Emerging Market Strategies

Strategies Consulting, a firm dedicated to analyzing June 25, 1999

and solving legal and economic problems associated

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Assessment of Legal Risk

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On January 12^th, 1999, Brazil's President, Fernando Henrique Cardoso, had taken refuge from the press in a public restroom at the Rio de Janeiro international airport. He contacted his finance minister on his cellular phone. The minister was ordered to allow the real to float. It lost almost half its value in the coming weeks before bouncing back.

The devaluation of the real was another step in the financial crises that has engulfed the world since Thailand devalued the baht in July 1997. The crises has broken economies, caused recessions and even toppled governments throughout Asia and Russia. But Brazil is different.

The devaluation of the real did not cause double digit GDP contractions or lengthy recessions. Brazil's economy is expected to contract by only 2% this year. Growth is expected to return in the second half. By the year 2000, the economic expansion will continue at a vigorous 4% pace. Inflation, instead of skyrocketing, will remain at a reasonable 10%. Brazil has even been able to return to international capital markets. Its recent five-year 2 billion dollar offering was three times oversubscribed. The price was 675 basis points above US Treasuries, almost half the 1000 basis points required at the time of the real's devaluation.

Unlike Asia, the banks did not collapse. Quite the reverse. Some reported spectacular profits. Bank Itau, Brazil's second largest private sector bank, reported first-quarter net income of 760.6m reals (US$ 429.2m), 159% more in dollar terms than a year earlier. The local branch of J.P. Morgan, increased its first quarter profits 480% more than last year.

In Korea it is estimated that 50,000 firms went bankrupt in 1998. In contrast, the damage in Brazil was quite limited. "In Sao Paulo, the nerve center of the economy, there were 1,035 court-ordered requests in March."⁽¹⁾ This number was an increase on the number of bankruptcies in1998, (982) but it was a decrease from the number of bankruptcies in 1996 (1,455).

Unlike many Asian jurisdictions, Brazil has modern laws regarding secured lending and bankruptcy. Although its origins are in German commercial law, the concept of the fiduciary sale has many of the same features found in US secured transactions law under Article 9 of the Uniform Commercial Code. "Under a fiduciary sale arrangement, title and indirect possession of the asset is vested with the creditor, while the debtor receives direct possession of the collateral during the term of the financing"⁽²⁾ unfortunately, unlike Article 9, fiduciary sales are not available for inventory and financing of fungible goods.

In addition to fiduciary sales, Brazil has seven other methods of secured financing arrangements depending on the type of asset. These arrangements include pledges, mortgages, collateral bonds, warehouse receipts, conditional sales, leases and lease backs and export financing. In contrast in Thailand there are only three types of secured transactions, personal guarantees, mortgages or a physical pledge of a movable asset. To solve this problem, new laws are under consideration.

China's laws are also limited. Recently, China implemented regulations allowing for lending secured by a mortgage on real estate. The regulations are limited to only 188 of the 223 State Council-mandated 'experimental' cities. They are not widely used. Although a state bank could seek the forfeiture of a flat default, they usually do not. The banks are discouraged by the municipal governments, particularly those in smaller cities, because it would add to homelessness.

Brazil's bankruptcy laws provide for both reorganization and insolvency. The law was originally adopted in 1945, and it was updated in 1992. The insolvency or bankruptcy proceedings involve a process that is similar to international and US standards. The process involves a judge and a trustee to identify, recover and liquidate the estate's assets. In addition the trustee identifies and distributes claims against the estate.

The reorganization proceeding is known as a "concordata." There are two types. The first is known as a preventative concordata. The second is a suspensive concordata. Both types are available to debtors who meet certain requirements and can be protested by the creditors.

A preventative concordata is granted to a debtor to allow the debtor to reorganize without declaring bankruptcy. It allows a debtor to pay unsecured creditors a reduced amount. It is available only if the debtor has assets worth more than 50% of its unsecured debts, has not been convicted of a bankruptcy crime, has been in business for more than two years and has not filed for a concordata within the last five years.

A suspensive concordata takes place once an insolvency proceeding has begun. It converts the liquidation process into a reorganization process. Requirements are similar to those of a preventative concordata. It can be elected only by the debtor at least five days before the Trustee's report is due. Under both the preventative and suspensive concordata the debtor retains control of the business. If the debtor fails to comply with the terms of and conditions of the concordata, the liquidation proceedings will be commenced in the case of a preventive concordata or resumed in the case of a suspensive concordata. The 1992 amendments helped to expedite and streamline both procedures.

