According to the classics of economic theory (A. Smith, J. M. Keynes, K. Marx), the natural driver of capitalist relations is credit relations.
Legally, these relations can be formalized in various ways – from concluding loan (credit) agreements to issuing debt securities, primarily bonds.
Thus, from an economic point of view, bonds are credit relations legally formalized by the issuance of securities into circulation by the debtor (issuer).
Advantages of bond issuance for the issuer:
The issuance of bonds allows for raising large sums of money from participants in the securities market.
The funds raised are typically "long-term," i.e., they are to be repaid after a long period (3-5 years, although longer issues are possible).
The interest rate is determined by the market, which often allows for raising money at a rate lower than that offered by most banks.
Placement of bonds through an open subscription transitions the company into the category of public companies, which increases trust in it and, consequently, positively impacts the company's reputation. A good reputation (which can be confirmed by rating agencies) seriously influences the credit rate offered to the company.
The company can expand the range of potential creditors, in particular by including pension funds and management companies placing citizens' pension savings (in accordance with Article 26 of the Federal Law of July 24, 2002, No. 111-FZ "On Investing Funds to Finance the Funded Part of the Labor Pension in the Russian Federation").
Throughout the developed world, bonds are today emission securities, i.e., they are under special state control (Securities and Exchange Commission (SEC) in the USA, United Kingdom Listing Authority (UKLA) in the UK, the Federal Financial Markets Service (FFMS) and the Central Bank of the Russian Federation (CBR) in Russia).
A bond loan is an alternative to a bank loan; consequently, issuing bonds reduces the issuer's dependence on specific banks and allows for diversification of funding sources.
A disadvantage of bond placement is the relatively high costs associated with it (including underwriting fees, various consultants' fees, state duty if the bonds are listed, exchange fees), as well as the necessity of public disclosure of information.
Bonds also represent significant interest for investors:
The bond terms (resolution on the bond issue) may provide for the possibility of the issuer acquiring bonds by agreement with their holders and/or at the demand of the bondholders, with the possibility of their subsequent circulation (buyback).
The bond terms (resolution on the (additional) issue of bonds) providing for the possibility of the issuer acquiring bonds must specify the price of such acquisition or the procedure for its determination.
The possibility of the issuer acquiring its own bonds by agreement with the holders in the absence of a corresponding provision in the bond terms or contrary to such procedure is currently widely discussed.
REDEMPTION OF BONDS FROM THE ORGANIZED MARKET IN RUSSIA
Today, in the conditions of the financial crisis, the market value of bonds of many Russian issuers has sharply fallen, reflecting the general trend of large and small investors withdrawing their investments. The economic rationale is simple: some investors needed money to cover incurred losses, others - solely for speculative purposes to acquire potentially profitable assets cheaper in the future. In such conditions, issuers with the necessary financial resources may well consider buying back their own monetary obligations, represented by bonds, from the organized market.
The desire of issuers to buy back their own securities is also reinforced by the fact that bonds whose circulation period has not expired can subsequently be reintroduced into circulation by the issuer without complying with the formalities of issuance (which usually takes about 2 months).
Such a buyback can most easily be carried out within the framework of the procedure established by the bond terms. This mechanism is well-developed and carries no risks for either the issuer or the bondholders (sellers). In this article, we will consider the admissibility of an issuer acquiring its own bonds if such a procedure is not established in the terms themselves, and will also highlight the risks associated with carrying out the acquisition in a manner different from that established by the terms.
To date, one can often encounter various opinions from specialists on whether such a buyback can be carried out exclusively in the manner determined in the bond terms, or whether such an acquisition can be made on the basis of ordinary civil law transactions, even if the buyback procedure is not provided for in the terms of the relevant bonds.
This article reflects our view on the legal regulation of such a buyback.
CIRCULATION OF BONDS
Limiting ourselves to the subject of research, we will not dwell in detail on the characteristics of legal and doctrinal definitions of bonds, using only the definition provided in Article 816 of the Civil Code of the Russian Federation (hereinafter - the Civil Code of the RF):
"A bond is a security certifying the right of its holder to receive from the person who issued the bond, within the period stipulated thereby, the nominal value of the bond or other property equivalent. The bond also grants its holder the right to receive a fixed percentage of the nominal value of the bond or other property rights."
