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Revenue Based Finance England and Wales Debt

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Revenue Based Finance England and Wales Equity

South Africa Revenue Based Finance – Loan

This analysis was provided by White & Case SA and Citibank N.A., South Africa Branch

Executive Summary

The revenue-based finance structures that have been discussed are the common structures that we see in the South African market, namely, revenue participating loans and participating preference share funding. These structures are similar in principle as both structures aim to allow investors to be able to also finance companies and startup business in a way that allows these companies to be able to build their business. Most investors believe that small and medium-sized enterprises and startup businesses have a fair amount of risk as not all start-up business will be successful. These structures are designed to give investors a share in the performance of the business.

Revenue Participating Loan

Investment Structure Summary

This investment structure involves a loan made by an investor to a business and instead of the investor receiving interest back on the loan, the return on the investment is calculated as a contractually agreed percentage of revenue or a contractually agreed percentage of profit.

Advantages of loans of this nature is that (a) because the return is not calculated with reference to a rate of interest, it is treated as a tax exempt dividend under section 8FA of the Income Tax Act, 1962 (“Income Tax Act”), and (b) the loan can be secured by taking security from the borrower and third parties. However, if security is taken from a third-party then the benefits of the tax-exempt dividend fall away.

The governance rights are contractual as opposed to a share-based structure where the governance rights can be and generally are built in to the investee company’s constitutional documents

Category for tax purposes

It is a hybrid debt instrument.

Interest received is treated under section 8FA of the Income Tax Act as a dividend. Section 8FA (2) of the Income Tax Act provides that any amount of interest incurred by an investor in respect of interest on or after the date that the interest becomes “hybrid interest” is (i) deemed to be a dividend in specie in respect of a share that is declared and paid by that company to the person to whom that amount accrued on the last day of the year of assessment of that company during which it is incurred, and (ii) is not deductible.

The definition of hybrid interest means any interest where the amount of that interest is not determined with reference to a specified rate of interest or not determined with reference to the time value of money

Governance Rights

Governance rights are generally in the form of negative undertakings and are purely contractual where the instrument is constructed as a loan. It is also possible to construct the instrument as a debt security under the Companies Act, 2008 (“Companies Act”) and therefore to include in the terms of the security certain governance rights that are built into the constitutional documents of the borrower.

These are typically constructed as a loan rather than debt security although it is technically possible to structure this investment as a debt security

Investor Qualification Requirements

There are no statutory limitations on an investor to make these loans other than that investor receiving exchange control approval, and registration as a credit provider in accordance with the National Credit Act, 2005 (“NCA”), to the extent applicable.

If a loan is acquired from a non-resident or an affected person (each as defined in the Exchange Control Regulations), the borrower is required to disclose and apply to the Financial Surveillance Department of the South African Reserve Bank (“SARB”) for approval for cross-border dealings.

In addition, if the loan is made to persons who fall within the scope of the NCA then the investor must be registered as a credit provider under the NCA. A lender who is required to be registered as a credit provider but who is not so registered, will not be able to enforce a loan agreement against a South African borrower as that loan agreement will be void in terms of the NCA.

Section 40(1) of the NCA states that “A person must apply to be registered as a credit provider if the total principal debt owed to that credit provider under all outstanding credit agreements, other than incidental credit agreements, exceeds the threshold prescribed in terms of section 42(1). Previously, the threshold of ZAR 500 000.00 excluded most casual lenders from having to register. However, on 11 May 2016, the Minister for the Department of Trade and Industry published a new determination of the threshold which has reduced the threshold to “nil R0), meaning all persons lending to persons in scope of the NCA would be required to register.

However, this applicability is limited in that the NCA does not apply to a loan agreement where the borrower is a South African juristic person and its net asset value or annual turnover of all persons related to the borrower equals or is in excess of ZAR 1 million and where the principal debt owing under the loan agreement or loan equals or exceeds ZAR 250 000 and the borrower is a juristic person whose net asset value or annual turnover is below ZAR 1 million, meaning the vast majority of corporate loans are out of scope of the NCA requirements.