Like other countries, the problem is not the quality of the laws. The problem is the quality of the legal system. Brazil's legal system is overwhelmed and inefficient. First, there are simply not enough judges. Brazil has one judge for every 23,000 people. In the US the ratio is one judge for every 9,000 people and in Germany there is one judge for every 3,500 citizens.

Second, there has been a massive increase in the amount of litigation. In "1989, 6,622 lawsuits were filed in the Supreme Federal Court ("STF"), while in 1997, the number was 15,385; moreover, by April of this [1998] year, 12,366 lawsuits were filed, doubling the 1989 figure. These numbers were also confirmed by the statistics of the Superior Justice Court ("STJ"), whose workload increased from 6,103 claims filed in 1989 to 96,376 in 1997. By March 1998, these figures had tripled in relation to 1989, when 18,133 claims were filed."⁽³⁾ Cases filed today will not be heard for three years. Since the end of military rule in 1984, Brazil has evolved stronger democratic institutions. It is believed "that democracy and belief in the rule of law can be considered the main reasons for the increase in litigation"⁽⁴⁾

Third, the procedural system is outdated and unproductive. In the US the highest court, the Supreme Court, has discretion over the cases it hears. As a result of the 4,000 appeals received each year, it selects only 350 cases of which over half are decided by a summary opinion. In Brazil, "The Brazilian Supreme Court ("STF") alone judged 29,066 cases in the first six months of 1998, which corresponds to more than one lawsuit per minute in the 114 sessions realized, each of which may last 4 hours."⁽⁵⁾ The massive case load results from the inability of the STF to control its docket and of the lack of the common law tradition of binding precedent. The concept of Binding Summula is under consideration, where each Summula (ruling) determined by the STF would be effectively a binding determination on a particular point of law for all Brazilian Courts.

In addition the system allows multiple and law suits and appeals that delay both government action and final determination of the case. For example, the privatization of Companhia Vale do Rio Doce (CVRD), the world's biggest iron ore producer was delayed by a record 120 legal challenges. Over 100 injunctions have been issued to halt the privatization auction of the state telephone company, Telebras, on July 29^th, 1999. The federal government mobilized a 30 man legal team to ensure the privatization of Furnas Centrais Eletricas, the state power company.

Fourth, there is the problem of corruption. Brazil rates a 4.0 on Transparency International's corruption index, below South Korea (4.2) but above China (3.5), Mexico (3.3) and Argentina (3.1). "Brazil's judiciary is proud of its independence, which it claims allowed it to maintain some of the civil liberties that were threatened under the military dictatorship which ended in 1985." ⁽⁶⁾ However, an investigation into corruption of the judiciary has been started by the Brazilian Senate's president Antonio Carlos Magalhaes. The accusations include judges who sell sentences to drug traffickers. Million dollar compensations paid by state and federal governments arranged among prosecutors, judges and the "victims." One of the most famous is a scandal of a gang of lawyers, judges and social security officials who defrauded the pension system of $531 million in bogus disability claims in 1988-91.

Against the back drop of judicial inefficiency, Brazilians have developed a process that would be easily recognizable in many Asian jurisdictions. The process is "what is known in Portuguese as jeito, (pronounced JAY-too)[literally skill/ somehow/ anyway] a term that describes the ability of Brazilians to find clever solutions to legal, bureaucratic or financial quagmires."⁽⁷⁾

The process also known as Brasileiro jeitinho, means bending the rules to get things done. It can encompass anything from extra legal methods of dealing with government bureaucracy to a willingness to negotiate to solve a problem. For example, during the present financial crises companies would negotiate with their debtors or customers to avoid insolvency. They would extend times for payments, provide more credit or help improve cash flow.

Although the cultural norms of jeito and the sophistication of the bankruptcy law may have eased the problems of a banking crises, the inefficiency of the courts would have exacerbated and lengthened the disaster. It was therefore indeed fortunate that the disaster never happened.

It did not happen in Brazil in part because it already had happened. The real crises for Brazilian banks occurred between 1995 and 1996. In 1994, the twin effects of the introduction of the Real Plan along with the "Tequila Effect" caused by the collapse of the Mexican peso, devastated the financial system. Many of the smaller banks had survived on income produced by lending their overnight cash float. This income disappeared with hyperinflation after the success of the real plan.

