The accumulated experience with defaulted bond issues has revealed systemic problems in the functioning of this financial instrument. Over the past year, we have witnessed the theory of "asymmetric information" in action on the debt market, the essence of which is that a borrower is always better informed about its real status than the most qualified investors.
The practice of defaults has clearly demonstrated not only investors' insufficient knowledge of the issuer's financial position but also their misunderstanding of some essential legal aspects of a bond issue.
Finding solutions to these problems, including by smoothing out the asymmetry in the level of information between the issuer and the investor, must become a priority for the investment community, as it is directly linked to the need to preserve the nascent debt financing market in Russia. In the absence of systemic guidelines from the state authorities, finding solutions is a difficult task, which can be tackled through an active dialogue between financiers and lawyers working in the Russian capital market. Thus, the task of lawyers in the context of a bond issue as a form of debt financing should primarily involve identifying legal risks affecting matters of liability and the effective enforcement of creditors' rights under the securities.
LEGAL RISKS
For the capital market, the issue of legal risks is central and even largely overshadows the topic of investor profit. This is confirmed by established court practice, which states the impossibility of: first – enforcing some formulations in standard bond issuance resolutions, and second – recovering funds through judicial process. The point of calculating a fair interest rate for such a loan vanishes. From a legal standpoint, bond issuance resolutions that are potentially unenforceable by court decision are no different from an aleatory contract. Investing in such bonds is like playing roulette, as the issuer may either fulfill its obligations (e.g., repurchase bonds via an offer) or, citing certain legal provisions, evade such performance.
The legal risks inherent in many existing bond loans are not new. Their discovery in practice is a consequence of professional investors' insufficient attention to risk management during the process of coordinating with the arranging bank for the acquisition of bonds. It is fair to say that some legal problems of bonds, discussed below, existed as a latent threat to the investor from the outset, when the bond was perceived and structured primarily as a convenient, liquid loan instrument, to which potential holders did not demand more than what was provided for by basic regulations.
In practice, the investment decision was based on the forecast of the investment bank arranging the specific issue regarding the issuer's solvency and the illusion that most loans within each tier of borrowers are homogeneous in quality. In addition, the registration of the issue by an authorized state body was seen by the investor as a sufficient sign of the bond loan's legal cleanliness, although this confidence had no clear regulatory justification.
Due to the identical wording of issuance resolutions from different issuers, virtually none of the transaction participants essentially scrutinized their content; and investors challenging such resolutions is mostly futile. The judicial system has logically punished the Russian investor for the lack of due attention to questions of legal validity and enforceability when acquiring bonds.
LIABILITY
The practice of the past year has shown that the formal fixation of rights in an issuance resolution can no longer be considered sufficient confirmation of the enforceability of a creditor's rights under the bonds, and consequently, the rationale for calculating investment efficiency disappears. Below we have summarized some examples that allow the issuer and its guarantors to evade the obligation to return the invested funds, as formally enshrined in the issuance resolution.
For the bond market, it is customary to establish so-called floating interest rates on bonds, which can change during the circulation period of the bonds, with the issuer adopting separate decisions at its discretion. This mechanism is convenient as it allows for reacting to market changes and setting a fair cost of borrowing. The interests of bondholders in a fair, not arbitrary, setting of the rate are protected by a normatively provided option to return the bonds to the issuer – to demand their repurchase or redemption if the rate seems unacceptable to the holders.
Nevertheless, floating rates and the resulting obligations of the issuer to acquire bonds at the request of their holders face significant practical difficulties.
For example, all public offers to acquire bonds in case of an interest rate change presuppose the execution of addressed trades on the exchange, for which the negotiated trades regime is used. However, under current regulations for investing pension savings, asset management companies are expressly prohibited from conducting such addressed trades. From a formal legal logic standpoint, this gives an unscrupulous issuer the right to set a coupon rate of 0.1% and use pension savings almost for free. This same problem of regulating pension savings investments serves as a barrier for asset management companies to participate in debt restructuring processes involving signing an agreement with the debtor. Thus, although the global financial system has essentially been in a poor state for two years now, Russian regulation of pension savings investments is still focused precisely on investing, even though it is high time to think about how to get such investments back.
