13.04.11

Restructuring Company Debt by Means of Debt-for-Equity Swaps
Leonid Romanov, Senior Lawyer,
Alinga Consulting Group

By Leonid Romanov, Senior Lawyer   Leonid received his legal education at the Moscow City Government University and is currently preparing his doctoral dissertation at the Russian Academy of Science’s Institute of State and Law. Leonid has extensive experience in the area of business law. To name just a few of his achievements, he has worked as a corporate lawyer and guided the construction of major business centers and hotels in Russia, the construction of holding companies in various regions of Russia as well as overseas, and guided several major transactions involving the acquisition of joint stock companies and limited liability companies. Leonid is a member of the Association of Lawyers of Russia. Follow Alinga:   Alinga Consulting Group +7 (495) 988-21-91 consult@acg.ru

It has been almost a year since the concepts of debt-for-equity swaps have come into practice in Russia. Prior to December 31st, 2009, Russian law directly prohibited such transactions, which caused particular bewilderment, especially, among overseas investors acting in Russia, since these methods of debt reconstruction have long been recognized by the legal systems in foreign countries. The lack of such mechanisms in Russia previously forced those conducting commerce in Russia to use various other “schemes,” which often carried significant risks for both the company, as well as the creditor trying to maintain control over the company and restructure its existing debt. The significance of debt-for-equity swaps cannot be overstated. Of the major transactions that have taken place in Europe in the past five years that have involved off setting debt, the following are particularly notable:

• Jarvis (Construction – 2005) – a debt of 350 million pounds sterling was exchanged for 95% of stock;
• Concordia (Bus company – 2005) – a debt of 160 million euro was off set;
• Schefenacker (Auto parts manufacturer – 2007) – a debt of 200 million euro was restructured.

By using debt for equity swaps in practice, creditors, company owners and management have received an effective means of liquidating debt, while at the same time receiving shares or bonds in the company. In addition, adopting this institution allows companies to retain financial solvency without filing for bankruptcy and incurring all the expenses that go along with it. Debt-for-equity swaps may also be used as a means for motivating a company’s upper management by means of distributing part of their compensation as shares. However, it should be taken into account that, in accordance with the Labor Code, no more than 20% of salary can be paid to an employee in a non-monetary form.

It is also necessary to note that the Federal Law “On Banks and Banking Activities” retains a prohibition on debt for equity swaps of credit organizations. The following limits related to debt for equity swaps are important to note:

• The statute of limitation on collecting the debt to be converted should not have expired as at the date of conversion. As a general rule, the limitation period is three years, however, this limit may be changed by conditions in the contract;
• Only monetary liabilities can be subject to such swaps; in other words, in the event that the company owes the creditor property or services and the company cannot fulfill its obligations to its creditor, it may propose swapping the non-monetary debts for monetary debts (which would incur a contract termination fee) and then perform a debt-for-equity swap for this portion;
• Participant or third parties can use debt-for-equity swap only in event of additional contributions to the equity. It means that debt-for-equity swap can not be applied with charter payments by participants in stage of company formation;
• The resolution to make a debt-for-equity swap in a limited liability company should be taken by all of the company’s shareholders unanimously; in other words, if even just one of the shareholders is absent for such a meeting, the other shareholders may not make a decision regarding the debt-for-equity swap;
• In joint-stock companies, only additional shares issued by means of a private offering may be used for the debt off set. The debt off set may not be applied for paying for shares distributed during the company’s founding or for paying for shares distributed by means of a public offering. The Federal Law “On Joint-Stock Companies” directly states that all other types of fi nancial instruments (bond certifi cates, for example) of the company should be paid for only with cash;
• In the event of a debt swap in jointstock companies, no less than 75% of votes from the shareholders with voting rights are needed in order to make an affirmative decision.

Aside from the limitations in Russian legislation outlined above, there are also additional pitfalls to consider when carrying out debt swaps. Therefore, a legal compliance review of the proposed plan for off setting a debt should always be performed in order to minimize risks.

In conclusion, it should be noted that debt for equity swap is a specific way of off setting mutual obligations between business partners. Although debt-for-equity swaps have been in practice for less than a year in Russian law, the concept of off setting claims between businesses has existed in Russian practice since the Russian Civil Code was adopted and was present even prior to this in soviet civil law. The practice of applying the general rules of mutual off sets may be applied to debt-for-equity swaps. Unfortunately, there are no major transactions involving debt-for-equity swaps with Russian companies, however, there have been positive applications of debt-for-equity swaps among small and mid-sized Russian companies created by both Russian and foreign investors.

The notable tendency toward liberalization in Russian corporate law, along with the introduction of new institutions and mechanisms well-known in business practices abroad, will be conducive to attracting additional investment to Russia as well as to allowing current investors to more effectively resolve pertinent issues. 

(Original article was published by AEB and may be viewed here (PDF). The article is reprinted by permission.)

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