EM Corporate Bonds: Legal and Practical Considerations - As Important as Fundamentals?
EMTA’s special presentation on Emerging Market Corporate Bonds: "Legal and Practical Considerations – As Important as Fundamentals?" was hosted by Fitch Ratings in London on October 15, 2008. The event attracted a large group of EM traders, investors and lawyers, who were treated to a very informative and provocative discussion that lasted well-beyond the scheduled conclusion.
Trevor Pitman of Fitch Ratings delivered the keynote address, which was followed by a panel discussion featuring Victoria Miles of JP Morgan, as moderator, and Konstantin Kroll of Allen & Overy’s Moscow office, Diane Roberts of Ashursts, Robin Forrest of Ashmore Investment Management and John Hatton of Fitch Ratings, as panellists. While the topic of discussion was EM corporate entities broadly, there was an emphasis on borrowers from the CIS region and Russia, due to the expertise of the panellists.
The Keynote Address
In his keynote address Trevor Pitman began by outlining for participants the special considerations Fitch applies when rating EM corporates as distinct from developed-market entities. While Fitch’s analytical approach is consistent for both, in the sense that it applies the same global methodology, he highlighted several areas of special consideration in the EM context, noting that the short answer to the question posed by the event title was "yes". He noted that the sovereign rating already captured within the corporate rating any country-specific risks, but from there, highlighted issues relating to corporate governance, local legal frameworks and political risk; group structures, bond documentation and deal structures, that are further taken into account in the corporate rating analysis. For example, whether the rule of law is respected, in particular as relates to private property, has become a line of inquiry that Fitch considers in its rating analysis for corporates following the Yukos debacle.
Pitman then discussed Fitch’s recovery ratings framework for secured debt. Fitch undertakes a bespoke and detailed recovery analysis for all entities rated B+ or lower, which examines the local legal regimes, corporate governance indicators and other relevant regulations, as these relate to a creditor’s likelihood to have its security interest recognized in the case of a default. If the jurisdiction has a creditor-friendly environment, the recovery rating could result in an uptick in the issuer default rating for secured debt. Whereas the UK has a recovery rating of 1, certain EM have their recovery rating capped at 4. This means that Fitch gives no benefit in its rating for secured debt, primarily due to uncertainty as to how the legal regime would operate in the case of a bankruptcy. South Africa was highlighted as an EM that does not have a capped recovery rating. Members only may Click Here for a breakdown of Fitch’s recovery ratings which can be found in the slides of his presentation available on EMTA’s website.
The next broad area of Pitman’s discussion focused on corporate groups and the prevalence of complicated and opaque group structures in the EM corporate world. From the rating agency perspective, it is important to have the whole picture of the borrowing group and how entities relate to one another, in particular when guaranties and/or sureties are being granted amongst group members, and oftentimes across jurisdictions. He mentioned that Fitch has come across EM entities that had not previously considered their borrowing structures, or put in place proper restrictions against internal transfers of assets or cash, before accessing the international debt markets. And he highlighted the case of Mirax, a Russian real estate company, which modified its group structure mid-stream, in essence changing the obligor.
Pitman closed his presentation with remarks about the current global liquidity crisis that is putting many Russian and Ukrainian entities under strain and has led to some Fitch rating actions, for example in connection with Mirax, Sistema Hals and PIK. Otherwise, in answer to a question about how the rating agencies will be reacting to the current crisis in terms of adjusting ratings downward to reflect the poor market conditions, Pitman responded that "we could lower everything to a CCC, but what useful information would that provide?" Instead, he suggested that they would focus on how highly companies are leveraged in determining whether to take ratings actions, with those companies whose leverage is out of line seeing their ratings under strain. Ironically, he pointed out that most EM corporates were less leveraged then their developed-market counterparts.
The Panel
In light of the fact that many EM Eurobonds are issued in complex off-shore transactions, the panel took up the question of governance and complicated group structures to discuss what options bondholders have to look after their interests when investing in EM corporates despite being several levels away from the operating company and assets backing up their investment. The lesson here was "know your borrower". Several panellists offered observations on this point. Pitman noted that bondholders needed to be aware when major shareholders engaged in transactions, such as disposing major assets, that could harm the overall creditworthiness of a borrower. Robin Forrest of Ashmore added that often when designing a "credit group" for purposes of borrowing, the investor and an EM owner/entrepreneur may have different groups in mind and that there was at times a blurring between debt and equity holders in these situations. His recommendation was for investors to "be cautious". Diane Roberts added that it was important to have confidence in the locals.
Konstantin Kroll noted that there were many reasons for issuers from jurisdictions adopting the Russian legal model to design off-shore structures (for example, shareholder agreements are not recognised under Russian law), but mentioned that a risk for international investors who are far removed from the local companies, was that owners might channel assets out of a group, despite the covenants. He noted that it was, at times, an issue of the borrower not being aware - or claiming not to be aware - that covenants create on-going obligations, so bondholders should insist on relevant covenants and be vigilant.