Another example is the establishment of a guarantee provided to an issuer-SPV by its parent company, which, unlike the issuer, possesses assets.
Thus, in one case, the court indicated that "under clause 1 of Article 367 of the Civil Code of the Russian Federation, a guarantee terminates upon the termination of the obligation it secures, as well as in the event of a change in that obligation, resulting in increased liability or other adverse consequences for the guarantor, without the latter's consent." Consequently, a subsequent increase in the interest rate, at the issuer's discretion, set as of the date of the start of the bond placement, i.e., the date of the guarantee agreement, constitutes an amendment to the guarantee agreement, resulting in increased liability for the guarantor without its consent.
If one follows this court logic, most circulating bonds, if they have already undergone an interest rate increase, are unsecured. And this is despite the fact that the structure of most bond borrowings is such that the holder of the assets on which the debt holder can rely is not the issuer but precisely the guarantor.
Practice also knows other cases of challenging guarantees, for example, based on the lack of proper corporate approval for the transaction to provide the guarantee. Such situations are not uncommon. In most cases, both the materiality of the transaction and conflict of interest are present, as the issuer and guarantors are often affiliated or connected by other factors causing a corporate conflict of interest.
The very content of the issuer's obligation to acquire bonds at the request of their holders is not entirely clear today. Issuers, creditors, courts, and even the financial market regulator still cannot develop a single logical position on this matter.
Multiple positions are developed depending on whose interests are involved. For example, a bondholder, demanding in court the payment of the sale price of the bonds, shows that they have performed all actions required by the terms of the issuance documents for the acquisition of the bonds by the issuer – accepted the offer, sent a notice, a sale application, etc. The issuer, on the contrary, convinces the court that the content of its obligations is not to pay money for the bonds but to have a duty to conclude a contract for their acquisition. Consequently, the claimant, demanding not specific performance to conclude a contract but money, has chosen an improper remedy, leading to dismissal of the claim.
Although justice (de lege ferenda) is obviously on the side of the first position (the bondholder, disagreeing with the set rate and wishing to get the invested funds back), a formal interpretation of the offer may indicate the correctness of the issuer's position (de lege lata). Indeed, the content of such offers boils down to a proposal to conclude a transaction ordinary for exchange trading – a sale-purchase. Thus, if the offer proposes to conclude a contract, the subject of which is the obligation of the parties to conclude a sale-purchase transaction on the exchange in the future, then, based on a literal understanding of the text of the contract concluded by the transaction parties, it is quite difficult to find formal grounds for qualifying such an offer as aimed at concluding a sale-purchase contract.
It is necessary to note here that the Supreme Arbitration Court of the Russian Federation (SAC RF), in one of its recent rulings, called the relations arising from the acceptance of an offer precisely a sale-purchase contract (thus formally recognizing that the bondholder is the seller and, therefore, has a monetary claim against the issuer). But an important feature of this case is that in the mentioned dispute, both parties insisted (although for different reasons the respondent-issuer, recognizing the relations as a sale-purchase contract, tried to protect the guarantor) that a sale-purchase contract, and not some other contract, was concluded between them. As a result, the SAC RF judges had no need to analyze such a contract, meaning the high instance's resolution of the qualification issue may not be final.
Consequently, capital market participants must not only change the mechanism of offers (note that regulatory framework provides such a possibility) but be fully informed about such transactions, i.e., have an exhaustive understanding of the associated risks and thus overcome information asymmetry and make the correct investment decision.
A new system of liability for market participants should facilitate this.
Public placement of securities presupposes that the subject of the offer is a certain standard product with pre-defined characteristics, which are determined in the securities issuance documentation: the issuance resolution, the securities prospectus, the information memorandum issued on behalf of the arranger, and so on.