Currency Considerations

The loan can be denominated in US Dollars or any other currency subject to exchange control approval, which must be obtained from the Financial Surveillance Department of the SARB in order to exchange the loan in that currency.

Collateral

A loan of this nature can be secured however, in order for the investor to benefit from receiving tax-exempt dividends as a return, security must be taken directly over the assets of the borrower. If security is taken from a third-party, then the benefit of the dividends being tax-exempt will be lost and the return will be treated as interest received for an ordinary loan and will be taxable.

Priority Payment Rights

An investment of this nature can provide for a preferential right for the investor to receive distributions based on an agreed portion of gross revenues, free cash flow or net income.

Distribution and Redemption Limitations

Unlike a distribution based on a share/equity based structure, the payment of the return as well as the redemption of the loan is not subject to any mandatory conditions. It is treated like an ordinary loan in terms of priority of ranking if the investor is a secured creditor.

Timing and frequency in payments and any mandatory conditions can be contractually agreed. Should the provisions in the loan agreement be breached, the investor is entitled to call a default and enforce against the borrower.

Legal limitations to pricing or total return

If a transaction falls within the scope of the NCA, the interest will be subject to a cap. Under common law, interest on a debt will cease to run where the total amount of arrear interest has accrued to an amount equal to the outstanding principal debt, i.e. the total amount owed at any one point cannot exceed two time the outstanding principal debt (the in duplum rule).

The NCA provides that despite any provision of the common law or a credit agreement to the contrary, the amounts contemplated in Section 101(1)(b) to (g) of the NCA that accrue whilst the consumer is in default under the credit agreement may not, in aggregate exceed the unpaid balance of the principal debt under the credit agreement as at the time that the default occurs.

The NCA applies to all credit agreements between parties dealing at arms-length (where there is no personal interest between the parties). “Arms-length” means that the transaction should have the substantive financial characteristics of a transaction between independent parties, where each party will strive to get the utmost possible benefit from the transaction.

The NCA does not apply to a loan agreement where the borrower is a South African juristic person and its net asset value or annual turnover of all persons related to the borrower equals or is in excess of ZAR 1 million and where the principal debt owing under the loan agreement or loan equals or exceeds ZAR 250 000, and the borrower is a juristic person whose net asset value or annual turnover is below ZAR 1 million.

A juristic person is considered to be ‘related’ to another juristic person if (a) one of them has direct or indirect control over the whole or part of the business of the other; or (b) the same person has direct or indirect control over both of them.

In a Supreme Court of Appeal judgement (Asmal v Essa (38/2013) [2013] ZASCA 62 (14 May 2014), the court considered whether moneys advanced were loans and the profit share amounts upon which the parties agreed constituted ‘a use consideration’ for the said loans. In light of section 4(5)(a) of the NCA, the loan transactions constituted credit agreements.

A credit agreement, as defined in the NCA, entails credit being granted and the imposition of a ‘fee, charge or interest’ in respect of the deferred repayment, for the use of the credit. The profit share contained in the credit agreement qualified as a ‘charge’, one of the three wide terms used in section 8(4)(f) of the NCA to describe payment for the use of money owed. The court held that the loans including the profit share construct constituted credit agreements and were subject to the provisions of the NCA and because the respondent was not registered as a credit provider, thus putting it in breach of section 40(1)(b) of the NCA. This resulted in the credit agreements being found to be unlawful and thus void in terms of section 89(2)(d).

Status in Insolvency Proceedings

In a case of a liquidation, there are 3 types of creditors to be considered when ranking creditors:

Secured creditors are creditors holding security for their claims in the form of a special mortgage, landlord’s hypothec, pledge or right of retention. They rank first and are paid from the proceeds of the sale of the secured asset. All types of security (other than general notarial bonds where the mortgagee has not taken possession of the property subject to the bond) will, if validly created, constitute the holder of a security interest as a secured creditor in relation to the secured asset. No special priority applies among the secured creditors, as each secured creditor has a secured claim in respect of a particular asset. To the extent that creditors have security over the same asset, the creditor granted security earlier in time usually has a higher-ranking claim in respect of that asset. Where a secured creditor’s claim is not satisfied in full, the unpaid balance is considered a concurrent claim as dealt with in terms of (c);

