DEBT-TO-EQUITY CONVERSION: NEW OPPORTUNITIES FOR RESTRUCTURING OF JOINT STOCK COMPANIES IN UKRAINE

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1 DEBT-TO-EQUITY CONVERSION: NEW OPPORTUNITIES FOR RESTRUCTURING OF JOINT STOCK COMPANIES IN UKRAINE The world financial crisis seriously affecting the Ukrainian economy became an "endurance test" for a greater part of Ukrainian companies at various sectors of national economy. Outstanding corporate debts are menacingly zooming up, and many companies, unable to service their debt burden, appeared next door to bankruptcy. In view of these ominous events the restructuring of a balance sheet and out-of-court settlement in bankruptcy proceedings became more than acute for those companies which try to avoid the judicial bankruptcy proceedings and to stay afloat in these tough financial times. This article seeks to focus on the debt-toequity conversion (debt-for-equity swaps) as a method of full or partial discharge of distressed corporate debts. Though currently being not in high favor compared to other ways of restructuring, it may eventually appear a preferred option for debt recovery both for a debtor and its creditors in a situation when available assets are evidently insufficient for immediate redemption and debt repackaging strategy may yield positive effect in future. Within the framework of a debt-for-equity swap a creditor receives equity interests in a company in consideration for full or partial cancellation of its debt claims against the company. As a result, the capital structure of a corporate debtor with negative cash flows and/or balance sheet solvency problems is significantly modified and such financial indicators as a debt-equity ratio and debt service charges are considerably improved. In practice this kind of restructuring may be 1

2 also referred to as "equitisation of debt". It may be effectively used both by corporations trying to renegotiate its debt, and the governments in order to settle state or municipal debts. In the former case a company believing that the current financial distress is only a temporary one tries to suggest a stake in its future revenues in return for a write-off of its debt. In the latter case the holder of a sovereign debt may opt to exchange it for a stake in a government-owned company in the privatization process. Each of the methods of debt restructuring has its apparent and hidden benefits and drawbacks, but all of them enable the debtor to avoid insolvency and continue to trade. In legal terms, the debt-to-equity conversion, succeeding in reducing debt burden, constitutes a novation cancellation of the initial commitments by parties' mutual agreement of their substitution for new commitments. The parties at the bargaining table should agree a part of the debt to be converted into equity, the type of equity to be allotted to the converting creditors, as well as the terms and conditions of this allocation. Such a compromise may secure approval of a bailout plan or a settlement agreement by the creditors' committee provided that the creditors are satisfied with the mechanism of such conversion, its tax consequences, as well as the level of protection granted by the debtor's jurisdiction. However, the debt-to-equity conversion may appear impracticable both from the debtor's and the creditor's perspectives. The management of a debtor may not tolerate the risk of loss of control and become reluctant to initiate the process (in fact, the main incentive for a creditor to waiver the immediate debt recovery is to 2

3 gain corporate control over a debtor the resulting benefits, by far exceeding the cancelled debt, may create a valuable business for participation of equity holders). The management team may seek to negotiate some equity for themselves in order to share in the future returns after the restructuring, bearing in mind, however, that the longer negotiating process is forestalled the less control the management team may have in its end. In practice, such conversions are sometimes used by creditors that intentionally acquire outstanding debts for the sole purpose of yielding control over a debtor (so called "loan to own" strategy). As a rule, the creditor purposefully underscores the portfolio of shares, thus the debt is rarely converted into equity on a pari passu basis. This form of restructuring may also happen to be inappropriate when numerous creditors are involved a statutory cram-down mechanism may be needed so that the decision of the creditors' majority can effectively bind a dissenting minority. The current shareholders of a debtor company whose stake will be diluted or entirely obliterated may also oppose to the change of control, and the terms of conversion acceptable for the creditors may appear unacceptable for the shareholders resulting in difficulties while approving the debt-to-equity conversion agreement and/or issuance of additional shares by the general meeting of shareholders. Last but not least, a debtor shall bear organizational and financial expenses in connection with the issue of new shares or relating to compliance with the statutory rules on redemption of shares. However, the creditors may consider it equally inappropriate to convert debt into equity they are more often motivated to get "hard cash" rather than the company's shares which are usually not listed and severely dropped in price due to 3