However, Russian practice lacks any standards establishing guarantees of the completeness and accuracy of information necessary for making investment decisions. Currently, market participants rely on very general standards of the financial market regulator and certain practices customs, for example, the need to prepare an information memorandum. At the same time, no one assumes responsibility for the accuracy of the information.
In our opinion, the most reliable guarantees of investors' interests will be not just formal regulatory requirements for the content of issuance documents and generally quite arbitrary parameters by which the arranging bank markets a particular instrument, but also a reliable system of liability for the correspondence of such information to reality in cases where its disclosure could be determinative for the investment decision.
The practice of holding professionals liable for the advice and opinions they issue is an integral part of developed securities markets worldwide. Among other things, this conclusion is based on a case in which Lord Denning stated: "It is perfectly clear that a professional man who gives judgment must be responsible not only to the client who hired him but also to any other person known to him who relies on his judgment in making a decision and expects to avoid losses." This is a basic principle for understanding the role of a legal opinion in the structure of a market economy.
In Russia, over the last decade, attempts have been made at the legislative level to introduce into the infrastructure of any public offering a figure that: a) could conduct its own independent examination of the securities being issued and b) would be liable for its assessments. This refers to authorized financial advisors. Unfortunately, or perhaps fortunately, the institution of financial advisors did not develop, and the requirement for the mandatory signing of securities prospectuses by a financial advisor was abolished.
However, this should not imply that the market can continue to passively regard issues of liability and recognize as the only entity legally responsible for the performance of bond obligations a potentially insolvent SPV.
The publication of an information memorandum, which has become very much like an absolute formality, does not entail liability for the arranging bank, as the memorandum sets out only the subjective assessments of the arranger itself, backed by the authority of the investment bank, the qualification of specialist analysts, and, ultimately, their reputation. At the same time, the analysis and assessment of legal risks remains outside the perimeter of any reliable assurances, let alone guarantees. The legal risks that are traditionally described in the prospectus, and how they are described, are merely a tribute to complying with the formal requirements necessary for issue registration.
The arranger of a bond issue acts as the global coordinator of the project. Its tasks include engaging a wide range of specialists whose joint work ensures the formation of the product. This includes the investment bank being highly interested in the participation of qualified lawyers in the work on the issue, who would be able to analyze all material aspects of the company and the planned loan, identify and formulate legal risks, and bear responsibility for the accuracy and completeness of their conclusions.
An effective form of lawyer participation in projects could be the issuance of a legal opinion based on conducted research of the bond placement transaction and, possibly, the legal status of the issuer.
The methodology for preparing a legal opinion that could be issued to the arranging bank should provide for standard rules for conducting comprehensive legal analysis. Such standards can be created by the law firm itself or their association and should be structured in such a way as to allow for a comprehensive understanding of the legal risks material to the arranger and the investor, thus overcoming the information imbalance between them.
Summarizing the above, we note that a legal opinion could be one of the effective ways to restore trust relations in the securities market, seriously undermined by some issuers, but far from the only one. The first word, in our opinion, should come from investment banks. It is they who should make maximum efforts to overcome the existing information asymmetry between the issuer and the investor. By accepting their share of responsibility for the information disclosed by the issuer (which is permitted by current legislation in various forms), it is the investment bank that should become the link between the borrower and the market.
We understand that the mechanisms proposed in this article may somewhat increase the cost of borrowing (at least for some time, until market competition establishes a fair price for the new services). At the same time, issuers must understand that introducing more representations and warranties into the practice of bond placements enhances the quality of the security. All this should, over time, lead to a reduction in the cost of bond loans. From the standpoint of investor protection, a bond loan for the offering of which both the issuer, the arranger, and their advisors are liable is more reliable. A bond issue vetted for all key legal aspects implies the absence of material legal risks and the need for additional costs associated with the performance of obligations, such as litigation costs.
The advantages of using specifically the form of a legal opinion as a legal assurance are, in our opinion, obvious. This includes a higher level of trust from foreign investors in such an instrument, as for the latter, the presence of a legal opinion is an integral basis for making an investment decision. Furthermore, rating agencies will be able to use legal opinions when assigning ratings to securities or their issuer, which, in turn, can confirm the level of reliability of the instruments necessary for the inclusion of securities in the Bank of Russia's Lombard list.
