Bankruptcy Law in Latin America: Past and Future

Abstract

"Bankruptcy Law in Latin America: Past and Future" increasingly recognizes the relevance of legal and institutional structures for the functioning and development of the economy. Bankruptcy laws are a crucial element of such institutions. This paper examines the laws that govern corporate bankruptcy procedures, their effects on the economic environment, and the recent bankruptcy reforms in Latin America, with a focus on Brazil.

Firms take on debts for several reasons. They generally intend to repay these debts with their future gains, but there is always the possibility that the borrowing firms will not fulfill the repayment promise. Bankruptcy law determines what happens in such circumstances.

In the absence of a bankruptcy law, creditors have two legal procedures at their disposal. In the case of secured loans, creditors can seize the firm's assets that serve as collateral for their loans. In the case of unsecured loans, creditors can go to court asking to sell some of the firm's assets. This method of debt collection runs into difficulties when there are many creditors and the debtor'€™s assets do not cover its liabilities (that is, when the firm is insolvent). Under these conditions, each creditor will try to be the first to recover its debts. This uncoordinated race of creditors may lead to the dismantling of the firm's assets and a loss of value for all creditors.

It is in the collective interest of creditors, and of society at large, that the disposition of the debtor's assets be carried out in an orderly way, via a centralized bankruptcy procedure. In a perfect world, there would be no need for a bankruptcy law because individuals could solve this problem through private contracts in which the debtor specified ex ante what would happen in case of default (for example, how to divide up assets and use them for debt repayment). Writing such contracts is very difficult, however. Debtors may acquire new creditors and assets after the contract is signed, and it is hard to specify how the division process should change as a function of such adjustments. Besides, contracts like this simply are not written in practice. Bankruptcy law provides a default option for this problem of contract incompleteness.

Most countries have two bankruptcy procedures: one for liquidating the assets of failing firms and another for reorganizing failing firms. Ideally, bankruptcy law should provide a good balance between liquidation and reorganization procedures.

When a firm files for bankruptcy liquidation, the bankruptcy court appoints a trustee who shuts down the firm and sells its assets. This can involve either the sale of the whole business or its productive units or the piecemeal sale of its assets, depending on demand and on which option maximizes the value of the company's assets. The absolute priority rule determines how the proceeds of sale are divided among the claimants. It specifies what claims are paid in full according to an order defined by bankruptcy law of each country.

Reorganization is the other alternative. When capital markets are imperfect, which is very common in developing countries, the best managers may not be able to raise the necessary cash to buy the firm. The firm may therefore be inefficiently dismantled and its assets sold cheaply. Reorganization provides a good alternative for countries with weak capital markets.