Power Sector Privatized

by Levy & Salomão Advogados

Brazil seeks to boost generating capacity

In an effort to almost double its current power-generating capacity, the Brazilian government has decided to privatize government-owned electrical power plants (98% of existing plants) and a substantial majority of the distribution utilities. The government also established regulations and tariff policies designed to stimulate investment in new plants. An estimated 35,000 to 50,000 megawatts will be added to the current generation capacity of 56,000 megawatts. Some estimates indicate that the assets to be privatized are worth over US$60 billion; a similar amount is required for investment in new power generation. The Brazilian private and public sectors agree that it will be impossible to meet such investment needs without substantial participation of foreign investors.

Basic Criteria for Evaluating Investments

Foreign investors typically evaluate investments in electricity generation and distribution based on the present value of the expected future net cash flow, discounted at a certain rate of return. The rate of return is itself a function of the opportunity cost (the rate at which the investor could otherwise invest its funds) plus a margin that reasonably compensates for the additional risks involved in the new investment under consideration. That rationale is used to evaluate direct investment as well as to determine interest rates for foreign-funded project financing.

Thus, the higher the risks or uncertainties the local legal environment presents, the higher the rate of return sought by the foreign investor; consequently, the lower the market value of the assets to be privatized (and/or the higher the future tariffs), the higher the corresponding financing interest rates will be.

In light of these considerations, the Brazilian government hired a team of foreign and local consultants to propose a new regulatory framework for the electrical power sector. The new rules are expected to create a friendlier legal environment for investors, thereby positively influencing the rate of return/present value/interest rate equations mentioned above.

Despite governmental efforts, at least two other risk factors which negatively influence the evaluation equations are not expected to be reduced by the new regulations: 1) the non-convertibility of the local currency, and 2) the complexity of the civil procedure rules, which renders the enforceability of contractual obligations costly and time consuming.

The Non-convertibility of Brazilian Currency

Foreign exchange control in Brazil dates back to the 1930s, when the obligation for exporters to sell their foreign currency proceeds to official banks against Brazilian currency was imposed. Foreign exchange control is a consequence of the inability of successive governments to curb governmental expenditures and balance the fiscal accounts. Direct or indirect control of foreign exchange allows the government to influence the price and availability of goods, thereby partially and artificially neutralizing the most visible symptom of inflation: price increases.

In 1962, the so-called “Foreign Capitals Law” (Law 4.131), which remains in force, was enacted. Similar to previous legislation, this law mandates that foreign currency invested in Brazil is to be exchanged for Brazilian currency by a bank authorized by the Central Bank of Brazil to undertake foreign exchange transactions. Law 4.131 also provides that upon such mandatory acquisition of Brazilian currency the foreign investor is to be granted a Central Bank “Investment Certificate”; this document authorizes the investor to purchase the same amount of foreign currency originally invested, plus an amount equivalent to the gains and profits produced by such investments, at the time the investor decides to return the invested capital abroad.

The investment certificate system has been working well for the last 35 years. There are no reports of holders of duly issued investment certificates having been prevented from acquiring foreign currency in the Brazilian foreign exchange market to repatriate their investments. An exception to the stability of the investment certificates system occurred during the developing countries’ debt crisis in the early 1980s, a consequence of which was the delay in some remittances of foreign capital abroad. This crisis nearly exhausted the Central Bank of Brazil’s foreign currency reserves. Unable to provide the banking system with enough foreign currency to honor all investment certificates, the Central Bank had to negotiate the restructuring of the Brazilian foreign debt with the international banking community.

Even during the 1980s crisis, however, equity investments, publicly traded bonds and similar securities were not affected by the restructuring, and the corresponding investment certificates were duly honored by the Central Bank. Today there are no signs that Brazil could be affected by another debt crisis. Indeed, the country has a comfortable amount of foreign currency reserves in relation to its foreign indebtedness. These reserves are sustained by steadily growing exports.

With the creation in 1989 of the so-called “Floating Rates Foreign Exchange Market” by the Brazilian Monetary Council, it became possible for anyone, through a foreign financial institution, to buy foreign currency. The fact that, after eight years, present exchange rates in the Floating Rates Market are very close to those in the Free Rates Market is an important indication of the current strength and stability of Brazilian reserves.

In view of the foregoing, and taking into consideration that the bulk of foreign investments in the Brazilian electrical power sector is expected to come either as equity or through project finance funded by publicly traded bonds, foreign investors should realistically have little concern as to the convertibility risk of Brazilian currency.

Enforcing Contractual Obligations in Brazil

Under the influence of a radical interpretation of the “due process of law” constitutional principle, the Brazilian Civil Procedure Code establishes a myriad of successive judicial phases and possible stays which render the enforcement of contractual obligations complex, costly and time consuming.

As a rule, there is no non-judicial foreclosure in Brazil, and the Civil Code generally prohibits the transfer of collateral property to the creditor. The foreclosure of guarantees follows a judicial procedure after which the collateral is sold in a public judicial auction. While the entire procedure normally lasts four to eight years, a particularly complex case could take fifteen years to resolve. As a rule, the debtor will retain possession and have unrestricted use of the collateral until the end of the foreclosure proceedings; the creditor can do virtually nothing to interrupt the debtor’s activities during the proceedings.

Changing this situation will necessarily involve substantial efforts on the part of the government. Politicians and judges, who tend to act in a protective and paternalistic manner with respect to the debtor, must realize that excessive protection of debtors compromises the country’s ability to attract investment at moderate costs.

In fact, the absence of a fast and effective way to enforce contractual rights reduces the country’s appeal to entrepreneurs and asset managers. Those investors who accept the risks of doing business in such an inhospitable environment are only doing so because of the possibility of obtaining higher returns than they would get elsewhere. On the other hand, those investors who, in principle, were to be “protected” find themselves paying higher interest rates or being forced to accept lower amounts for their assets which are being sold.

In the case of electrical power sector privatization, the additional “risk margin” required by the foreign investor represents a huge cost. That cost will be borne by the country itself, as its assets will be sold for less than they would be worth in a more stable environment. Moreover, that cost will be shared by the consumer in the form of higher tariffs and the potential for increased inflation rates.

The law firm of Levy & Salomão Advogados is located in São Paulo, Brazil. Its practice areas include international banking, contracts, taxes, litigation and corporations.