Segregate estates relating to judicial recovery in Brazil and the Esser Group case
Rossana Fernandes Duarte
Mattos Filho, São Paulo
Bruna Carolina Fernandes Teixeira
Mattos Filho, São Paulo
In Brazil, real estate developments are defined by Federal Law No 4,591/1964 as the activity undertaken to promote the construction, for total or partial sale, of buildings or complexes of buildings comprising autonomous units. In particular, the obligations of developers are regulated in detail, as they involve the advance payment of assets which will only exist in the future.
As a general legal concept, the doctrine of segregate estates dates back to the late 19th century.
Previous legislation contained tools which were not effective in protecting the interests of buyers in the case of a developer’s insolvency. Only recently was Law No 10,931/2004 enacted to amend legislation and, specifically, deal with segregate estates in the context of real estate developments. The regulation of segregate estates in the case of real estate developments was triggered by the crisis that took place in the Brazilian property market in the 1990s. The crisis included the bankruptcy of a major player which left buyers without properties they had paid for, and any form of compensation. Accordingly, lawmakers realised the relevance of establishing rules to ensure the completion of real estate developments in an insolvency scenario, ensuring the delivery of purchased properties to buyers by tying the funds paid by them to the completion of constructions.
The matter is far from simple however, given that, in addition to all peculiarities of real estate developments, it has become increasingly common for developers to use special purpose vehicles (SPVs) when structuring their business.
This article addresses whether or not judicial recovery can be applied to such SPVs where a segregate estate is created for each SPV. Recently, the judicial recovery of a major Brazilian developer which used this business model, namely the Esser Group, has been the subject of considerable discussion within the judiciary. Although the issue has not been solidified in Brazilian case law, the Esser Group case, decided by the Superior Court of Justice at the highest level of the judiciary for matters of federal law, may indicate the current direction of case law.
This structure, the creation of a segregate estate, and the use of SPVs are particularly important for cross-border lawyers representing foreign and international financial institutions which finance real estate developments in Brazil and foreign shareholders of Brazilian construction companies.
Summary of conclusions
The assets comprising a segregate estate are not be subject to the developer’s recovery plan to ensure that the credits of each development are reserved for the relevant group of creditors.
In case of a developer’s judicial recovery, each real estate development for which segregate estate was created can normally be continued.
On the completion of a real estate development, any credit balance reverts to the judicial recovery estate and, as such, is subject to the effects of the recovery plan.
There is no solidified case law determining whether judicial recovery is available to an SPV active in a real estate development.
SPVs for which no segregate estate was created can pursue judicial recovery, subject to certain conditions.
Segregate estates in Brazil: real estate developments
In Brazil, segregate estates are characterised as follows: (1) the segregate estate is not touchable by the general liabilities of the developer or other segregate estates created by the developer; (2) the developer is liable for losses caused to a segregate estate; (3) the components of a segregate estate (land, accessions, sales revenues, obligations resulting from the business, and the relevant tax, employment and social security charges) can only be used for credit transactions whose product fully reverts to the pursuit of the completion of the relevant development and the delivery of the real estate units to their buyers; (4) in case of full or fiduciary assignment of receivables resulting from the development, the relevant consideration must revert to the segregate estate; and (5) the funds comprising the segregate estate must be applied solely towards payment of the obligations inherent to the development.
However, funds exceeding the amount required for the completion of the construction and full payment of financing taken to complete the development are excluded from segregate estates. In specific cases, so is the amount relating to the sale price of the ideal share of land ascribed to each unit sold.
One important characteristic of segregate estates in Brazil is that subjecting a development to this regime is a right exercisable at the discretion of the developer. However, although the institution of a segregate estate creates additional obligations for a developer, it also has a major advantage, since the creation of a segregate estate entitles the developer to a lower levels of federal taxation.
A segregate estate is terminated: (1) on completion of all the developer’s obligations towards the creditors of the development (buyers and financier); (2) if the development is terminated within the relevant grace period of the development, if any, at the discretion of the developer; or (3) if a final decree of bankruptcy or insolvency of the developer is entered and the buyers, represented by their representatives’ commission, elect to liquidate the development.
Law No 14,382/2022 provides further details on the time of occurrence of a termination event, with respect to each autonomous unit sold by a developer while undertaking its business.
