Russia: Dealing with defaulted bonds

Author: | Published: 1 Apr 2009
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Corporate shares and bonds, government bonds, and bills issued by banks and companies are the main types of the securities circulating in the Russian financial market.

This article is dedicated to the problem of default by Russian corporate bond issuers on their bonded loan obligations, because starting in the fourth quarter of 2008 the attention of all the securities market participants has been drawn to Russian bonded loans' default problem and to the consequences of such default.

According to Article 2 of Federal Law number 39-FZ of April 22 1996 On the Securities Market, a bond is an issued security, so a security, including paperless securities, having the following features at the same time: it formalises the aggregate of proprietary and non-proprietary rights subject to certifying, assignment and unconditional realisation compliant with the form and the order as provided by the law; it is placed in issues; it has equal volume and terms of realisation of the rights within one issue regardless of the time of such security acquisition.

The holder rights in securities issued in documentary form are verified with certificates (if certificates are kept by the holders themselves) or with certificates and records made to the appropriate custody accounts in depositaries (if certificates were transferred to be stored with a depositary). The holder rights in paperless bonds are confirmed in the register-keeping system – with records to personal accounts with the register keeper, or in case of a depositary, with records made to the appropriate custody accounts in depositaries (Article 28, Federal Law On the Securities Market).

A bonded loan agreement is executed by way of issuing and selling the bonds.

Contemporary Russia has seen a lot of Russian companies using bonds as a tool of raising extra funds for their further expansion. It should be noted that the state (the Russian Federation) in turn has been actively promoting the exchange-traded bond market by perfecting the procedure for bond structuring and placement, and by providing new groups of investors with normative possibilities to become engaged in transactions with corporate bonds.

However, starting in the fourth quarter of 2008, there has been an avalanche of Russian bond issuers defaulting on their bonded loans. Every third issuer defaults on its bonds; such issuers cannot or sometimes do not wish to honour their obligations. Various mechanisms are used to avoid such obligations, including voluntary disbanding of issuers and guarantors or declaring themselves insolvent (bankrupt).

In our opinion, the Russian legislation was not ready for such a turn of events.

The Russian corporate bond market is special in that despite the unified character of normative regulation by the government of bond issuing procedures and the existing common standards (the Russian Federation Civil Code, the Federal Law On the Securities Market, Standards of Issuing the Securities and Registration of the Security Prospectuses, approved by the RF FFMS Order number 07-4/pz-n of January 25 2007), each of the companies entering the corporate bond market tries to state its bond issue decision provisions related to the issuer's default, its consequences and the order of presenting claims to the issuer and the guarantors, in a way creating the maximum number of obstacles to the bondholder trying to utilise the said provisions.

Let's consider some of the problems that holders of corporate bonds by Russian issuers have to face.

Provisions associated with the issuer's default and with investor actions in such a default on bonds shall be stipulated in Item 9.7. of any issuer's Decision to Issue Securities.

According to Item 6.2.10. of the Standards of Issuing the Securities and Registration of the Security Prospectuses, approved by the RF FFMS Order number 07-4/pz-n of January 25 2007 (hereinafter referred to as Issuing Standards), failure by the issuer to fulfill its obligations under the bonds constitutes a material breach of the terms and conditions of the concluded loan agreement (default) if:

  • payment of regular interest (coupon) on the bond is more than seven days late, or the issuer refuses to fulfill the obligation;
  • repayment of the bond principal is more than 30 days late, or the issuer refuses to fulfill the obligation.

Fulfillment of the appropriate obligations with delay, however, within the timeframe prescribed by this item of the Standards, constitutes a technical default. The said provisions must be contained in the Decision to Issue Securities by any issuer being a Russian legal entity because those provisions are imperatively established by the Issuing Standards.

According to Item 9.7. of any issuer's Decision to Issue Securities, default – as a failure by the issuer to fulfill its obligations under the bonds – constitutes a material violation of the loan contract's terms and conditions, providing the bondholder with the right to claim from the issuer payment of the bond principal or income on the bond, as well as interest on such delayed payment of the bond principal or income on the bond, as stipulated in Articles 395 and 811 of the Russian Federation Civil Code, if:

  • payment of coupon income on the bond is more than seven days late, or the issuer refuses to fulfill the said obligation;
  • repayment of the bond principal (part of the principal) is more than 30 days late, or the issuer refuses to fulfill the said obligation.

Thus, both the Russian Federation legislation and issuers' decisions to issue securities contain the two above-stated grounds for declaring default of the issuer. Let's consider each of them in detail.

Payment of coupon income on the bond is more than 7 days late, or the issuer refuses to fulfill the said obligation

Because the bond provides its holder with the right to earn some fixed interest on the nominal value of the bond or other proprietary rights, the issuer's decision to issue securities establishes responsibility of the issuer to pay such coupon (interest) income on the bonds, as well as the order of defining the amount of such income and the exact terms of its payment.

Failure by the issuer to fulfill its responsibility to pay the coupon (interest) income within the timeframe specified in the decision to issue securities constitutes violation of the concluded bonded loan agreement and triggers consequences in the form of the bondholder's right to demand fulfillment of the said obligations both from the issuer, and from the persons who have provided collateral to the bonded loan, as stipulated with Item 9.7. of the issuer's Decisions to Issue Securities, including by way of filing the appropriate claim with the court of general jurisdiction or arbitration court depending on whether the bondholder is an individual or a legal entity.

