Against the backdrop of an ongoing geopolitical storm, Russian market participants are still largely engaged in restructuring debt assets for sanctions protection. In this article, we would like to highlight the emerging opportunities for launching new products on the Russian bond market, which LECAP advises not to miss.
Spaces for "sowing" new financial products are opening up for debt market participants for reasons such as:
Investors who have lost access to "unfriendly" markets are seeking new niches for investment within Russia;
Loss of access to foreign financial products, such as reinsurance, structured notes under foreign law, etc., and the market's need for import substitution;
Relocation of head companies of Russian holdings, especially in the IT sector, from offshore jurisdictions to Russia, and the consequent need to transfer their financing schemes (like convertible bonds) into the domestic legal framework;
The Bank of Russia's understanding of its role as a regulator in the sphere of financial instruments under new conditions and its readiness for somewhat more flexible solutions.
Russian players, especially state-related ones, often expect ready-made legislative solutions for the legal "wrapping" of new financial products. Indeed, specific laws were adopted at different times to regulate mortgage and later non-mortgage securitization, banks' subordinated bonds, perpetual and structured bonds. However, under current conditions, expecting rapid adoption of such bills is unrealistic. Legislators have many more urgent tasks in the spheres of geopolitics and "counter-sanctions."
Therefore, new financial products will in many cases need to be implemented based on the existing legal arsenal. It should be said that this arsenal was filled with "ammunition" during the 2010s, the potential of which has not yet been fully appreciated by the market community. These include, for example, structures involving specialized vehicles (SPVs and SPSPFs), bondholders' representatives, irrevocable proxies, nominal and escrow accounts, intercreditor agreements, etc.
New instruments are also maturing in the practice of the bond market, primarily in private placements. For instance, over the last 2-3 years, LECAP has advised on successful bond issues featuring the possibility of non-cash payment and introducing new forms of interaction between bondholders and issuers.
To optimally implement these structures, businesses will require the skilled hands of lawyers. Such lawyers, like Lefty from Leskov's tale, are capable of using domestic tools to "shoe" foreign financial mechanisms, and sometimes even forge their Russian analogues. LECAP, for its part, is ready to share its unique experience in launching new products on the Russian market. We are also always happy to offer the services of LCPIS – the leading bondholders' representative on the Russian market, and now also our own management company for specialized vehicles.
NEW FINANCIAL INSTRUMENTS
Convertible and Subordinated Bonds of Non-Financial Companies
"Converts" and "sub-debt" are instruments of so-called mezzanine financing, occupying an intermediate position between senior debt and a company's equity capital. In developed markets, mezzanine bonds play an important role in company financing. Quite recently, the investment community discussed, for example, the fate of the "converts" of the holding companies of Yandex and Ozon with great interest.
In the Russian market, banks issue "sub-debt," including instruments convertible into shares. Borrowers with high credit ratings also have access to perpetual bonds.
The issuance of "converts" by non-financial companies on the Russian market has been periodically discussed by participants for over a decade, though with little result. Historically, regulatory restrictions impeded the issuance of "converts": until 2019, holders of convertible bonds under Russian law had no legal means to force the issuer to deliver shares upon the conversion event. Since 2019, such a possibility appeared under the so-called "law on simplification of issuance." However, the model proposed by the law turned out to be rather inconvenient: issuers are required to periodically re-register the share issue for potential conversion. Alternative models for issuing convertible bonds off the balance sheet of a specialized vehicle, independent of the issuer, are also possible, which could circumvent the inconveniences of the statutory construct.
A obstacle to the issuance of subordinated debt by non-financial companies in Russia is posed by the provisions of bankruptcy law, which do not guarantee the right of "senior" creditors of non-financial companies to receive repayment ahead of subordinated creditors. Structuring subordinated bonds, however, is also possible using a specialized vehicle. A specialized vehicle could, in particular, serve as a buffer preventing improper behavior by subordinated creditors in bankruptcy.
