Extract taken from 'The Lending and Secured Finance Review' – edition 5

Credit support and subordination

i Security

This section provides an overview of the common methods of taking securities over different types of assets in Brazil.

The following methods of credit support are available:

  1. in rem guarantees;
  2. personal guarantees;
  3. contract bonds;
  4. standby letters of credit or demand guarantees; and
  5. avals on promissory notes.

A fiduciary sale or assignment, mortgages and pledges are in rem guarantees, which create a privilege over the collateral in favour of the creditor, with this being the asset granted in collateral bound to the secured obligation. In such cases, creditors do not have recourse against the guarantor that provided an in rem guarantee to collect outstanding amounts after the foreclosure of the collateral, unless agreed otherwise.

The most common types of in rem guarantees are the fiduciary sale, mortgage and pledge.

A fiduciary sale is a type of security interest pursuant to which the guarantor assigns to the creditor the title of certain assets. Therefore, the guarantor continues to have possession of the assets, still being liable for the duties of an escrow agent or bailee, or a trust in relation to them. Title of the asset granted in a fiduciary sale is only given back to the guarantor when the latter has fulfilled all of its obligations under the guaranteed credit.

The fiduciary sale was introduced in Brazil in 1965, but the applicable legal framework changed in the early 2000s with the enactment of a new Civil Code and other laws. These modifications fostered the use of fiduciary sale, which is currently one of the main credit support transactions, especially because of its bankruptcy remoteness feature. Since a fiduciary sale entails the transfer of the ownership of the underlying assets to the creditors, the creditors are not exposed to the risks inherent to a guarantor's bankruptcy. This is the main difference between a fiduciary sale and the other guarantees, which do not entail the transfer of ownership of collateral and, therefore, the creditor may be subject to bankruptcy apportionment of the guarantor.

There are two regimes applicable to fiduciary sales. On one hand, Law No. 4,728/1965 and Law No. 10,931/2004 regulate fiduciary sales within the scope of the financial and capital markets, expressly allowing the fiduciary sale of fungible and non-fungible property and credit rights. On the other hand, the Civil Code applies to fiduciary sales that are not within the scope of the above-mentioned markets. Although the Civil Code makes no provision regarding the characteristics of the asset given as collateral in a fiduciary sale, there are precedents of the Brazilian Superior Court of Justice (STJ) narrowing the fiduciary sale under the Civil Code to non-fungible assets. Since foreign lenders do not qualify as financial institutions under Brazilian law, it is disputable whether a transaction with such entities would qualify as a transaction within the scope of the financial or capital markets and, therefore, it is also disputable whether these entities could benefit from a fiduciary sale of fungible assets or credit rights.

Pledges and mortgages are also commonly used as collateral in lending transactions, with pledges being applicable to movable assets and rights (e.g., machinery, inventory, vehicles, credits and shares) and mortgages to immovable assets (e.g., real estate). Different from the fiduciary sale, in pledges and mortgages the guarantor keeps the title of the collateral and, therefore, creditors may be affected by the bankruptcy of the guarantor. In addition to that, pledges and mortgages are subject to multiple liens (first, second, third priority or more); therefore, the creditor may not necessarily receive a first priority security interest with respect to a particular asset if the asset has already been encumbered in favour of another creditor. Fiduciary sale is not subject to multiple liens, since it involves a transfer of ownership to the creditor.

Brazilian law does not provide any specific restriction on taking security over all or substantially all of the assets of a debtor or guarantor. Nonetheless, it is impossible to document such a security interest in a single document, since in rem guarantees need to be registered before different authorities depending on the type and location of the asset granted as collateral (registration with the competent authorities is a condition for perfection of such security interests).

Brazilian law forbids the creditor to keep or obtain title of collateral in the event of default (prohibition of commissoria lex), unless the guarantor grants express consent after the maturity date of the debt or its acceleration. In view of that, if the guarantor does not grant this consent, the collateral should be sold at a public auction, the proceeds of which will be applied to the payment of the principal and interest of the debt, judicial expenses and legal fees, provided that, in the case of attachment of quotas or shares requested by a creditor who is not a shareholder or partner (as the case may be) of the company, the company shall be summoned for the purposes of securing the right of first refusal of its shareholders or partners. In any case, the balance amount (surplus), if any, shall be returned to the guarantor.

ii Guarantees and other forms of credit support

Besides in rem guarantees, lending transactions may be secured by personal guarantees. Under Brazilian law, a personal guarantee is likely to be perceived as a surety and may be defined as a contract of a person or corporate entity by which one guarantees, in whole or in part, the performance of an obligation of someone else.

In summary, under Brazilian law:

  1. personal guarantees may encompass the principal amount and ancillary charges (monetary correction, interest and other fees);
  2. personal guarantees are granted by a guarantor and do not require the debtor's prior consent;
  3. if the personal guarantee is granted by a married individual, consent of the spouse is required; and
  4. the guarantor has a series of benefits granted by law, which are generally waived by the parties.

Contract bonds are a type of insurance wherein the insurance company guarantees the performance of the insurance taker's (the debtor's) underlying obligations under the lending agreement by providing the funds for the insured party to contract another company to perform the insured obligations. Local companies or individuals domiciled in Brazil shall take out insurance coverage before local insurers for risks run in Brazil. There are a few exceptions to this rule; for example, local companies or individuals are allowed to take out insurance coverage abroad if the insurance in question is not offered by local insurance companies.

Standby letters of credit and demand guarantees are also used to guarantee loan transactions. Brazilian banks and affiliates of international banks in Brazil in general do not issue standby letters of credit or demand guarantees for local transactions. These guarantees are usually issued in connection with cross-border transactions or by financial institutions headquartered abroad.

Promissory notes are documents that represent amounts owed. Although promissory notes are not considered additional guarantees for the payment of debts, they are used to represent amounts owed under the lending transaction, and the debt stated in the promissory note may be guaranteed by a third party by means of an aval guarantee. Any legal entity or individual may issue a promissory note or grant an aval guarantee (additional requirements may be applicable if the aval guarantee is granted by individuals).

iii Priorities and subordination

In the event of bankruptcy liquidation, certain credits are excluded from bankruptcy apportionment, such as assets granted in a fiduciary sale, post-petition claims and certain labour claims. After those credits are paid, the balance of the funds received from the liquidation of the assets must be used to pay the pre-petition claims, in accordance with the following order:

  1. labour-related claims, limited to 150 minimum wages per creditor, and occupational accident claims;
  2. secured claims, up to value of the collateral;
  3. tax claims, except for tax fines;
  4. special priority claims;
  5. general priority claims;
  6. unsecured claims;
  7. contractual penalties and monetary penalties for breach of criminal or administrative law, including tax law; and
  8. subordinated claims.

Exception is made for a fiduciary sale, which is bankruptcy-remote and is, therefore, not subject to this list of priorities.