Preferent creditors are creditors who do not hold specific security for their claims, but rank above concurrent creditors. They are paid from the proceeds of unencumbered assets in a predetermined order as set out in the Insolvency Act, 1936. Preferent creditors include employees’ remuneration (up to a prescribed amount) and the South African Revenue Services. The holder of an unperfected general notarial bond is also a preferent creditor; and

Concurrent creditors are paid from any proceeds of unencumbered assets that remain after preferent creditors have been paid in full. They are paid in proportion to the amounts owing to them. Any amount that remains after the payment of all concurrent claims in full must be used to satisfy the interest on concurrent claims from the date of liquidation to the date of payment, in proportion to the amount of each concurrent claim

The ranking of claims during business rescue—the regime analogous to bankruptcy in terms of South African law—is slightly different from the general liquidation process and ranking. It is also subject of some controversy, but is regarded as being as follows:

fees and expenses (including legal and the other professional fees) of the practitioner incurred during business rescue proceedings;
amounts due to employees which become due and payable after the commencement of business rescue;
claims of secured lenders or creditors before business rescue (although this is open to some debate);
secured claims by post-commencement financiers, lenders or creditors in the order in which the claims were incurred;
unsecured claims by post-commencement financiers or creditors in the order in which they were incurred;
remuneration of employees which became due and payable before business rescue commenced; and
unsecured claims of lenders or creditors incurred prior to business rescue.

Limitation of Liability

An investor’s liability towards the company and its creditors will be limited to its funded investment. There are certain exceptions to this, an investor may be liable the most notable example of which is the extension of liability to investors in environmental law breaches.

As an example, the National Environmental Management Act 1998 and the National Water Act, 1998 extend the net of liability for pollution and environmental degradation to include, among others, persons:

responsible for or who have directly or indirectly contributed to pollution or environmental degradation; and/or
who negligently failed to prevent the activity being performed that resulted in the pollution or environmental degradation.

It would however be difficult to show that the investor would have been empowered to prevent the activity being performed that resulted in the pollution or environmental degradation.

Transfer Restrictions

It is possible to transfer the loan to another investor provided it is permitted under the terms of the loan agreement and it is not restricted. A transfer in whole would generally not be restricted unless it is contractually restricted however, a transfer in part would require consent from the borrower which consent can either be given at the time of transfer or as an exclusion in the loan agreement to allow for partial transfer.

Critical Tax Considerations

These loans would be typically structured to fall within the ambit of section 8FA of the Income Tax Act so that the returns are received by investors in the form of dividends which are tax exempt. South African investors receive a tax-exempt return. It’s not clear if this is the case for a foreign investor, as they may be liable for withholding tax. Whether or not that dividend withholding tax can be reduced is dependent on the existence and applicability of the double tax treaty between the country of the foreign investor and South Africa

Mexico Revenue Based Finance – Debt

This analysis was provided by Hogan Lovells

Investment in Debt with Interest over Gross Revenues

Investment Structure Summary

Under Mexican Law it is possible for companies to issue debt, linking both principal and interest payments to gross revenues. If principal repayment is based on revenues and the amount payable is higher than the originally disbursed amount, then the excess will be deemed interest. If the amount payable is lower than the originally disbursed amount, then a write off / haircut on principal shall be deemed to have occurred.

In this case the amount owed by the company will be treated as a liability.

Category for tax purposes

Interest and fees payable to investors will be deemed as income sourced in Mexico (if the issuer is a Mexican entity) and subject to withholding taxes. The rate varies depending on the tax residence of the investor and its beneficial owners and availability of tax treaties

Governance Rights

No, debt instruments do not grant to their holders any type of corporate or voting rights over the company or its management. However, control over management may be achieved through affirmative and negative covenants. Breach of affirmative and negative covenants may only trigger debt acceleration and payment obligations and it will not be possible for investors to enjoin any action taken by the company in breach of those covenants.

Investor Qualification Requirements

No, there is no need investors need to comply with any particular qualification or requirement.

