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UNCLAS SECTION 01 OF 03 BRASILIA 001185 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: EAIR EIND OPRC BR
SUBJECT: BRAZIL'S VARIG AUCTION: DESTINED TO FAIL, IT DID 
 
 
(U) This cable is business-sensitive. Please protect accordingly. 
 
¶1. (SBU) VARIG, Brazil's troubled airline with USD 3.5 billion in 
debt, went for auction in two rounds on June 8.  After failing to 
attract any bids at the USD 860 million minimum in the first round, 
the company received a USD 449 million bid from an employees' group 
(TGV) in the no-minimum-bid second round.  The Rio judge presiding 
over the auction has delayed decision about acceptance of the 
employees' bid.  Meanwhile, New York bankruptcy court judges gave 
Boeing the go-ahead to repossess 7 aircraft.  VARIG's fuel payment 
abeyance granted by Petrobras ran out on June 9 with no signs of a 
new agreement.  Consequently, VARIG was forced to cancel at least 63 
flights (4 of them indefinitely) over the period June 10-13 as the 
airline was unable to pay for fuel.  Competing airlines TAM and GOL 
are the big winners from the uncertainty, with their stocks rising 
12 percent and 5 percent, respectively, in the first day after the 
auction.  End Summary. 
 
A BYZANTINE PROCESS, UNCLEAR RESULTS 
------------------------------------ 
 
¶2. (SBU) Boeing executive Jose Sicilla explained to Econoff that, in 
the opinion of industry insiders, the auction, which required 
up-front injections of cash but offered little security for 
investors, was destined to fail.  To comply with Brazilian 
investment restrictions, a foreign investor would have to bring in a 
Brazilian partner.  The airline was to be sold in an open bid in 
which a buyer could purchase VARIG's domestic operations (termed 
"VARIG Regional") for USD 700 million or the entire airline ("VARIG 
Operational") for USD 860 million.  Within, three days after the bid 
acceptance, the winning bidder, if any, would have had to inject USD 
75 million in cash for immediate operations requirements.  Thirty 
(30) days after purchase, the winning bidder would have had to 
inject another 50 million in cash into the company.  Sicilla pointed 
out that the minimum amount of time required to obtain all the 
necessary legal operational approvals from Brazilian authorities is 
30-60 days.  Therefore, the winner, despite having injected up front 
cash into the operation, could not move quickly to make any major 
management decisions, for example dealing with the critical issues 
of downsizing the workforce, the renegotiation of leasing contracts, 
or achieving a collective bargaining agreement. 
 
¶3. (SBU) In the event the winner of the initial round did not 
receive all the necessary approvals, Sicilla continued, then the 
second-place bidder would be declared the winner and would have to 
pay back the first bidder's investments in the company (USD 125 
million), but would still be required to start the approvals process 
with Brazilian authorities from scratch.  Moreover, if the money to 
be used to re-pay the first bidder were needed to cover VARIG 
operational needs, then the funding could be diverted to that 
purpose instead, leaving the first bidder out USD 125 million with 
nothing to show for its investment.   The winner would then have to 
wait through a legal process to recoup its investment.  "What 
business would put itself through that?" Sicilla asked. 
 
¶4. (SBU) Initially, TAM, GOL, OceanAir, Ceu Azul  and NV 
Participacoes all paid Reals 60,000 (USD 26,000) to access the VARIG 
data room, giving them access to what was supposedly the most 
complete and accurate information on the airline.  According to 
Sicilla, nothing could have been further from the truth.  The data 
room was open for a mere 7 days, key officers lists in the company 
were incorrect and valuation data included assets that had been 
offloaded to TAP, Portugal's flagship carrier. 
 
FINAL BID ABOUT HALF OF THE ASKING PRICE 
---------------------------------------- 
 
¶5. (SBU) In the end, only the employees' association TGV (VARIG 
Workers' Group) placed a Reals 1.01 billion (USD 449 million) bid on 
the entire airline.  The "winning" 449 million bid came in the 
second round of bidding, which carried no minimum, after no bids 
were received in the first round.  To be valid, the 8th Circuit 
Court judge in Rio has to accept the terms of the bid.  The judge 
delayed his decision to accept the bid from June 9 to June 14, 
giving himself the weekend to interpret the law and later placing 
 
BRASILIA 00001185  002 OF 003 
 
 
two more conditions upon the bid.  First TGV would have to increase 
the cash portion of its offer from USD 125 million to USD 346 
million (from a 28 percent to a 77 percent cash offer).  Second, the 
group has to prove it has the obligatory USD 75 million to inject 
immediately into the company to pay VARIG creditors.  Upon getting 
the news, some members of the Brazilian Congress expressed concern 
about how the employees would raise cash necessary to make the 
upfront payments, a detail that has not been clear. 
 
BIGGEST PROBLEM: UNCERTAINTY 
---------------------------- 
 
¶6. (SBU) Many of the interested parties were unclear just what they 
would be getting themselves into by buying the airline.  Sicilla 
estimates that about 46 percent of VARIG's USD 3.5 billion debt is 
off-balance sheet (operating leases, synthetic leases, 
securitizations, special purpose entities, etc.) and it is still 
unclear as to how much exposure the 'winner' leaves itself open. 
Officially, the auction did not include past due liabilities. 
However, legal experts and industry analysts disagree with this 
simple pronouncement.  Nothing in Brazilian law has changed that 
would prevent any debtor from suing the new owner of VARIG in court. 
 Just as unclear is whether the new owner or creditor litigants 
would prevail in a court battle.  Most experts agree that, more than 
likely, the creditors would. 
 
