidity to customers while enabling the lender to benefit from an otherwise unavailable opportunity.
This article provides a very brief overview of Brazil’s recent political and economic history – which is essential to understanding the local business environment – and some general concepts of interest to the lending community to guide investment in the country.
A Brief Primer on Brazil - The Last 20 Years
Brazil’s recent economic history is marked by the fits and starts of many nascent global economies as the country’s systems adapt to support its growing scale. Beginning in the 1980’s, Brazil pursued several stabilization plans and multiple currency changes to reduce inflation and foster development. Only after the implementation of the Real Plan in 1994, however, did this actually occur. While the Plan initially involved a fixed exchange rate, it gradually migrated to a three pillar system based on inflation targeting, floating currency, and fiscal responsibility. Significant reforms to financial legislation and economic regulations since that time allowed for greater participation of private players and improved investment. Infrastructure received a boost, with privatizations and concessions of railways, highways, ports and electricity distribution networks. As a result, foreign direct investment jumped from US $16.2 billion throughout the 1980s to US $131 billion through the 1990s, up to US $255.3 billion in the following decade.
Beginning in 1995 under President Fernando Henrique Cardoso, a series of developments took place that included the ultimate stemming of hyperinflation, which benefitted the worst-off segments of the population; an increase in the literacy rate; a reduction in infant mortality; and redistribution of land. The state apparatus in many respects experienced genuine modernization during this time, leaving it less opaque and more efficient. Levels of corruption fell and tighter budget controls were implemented. While these advancements did little to boost the Brazilian economy at the time, Cardoso’s policies brought stability to the country and prepared it for a period of significant growth.
Luis Inacio Lula da Silva, President from 2003 to 2010, inherited those effective macroeconomic policies and was clever enough to ride that wave. During his term, roughly 20 million Brazilians emerged from poverty and participated in the economy as consumers of goods and services ranging from cars to cookware and everything in between. This activity was supplemented by export demand from China for iron ore, meat, soy, etc. All told, this moment in history is often cited by experts as defining the apex of recent economic development for the country. However, after his reelection in 2006 despite a vote buying scandal, da Silva’s administration strayed from its commitment to fiscal rectitude. He expanded state control of the economy and increased spending in 2008. While this spending shortened the length of the Brazilian recession, it excluded investment in infrastructure and failed to fully reverse the economic decline.
In 2010, Dilma Rousseff, was elected as Brazil’s first female president. Three years later, the first demonstrations against the corruption of public officers began. With the so-called “Operation Car Wash” scandal, a corruption and money laundering investigation of public officials by the Federal Police of Brazil, public indignation mounted to record levels. A sustained economic downturn quickly ensued as a result of unfavorable fiscal and monetary policies and continuous microeconomic interventionism throughout Rousseff’s first term. In May 2016, the Brazilian congress overwhelmingly approved an impeachment process and she was suspended from her presidential duties pending the outcome of the proceedings. Vice President, Michel Temer, assumed the post.
While the economy has certainly experienced its ups and downs over the past 20 years, the most profound result has been the development of a solid substructure to support the long-term growth of the Brazilian economy. While many investors have fled the country following recent political instability and economic decline, the underlying promise of the market for investors and operators with access to vast natural resources and a highly literate workforce is compelling—and one of the reasons Gordon Brothers has chosen to enter the market at this time. While the financial infrastructure for asset-based lenders in still in development, the potential of the market is astounding.
The Brazilian Environment for ABLs
Today Brazil boasts a very large and sophisticated banking system. Secured lending is well developed with respect to tangible assets such as real estate, machinery and equipment, and receivables. However, asset based lending against movable assets (such as retail inventory) does not resemble established practices in the US or UK and in this respect, lenders should give consideration to some of the jurisdictional differences in Brazil.
While it is not uncommon for lenders to obtain a pledge of all of a borrower’s assets – and there are legal mechanisms to create and perfect security interests in any type of assets – there is no concept of a US security interest on after-acquired property or a UK floating charge under Brazilian law. In fact, each item of collateral must be specifically identified, which makes perfecting and enforcing a security interest in, for example, after-acquired retail inventory feasible in theory, but practically impossible. As a result, banks seeking to provide working capital financing to borrowers such as retailers must rely on their borrowers’ cash flow, fixed assets, or significant corporate guarantees, and many such retailers must also resort to receivables factoring to fund their operating cash needs.
Significant regulatory differences also merit special scrutiny as well. While any private party is legally entitled to make loans in Brazil, only financial institutions can lend above certain rates. Under existing regulations and well established jurisprudence, non-financial institutions receiving interest above 12% per annum will be deemed to be charging usury rates. If the borrower disputes pricing during enforcement, the applicable rate will be reduced to the maximum allowed by law to non-financial institutions. While 12% today is certainly above many Libor-based secured loans in northern hemisphere jurisdictions, it is well below the 14.25% Brazilian central bank rate (as of the writing of this article) and the rates many regulated banks charge their customers. Moreover, pricing below 12% will, in most instances, not compensate a US or UK lender for the level of jurisdictional and legal risk it would assume in lending against collateral in Brazil.
In terms of enforceability, lenders in countries like the US or UK underwrite loans on the basis of a generally well-established set of rules and precedent. This provides lenders with a fair degree of certainty in regards to the treatment of their loan facilities in the event of their borrower’s insolvency. For example, although the concept of a retail liquidation sale is not explicitly addressed in the US bankruptcy code, bankruptcy courts across the US have adopted generally accepted principles regarding the disposition of pledged retail inventory through store closings or going out of business sales. This affords lenders the level of comfort necessary to provide significant liquidity against retail inventory in the US. Similarly, lender-appointed insolvency administrators in the UK have significant leeway to conduct a sale process that maximizes value to creditors while respecting a secured lender’s first priority rank. There is no such certainty in Brazilian insolvency.
Brazil enacted a new bankruptcy law in 2005, which was modelled after chapter 11 in the US and was intended to modernize the insolvency regime in the country. The law even includes the concept of debtor-in-possession (DIP) financing. However, only a handful of DIP loans – mainly in mega cases – have been made in Brazilian reorganization cases since the law went into effect. Security interests and priority are generally respected in insolvency, but the path to enforcement is fraught with delays and detours. While this may be an acceptable risk with respect to some types of collateral, it is not when it comes to floating liens on assets like inventory or intellectual property such as consumer brands, which may be damaged by extended insolvency proceedings.
While the Brazilian financial industry is sophisticated, differences in legal structures, regulations and enforceability demand special consideration for any loan that includes collateral in Brazil. The market is rife with opportunity and the long-term growth story is a compelling one. But it requires careful analysis and advice from experienced local practitioners to navigate this new territory that is still being explored today.