Legal relations arising in the process of issuance and circulation of bonds are one of the ways of legally formalizing actual (economic) credit relations, which are very important for the normal existence of any economy.
Bonds as a financial instrument have long proven their effectiveness. Formalizing loan relations, they, on the one hand, allow for the accumulation of funds for the implementation of a pre-determined, costly goal; on the other hand, the investor can determine the maximum efficiency of their investments using market mechanisms of supply and demand for their money, and also, using the method of alternative costs, determine the potential benefit of their deposits by comparing them with investments in financial instruments with a similar level of risk.
Today, the Russian bond market is an established system of counterparty relationships, quite successfully ensuring the mechanism for legal entities to attract long-term loans.
It is the organization of the securities market that distinguishes bonds from ordinary civil law loan and credit agreements in the eyes of investors. This effect is achieved in civil law by recognizing securities as movable things, to which all provisions on property rights apply, and first of all – the provision on ownership rights, the transfer of which in circulation is much simpler than the change of persons in obligations (contracts). This feature of securities has been formalized in civil law theory as the principle of public reliability, according to which ownership of the paper certifies the property rights arising from the paper (otherwise, the creditor under the loan obligation is legitimized by proving title to the paper). For a long time, this principle was successfully implemented under conditions where a bond was recognized as a paper (a material thing), ownership of which was proven in the same ways as for any movable thing. Today, in conditions of the widespread elimination of emission securities as things, the application to them of provisions on ownership rights as the strongest right allows for the organization of an efficient securities market, on which, as a rule, civil law contracts are concluded by owners of things. For participants in economic turnover, this property takes on the character of liquidity, i.e., the higher the level of negotiability (the ability of a commodity to be the subject of sale and purchase) of debt securities, the more effective (from the point of view of the possibility of being sold) such debt papers are for the market. Normal circulation of securities is the circulation of owners, whose legal capacity, as a rule, is either not limited at all or is limited by the legislator.
This reasoning is intended to show that any restriction of the rights of participants in circulation regarding such an object of rights as bonds must have a specific economic justification because, by constraining the activity of participants in the securities market, for example, by acts of a subordinate nature, we can reduce the volume of lending in the country and, as a consequence, reduce the real production of goods and services. Therefore, any restriction on the circulation of such objects of civil law as securities must be enshrined in law as a normative act of higher legal force than subordinate acts. Thus, the procedure for the buyback of shares by joint-stock companies (which restricts the possibility of arbitrary buyback of its own shares by a joint-stock company) is enshrined in Chapter 9 of the Federal Law "On Joint-Stock Companies".
Let us recall that in accordance with paragraphs 2 and 7 of Article 3 of the Civil Code of the RF, "civil legislation consists of this Code and other federal laws adopted in accordance with it (hereinafter - laws) regulating the relations specified in paragraphs 1 and 2 of Article 2 of this Code", and further: "ministries and other federal executive bodies may issue acts containing norms of civil law in the cases and within the limits provided for by this Code, other laws and other legal acts". It should be noted that neither the Civil Code of the RF nor the Federal Law on the Securities Market empowered the FFMS of Russia or the CBR to regulate the circulation of securities, establish grounds for challenging transactions with securities, etc.
A formal restriction through the regulation of the procedure for companies to buy back bonds, in turn, unexpectedly found its way into clauses 6.2.32-6.2.37 of the Standards and clause 10.5 of the Instruction of the Bank of Russia dated March 10, 2006, No. 128-I "On the Rules for the Issue and Registration of Securities by Credit Institutions on the Territory of the Russian Federation" (hereinafter - the Instruction).
In conclusion, let's consider the arguments for and against the buyback of bonds from the organized market in the absence of regulation of such a buyback in the bond terms.
Arguments contra:
1. If such a buyback begins before the registration of the report on the results of the issue (submission of the notification), the registrar may see a violation of the placement conditions of the securities and the provisions of clause 6.2.34 of the Standards, in connection with which there is a risk of refusal to register the report and recognition of the issue as invalid. This risk is mitigated quite simply: the issuer should not acquire its own bonds before the registration of the report on the results of the issue (it is quite difficult to imagine a case where the issuer would have a desire to carry out a buyback just a month after raising funds through the placement of bonds). After such registration, the regulator's powers to cancel the issue cease.