4 the issuer's financial straits as well. At the same time, while a debtor negotiating the restructuring deal by other ways has to convince the creditor that in the measurable future the company will pay off the debt in full, and the creditor often has to rely on his bare word, the debt-to-equity conversion enables the creditor to take the reins of power and maintain a hold upon the debtor's affairs. Vital is the correct analysis by the creditor of the expected future upsurge of the company's financial indicators or other factors which may substantively increase the value of the issuer's business and justify the waiver of commencing the insolvency proceedings. Should the plan of financial rehabilitation of the debtor have no positive effect and other creditors commence insolvency proceedings, the former secured creditors, now reduced to the shareholders, are shifted from the first rank straight to the eighth during the division of property of the insolvent debtor. Over past decades high-profile debt-to-equity conversion was not uncommon in European debt restructurings. For example, in the UK in 1990s many lending banks were more or less inclined to abstain from pursuing enforcement strategies in exchange for receiving equity rights in a debtor company. This trend has survived in the recent years. In 2002, for instance, as a consequence of restructuring the creditors of Marconi, the British company in telecommunications sector, exchanged approximately 4 billion of debt for 99.5% of the ordinary equity in the company. This was also the way for British Energy (97.5% of equity and 425 million of new bonds in exchange for 1.3 billion of debt), Telewest (98.5% of ordinary equity were exchanged for 3.8 billion of bond 4

5 debt) and Concordia (97.5% of the equity in Concordia were offered to the holders of 160 million senior subordinated notes). One of the major obstacles to the common use of this method of debt restructuring in Ukraine is scarcity of legal regulation concerning such conversion. The available legislative rules envisage only a hypothetic possibility of such conversion leaving aside the practical mechanism of its implementation. Pursuant to Article 18 of On Restoration of Solvency of the Debtor or Recognition of Bankruptcy Act of Ukraine of 14 May 1992 No.2343-XII, the bailout plan may contain, inter alia, provisions on the exchange of creditors' claims for the debtor's assets and/or its equity rights. Similar condition may be included into a settlement agreement, in accordance with Article 37 of the said Act. Article 21 of On Joint- Stock Companies Act of Ukraine of 17 September 2008 No. 514-VI, permits the joint-stock companies to issue shares and bonds to cover conversion of the company's debts into securities. This rule does not link the debt-to-equity conversion with any judicial bankruptcy proceeding and imposes no ban on such conversion to be effected at any stage of bankruptcy proceeding. By now the Securities and Stock Market State Commission prepared the draft Regulation On the Order of Conversion of Debts of Joint-Stock Companies into Securities (the "Draft Regulation"), to be approved in the near future. According to the Draft Regulation, the debt of a joint-stock company may be converted into securities of this company during securities offering as well as in case of selling own securities redeemed by the company. Thus, the issuance of new shares is not necessarily required to cover the conversion the company may 5

6 redeem the shares and sell them to the creditor. The legal framework of such restructuring is the sale and purchase agreement entered into between the issuer and the creditor and subsequent set-off. The Draft Regulation provides that only monetary debts of a joint-stock company may be converted into securities by setoff; this follows from the legally required uniformity of the claims to be cancelled by set-off. In this case the issue of shares is effected in regular order provided for by Regulation On the Order of Registration of the Shares' Issue, approved by the Decision of the Securities and Stock Market State Commission of 26 April 2007 No.942. However, following the debt restructuring negotiation the creditors may wish to execute an agreement securing the debtor's commitment to deliver its shares to the creditors in the future. Therefore the Draft Regulation also stipulates for the agreement to be entered into between the creditor and the debtor on the novation the cancellation of initial debt of the company and origination of a new commitment on delivery of the debtor's securities to the creditor. The Draft Regulation is silent on the formal enforcement mechanism which may be needed for the creditors to gain corporate control. Debt-to-equity conversion may also be effected by means of convertible bonds. Pursuant to Article 8 of On the Securities and Stock Market Act of Ukraine of 23 February 2006 No.3448-IV, the terms of bonds offering issued by a jointstock company may provide for the option of their conversion into the issuer's shares redeemed by the company and appeared on the balance sheet of the company (convertible bonds). The issue of ordinary shares during conversion of 6

7 the bonds results in the increase of the issuer's charter capital. The swap ratio determines the number of shares to be distributed among the bondholders. Summarizing this brief review, we can conclude that the debt-to-equity conversion stands a chance to become an in-demand way of debt restructuring in this recessionary season of our national economy. Featuring undeniable advantages both for the creditors and the debtors, it can be of practical help for the latter in their attempts to avoid insolvency and turn over a new leaf in their business history. However, there is an obvious need in a regulatory mechanism for such conversion designed to protect both parties the creditor and the debtor. Subject to due finalization, the above-mentioned Draft Regulation may provide a good framework for such a mechanism... The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of Asters Law Firm. 7

8 Information about Author Oleksandr Igorovych Vygovskyy, LL.M (University of London), Ph.D (University of Kiev), Attorney at law (Kyiv Bar Association), Associate (Asters Law Firm), Lecturer in Private International Law (Institute of International Relations, University of Kiev). 8