Currency Considerations

Debt may be denominated in foreign currency.

However, as a general rule, under Mexican law, payment obligations denominated in foreign currencies and payable in Mexican territory may be discharged by paying the amount equivalent in Mexican Pesos pursuant to the exchange rate set forth by the Mexican Central Bank (Banco de México) one day before the applicable payment date.

Collateral

Debt instruments, can be secured or guaranteed by any type liens or collateral, or third-party guarantees.

Priority Payment Rights

Ranking will depend on whether the debt is secured or unsecured. Unsecured debt is generally paid after all employees, secured creditors and other creditors with special preferences are paid. See Status in Insolvency Proceedings below for further detail.

Distribution and Redemption Limitations

For the payment of debt instruments there is no limitation or restriction. Investors or holders are considered creditors and are to be paid and liquidated at the maturity of the instrument.

Legal limitations to pricing or total return

In all instances usury laws shall be honored. Usury laws generally provide that interest shall not be that disproportionate or excessive preventing the investor from gaining an excess profit.

Pursuant to Mexican law, there is no statutory definition of usury, however it is sanctioned by both civil and criminal laws.

Article 2395 of the Federal Civil Code caps ordinary interest rates by providing that when such an interest rate is so disproportionate that it creates the appearance of abuse by the creditor due to the debtor’s ignorance or inexperience, a debtor may request the judge to equitably reduce it to the legal interest rate. Likewise, under civil law, the legal annual ordinary interest rate is 9%, unless otherwise agreed by the parties.

On the other hand, under Article 387 subsection VIII of the Federal Criminal Code, usury is a felony, sanctioning usury advantages by means of contracts or agreements providing for higher yields or profits than those usual in the market.

In commercial law, according to several precedents issued by the Mexican Supreme Court of Justice, usurious interest rates are prohibited by law. In this sense it has ruled that upon judges’ knowledge of an interest rate that may be considered usurious in a commercial proceeding, they are obliged to analyze it ex officio and reduce it to market standards.¹

Additionally, below please several court precedents regarding usury and the parameters to be observed for its determination:

Under court precedent 1a./J. 46/2014 (10a.)² issued by the First Chamber of the Mexican Supreme Court of Justice, the Supreme Court resolved that usurious interest rates contravene the provisions of Article 21 paragraph 3 of the American Convention on Human Rights (the “Convention”), which provides that all forms of exploitation of man by man, including usury, must be prohibited by law. In this sense, if a judge notices an excessive or usurious interest rate, it must disregard the agreed interest rate and impose a cautious interest rate in a reasoned and motivated manner according to the particular circumstances of the case at hand. Interest accrued at the usurious interest rate cannot be collected by the lender.

Under court precedent 1a./J. 47/2014 (10a.)³, the First Chamber of the Mexican Supreme Court of Justice ruled that judges must reduce excessive interest rates to avoid usury. To determine whether an interest rate is usurious, judges have to take into consideration the following parameters:

The nature of the relationship between the parties;

The nature of the parties involved in the credit and whether the creditor’s activity is regulated;

The credit purpose;

The credit amount;

The use of the proceeds;

The tenor of the credit;

The existence of collateral or guarantees;

The interest rates of the banking institutions for similar operations to those under analysis (this element only constitutes a reference);

The variation of the national inflationary index during the actual life of the loan;

Market conditions; and,

Other matters that generate conviction in the judge.

On top of the foregoing, judges must evaluate whether there are circumstances that reflect any kind of disadvantage of the debtor in the credit relationship with the lender.

In conclusion, there is no objective standard or percentage of what is considered usury being subject to court interpretation considering the court precedents previously mentioned.

In this sense, it is not that this limitation would prohibit revenue based financing, as long as the interest is proportionate to gross revenues, irrespective of the fact that there could be periods with high payments. What must be observed is the principle of no excessiveness and usury, taking into account the parameters and considerations mentioned above.