2. If the acquisition we are considering is carried out after the registration of the report, the risk remains of the issuer recognizing such an acquisition as price manipulation. For this, the regulator will need to establish that such an acquisition was carried out "to create the appearance of an increase and/or decrease in prices and/or trading activity on the securities market relative to the existing price level and/or existing trading activity on the securities market in order to induce investors to sell or acquire publicly placed and/or publicly traded securities".
3. The risk of liability to other bondholders if they prove in court a violation of their rights. For example, holders of bonds that were not bought back may claim "discrimination" of their rights or non-performance by the issuer of obligations enshrined in the bonds, which entails the issuer's liability in accordance with the terms. In this case, the bondholders will have to at least prove the existence of the right to demand the buyback of securities from the issuer, enshrined in the security itself, and its violation. In the absence of relevant judicial practice, in our opinion, this argument is difficult to assess.
4. There are difficulties in accounting for operations for the acquisition of own bonds.
In accordance with RAS (RAS No. 19/02 does not provide grounds for classifying the acquisition of own bonds as a group of financial investments) and IFRS (IAS 39 p41 speaks about accounting for the difference), bonds issued by the company are considered financial liabilities and, therefore, in case of their acquisition, for accounting purposes, they must be redeemed. Both of these reporting standards are based on an economic, not a legal, understanding of bonds, and in this regard, they may need to be clarified.
Arguments pro:
1. The possibility of the issuer buying back bonds stems from the very essence of securities. This position is based on the classical, still prevailing in lawmaking, civilistic approach to defining the essence of a bond as a security (Article 142 of the Civil Code of the RF). In some cases, the law (or by direct reference, a by-law) may establish a procedure for the buyback of securities, for example, shares. However, the legal nature of shares and bonds differs significantly, since the nominal value of shares forms the authorized capital of companies, which, together with the share premium, is the initial form of the issuer's own funds.
2. The law does not establish a procedure for the buyback of bonds, while the circulation of securities should be regulated precisely at the level of federal legislation. Moreover, as shown above, there is no reference norm that such a procedure can be established by by-laws.
3. The right to acquire a thing not limited in circulation stems from the general legal capacity of participants in civil transactions (just like the ability to possess any thing by right of ownership). Such legal capacity is undoubtedly retained by the issuer as well. The legal capacity of participants in civil transactions (issuers) cannot be arbitrarily limited by by-laws.
4. Emission securities, despite the absence of a "material" form, are subject to the general provisions of civil law on securities, including the right of the person obligated under the security (the issuer) to conclude a purchase and sale agreement regarding such securities.
5. Bonds, as a rule, are admitted to trading on organized markets. At the same time, the exchange does not have the technical ability to track every transaction for compliance with the Standards (or the Instruction). If we recognize the possibility of challenging purchase and sale transactions between the issuer and the bondholder on the basis of an ordinary civil law contract, then, consequently, exchange turnover could be threatened with destruction if, for example, it is proven that the issuer participated in the chain of purchase and sale of the bond as an ordinary participant in the securities market.
Taking into account all of the above, we conclude that until the issue of bond buyback is directly regulated at the level of federal legislation, transactions aimed at the company acquiring its own bonds cannot be challenged or declared null and void, even if the issuer does not comply with the procedure for their acquisition regulated by the terms of their issue. At the same time, we fully admit that the legislator may introduce special requirements for the disclosure of information about the start of the issuer's buyback of bonds from the market, and non-compliance with such requirements will entail administrative sanctions from the regulator (but by no means consequences in the form of challenging or even nullity of such transactions).
How then can we qualify the enshrinement of such a procedure in the bond terms? We believe that in this case, the actions of the issuer should carry a high risk to its reputation. Drawing an analogy with Roman law, a company that violates the buyback procedure established by itself and its word to investors in such a case violates a natural obligation (pacta). Let us recall that the violation of pacta entails not a claim (unlike the violation of conventio), but the "civil death" of the debtor, i.e., a situation where he is no longer of interest to members of society as a counterparty.