The practice of defaults has clearly demonstrated not only investors' insufficient knowledge of the issuer's financial position but also their misunderstanding of some essential legal aspects of a bond issue.
Finding solutions to these problems, including by smoothing out the asymmetry in the level of information between the issuer and the investor, must become a priority for the investment community, as it is directly linked to the need to preserve the nascent debt financing market in Russia. In the absence of systemic guidelines from the state authorities, finding solutions is a difficult task, which can be tackled through an active dialogue between financiers and lawyers working in the Russian capital market. Thus, the task of lawyers in the context of a bond issue as a form of debt financing should primarily involve identifying legal risks affecting matters of liability and the effective enforcement of creditors' rights under the securities.
LEGAL RISKS
For the capital market, the issue of legal risks is central and even largely overshadows the topic of investor profit. This is confirmed by established court practice, which states the impossibility of: first – enforcing some formulations in standard bond issuance resolutions, and second – recovering funds through judicial process. The point of calculating a fair interest rate for such a loan vanishes. From a legal standpoint, bond issuance resolutions that are potentially unenforceable by court decision are no different from an aleatory contract. Investing in such bonds is like playing roulette, as the issuer may either fulfill its obligations (e.g., repurchase bonds via an offer) or, citing certain legal provisions, evade such performance.
The legal risks inherent in many existing bond loans are not new. Their discovery in practice is a consequence of professional investors' insufficient attention to risk management during the process of coordinating with the arranging bank for the acquisition of bonds. It is fair to say that some legal problems of bonds, discussed below, existed as a latent threat to the investor from the outset, when the bond was perceived and structured primarily as a convenient, liquid loan instrument, to which potential holders did not demand more than what was provided for by basic regulations.
In practice, the investment decision was based on the forecast of the investment bank arranging the specific issue regarding the issuer's solvency and the illusion that most loans within each tier of borrowers are homogeneous in quality. In addition, the registration of the issue by an authorized state body was seen by the investor as a sufficient sign of the bond loan's legal cleanliness, although this confidence had no clear regulatory justification.
Due to the identical wording of issuance resolutions from different issuers, virtually none of the transaction participants essentially scrutinized their content; and investors challenging such resolutions is mostly futile. The judicial system has logically punished the Russian investor for the lack of due attention to questions of legal validity and enforceability when acquiring bonds.
LIABILITY
The practice of the past year has shown that the formal fixation of rights in an issuance resolution can no longer be considered sufficient confirmation of the enforceability of a creditor's rights under the bonds, and consequently, the rationale for calculating investment efficiency disappears. Below we have summarized some examples that allow the issuer and its guarantors to evade the obligation to return the invested funds, as formally enshrined in the issuance resolution.
For the bond market, it is customary to establish so-called floating interest rates on bonds, which can change during the circulation period of the bonds, with the issuer adopting separate decisions at its discretion. This mechanism is convenient as it allows for reacting to market changes and setting a fair cost of borrowing. The interests of bondholders in a fair, not arbitrary, setting of the rate are protected by a normatively provided option to return the bonds to the issuer – to demand their repurchase or redemption if the rate seems unacceptable to the holders.
Nevertheless, floating rates and the resulting obligations of the issuer to acquire bonds at the request of their holders face significant practical difficulties.
For example, all public offers to acquire bonds in case of an interest rate change presuppose the execution of addressed trades on the exchange, for which the negotiated trades regime is used. However, under current regulations for investing pension savings, asset management companies are expressly prohibited from conducting such addressed trades. From a formal legal logic standpoint, this gives an unscrupulous issuer the right to set a coupon rate of 0.1% and use pension savings almost for free. This same problem of regulating pension savings investments serves as a barrier for asset management companies to participate in debt restructuring processes involving signing an agreement with the debtor. Thus, although the global financial system has essentially been in a poor state for two years now, Russian regulation of pension savings investments is still focused precisely on investing, even though it is high time to think about how to get such investments back.