New Types of Structured Bonds
Current Russian regulation limits the list of assets and other circumstances on which payments under derivative contracts and debt write-downs for structured bonds (underlying assets) can depend. Permissible underlying assets include only:
Prices of financial instruments, commodities, currencies, and the values of their indices;
Inflation and interest rate values;
Defaults on obligations of third parties;
Government statistics data and environmental indicators.
Such regulation prevents the implementation of a number of deals well-known in foreign debt markets and for which demand is already felt in Russia.
For example, domestic insurance companies have lost the ability to reinsure abroad. They are in need of new instruments for transferring insurance risk. These could include structured bonds linked to insurance risk (insurance-linked bonds, ILS). Among these, so-called catastrophe bonds (cat bonds), linked to the risk of natural disasters and other catastrophes, are the most common in foreign markets. The trigger for writing down debt on such bonds can be parameters of the disaster itself, losses for the insurance industry, or losses for the insurer-borrower. The most common type of trigger in foreign markets is precisely losses for the insurer-borrower. But this very type of trigger is not permitted under Russian regulation.
Other possible types of permissible underlying assets could be, for example:
Prices of alternative assets, such as property rights, carbon certificates, and digital tokens;
Indicators from financial and non-financial reporting;
Dividend payments and waivers of interest payments on subordinated debt.
The Bank of Russia announced the expansion of the list of underlying assets in its Main Directions for the Development of the Financial Market for 2023-2025. However, according to our information, work on this is not planned to begin before 2024.
Nevertheless, we believe that before changes are made to the regulations, there is an opportunity to issue at least some structured bonds with new types of underlying assets. A specialized vehicle in this structure can also play the role of a buffer and ensure the protection of the interests of both the borrower and investors in the structured notes.
NEW SOLUTIONS IN THE BOND MARKET
Non-Cash Payments on Bonds
Participants in the Eurobond market are well acquainted with structures for non-cash payments or physical settlement on bonds. In Eurobonds, such structures allow the SPV – issuer of the Eurobonds – to transfer the claim against the borrower to the bondholders in the event of the borrower's default. As a result, the SPV and its management company avoid liability for the borrower (the principle of no recourse), and investors receive a direct claim against the borrower and can participate in legal proceedings against it. Other types of physical settlement are also conceptually possible, for example, the delivery of shares or other securities to bondholders.
Since the 90s, Russian legislation has in principle allowed the redemption of bonds not only with money but also with property. Nevertheless, certain statutory formulations regarding physical settlement have always raised doubts among market participants and the regulator. For structured bonds, these concerns were removed at the legislative level, enabling a number of issues with the possibility of non-cash redemption.
This year, the LECAP team also managed, for the first time, to secure the registration by the Bank of Russia of several issues of non-structured bonds with the possibility of physical settlement. Issues of statutory interpretation concerning physical settlement were resolved through precise wording.
The structure of non-cash payments on bonds is important for implementing a whole range of deals new to the Russian market. In particular, using this structure, Russian analogues of Eurobonds – LPNs (Local Payment Notes) – as well as convertible bonds can be issued.
New Forms of Interaction between Issuer and Bondholders
Since their introduction in 2013, the institutions of the general meeting and the bondholders' representative in Russian legislation have repeatedly proven their effectiveness. They allow for quick and sufficiently transparent bond restructurings and in some aspects surpass foreign analogues. However, practice has also revealed some shortcomings in the general meeting procedure.
For instance, with a small number of holders who are ready to vote unanimously, the 20-day period for convening a meeting sometimes seems excessive. In this regard, the terms of a number of recent private placements provide for interaction between holders and the issuer based on a so-called "unanimous written instruction." Under this procedure, holders can unanimously express their will to the issuer (e.g., forgive a covenant breach) without observing the procedure and timelines of a general meeting.
Overall, we anticipate that new formats of interaction with bondholders will develop. For example, alongside absentee voting at general meetings, video conferences and chats may be in demand. New forms of communication are especially important for interaction with retail investors.