Legally, these relations can be formalized in various ways – from concluding loan (credit) agreements to issuing debt securities, primarily bonds.
Thus, from an economic point of view, bonds are credit relations legally formalized by the issuance of securities into circulation by the debtor (issuer).
Advantages of bond issuance for the issuer:
The issuance of bonds allows for raising large sums of money from participants in the securities market.
The funds raised are typically "long-term," i.e., they are to be repaid after a long period (3-5 years, although longer issues are possible).
The interest rate is determined by the market, which often allows for raising money at a rate lower than that offered by most banks.
Placement of bonds through an open subscription transitions the company into the category of public companies, which increases trust in it and, consequently, positively impacts the company's reputation. A good reputation (which can be confirmed by rating agencies) seriously influences the credit rate offered to the company.
The company can expand the range of potential creditors, in particular by including pension funds and management companies placing citizens' pension savings (in accordance with Article 26 of the Federal Law of July 24, 2002, No. 111-FZ "On Investing Funds to Finance the Funded Part of the Labor Pension in the Russian Federation").
Throughout the developed world, bonds are today emission securities, i.e., they are under special state control (Securities and Exchange Commission (SEC) in the USA, United Kingdom Listing Authority (UKLA) in the UK, the Federal Financial Markets Service (FFMS) and the Central Bank of the Russian Federation (CBR) in Russia).
A bond loan is an alternative to a bank loan; consequently, issuing bonds reduces the issuer's dependence on specific banks and allows for diversification of funding sources.
A disadvantage of bond placement is the relatively high costs associated with it (including underwriting fees, various consultants' fees, state duty if the bonds are listed, exchange fees), as well as the necessity of public disclosure of information.
Bonds also represent significant interest for investors:
- it is a market-based determination of the "cost" of their money;
- bonds are liquid securities, typically traded on an exchange, allowing for easy sale at any time at their market value (unlike, for example, a loan agreement, the assignment of rights under which requires a cession, notification of the debtor, etc.).
The bond terms (resolution on the bond issue) may provide for the possibility of the issuer acquiring bonds by agreement with their holders and/or at the demand of the bondholders, with the possibility of their subsequent circulation (buyback).
The bond terms (resolution on the (additional) issue of bonds) providing for the possibility of the issuer acquiring bonds must specify the price of such acquisition or the procedure for its determination.
The possibility of the issuer acquiring its own bonds by agreement with the holders in the absence of a corresponding provision in the bond terms or contrary to such procedure is currently widely discussed.
REDEMPTION OF BONDS FROM THE ORGANIZED MARKET IN RUSSIA
Today, in the conditions of the financial crisis, the market value of bonds of many Russian issuers has sharply fallen, reflecting the general trend of large and small investors withdrawing their investments. The economic rationale is simple: some investors needed money to cover incurred losses, others - solely for speculative purposes to acquire potentially profitable assets cheaper in the future. In such conditions, issuers with the necessary financial resources may well consider buying back their own monetary obligations, represented by bonds, from the organized market.
The desire of issuers to buy back their own securities is also reinforced by the fact that bonds whose circulation period has not expired can subsequently be reintroduced into circulation by the issuer without complying with the formalities of issuance (which usually takes about 2 months).
Such a buyback can most easily be carried out within the framework of the procedure established by the bond terms. This mechanism is well-developed and carries no risks for either the issuer or the bondholders (sellers). In this article, we will consider the admissibility of an issuer acquiring its own bonds if such a procedure is not established in the terms themselves, and will also highlight the risks associated with carrying out the acquisition in a manner different from that established by the terms.
To date, one can often encounter various opinions from specialists on whether such a buyback can be carried out exclusively in the manner determined in the bond terms, or whether such an acquisition can be made on the basis of ordinary civil law transactions, even if the buyback procedure is not provided for in the terms of the relevant bonds.
This article reflects our view on the legal regulation of such a buyback.
CIRCULATION OF BONDS
Limiting ourselves to the subject of research, we will not dwell in detail on the characteristics of legal and doctrinal definitions of bonds, using only the definition provided in Article 816 of the Civil Code of the Russian Federation (hereinafter - the Civil Code of the RF):
"A bond is a security certifying the right of its holder to receive from the person who issued the bond, within the period stipulated thereby, the nominal value of the bond or other property equivalent. The bond also grants its holder the right to receive a fixed percentage of the nominal value of the bond or other property rights."
