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02 December 2009
One of the innovations of the Brazilian Bankruptcy Law was to allow airlines to seek bankruptcy restructuring protection. Previously, airlines were prohibited from seeking judicial protection from creditors through the former bankruptcy procedure. Since the law entered into force in 2005, five Brazilian airlines - Varig, VASP, BRA, Pantanal and VarigLog - have sought judicial protection to allow for restructuring. In Brazil, restructuring procedures are called 'judicial recuperation'. The procedures have some parallels with US Chapter 11 proceedings; however, there are many fundamental differences between a Brazilian judicial recuperation case and a US Chapter 11 proceeding.
Two judicial recuperation cases - Varig and VarigLog - produced precedents that threaten the exercise of creditor voting rights. This update addresses these voting right issues as they recently arose in the VarigLog Case. The VarigLog Case also raises other issues such as preferential treatment of certain creditors in restructuring plans and requirements for approval of transfers of control. Further, despite the similarity in names and the fact that VarigLog was once a subsidiary of Varig, the two cases are distinct.
The Bankruptcy Law sets forth rules for voting at creditors' meetings (also called 'creditors' assemblies'). Creditors vote in three distinct classes: labour, secured and unsecured. In the labour class, vote tallies are calculated on a 'per-head' basis only. In the secured and unsecured creditor classes, tallies are taken both on a per-head basis and on a weighted basis, taking into account the value of each creditor's claim. To be approved, a restructuring plan must be approved by simple majority of all three classes present at an assembly. In case of the secured and unsecured classes, approval must be obtained in both tallies (ie, per creditor and by weighted value). In cases where a debtor has fewer than three classes, approval of the remaining classes is required.
The Bankruptcy Law contains provisions that allow the bankruptcy court to override creditor rejection of a proposed plan. These provisions, sometimes compared to the 'cram-down' provisions of the US Bankruptcy Code, were at the centre of the controversy in the VarigLog proceedings. The Bankruptcy Law allows a court to approve a proposed plan judicially, provided that each of the following tests is met:
In addition, the law provides that a court may approve a plan using the criteria above only if "the plan does not include differentiated treatment to the class of creditors that rejected the plan".
According to the Bankruptcy Law, a debtor must propose a restructuring plan and its creditors must meet to vote on the plan within 150 days of the date on which the debtor filed for protection. If such approval is not obtained, the court is supposed to declare the debtor bankrupt and commence liquidation proceedins. The language of the Bankruptcy Law that establishes these basic principles is relatively simple and straightforward.
In March 2009 Brazilian cargo carrier VarigLog sought judicial recuperation protection. In the bankruptcy proceedings there were two classes of creditor: labour and unsecured. VarigLog had no secured creditors when it filed for protection. The creditors' assembly that was convened to vote on VarigLog's restructuring plan was held on September 23 2009 (after being commenced and postponed on two occasions). In the days and hours leading up to the meeting, several creditors proposed changes to VarigLog's plan, some of which the airline accepted. However, no fundamental alterations were made.
For unsecured creditors, the plan rescheduled 15% of the face value of indebtedness, without interest, with monthly payments commencing in 2012 and ending in 2022. The remaining 85% of the debt would be paid from earnings before interest, tax, depreciation and amortization (EBITDA), provided that the airline generated EBITDA above certain projected levels. Only 35% of the excess generated in the years 2013 to 2016 would be allocated to unsecured debt repayment. Debt remaining unpaid after 2016 would be due in a bullet payment in 2052 (with no interest). In short, the intent of the plan was that 15% of the unsecured indebtedness be repaid without interest in five years after a grace period of three years, and that the remainder of the debt be repaid only from a portion of excess EBITDA during a five-year period commencing four years after the plan's approval. Unsurprisingly, many of the unsecured creditors found these terms to be unacceptable. The plan provided for labour creditors to receive 100% of their claims within one year.
At the September 23 2009 creditors' assembly the labour class unanimously approved the plan, while the unsecured class rejected the plan. Of the three-prong test mentioned above, the second and third parts were met; however, the first part was clearly not met. When considering the values of the claims of creditors present at the meeting, the plan was rejected by approximately 60% of creditors. Therefore, the court, by the simple language of the law, should have declared VarigLog bankrupt and commenced liquidation proceedings. Instead, however, on October 5 2009 the court ruled that the plan was approved under the special powers mentioned above, even though one of the necessary tests (ie, approval of at least half the creditors present) was clearly missing.
The decision emphasizes the social value of keeping companies afloat and retaining job posts. However, the court justified its decision with several other arguments that create doubts about creditors' voting rights. First, it questioned the motives of one of the major creditors that, in addition to being a creditor of VarigLog, indirectly owns an equity position in a carrier that is one of VarigLog's competitors. Then it questioned the motives of the aircraft and engine lessors that rejected the plan. According to the court's decision, there were "strange nuances" in the lessors' votes, in part because the lessors were separately arguing that claims arising under aircraft and engine leases are exempt from the terms of restructuring plans based on a different provision of the Bankruptcy Law. The court held that it was inconsistent for a lessor on the one hand to argue that it was not subject to the plan and, on the other hand, to vote against the plan. It ignored the fact that it had not yet ruled on the lessor petitions requesting exclusion from the plan, so as of the date of the creditors' assembly, the lessors' claims - as far as they knew - were still subject to the terms of the proposed plan. In the case of a fuel supplier that voted against the plan, the court held that the supplier had demanded an exclusive fuel-supply agreement, and that this demand tainted its vote. Based on these arguments, the bankruptcy court decided that these creditors had "abused" their voting rights. Therefore, the court essentially annulled the votes and declared the plan approved.
This decision demonstrates the extreme lengths to which Brazilian bankruptcy courts will go to preserve restructuring companies, particularly airlines. In the face of a clear failure to meet a statutory test, the court decided to ignore the provisions of the law and the legislative intent, and to issue a ruling exercising an authority that it may not have. Three years ago, in the Varig Case, a different court also went to considerable lengths to declare a proposed restructuring plan approved, despite shareholder rejection. In that case a court determined that a lessor that had leased aircraft through several special purpose vehicles should be counted as a single vote in the per-head voting tally.
These decisions create doubts about the ability of creditors to exercise freely their right to vote. In some passages of its decision the VarigLog court implied that there was no valid reason why a creditor might reject the plan. It accepted that VarigLog, an airline that by its own admission had lost over $60 million in operations over the previous two years, would magically recover under new management. It did not for a moment consider that a creditor might be dissatisfied with a restructuring plan that rescheduled 15% of unsecured debt and left the remainder payable under extraordinary circumstances. Unfortunately, the message that this decision sends to the airline community is that draconian restructuring plans can be judicially approved in the blind interest of 'saving the company'.
However, not all of the news surrounding this case is bad for aircraft lessors. First, the bankruptcy court's decision may be reversed on appeal. At present, approximately 12 appeals have been made against the decision. On a temporary basis, an appeals court judge has suspended the bankruptcy court's approval. In addition, although this update does not address repossession rights, lessors should know that the VarigLog Case, together with the BRA proceeding, solidified lessor rights to repossession of leased aircraft from restructuring airlines. The risks highlighted by the VarigLog Case relate to repayment of pre-petition debt; however, repossession rights are fairly strong in Brazil under the Bankruptcy Law. In the coming weeks and months, after appeals have been decided on the merits, the Brazilian judiciary will reveal the lengths to which it will go to save failing airlines.
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