Status in Insolvency Proceedings

Below is the waterfall of payments in an insolvency proceeding:

Employee-creditors (wages, salary and other employment benefits accrued during the last year);
Credits regarding essential expenses for the operation of the debtor’s business, or credits regarding expenses for the conservation, protection and administration of the insolvency estate, approved by the estate’s representative;
Singularly privileged creditors (burial and illness expenses);
Secured creditors;
Tax creditors and other employee and labor creditors;
Special privileged creditors;
Unsecured (common) creditors; and
Subordinated creditors.

As of the day of company’s declaration of insolvency:

Unsecured capital and ancillary obligations of credits arranged in Mexican currency will stop accruing interest and will be converted into UDIs (a Mexican-inflation pegged index);
Unsecured capital and ancillary obligations of credits arranged in foreign currency will stop accruing interest and will be converted into Mexican currency and into UDIs;
Secured credits will be maintained in the agreed currency or unit and will only accrue interest up to the collateral value

Limitation of Liability

Lenders’ liability is limited to disbursing committed funds in agreed terms. They are not liable vis-à-vis third parties for actions or omissions of the company.

Transfer Restrictions

No statutory restriction except that public offerings may be subject to registration and authorization by the securities regulator (Comisión Nacional Bancaria y de Valores)

Critical Tax Considerations

Brazil Revenue Based Finance – Debt

This analysis was provided by TozziniFreire Advogados

Executive Summary

This research paper summarizes the main structures identified for revenue-based financings available in Brazil.

While Brazilian laws does not provide for concepts that are designed specifically for revenue-based financing , companies and investors may structure transactions by adjusting existing types of funding mechanisms available under existing regulations. For the purposes herein, we will suggest three types of structures, under equity, debt and receivables discount models:

Equity: investment by acquiring equity interest is one of the most common types of investment in Brazil. The acquisition of equity interest may occur by means of (i) execution of a share/quota purchase agreement, (ii) execution of a convertible loan, (iii) increasing the corporate capital by means of execution of an investment agreement, and (iv) incorporating a Brazilian subsidiary. Brazilian law provides for several types of legal entities, of which the Sociedade Limitada (limited liability company) and the Sociedade Anônima (corporation) are the most commonly used. Other company types are seldom used in practice, because most of them provide for unlimited liability of their partners. For limited liability companies and corporations, the partners liability is limited to their paid stake in the corporate capital and there are generally no minimum capital requirements. Moreover, dividends are currently tax exempt in Brazil, regardless of the status of the beneficiary. In this type of investment, it is possible to ensure a minimum return by means of (i) defining the interest in the convertible loan agreement; (ii) a put option, granted in an agreement between the partners and the company; or (iii) using redeemable shares.

Debt: issuance of debentures. A debenture is a security issued by a corporation (sociedade anônima), with mechanics that are similar to bonds governed by New York laws. The terms and conditions of the issuance of the debentures are regulated in an indenture executed by the issuing company. The debentures are essentially fixed-income debt instruments where the debenture holders are entitled to receive the repayment of the principal amount plus an accrued interest (fixed or floating). However, Brazilian laws allow the issuing company to stipulate that debenture holders may have the right to receive a share in the company’s profits or even an additional premium fee, which is based on income or profit variations of the company. The investors are usually represented by a fiduciary agent (similar in nature to a trustee). Debentures are one of the most relevant debt instruments used by companies in the Brazilian capital markets.

Receivables discount (securitization): funding granted by receivables investment funds (Fundos de Investimento em Direitos Creditórios – “FIDC”), which is a form of condominium regulated by the Brazilian Securities Commission (Comissão de Valores Mobiliários – “CVM”). The FIDC is a fund whose main purpose is to purchase receivables from Brazilian entities, and it benefits from technical and specialized services of administration, portfolio management and custody of the investments, provided by regulated entities. The FIDC is funded by investors, which in turn receives quotas issued by the FIDC. Although the FIDC (and investment funds in general) operate similarly to companies, it does not have a legal personality. Earnings from investments are distributed to FIDC’s quotaholders. On the other hand, the FIDC’s quotaholders also bear losses and other expenses that compose its liabilities. The FIDC is a viable way of ensuring that companies obtain cash by anticipating their receivables (revenues) without incurring in additional debt.