Legal relations arising in the process of issuance and circulation of bonds are one of the ways of legally formalizing actual (economic) credit relations, which are very important for the normal existence of any economy.
Bonds as a financial instrument have long proven their effectiveness. Formalizing loan relations, they, on the one hand, allow for the accumulation of funds for the implementation of a pre-determined, costly goal; on the other hand, the investor can determine the maximum efficiency of their investments using market mechanisms of supply and demand for their money, and also, using the method of alternative costs, determine the potential benefit of their deposits by comparing them with investments in financial instruments with a similar level of risk.
Today, the Russian bond market is an established system of counterparty relationships, quite successfully ensuring the mechanism for legal entities to attract long-term loans.
It is the organization of the securities market that distinguishes bonds from ordinary civil law loan and credit agreements in the eyes of investors. This effect is achieved in civil law by recognizing securities as movable things, to which all provisions on property rights apply, and first of all – the provision on ownership rights, the transfer of which in circulation is much simpler than the change of persons in obligations (contracts). This feature of securities has been formalized in civil law theory as the principle of public reliability, according to which ownership of the paper certifies the property rights arising from the paper (otherwise, the creditor under the loan obligation is legitimized by proving title to the paper). For a long time, this principle was successfully implemented under conditions where a bond was recognized as a paper (a material thing), ownership of which was proven in the same ways as for any movable thing. Today, in conditions of the widespread elimination of emission securities as things, the application to them of provisions on ownership rights as the strongest right allows for the organization of an efficient securities market, on which, as a rule, civil law contracts are concluded by owners of things. For participants in economic turnover, this property takes on the character of liquidity, i.e., the higher the level of negotiability (the ability of a commodity to be the subject of sale and purchase) of debt securities, the more effective (from the point of view of the possibility of being sold) such debt papers are for the market. Normal circulation of securities is the circulation of owners, whose legal capacity, as a rule, is either not limited at all or is limited by the legislator.
This reasoning is intended to show that any restriction of the rights of participants in circulation regarding such an object of rights as bonds must have a specific economic justification because, by constraining the activity of participants in the securities market, for example, by acts of a subordinate nature, we can reduce the volume of lending in the country and, as a consequence, reduce the real production of goods and services. Therefore, any restriction on the circulation of such objects of civil law as securities must be enshrined in law as a normative act of higher legal force than subordinate acts. Thus, the procedure for the buyback of shares by joint-stock companies (which restricts the possibility of arbitrary buyback of its own shares by a joint-stock company) is enshrined in Chapter 9 of the Federal Law "On Joint-Stock Companies".
Let us recall that in accordance with paragraphs 2 and 7 of Article 3 of the Civil Code of the RF, "civil legislation consists of this Code and other federal laws adopted in accordance with it (hereinafter - laws) regulating the relations specified in paragraphs 1 and 2 of Article 2 of this Code", and further: "ministries and other federal executive bodies may issue acts containing norms of civil law in the cases and within the limits provided for by this Code, other laws and other legal acts". It should be noted that neither the Civil Code of the RF nor the Federal Law on the Securities Market empowered the FFMS of Russia or the CBR to regulate the circulation of securities, establish grounds for challenging transactions with securities, etc.
A formal restriction through the regulation of the procedure for companies to buy back bonds, in turn, unexpectedly found its way into clauses 6.2.32-6.2.37 of the Standards and clause 10.5 of the Instruction of the Bank of Russia dated March 10, 2006, No. 128-I "On the Rules for the Issue and Registration of Securities by Credit Institutions on the Territory of the Russian Federation" (hereinafter - the Instruction).
In conclusion, let's consider the arguments for and against the buyback of bonds from the organized market in the absence of regulation of such a buyback in the bond terms.
Arguments contra:
1. If such a buyback begins before the registration of the report on the results of the issue (submission of the notification), the registrar may see a violation of the placement conditions of the securities and the provisions of clause 6.2.34 of the Standards, in connection with which there is a risk of refusal to register the report and recognition of the issue as invalid. This risk is mitigated quite simply: the issuer should not acquire its own bonds before the registration of the report on the results of the issue (it is quite difficult to imagine a case where the issuer would have a desire to carry out a buyback just a month after raising funds through the placement of bonds). After such registration, the regulator's powers to cancel the issue cease.