Another example is the establishment of a guarantee provided to an issuer-SPV by its parent company, which, unlike the issuer, possesses assets.
Thus, in one case, the court indicated that "under clause 1 of Article 367 of the Civil Code of the Russian Federation, a guarantee terminates upon the termination of the obligation it secures, as well as in the event of a change in that obligation, resulting in increased liability or other adverse consequences for the guarantor, without the latter's consent." Consequently, a subsequent increase in the interest rate, at the issuer's discretion, set as of the date of the start of the bond placement, i.e., the date of the guarantee agreement, constitutes an amendment to the guarantee agreement, resulting in increased liability for the guarantor without its consent.
If one follows this court logic, most circulating bonds, if they have already undergone an interest rate increase, are unsecured. And this is despite the fact that the structure of most bond borrowings is such that the holder of the assets on which the debt holder can rely is not the issuer but precisely the guarantor.
Practice also knows other cases of challenging guarantees, for example, based on the lack of proper corporate approval for the transaction to provide the guarantee. Such situations are not uncommon. In most cases, both the materiality of the transaction and conflict of interest are present, as the issuer and guarantors are often affiliated or connected by other factors causing a corporate conflict of interest.
The very content of the issuer's obligation to acquire bonds at the request of their holders is not entirely clear today. Issuers, creditors, courts, and even the financial market regulator still cannot develop a single logical position on this matter.
Multiple positions are developed depending on whose interests are involved. For example, a bondholder, demanding in court the payment of the sale price of the bonds, shows that they have performed all actions required by the terms of the issuance documents for the acquisition of the bonds by the issuer – accepted the offer, sent a notice, a sale application, etc. The issuer, on the contrary, convinces the court that the content of its obligations is not to pay money for the bonds but to have a duty to conclude a contract for their acquisition. Consequently, the claimant, demanding not specific performance to conclude a contract but money, has chosen an improper remedy, leading to dismissal of the claim.
Although justice (de lege ferenda) is obviously on the side of the first position (the bondholder, disagreeing with the set rate and wishing to get the invested funds back), a formal interpretation of the offer may indicate the correctness of the issuer's position (de lege lata). Indeed, the content of such offers boils down to a proposal to conclude a transaction ordinary for exchange trading – a sale-purchase. Thus, if the offer proposes to conclude a contract, the subject of which is the obligation of the parties to conclude a sale-purchase transaction on the exchange in the future, then, based on a literal understanding of the text of the contract concluded by the transaction parties, it is quite difficult to find formal grounds for qualifying such an offer as aimed at concluding a sale-purchase contract.
It is necessary to note here that the Supreme Arbitration Court of the Russian Federation (SAC RF), in one of its recent rulings, called the relations arising from the acceptance of an offer precisely a sale-purchase contract (thus formally recognizing that the bondholder is the seller and, therefore, has a monetary claim against the issuer). But an important feature of this case is that in the mentioned dispute, both parties insisted (although for different reasons the respondent-issuer, recognizing the relations as a sale-purchase contract, tried to protect the guarantor) that a sale-purchase contract, and not some other contract, was concluded between them. As a result, the SAC RF judges had no need to analyze such a contract, meaning the high instance's resolution of the qualification issue may not be final.
Consequently, capital market participants must not only change the mechanism of offers (note that regulatory framework provides such a possibility) but be fully informed about such transactions, i.e., have an exhaustive understanding of the associated risks and thus overcome information asymmetry and make the correct investment decision.
A new system of liability for market participants should facilitate this.
Public placement of securities presupposes that the subject of the offer is a certain standard product with pre-defined characteristics, which are determined in the securities issuance documentation: the issuance resolution, the securities prospectus, the information memorandum issued on behalf of the arranger, and so on.
However, Russian practice lacks any standards establishing guarantees of the completeness and accuracy of information necessary for making investment decisions. Currently, market participants rely on very general standards of the financial market regulator and certain practices customs, for example, the need to prepare an information memorandum. At the same time, no one assumes responsibility for the accuracy of the information.