Members of TozziniFreire Advogados are qualified to practice law in the Federative Republic of Brazil. We do not express herein any answer concerning any law other than the law of the Federative Republic of Brazil.

Investment Structure Summary

Transactions in Brazil usually do not provide for preferential rights to receive distributions based on an agreed portion of gross revenues, free cash flow or net income. Nonetheless, there is no explicit prohibition in this regard under Brazilian law, hence, initially, it is possible that a debt instrument provides for preferential rights regarding the company’s profits if agreed between the parties.

One common example of debt structure that may provide for this type of preferential rights in Brazil is the issuance of debentures. Debentures are securities regulated by Law No. 6404 of December 15, 1976, which provides that corporations (sociedades anônimas) may issue debentures entitling its holders to credit rights according to the conditions set forth in the indenture. Debentures are debt instruments that may or may not be convertible into shares against the issuing company. The debentures are essentially fixed-income debt instruments where the debenture holders are entitled to receive the repayment of the principal amount plus an accrued interest (fixed or floating). However, Brazilian laws allow the issuing company to stipulate that debenture holders may have the right to receive a share in the company’s profits or even an additional premium fee, which is based on income or profit variations of the company. This permission to estipulate premium or variable coupon based on company’s income or profit variations allows Brazilian players to structure debt financing that follows a rationale that is similar to a revenue-based financing, given that the investors will have the right to receive additional payments deriving from company’s profits (as premium or variable coupon) and, generally speaking, Brazilian bankruptcy laws determine that creditors of the company have preference in payments compared to its shareholders.

Debentures may be subject to private placements or public offerings. If public offered to investors, it must observe the rules of the CVM concerning public offerings of securities.

Two types of ESG related debentures have been issued in the past few years, (a) green, social and sustainable bonds, and (b) sustainability-linked bonds (“SLB”).

The green, social and sustainable bonds aim to attract capital to projects that have a positive social and environmental impact. On the other hand, through SLB, companies are required to achieve agreed ESG goals and following key ESG performance indicators (KPIs).

Category for tax purposes

Debentures’ income is categorized for tax purposes as fixed income investment (see Critical Tax Considerations below).

Governance Rights

The debentures’ indenture may provide for clauses determining the need of prior consent of the investors for the approval of specific matters in shareholders’ meetings. This is not mandatory and commercially negotiable. Debentures used in venture debt or private equity deals tend to be more restrict in terms of what companies may or may not do in terms of governance.

Investor Qualification Requirements

Investor qualification requirements could apply depending on the public offering regime adopted, in accordance with CVM regulations. The issuance of convertible debentures from companies in the preoperational stage (A-Category) can only be acquired by professional or qualified investors. Moreover, the issuance of convertible debentures from operational companies (A-Category) in the automatic registration regime, without prior review by a self-regulatory authority, after January 2, 2023, should also only be acquired by professional and qualified investors. Common debentures (i.e., not convertible) issued following the automatic registration regime, without prior review by a self-regulatory authority, may be acquired by qualified or professional investors, and by retail investors only in certain specific situations, such as the case of standardized debentures.

For reference, qualified investors are:

professional investors.
individuals or legal entities that have financial investments worth over R$ 1,000,000.00 (one million reais). Statement of their status as qualified investors also needs to be provided.
individuals that have been approved in technical qualification exams or have certifications approved by the CVM as requirements for registration as autonomous investment agents, securities portfolio managers, securities analysts, and securities consultants, in relation to their own resources.
investment clubs, provided they have a portfolio managed by one or more quota holders that are qualified investors.

And professional investors are:

financial institutions and other institutions authorized to operate by the Central Bank of Brazil.
insurance companies and capitalization companies.
open and closed complementary pension fund entities.
individuals or legal entities that have financial investments worth more than R$ 10,000,000.00 (ten million reais). Statement of their status as professional investors also needs to be provided.
investment funds.
autonomous investment agents, securities portfolio administrators, securities analysts, and securities consultants authorized by the CVM, in relation to their own resources.
non-resident investors.