2. If the acquisition we are considering is carried out after the registration of the report, the risk remains of the issuer recognizing such an acquisition as price manipulation. For this, the regulator will need to establish that such an acquisition was carried out "to create the appearance of an increase and/or decrease in prices and/or trading activity on the securities market relative to the existing price level and/or existing trading activity on the securities market in order to induce investors to sell or acquire publicly placed and/or publicly traded securities".
3. The risk of liability to other bondholders if they prove in court a violation of their rights. For example, holders of bonds that were not bought back may claim "discrimination" of their rights or non-performance by the issuer of obligations enshrined in the bonds, which entails the issuer's liability in accordance with the terms. In this case, the bondholders will have to at least prove the existence of the right to demand the buyback of securities from the issuer, enshrined in the security itself, and its violation. In the absence of relevant judicial practice, in our opinion, this argument is difficult to assess.
4. There are difficulties in accounting for operations for the acquisition of own bonds.
In accordance with RAS (RAS No. 19/02 does not provide grounds for classifying the acquisition of own bonds as a group of financial investments) and IFRS (IAS 39 p41 speaks about accounting for the difference), bonds issued by the company are considered financial liabilities and, therefore, in case of their acquisition, for accounting purposes, they must be redeemed. Both of these reporting standards are based on an economic, not a legal, understanding of bonds, and in this regard, they may need to be clarified.
Arguments pro:
1. The possibility of the issuer buying back bonds stems from the very essence of securities. This position is based on the classical, still prevailing in lawmaking, civilistic approach to defining the essence of a bond as a security (Article 142 of the Civil Code of the RF). In some cases, the law (or by direct reference, a by-law) may establish a procedure for the buyback of securities, for example, shares. However, the legal nature of shares and bonds differs significantly, since the nominal value of shares forms the authorized capital of companies, which, together with the share premium, is the initial form of the issuer's own funds.
2. The law does not establish a procedure for the buyback of bonds, while the circulation of securities should be regulated precisely at the level of federal legislation. Moreover, as shown above, there is no reference norm that such a procedure can be established by by-laws.
3. The right to acquire a thing not limited in circulation stems from the general legal capacity of participants in civil transactions (just like the ability to possess any thing by right of ownership). Such legal capacity is undoubtedly retained by the issuer as well. The legal capacity of participants in civil transactions (issuers) cannot be arbitrarily limited by by-laws.
4. Emission securities, despite the absence of a "material" form, are subject to the general provisions of civil law on securities, including the right of the person obligated under the security (the issuer) to conclude a purchase and sale agreement regarding such securities.
5. Bonds, as a rule, are admitted to trading on organized markets. At the same time, the exchange does not have the technical ability to track every transaction for compliance with the Standards (or the Instruction). If we recognize the possibility of challenging purchase and sale transactions between the issuer and the bondholder on the basis of an ordinary civil law contract, then, consequently, exchange turnover could be threatened with destruction if, for example, it is proven that the issuer participated in the chain of purchase and sale of the bond as an ordinary participant in the securities market.
Taking into account all of the above, we conclude that until the issue of bond buyback is directly regulated at the level of federal legislation, transactions aimed at the company acquiring its own bonds cannot be challenged or declared null and void, even if the issuer does not comply with the procedure for their acquisition regulated by the terms of their issue. At the same time, we fully admit that the legislator may introduce special requirements for the disclosure of information about the start of the issuer's buyback of bonds from the market, and non-compliance with such requirements will entail administrative sanctions from the regulator (but by no means consequences in the form of challenging or even nullity of such transactions).
How then can we qualify the enshrinement of such a procedure in the bond terms? We believe that in this case, the actions of the issuer should carry a high risk to its reputation. Drawing an analogy with Roman law, a company that violates the buyback procedure established by itself and its word to investors in such a case violates a natural obligation (pacta). Let us recall that the violation of pacta entails not a claim (unlike the violation of conventio), but the "civil death" of the debtor, i.e., a situation where he is no longer of interest to members of society as a counterparty.