VARIG FINANCIAL CRISIS DEEPENS

UNCLAS SECTION 01 OF 03 BRASILIA 001566

SIPDIS

SENSITIVE

STATE PLEASE PASS TO USTR
NSC FOR BREIER
DEPT OF TREASURY FOR FPARODI
USDOC FOR 3000/JOHN TOCCO
USDOC FOR 3134/USFCS/OIO/WH/EOLSON
USDOC FOR 4332/ITA/MAC/WH/OLAC/MWARD
USDOC FOR 6950/DEAN WODDARD - AEROSPACE
DOT FOR SUSAN MCDERMOTT, CAROLYN COLDREN
FAA MIAMI FOR MARK RIOS

E.O. 12958: N/A
TAGS: EAIR EINV PGOV ETRD BR
SUBJECT: VARIG FINANCIAL CRISIS DEEPENS

REF: A) 2004 BRASILIA 2939, B) RIO DE JANEIRO 198


1. (U) This cable is based upon information gathered by the
Econ and FCS Sections at AmEmbassy Brasilia.


2. (SBU) Summary. The financial situation of VARIG,
Brazil's troubled flagship carrier, is worsening. Airline
officials have told Deputy Senior Commercial Officer that
in the absence of some sort of rescue package the company
would only survive 30 days. So far, however, key GOB
officials have not signed on to the restructuring deal
being negotiated by VARIG's new board. Meanwhile, one of
companies which leases aircraft to VARIG has demanded the
return of its planes because of the failure of the airline
to pay the lease expenses. We foresee the current crisis
shortly becoming very public and very messy. End Summary.


3. (SBU) On June 7, USCS Deputy Senior Commercial Officer
(DSCO) telephoned Vice-President (and Defense Minister)
Alencar's Chief of Staff to inquire about the status of
VARIG. Our interlocutor pledged to pass this query to
VARIG; ten minutes later VARIG President Henrique Neves
called back to relay the following information:

-- On May 9, VARIG's management was taken over by a new
board of directors comprised of executives from major
multinational corporations doing business in Brazil. The
Rubem Berta Foundation (i.e., the VARIG employee
association),which proved incapable of making difficult
decisions, now no longer has any direct involvement in
company management.

-- VARIG and the Portuguese airline TAP are working on a
4-stage plan to return the company to financial health.
Stage 1 of the plan contemplates conversion of much of
VARIG's outstanding debt into equity shares of a
reorganized corporation.

-- Stage 2 of the plane envisions TAP purchasing 20
percent (US$300 to $400 million) of the reorganized
corporation. This, along with the debt restructuring,
would generate approximately US$500 million.

-- Stage 3 involves VARIG and the GOB coming to an accord,
whereby the latter agrees to drop its appeals to a US$1.1
billion judgment in the airline's favor and VARIG, after a
six-month grace period, agrees to start paying its debt to
the GOB.

-- Finally, in Stage 4 the shares from the newly-formed
VARIG would be sold on the market and the creditors who
became asset holders would then receive their cash.


4. (SBU) Significant obstacles stand in the way of the
realization of this plan. First, VARIG reports that while
creditors such as Boeing and GE Engines have agreed to the
plan, leasing companies with newer planes - such as the
International Lease Financing Corporation (ILFC),a
subsidiary of AIG -- are balking as they believe that their
aircraft could be profitably diverted to another paying
lessee. VARIG worries that if ILFC, which supplies 11 of
the company's 82 aircraft, remains recalcitrant, other
lessors (like GECAS, GE's leasing arm) may adopt a similar
stance. (Indeed, even the extent to which Boeing is on
board is still up in the air as in our contacts with Boeing
representatives they declined to confirm any accord with
VARIG.) And without the debt-for-equity swap, TAP would
not proceed with the purchase of 20 percent of the
restructured company.


5. (SBU) Second, key questions such as who would control
the restructured company and the status of TAP's debt to
the GOB remain unresolved. Given its substantial
investment, presumably TAP would want a majority of the
voting (as opposed to the common) shares of the company.
However, Brazilian law explicitly provides that foreign
investors in the aviation sector may hold no more than 20
percent of the voting shares of a carrier. In addition,
TAP itself owes approximately US$23 million in taxes to the
GOB, although it maintains that a 2002 presidential decree
partially extinguished at least part of this debt.


6. (SBU) Third, the GOB has not yet agreed to drop its
appeal in the US$1.1 billion court case, nor has it agreed
to the six-month moratorium on payment of outstanding debt
owed to government agencies. Presidential Chief of Staff
Jose Dirceu publicly characterized a recent meeting between
VARIG, TAP, and high-level Lula administration officials on
this issue as a "waste of time," federal attorneys who have
reviewed the matter have weighed in against such a
transaction. Among other things, Dirceu and Finance
Minister Palocci likely worry that if the government cuts a
special deal for VARIG, it may face similar demands from
both plaintiffs with similar lawsuits and recalcitrant
debtors with just as compelling excuses. For its part,
VARIG reports that Dirceu has pledged that the GOB will
analyze the carrier's proposal and respond within ten days
after the June 2 meeting. Meanwhile, VARIG says the GOB
has released US$40 million in cash to allow the company to
make its payroll.


7. (SBU) Finally, even after the restructuring was
completed, Neves told DSCO that the company would need to
lay off 5,000 employees and gain access for four to six
months to a US$100-150,000 line of cash per month. And
while the new airline would possess key national and
international routes, it would also inherit a fleet of
aging, high-maintenance aircraft, declining market share,
and stiff competition from an increasing array of low-cost
domestic carriers.


8. (SBU) Comment. There is ample reason to believe that
the hour of reckoning for VARIG has arrived. Unidentified
VARIG officials have been quoted in the local press as
stating that without a rescue package the airline won't be
able to survive past year's end. Neves was even more
pessimistic, declaring that if the restructuring did not
work the airline would only survive 30 days. While VARIG
certainly has an ulterior motive for emphasizing its dire
straits, the tone of its contacts with the Embassy over the
past few days has become increasingly desperate. Whether
the proposed restructuring will inject enough capital into
the carrier to actually satisfy all the creditors will soon
become apparent. Now could truly be make or break time for
the airline.


9. (SBU) While Vice President Alencar -- the GOB's
principal point man on VARIG issues -- has vacillated
between a bail-out and the "let the market resolve the
situation" option, VARIG's selection of a new management
team may well have precipitated its end rather than its
rescue. The new president of the company's Administrative
Council is David Zylbersztajn, the son-in-law of former
President (and now opposition leader) Fernando Henrique
Cardoso. Analysts here had worried that Zylbersztajn and
his hand-picked team, members of which are closely
associated with the PSDB - i.e., the rival party to the
Lula administration, would set VARIG on a "collision"
course with the GOB.


10. (SBU) Who blinks first and the ultimate consequences
for VARIG are still open questions. While the demise of
VARIG, for years the country's flagship carrier, would
definitely be a bitter pill for the Brazilian public to
swallow, the prospect of a cash-strapped government using
public funds to heal a private company is medicine just as
unpalatable.

Danilovich