Bringing recovery and investment together: regulating “DIP financing”
The Brazilian Business Insolvency Act reform, which is in an advanced stage of analysis before the National Congress, is about to enact new rules regarding “debtor-in-possession” (DIP) financing. The economic scenario is conducive to this reform: the increasing number of companies filing for judicial recovery (in part due to the COVID-19-driven crisis), the lowest base interest rate in Brazil’s history, and the appreciated foreign exchange rate may create the “perfect storm” to encourage financing into such companies.
While the Business Insolvency Act allows DIP financing, it does not offer detailed rules on this kind of funding. According to the current legal regime, credits arising from obligations undertaken during the judicial recovery procedure are classified as out-of-court (“extraconcursais”) and have a general priority over prepetition credits. Although this priority offers some protection to creditors, it benefits DIP financing only if and when bankruptcy is declared, having no practical effect while financed companies are still under judicial recovery procedures. Furthermore, the priority is not absolute, as other credits outside the bankruptcy proceeding shall be paid first. Despite the limited protection, a few DIP financing transactions have taken place in Brazil in recent years, suggesting that there is investor appetite for this type of transaction.
Means for recovery currently allowed by Brazilian law may not be enough or feasible in certain cases to protect the company from bankruptcy. From the debtor’s perspective, access to new money is almost always essential to overcome judicial recovery.
This is the rationale underlying the reform. The new rules under analysis grant credits arising from DIP financing loans the status of privileged credits, ranking lower only than labor-related credits, which, by their turn, shall be limited to a certain amount for this scope if the reform passes.
Although the precedence of labor-related credits is in line with the workers’ protection principle provided by Brazilian laws, it increases the costs of DIP financing, potentially making it not feasible, thus jeopardizing the company’s survival and the very chances of employees being paid. Granting a “super senior” status to DIP-related credits, as done in some other jurisdictions, is the basis for a modern insolvency system. The existence of a developed DIP financing market in Brazil depends on the assurance of super-priority to post-petition credits both by law and by courts.
As per the proposed reform, DIP financing transactions shall be approved by the general creditors’ meeting after consultation with the creditors’ committee. Means to expedite such approval are still to be designed and might include tools to block groundless delaying measures taken by other creditors, and even prove courts with powers to approve DIP financings in some circumstances.
The new proposed provisions also ensure that, if a DIP financing transaction is challenged by prepetition creditors and the relevant funds have already been disbursed, an appeal ruling cannot alter the privilege assigned to DIP-related credits nor the related guarantees.
The prospective new rules establish that non-current assets of the recovery entity may be encumbered to secure DIP financing transactions, including through fiduciary transfer of assets (“alienação fiduciária”), a guarantee modality that enables faster and out-of-court foreclosure procedures. Such rules also allow for the creation of subordinated security over encumbered assets depending on the type of the original security, which may facilitate funding structures and negotiations by the recovering entity.
Finally, the reform expressly permits any parties to undertake the role of a DIP financing creditor (including prior creditors and the recovering entities’ shareholders or parties related thereto) and of a guarantor and security provider (including the recovering entity and related parties). Claims based on purported conflicts of interests may arise since creditors are usually opposed to increasing control of shareholders over the recovering company. However, the law should not be restrictive in this regard because broad possibilities in this context expand possible sources of financing thus increasing chances of recovery. Therefore, they are a positive development. When judging these kinds of claims, courts should consider whether financing could be obtained on better terms with unrelated parties, and what are the best interests of debtors and creditors.
Certain DIP financing practices admitted by foreign legislations have not been included in the reform, but some of them can be implemented through negotiations between the parties, provided that they are approved by the general creditors’ meeting. One of these possibilities is the “roll-up” of DIP creditors’ prepetition claims, meaning the granting of DIP financing-like priority to pre-existing claims, which may make it more attractive for investors to finance risky companies. Another possibility is the establishment of specific obligations and acceleration events in the DIP-transaction agreement regarding the proper development of the judicial recovery procedure, such as the approval of the recovery plan within a certain deadline.
The reform is a chance to give legal certainty to DIP financings and modernize the Brazilian insolvency regime, by adopting a more efficient and predictable process. It is also an opportunity to implement successful market practices and stimulate the use of broader means to corporate recovery. The time for such an initiative could not be more precise.