¶7. (SBU) The airline's debt to the labor union and the pension fund, 
taxes owed to the government, and the lack of a collective 
bargaining agreement mean the airline's attractiveness to any 
serious bidder drops to zero, said Sicilla.  The lack of a 
collective bargaining agreement is a particular hindrance to any 
potential suitor, as the new owner would be unable to fire workers 
to bring the workforce in line with the current minimal operational 
levels without being sued -- a suit the employees would more than 
likely win, according to Sicilla. 
 
¶8. (SBU) Another uncertainty was the question of what exactly the 
winning bidder would be buying.  Sicilla cited as an example the 
failure of the data initially made public to clarify precisely what 
rights the purchaser of VARIG regional would gain.  Only after 
inquiries from some of the potential bidders was it made clear that 
the domestic VARIG operations would not include rights to trunk 
routes, the domestic routes that feed into VARIG's (relatively) 
profitable international routes.  As public property, the rights to 
those trunk routes would revert to ANAC, the Brazilian Civil 
Aviation Authority, which would be free to assign routes and airport 
space as it sees fit.  Sicilla stated that most of these would not 
be transferred to VARIG's new owner. 
 
IT'S NOT THAT WE'RE LAZY, BUT WHAT'S OUR MOTIVATION? 
--------------------------------------------- ------- 
 
¶9. (SBU) Sicilla noted that private debtors are well down the 
priority queue to recover their debt once VARIG is at last declared 
bankrupt.  The debt owed private debtors like the 19 American 
aircraft leasing companies (of the total of 29 aircraft lessors) 
would receive very low precedence, after the labor union, the 
pension fund, Brazilian IRS, Petrobras and INFRAERO.  Aircraft 
lessors, however, can work to recover their assets, even if they 
have little prospect of recovering their back payments.  Until last 
week, VARIG had still been paying its largest aircraft lessor, ILFC, 
even if not in full, according to Sicilla.  He added that Bristol, 
the company that repossessed its aircraft at JFK two weeks ago, has 
3 more craft with VARIG and will process the paperwork to get those 
back.  FOCUS, a company with 6 MD-11s, intends to pull out their 
aircraft at lease term end, at the rate of one a month through 
February 2007.  While Boeing was unable to get some other lessors to 
agree to take collective action on repossessing their aircraft, the 
company was able to get the New York Bankruptcy court judge to grant 
them the right to repossess seven of the ten aircraft it is leasing 
to VARIG.  Sicilla expects Boeing to be more successful this time 
compared to its last abortive attempt to repossess one of its 
VARIG-leased aircraft, when VARIG cancelled a Miami flight that was 
serviced with Boeing's plane and then switched the aircraft to a 
European route.  From June 10-13, VARIG cancelled 63 flights and 
 
BRASILIA 00001185  003 OF 003 
 
 
counting.  It has also suspended indefinitely four international 
flights to Miami, New York, Mexico City and Santiago, Chile, all of 
which are served by Boeing aircraft. 
 
AND THE WINNERS ARE: TAM AND GOL 
-------------------------------- 
¶10. (SBU) For a mere Reals 60,000, TAM and GOL, VARIG's largest 
competitors, got a cheap look at just how bad off VARIG was.  After 
seeing what was an unattractive prospect, a TAM executive offered, 
"after a detailed analysis of the risk/return, we opted not to make 
an offer on VARIG."  GOL did not even bother to make an excuse. 
Now, if VARIG is liquidated, TAM and GOL will get the bulk of the 
airport slots and routes.  As successful airline companies, they 
look like attractive partners for leasing companies who will court 
them.  They are almost guaranteed VARIG customers for free.  On the 
news of the failed auction, TAM stock jumped 12 percent and GOL 
stock rose 5 percent the day after the auction.  May year on year, 
TAM improved its local market share to 45.6 percent and GOL 
increased to 33.6 percent.  On the international front, TAM's market 
share increased to an all-time high of 28.6 percent, exceeding many 
analyst expectations. Airline industry experts now predict an even 
higher market share increase by December 2006. 
 
COMMENT 
------- 
 
¶11. (SBU) None of the proceedings of the auction come as much of a 
surprise, not even the Rio judge's weaseling out of an immediate 
decision.  The bankruptcy law states that immediate liquidation is 
required in the case of a failed auction -- and 52 percent of the 
asking price looks like a failure to us.  Worse still is the judge's 
final decision to place two more requirements on the TGV offer, thus 
merely postponing VARIG's certain death.  There was a momentary stay 
of execution for the carrier as creditors waited to see how the 
auction went.  Now that the result has come, creditors like 
Petrobras -- an immediate threat to VARIG operations since its 
agreement to supply gas on credit has not yet been renegotiated -- 
could pound the final nail into the VARIG coffin.  Other leasing 
creditors will await the results of this week's ordered return of 
craft, and more than likely follow suit. The lack of fuel, which has 
already led to numerous flight cancellations, impending 
repossessions, and failing public confidence may make the Rio 
judge's decision moot. 
 
CHICOLA