In our opinion, the most reliable guarantees of investors' interests will be not just formal regulatory requirements for the content of issuance documents and generally quite arbitrary parameters by which the arranging bank markets a particular instrument, but also a reliable system of liability for the correspondence of such information to reality in cases where its disclosure could be determinative for the investment decision.
The practice of holding professionals liable for the advice and opinions they issue is an integral part of developed securities markets worldwide. Among other things, this conclusion is based on a case in which Lord Denning stated: "It is perfectly clear that a professional man who gives judgment must be responsible not only to the client who hired him but also to any other person known to him who relies on his judgment in making a decision and expects to avoid losses." This is a basic principle for understanding the role of a legal opinion in the structure of a market economy.
In Russia, over the last decade, attempts have been made at the legislative level to introduce into the infrastructure of any public offering a figure that: a) could conduct its own independent examination of the securities being issued and b) would be liable for its assessments. This refers to authorized financial advisors. Unfortunately, or perhaps fortunately, the institution of financial advisors did not develop, and the requirement for the mandatory signing of securities prospectuses by a financial advisor was abolished.
However, this should not imply that the market can continue to passively regard issues of liability and recognize as the only entity legally responsible for the performance of bond obligations a potentially insolvent SPV.
The publication of an information memorandum, which has become very much like an absolute formality, does not entail liability for the arranging bank, as the memorandum sets out only the subjective assessments of the arranger itself, backed by the authority of the investment bank, the qualification of specialist analysts, and, ultimately, their reputation. At the same time, the analysis and assessment of legal risks remains outside the perimeter of any reliable assurances, let alone guarantees. The legal risks that are traditionally described in the prospectus, and how they are described, are merely a tribute to complying with the formal requirements necessary for issue registration.
The arranger of a bond issue acts as the global coordinator of the project. Its tasks include engaging a wide range of specialists whose joint work ensures the formation of the product. This includes the investment bank being highly interested in the participation of qualified lawyers in the work on the issue, who would be able to analyze all material aspects of the company and the planned loan, identify and formulate legal risks, and bear responsibility for the accuracy and completeness of their conclusions.
An effective form of lawyer participation in projects could be the issuance of a legal opinion based on conducted research of the bond placement transaction and, possibly, the legal status of the issuer.
The methodology for preparing a legal opinion that could be issued to the arranging bank should provide for standard rules for conducting comprehensive legal analysis. Such standards can be created by the law firm itself or their association and should be structured in such a way as to allow for a comprehensive understanding of the legal risks material to the arranger and the investor, thus overcoming the information imbalance between them.
Summarizing the above, we note that a legal opinion could be one of the effective ways to restore trust relations in the securities market, seriously undermined by some issuers, but far from the only one. The first word, in our opinion, should come from investment banks. It is they who should make maximum efforts to overcome the existing information asymmetry between the issuer and the investor. By accepting their share of responsibility for the information disclosed by the issuer (which is permitted by current legislation in various forms), it is the investment bank that should become the link between the borrower and the market.
We understand that the mechanisms proposed in this article may somewhat increase the cost of borrowing (at least for some time, until market competition establishes a fair price for the new services). At the same time, issuers must understand that introducing more representations and warranties into the practice of bond placements enhances the quality of the security. All this should, over time, lead to a reduction in the cost of bond loans. From the standpoint of investor protection, a bond loan for the offering of which both the issuer, the arranger, and their advisors are liable is more reliable. A bond issue vetted for all key legal aspects implies the absence of material legal risks and the need for additional costs associated with the performance of obligations, such as litigation costs.
The advantages of using specifically the form of a legal opinion as a legal assurance are, in our opinion, obvious. This includes a higher level of trust from foreign investors in such an instrument, as for the latter, the presence of a legal opinion is an integral basis for making an investment decision. Furthermore, rating agencies will be able to use legal opinions when assigning ratings to securities or their issuer, which, in turn, can confirm the level of reliability of the instruments necessary for the inclusion of securities in the Bank of Russia's Lombard list.