Conversion of Debt Into Equity

Illya O. Tkachuk

It goes without saying that each legal system should provide effective mechanisms for conducting business, in particular, provisions relating to operation and management of companies. One such mechanism is the possibility to convert a company’s obligations into equity. This mechanism allows the company to issues shares to offset its due and payable obligations and, thus, to avoid transformation of such obligations into debt and to use available funds for other business purposes.

Indeed, such a mechanism is widely used in Europe and the USA. For example, according to Article L225-128 of the Commercial Code of France, newly issued shares may be paid by a cash contribution, including by way of offset against the due and marketable (liquid) receivables of the company.

The possibility of conversion of debt into equity is also allowed by the laws of the Russian Federation. In particular, according to Article 34.2 of the On Joint Stock Companies Act of the Russian Federation, payment for additionally issued shares through offsetting of monetary claims against the company is allowed in the event of private placement of shares. Also, according to Article 19.4 of the On Limited Liability Companies Act of the Russian Federation, the company’s participants shall be allowed to offset their monetary claims against the company against their new contributions, and/or third persons shall be allowed to offset their monetary claims against the company against their contributions.

As one can see, the mechanism of conversion of debt into equity is recognized by and widely used in numerous jurisdictions. The aim of this Article is to draw attention to such an important mechanism and the features of its implementation in Ukraine.

Ukrainian background

Without going deeply into the history, it is worth mentioning that conversion of debt into equity was not possible under the legislation inherited by Ukraine after Soviet times. Naturally, having the principle, according to which it is not possible to increase the company’s share capital for the purpose of covering losses, it was not feasible to even imagine a situation where the share capital is increased without injecting real money.

Following numerous amendments and modifications, existing Ukrainian legislation contains a number of provisions relating to conversion of debt into equity. However, it is too early to say that the concept of conversion of debt into equity is being effectively introduced into the Ukrainian legal system.

It is worth mentioning that the laws of Ukraine differentiate between and provide different regulation for conversion of debt into equity in the case of joint stock companies and limited liability companies. While the On Joint Stock Companies Act of Ukraine directly provides for the right “to issue shares and bonds to convert their obligations into securities”, the laws of Ukraine do not clearly provide for the same right for limited liability companies. Moreover, according to the Civil Code of Ukraine, it shall not be allowed to release a participant of a limited liability company from the obligation to make a contribution to the company’s charter capital, including by way of the offsetting of claims against the company.

Following a narrow interpretation of the above provision of the Civil Code of Ukraine, it appears that conversion of debt into equity is prohibited for limited liability companies. However, according to Letter No.1768 of 18 March 2005 of the State Committee of Ukraine on Regulatory Policy and Entrepreneurship, this rule relates only to initial contributions during creation of a limited liability company. Moreover, in the above-mentioned Letter, the State Committee clearly states that offsetting of claims is possible under Article 601 of the Civil Code of Ukraine.

There is no need to say that such progressive clarification of the State Committee of Ukraine on Regulatory Policy and Entrepreneurship was highly supported by limited liability companies, whereas in practice it is now possible to perform conversion of a company’s debt into its equity.

Although the right of joint stock companies to convert their liabilities into securities is clearly specified in legislation, the practice of implementation of this provision has not been very successful to date. Indeed, the existing procedure for registration of share issuance with the National Commission for Securities and Stock Market (NCSSM), has not yet been adapted to the On Joint Stock Companies Act and does not regulate the offsetting of claims against the company. Considering this and based on Section 2.13 of the Regulations on the Procedure for Registration of Issue of Shares, in practice, local departments of the NCSSM refuse to register reports on placement of shares without documents evidencing payment for shares.

It is worth mentioning that the position of the NCSSM announced by its officials during numerous conferences and meetings, as well as stated in individual letters issued by the NCSSM, is that for the time being there is no procedure for conversion of debt into equity for joint stock companies.

Therefore, the right of joint stock companies to convert their obligations into securities remains a declaration rather than a real option.

Draft Regulations of the NCSSM

It is important to say that the NCSSM is currently working on Regulations on issuance of shares and bonds for the conversion of a company’s obligations into securities. As of today, the following Regulations are being drafted by the NCSSM:

— Draft Regulations on Amendments to Regulations No.322 (announced on 30 September 2011);

— Draft Regulations on the Procedure for issuance of shares and bonds by joint stock companies for conversion of their obligations into securities (announced on 14 January 2011); and

— Draft Regulations on the Procedure for conversion of obligations of joint stock companies into securities (announced on

27 July 2009).

Unfortunately, only one of these Draft Regulations refers to the issuance of shares, whereas the other two refer to issuance of bonds for conversion of liabilities into securities. Moreover, the one related to the issuance of shares provides for a possibility to issue shares for conversion of debt into equity only in the course of financial rehabilitation (sanatsiya) of the company. In fact, a corresponding article was also introduced into a new version of the On Restoring Debtor’s Solvency or Declaring It Bankrupt Act.

Apparently, the NCSSM intended to introduce debt-for-equity swaps, which are well known in Europe, when the company’s creditors agree to cancel some or all of the debts in exchange for equity when the company runs into serious financial trouble. Still the Draft Regulations unreasonably limit the discretion of the company to use debt-for-equity swaps only to the financial rehabilitation stage of the bankruptcy procedure.

As a result, even when these Draft Regulations are adopted they will not allow joint stock companies to enjoy the statutory right to convert their obligations into equity without going into bankruptcy.

Currency control

One of the most common situations when Ukrainian joint stock companies would prefer to enjoy the right to convert their obligations into equity is when there is an outstanding loan from one of shareholders (usually the majority shareholder). In case such shareholder is a foreign legal entity, the underlying loan agreement must be registered with the National Bank of Ukraine.

In the envisaged situation, the procedure for conversion of the company’s obligations under the loan agreement into its shares should also take into account the peculiarities of currency control rules. However, NBU Resolution No.2705 does not expressly provide for procedure for the offsetting of obligations of joint stock companies under loan agreements by additionally issued shares.

As a result, in order to be effective, the procedure for conversion of debt into equity should foresee amendments to NBU Regulation No.270 allowing discharge of the obligations under the loan agreement by set-off. Otherwise, there is a risk that the loan agreement will not be released from currency control.

Repatriation of investment

While converting the obligations of the company into shares, it is important to foresee the return of such investment by the purchaser of the shares. In this case, investors also may face additional obstacles relating to the purchase of foreign currency to return the investment.

Indeed, NBU Resolution No.2816 does not specifically state which document should be submitted to the bank for the purchase of foreign currency in cases where shares are bought by way of set-off. Therefore, the procedure for conversion of debt into equity should also foresee modifications to NBU Resolution No.281, otherwise the risk exists that the bank will not be able to purchase foreign currency for the purpose of repatriation.

Summary

Summing up the above, we may note that it is extremely important that the laws of Ukraine now provide for the right to convert a company’s obligations into equity. This is definitely a step towards adaptation of Ukrainian legislation in line with European legal standards. However, in order to make the mechanism of conversion of debt into equity effective, the respective procedure should be further developed.

Considering the comprehensive character, it is very important that the NCSSM and the NBU coordinate actions on mutual development of the procedure. It is apparent that the most important thing will be the procedure for issuance of shares and bonds for conversion of the company’s obligations into equity to be further adapted by the NCSSM. Hopefully, this procedure will refer to the right of a joint stock company to issue shares for conversion of its obligations in day to day activity, but not only in the bankruptcy procedure.