Investors of debentures may be either local or foreign. Any investment by foreign investor in debentures that are subject to public offerings and registered in organized markets must be made in accordance with Resolution No. 4,373. Resolution No. 4,373 provides that financial instruments and securities acquired by non-resident investors (including registered debentures) must be: (i) registered and deposited in an institution authorized by the Central Bank of Brazil or the CVM; or (ii) registered in a clearing and settlement system authorized by the Central Bank of Brazil or the CVM to render this service.

Before making the investment, the non-resident investor must (i) appoint a legal representative in Brazil, which must be a financial institution authorized by the CVM or the Central Bank of Brazil; (ii) obtain a registration as a foreign investor with the CVM; and (iii) appoint a custodian of securities authorized by the CVM (which may be the same entity as the legal representative).

Additionally, the assets owned by the foreign investor (i.e., the registered debentures) must be deposited in the non-resident investor’s account or in a collective account in a financial institution authorized by the CVM or Central Bank of Brazil to provide these services. The foreign investor must also be registered at a local brokerage firm.

Currency Considerations

The debentures must be denominated in Brazilian reais, except in case of obligations in which Brazilian laws authorizes payments in foreign currencies. Exceptions include situations of foreign investors. Accordingly, debentures issued abroad may be denominated in foreign currency.

For local debentures, Brazilian law authorized the issuance in Brazilian reais and indexed to foreign currencies.

Collateral

Security interest and guarantees may be granted by the issuer if required by investors. The following types are usually requested in the financial and capital markets, cumulatively or alternatively:

Fiduciary transfers;
Pledges;
Mortgages; and
Personal guarantees.

In a fiduciary transfer structure, a certain asset is transferred to the debenture holders on a fiduciary basis and by way of security to ensure payment of a given obligation. Upon fulfillment of the secured obligation, the debtor reacquires full title to the asset, thereby extinguishing the fiduciary ownership held until then by the debenture holders. In the event of default by the debtor, however, the debenture holders obtain full title to the asset, which must then be sold to satisfy the unpaid debt.

In the pledge structure, if the debtor fails to pay the relevant obligation, the creditor will have the right to sell the pledged asset through a judicial sale or through a private sale, if authorized by the pledge agreement or by a special power of attorney granted by the pledgee. The proceeds will be applied to the unpaid debt. As a matter of Brazilian law, pledge agreements cannot provide that creditors are entitled to keep pledged assets if debtors fail to pay. However, in case of credit rights the creditor will use the relevant amounts to be reimbursed on the value of its credit. Structures involving liens over bank accounts where the credit rights are deposited are common in Brazil.

A mortgage is a security interest created over real estate or other certain asset specified by law. Under a mortgage structure, if the debtor fails to pay the relevant obligation, the creditor will have the right to sell the mortgaged asset through a judicial sale and use the proceeds to satisfy the unpaid debt. As a matter of Brazilian law, mortgage agreements cannot provide that creditors are entitled to keep mortgaged assets if debtors fail to pay.

A security interest may be created over a variety of assets: real estate, fungible movable assets, non-fungible movable assets, rights and credit rights. Depending on the asset to which the security refers, the agreement must be registered with either a Real Estate Registry Office, a Registry of Deeds and Documents or another type of registry (such as corporate books in case of shares).

Priority Payment Rights

Preferential rights are not necessarily linked to equity rights, but to an obligation of the company to pay to investors a certain premium or variable coupons of the debentures based on financial factors of the company. Under local bankruptcy laws, the investors of the debentures will have priority of payments compared to existing shareholders.

For example, it is possible to establish that the issuing company will have to pay an additional premium to investors calculated over a percentage of payments received from certain commercial contracts executed with clients (i.e., if those receivables are not paid, then the company will not have an obligation to pay the premium). Another example is to provide in the indenture that the company will have to pay a variable coupon calculated over an agreed formula that takes into consideration certain its financial conditions (for example: monthly income x EBITDA x fixed percentage).

Distribution and Redemption Limitations

The indenture may provide for negative covenants in which the issuer is not allowed to distribute dividends and profits to its shareholders above the minimum legal amount, without prior consent of the investors.