Segregate estates and judicial recovery in Brazil
Judicial recoveries are regulated by Law No 11,101/2005 and seek a balance between the protection of creditors and the survival of companies. Ultimately, it is intended that the company achieves its social function by retaining jobs and the supply chain relating to the respective business, providing an incentive to the economy, and protecting creditors. When a company goes through judicial recovery, its debts are novated.
A judicial recovery is processed in court and the creditors consider the recovery plan submitted by the company seeking recovery. If the recovery plan is not approved, or approved but the company defaults in the plan, then the judicial recovery is converted into a bankruptcy decree. Pursuant to the amendments brought about by Law No 10,931/2004, segregate estates cannot be included in a judicial recovery or bankruptcy estate.
Law No 10,931/2004 did not contemplate how segregate estates created specifically in the context of real estate developments are to be treated in cases of the developer seeking judicial recovery. In accordance with the recovery and bankruptcy law (Law No 11,101/2005), the provisions applicable to segregate estates in cases of bankruptcy under specific Law No 4,591/1964 are used to address cases of judicial recovery. Therefore, as mentioned, the buyers may elect either to liquidate the construction and the segregate estate or continue the construction. However, a resolution to continue the construction will become ineffective in case of default on the tax, employment and social security obligations associated with the segregate estate by the deadlines specified in law.
On completion of the construction and delivery of the units, any remaining credit balance reverts to the estate of the recovering company.
As discussed above, it has become usual for developers to use SPVs to structure their projects. As a rule, the SPVs are affiliates of a holding company and together they constitute an economic group in which the purpose of each SPV is one sole real estate development. However, simply restricting the purpose of each SPV to one development does not have the same effect as the creation of a segregate estate, as creditors of an SPV are subject to its insolvency because it touches all rights and liabilities of the SPV.
The Esser Group case
The Esser Group focused on real estate developments, construction, and sale of residential and non-residential properties. The group comprised three holding companies and several SPVs. The corporate purpose of each SPV was the real estate development of one project.
In April 2020, the Esser Group filed for judicial recovery, the availability of which was the subject of much debate within the different levels of the judiciary.
Initially, the lower court accepted to process the judicial recovery.
The Court of Appeal, however, held that SPVs used in real estate developments, irrespective of whether they had segregate estates, was inconsistent with the nature of judicial recovery. After examining each holding company and SPV, the Court held that the mere existence of a project to build a development was insufficient to prove that the purpose of each such company had been pursued. The Court of Appeal further held that recovery did not apply to temporary activities, such as real estate developments, because even though they have the characteristics of a company’s enterprise, the activities of such companies end on the completion of the construction and delivery of the units. In cases of SPVs with segregate estates, this inconsistency is more patent because the segregate estate is only liable for one given project. The decision not to accept to process the judicial recovery of the controlled SPVs was also applied to their controlling holding companies.
More recently, the case was brought to the Superior Court of Justice, which held that the characteristics of a segregate estate are inconsistent with the nature of judicial recovery because credits resulting from the unit sale agreements and obligations resulting from the construction and delivery of the units cannot be novated. Additionally, the segregate estate cannot be touched by other liabilities of the group’s companies. SPVs which did not employ segregate estates can apply for judicial recovery subject to two conditions: (1) not having been removed from management by the representatives’ commission; and (2) not using substantial consolidation so that a single recovery plan would not be possible. This resulted in the judicial recovery of the whole Esser Group being denied.
The view that the assets comprising a segregate estate should not be subject to the developer’s recovery plan is in line with the protection of social values. This is as envisaged by Law No 10,931/2004, namely, to ensure that the credits of each development are reserved for the relevant group of creditors, excluding the general creditors of the developer unrelated to the project. This ensures the completion of the construction and secure buyers and financiers.
Because judicial recovery seeks first and foremost to preserve the activities of companies, in cases of a developer’s judicial recovery, each real estate development for which segregate estate was created can normally be continued by its management, fed by the receivables resulting from sales of future units and the financing of the project. The use of such funds for other purposes is prohibited.
On the completion of a real estate development, the purpose of the segregation ends. The segregate estate terminates and the assets comprising it are no longer untouchable. Any remaining credit balance reverts to the judicial recovery estate and is, therefore, subject to the effects of the recovery plan.
The Esser Group case demonstrates that there is no solidified case law determining whether judicial recovery is available to an SPV active in the real estate development of projects, having a segregate estate or not.
As recently held by the Superior Court of Justice, SPVs for which no segregate estate was created can pursue judicial recovery, provided that the SPVs do not do so in the form of substantial consolidation of the economic group, further provided that they have not been removed from the management of their projects.