Unlike Japan or Mexico, the Brazilian government fortunately did not use public funds to keep the private banks afloat. "Of 271 Brazilian banks, 58 suffered Central Bank intervention or liquidation or changed ownership in the past two years. Of these, 26 private banks came under Central Bank management. Another 22 changed owners without Central Bank."⁽⁸⁾ Three of the country's ten largest banks failed and were taken over by other banks in exchange for the government assuming bad debts. Foreign banks including Netherlands' ABN Amro, Britain's HSBC and Spain's BBV and Santander (now BSCH), bought medium-sized Brazilian banks.

The real problem was the state banks. These banks were owned and controlled by each individual state. For years state governments borrowed huge amounts from these banks. By 1996 most of these banks were insolvent. The states owed with billions of dollars in nonperforming loans. The worst was one of the largest. Bank Banespa, the State Bank of São Paulo, was until recently Brazil's second-largest bank. Bank Banespa had a 24 billion-dollar hole in its balance sheet. The state-owned Banco do Brasil, the country's largest bank, cost the government only $8 billion. Of the other 31 state banking institutions, an estimated two-thirds will be liquidated, privatized, or transformed into development agencies. The cost will be approximately $100 billion since the introduction of the real plan. Most of the money was raised on local markets in reals.

After they were restructured at taxpayer expense, the surviving banks were strong and had a large incentive to stay that way. With high reserve requirements and bank loans for small businesses costing 50-90% a year in real terms, the banks simply were not lending. "Neither Brazil's banks nor its big companies are highly leveraged. Geraldo Carbone, who runs BankBoston's Brazilian operation, points out that the banking system's total loans are only about nine times its capital, compared with 18 times in Mexico and 33 times in South Korea"⁽⁹⁾

"In some ways, it's miraculous that any productive activity can take place in a country where credit is so costly. One reason is that cash is still preferred and used, whenever possible -- a legacy of Brazil's long history of economic instability. Credit has expanded significantly only since the real created a more predictable climate, and credit is still less widely available than in developed economies" ⁽¹⁰⁾

The answer to the paradox is quite simple. Unlike Asia, there were no widespread bankruptcies in Brazil, because they had already happened. The banking system did not collapse because it had already collapsed. Firms did not go under because they had no access to debt. The inefficiency of the courts was not a problem, because there were no bankruptcies to administer. The government had effectively squeezed local companies out of the debt market at the expense of growth.

The only thing left to go bankrupt is the government itself, which is a real worry.

By: William Gamble, J.D., LL.M.

Emerging Market Strategies Company

281 Olney Street, Providence, Rhode Island, United States 02906

Tel. 401-454-5899, Fax 401-454-3888, Internet: xgamble@cs.com

This article also appears on the University of Virginia Darden Graduate School of Business Administration Alumni Forum (http://www.Darden.Virginia.edu/), the New York University Stern Graduate School of Business Administration Asia Crises Home page (http://www.stern.nyu.edu/~nroubini/asia/AsiaHomepage.html) and the EMS home page. (http://www.Xensei.Com/users/gamblet) Articles are also translated into Korean at www.seri-samsung.org. Other articles are also published in the Providence Journal.1. Simon Romero, "Brazil, Though Struggling, Proves Surprisingly Resilient", The New York Times, April 6, 1999, Page 4, Column 3

2. L. B. Gomide and J. R. de Castro Neves, Commercial Finacing and Insovency Law in Brazil, 2 SW J. L. Trade in the Americas 123 (1995).

3. Noronha Advogados, Brazilians' increasing litigation, Observador Legal, http://www.noronhaadvogados.com.br/B.htm Year, no.64, August 1998

4. Ibid

5. Noronha Advogados, Reforms inthe Judiciary, Observador Legal, http://www.noronhaadvogados.com.br/B.htm Year, no.64, August 1998

6. Row over iron ore company sell-off; Financial Times ; May 3 1997

7. Romero, Simon, Brazil, Though Struggling, Proves Surprisingly Resilient, Business/Financial Desk; Section C International Business Page 4, Column 3 The New York Times, April 4, 1999

8. Norman Gall, King Kong in Brazil, Instituto Fernand Braudel de Economia Mundial (FAAP) nš 16, 1997.

9. The Economist Brazil: a Survey of Brazil: the Battle for Confidence: at best, the Economy Faces a Nervous Few Months. At Worst, the Jitters Could Prove Justified, Mar 27, 1999.

10. Moffett, Matt, Real Pain: With Interest Rates Soaring, Brazilians Fall Deep Into Debt,
The Wall Street Journal , Page A1, January 6,1999.