Legal limitations to pricing or total return

Decree No. 22.626/1933 (Usury Law), prohibits and establishes penalties if there is stipulation in any contracts of interest rates higher than twice the legal rate. Thus, the Usury Law functions as an interest control mechanism for loans offered to the private productive sector. It is also worth mentioning that usurious stipulations that establish interest rates higher than legally permitted in civil loan contracts are null and void, in which case the judge must, if requested, adjust them to the legal measure or, if they have already been complied with, order the refund in double of the amount overpaid, with legal interest from the date of the undue payment, as provided by Provisional Measure No. 2,172-32, dated August 23, 2001.

It is worth noting that the Brazilian Superior Court of Justice (“STJ”) has a settled understanding that financial institutions are governed by a specific law and, therefore, the above-mentioned interest limitation does not apply to them. In addition, in a decision by STJ (SPECIAL APPEAL No. 1.634.958 – SP (2016/0277295-7)) on the applicability of the legal rate limits to investment funds, the STJ held that investment funds have similar roles as financial institutions, given that their activities involve attracting popular savings through the issue and subscription of securities for the granting of credit, and therefore they also do not need to observe usury rules.

Thus, for the reasons given by the STJ, our understanding is that the legal rate limit is not applicable to financial and capital markets transactions. However, interest limitations may apply to debentures and other securities subject to private placements that do not involve financial institutions and that are not registered in organized markets and, therefore, follow the same rationale as loan transactions (as opposed to debentures subject to public offerings, which are considered investments in the capital markets).

For reference, although there are certain discussions about what is the “legal rate” for the purposes of interest limitation, our understanding is that interest should be limited to the Special System for Settlement and Custody (“SELIC”) rate. Any interest due above the SELIC rate may be considered by Brazilian courts null.

Status in Insolvency Proceedings

Status in insolvency proceedings will depend on whether the credit rights are collateralized. The debentures may also be subordinated, which means that the credit of the debenture holder would have preference only over the shareholders of the issuer, in the event of bankruptcy.

Brazilian insolvency law provides for the following priority of payment in bankruptcy scenario of a debtor: (i) claims arising from labor legislation, limited to one hundred and fifty (150) minimum wages per creditor, and without limit for those resulting from an occupational accident; (ii) credits encumbered with security interest up to the limit of the value of the burdened asset; (iii) tax claims, regardless of their nature and the time when tax event occurred (an exception to non-concurrent claims and tax fines); (iv) unsecured claims; (v) contractual fines and pecuniary penalties for breach of criminal or administrative law, including tax fines; (vi) subordinated credits; (vii) interest accrued after the decree of bankruptcy.

Furthermore, bankruptcy and judicial reorganization proceedings bind all the existing credits against the relevant debtor at the time of the request (pre-petition claims), even those undetermined or not yet matured or disputed, contingent, or unsettled at the time of the filing except for (i) tax and social security-related credits; (ii) credits related to forward foreign exchange agreements; and (iii) claims (a) arising from financial leases, (b) secured by a fiduciary lien (“alienação fiduciária”), (c) of owners or committed sellers of real estate which respective agreements include an irrevocable and or irreversible provision, and (d) purchase agreements containing a title retention provision.

Limitation of Liability

Investors’ liability towards the issuer is limited to its funded or committed investment.

Transfer Restrictions

The debentures may be subject to transfer restrictions of up to eighteen (18) months depending on the public offerings regime, the situation of the company (if operational or preoperational) and the types of investors involved

Critical Tax Considerations

Debentures’ interest is taxed as follows:

Foreign investor duly registered with the Brazilian Central Bank as portfolio investor (Resolution 4.373) and not located in a tax haven: 15% withholding tax;
Foreign investor not registered with the Brazilian Central Bank as portfolio investor (Resolution 4.373) and located in a tax haven: 25% withholding tax;
Local investor – Individual: 15% to 22.5% regressive withholding tax rates (according to the maturity of the investment);
Local investor – Legal entity: same rates described above, but the final tax cost will vary according to the legal entity’s tax regime.

The Netherlands Revenue Based Finance- Debt

This analysis was provided by Hogan Lovells

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