Enforcing Creditors’ Rights
The panel then turned to enforcement of international creditor rights in local jurisdictions. Additional risks associated with synthetic deal structures, in particular credit-linked structures and loan participation structures used in some bond deals, were also discussed.
Konstantin Kroll kicked off the discussion by explaining that foreign court judgments are not enforceable in Russia (or other jurisdictions which follow the Russian legal model). Therefore, for any creditor enforcement action in these countries, bond documentation must include a provision for arbitration. However, arbitral awards are not automatically enforceable and may not be if a court determines that the enforcement would be contrary to public policy or to mandatory provisions of the local law. Therefore, a great deal of uncertainty remains. Kroll further explained that all Russian Eurobonds were issued through indirect, off-shore structures for legal and tax reasons. In these structures, a trustee always represents the noteholders and would need to step into the shoes of the bondholder to enforce its rights The use of trustees in these deal structures - including whether the trustee would ultimately be recognized as the valid representative of bondholders by a local court - elicited a great deal of commentary.
In response to a question about what rights individual bondholders have in trustee structures, the panel clarified the difference between trustee responsibilities under U.K. and New York law: under U.K. law, only the trustee may act on behalf of noteholders, and individual noteholders have no individual right of action unless the Trustee refuses to act; under New York law governed structures following the Trust Indenture Act of 1939 (which many LatAm bonds incorporate), holders have certain individual rights of action. It was pointed out that indemnification issues and the need for swift action make the trustee structure less than ideal for investors. Diane Roberts underscored the point about trustees becoming more forceful with respect to payment, sharing a recent experience where a trustee was demanding hard-cash up-front before acting on behalf of investors. Robin Forrest also stated that trustee structures were problematic because they were slow to act and bureaucratic at times when investors would be seeking quick action and direct negotiations with the debtor.
How Can Bondholders Protect Themselves?
The panel next turned to the situation where foreign bondholders could be compromised by other creditor actions, in particular bank creditors, and what bondholders could do to protect their interests. Everyone acknowledged that bank creditors have better covenants, more control and more flexibility when dealing with borrowers, and admitted that in many jurisdictions, bondholders were essentially viewed like senior equity, as they had to deal with, in some cases, both structural subordination and contractual subordination as well.
To improve one’s position as a bondholder, the panellists provided a number of suggestions.
Bondholders should seek additional security, if possible outside the local jurisdiction, but if not possible then even in the local jurisdiction. Konstantin Kroll admitted that it is difficult to enforce security interests in Russia (in particular because investors had to rely on their trustee to act for them, and security must be disposed of through public auction), but it was still advisable to have security, and it was becoming more common for debtors to provide security.
Investors should use their influence to convince some of the more qualified and respected trustees to work in the EM.
Investors should demand a full set of covenants in bond documentation to give them equal rights to sit around the table with bank creditors in times of stress.
Investors should seek more amortizing repayment structures to ensure repayment and put some discipline into the process, with Diane Roberts suggesting that the days of the bullet payment were over.
Trevor Pitman suggested that financial covenants might be appropriate in bond documentation as they are customary in loan documentation, again, to provide leverage to creditors at times of stress.
The rating agencies explained that they were probably not best placed to provide information once a situation had deteriorated to the point of bankruptcy or administration simply because experience in EM, with Turkey being held out as the example in one case, was that the information flow was cut off at some point prior to the work-out stage, or they were asked to remove their ratings by the companies once insolvency loomed.
Konstantin Kroll shared a Russian bank insolvency example from the late 1990’s, noting that there have been no cross-border defaults of late (with the exception of a Yukos-related transaction). The note of caution here was that the Russian legal system is untested, still developing and not consistently applied. However, in the bankruptcy case in 1999 – 2000, Konstantin explained that the agent for a syndicate of creditor banks was not recognized as the proper representative, and suggested that this might not bode well for trustees trying to argue that they represent noteholders. He added that a major challenge for international bondholders today would be to be represented on the ground and get oneself registered as a creditor and one’s claims recognized as soon as possible.
A final note of warning was that investors should be wary when trying to apply legal concepts from English or New York law, for example, into deals involving Russian or other legal systems. To illustrate, Konstantin Kroll used the examples of guaranties and sureties. Under Russian law, only banks may issue guarantees, which are stand-alone obligations. Corporations can issue sureties, but they are ancillary to the underlying obligation. It is unclear if investors tried to create an English style guaranty (i.e., stand-alone and issued by a non-bank entity), whether Russian courts would recognize that or say that it was counter to mandatory provisions of Russian law.
For more information about this meeting, please contact Starla Griffin at sgriffin@emta.org.