In this connection, the following question becomes of interest: could a delay in the issuer's fulfillment of its obligation to pay the coupon (interest) income on the bonds for a period exceeding seven days (so a default according to item 9.7 of the decision to issue securities) be considered as the grounds for the bondholder to present the issuer and the bond issue collateral providers with its claim of early redemption of the bond principal (early termination of the bonded loan agreement)?

As of now, there is no unequivocal answer to this question, since bondholders and issuers have different opinions on this matter, and there has been no relevant judicial precedent yet.

The issuer could take the following position: in such a case, the bondholder acquires only the right to claim that the issuer and the bond issue collateral providers pay the unpaid coupon income and the interest for delay in performance of obligations, as stipulated in Article 395 of the Russian Federation Civil Code.

The following supports this point of view: since the Russian Federation Civil Code provisions can be applied to legal relations associated with a bonded loan as long as nothing else is provided with the law or its order, Paragraph 1 of Chapter 42 of the Russian Federation Civil Code (including Article 811) does not provide the borrower with the right to demand any early execution of the loan agreement by the lender in case of such loan interest being overdue.

Based on the abovementioned paragraph's provisions, one could come to a conclusion that the bondholders acquire the right to claim from the issuer and the bond issue collateral providers early repayment of the bond principal (early termination of the bonded loan agreement) if the issuer is late on its obligations to pay the coupon (interest) income or refuses to fulfill the said obligation, only in case of express statement of such right in the issuer's decision to issue securities (the bonded loan agreement).

The bondholders could take the following position: the bondholder not only acquires the right to claim from the issuer and the bond issue collateral providers payment of the unpaid coupon income and the interest for delay in performance of obligations, as stipulated in Article 395 of the Russian Federation Civil Code, but also the right to claim early redemption of that issue's bonds, so early execution of the bonded loan agreement obligations.

The following supports this point of view: as follows from any bond issue decision, the issuer's default on payment of the coupon income constitutes a material violation of the terms and conditions of the loan agreement.

According to Item 2, Article 450, of the RF Civil Code, any agreement between the parties can be amended or terminated upon request of one of the parties based on the court decision if there is a material violation of the agreement by the other party.

Based on this Article, a breach of contract by one of the parties should be recognised as material whenever such breach results in a damage for the other party to the extent considerably erasing the benefits the other party could reasonably expect to receive at the time of signing the contract.

As follows from Article 816 of the Russian Federation Civil Code, a bond gives its holder the right to earn the fixed interest of the bonds' face value.

Thus, presuming that the bondholder, when concluding the bonded loan agreement, expected to receive his or her stable bond coupon income on time and in full, taking into consideration the provision of the decision to issue securities stating that failure by the issuer to fulfill its coupon income payment obligations shall be considered as a material breach of the terms and conditions of the loan agreement, it is possible to conclude that in case of failure by the issuer to fulfill its coupon (interest) income payment obligations, or delay in fulfillment by the issuer of such obligations, the bondholder has the right to take legal action claiming early termination of his or her bonded loan agreement with the issuer and collection from the issuer and the bond issue collateral providers of the bond principal, the unpaid coupon (interest) income and interest as provided by Article 395 of the Russian Federation Civil Code.

Repayment of the part of the bond principal is more than 30 days late, or the issuer refuses to fulfill the said obligation.

The issuer's decision to issue securities may include the issuer's obligations of early redemption of all or part of the bonds in the issue, as well as terms and conditions of occurrence of such responsibility of the issuer in the following cases.

In the decision to issue securities, direct statement of the period for presenting bonds for redemption by the issuer (for example, within the last five days of the third and the sixth coupon periods) (public irrevocable offer by the issuer to buy back the bonds of the issue included in the text of the decision to issue securities and that of the security prospectus. Its realisation does not require the issuer to arrange a separate public irrevocable offer to acquire its own bonds and provides the bondholders with the right to take actions as stipulated in the decision to present their bonds for acquisition by the issuer and to request the issuer to unconditionally fulfill such public offer within the timeframe as stated in the decision to issue securities);

In the decision to issue securities and in the security prospectus, statement of possible occurrences with the issuer of the obligation to buy the bonds (for example, if after the announcement of coupon rates the bond still has undecided rates in respect of at least one of the subsequent coupons then simultaneously with announcing the rates of interest and other determined bond coupons the issuer must provide the bondholders with the right to request the issuer to buy the bonds within the last seven days of the last determined coupon period). In that case the text of the public irrevocable offer by the issuer to buy back bonds of the issue may be included in the text of the decision to issue securities and that of the security prospectus, or the decision to issue securities may include the issuer's obligation to arrange (sign) a public irrevocable offer to buy back its bonds, determining the procedure of acquiring the bonds by the issuer.

Besides, the decision to issue securities and the security prospectus may provide for an option of the issuer buying the bonds of the issue based on agreement with their holder. In that case, the decision to buy the bonds shall be taken by the authorised body of the issuer, and such decision shall include the number of the bonds, the price, which the issuer will pay for the bonds based on the agreement with their holders, the order and the term of buying such bonds.

The latter case is realised by making the issuer responsible for arranging (signing) a public irrevocable offer to buy back the bonds determining the procedure of acquiring the bonds based on the agreement with their holders.

Delay or failure by the issuer to fulfill its obligations in respect of any of the above-stated public irrevocable offers is exactly, as stipulated in item 9.7. of the issuer's decision to issue securities, the case described as "repayment of the bond principal (part of the principal) is more than 30 days late, or the issuer refuses to fulfill the said obligation".

However, it should be noted that all the aforesaid cases do not entail unconditional obligation of the issuer to redeem the bonds paying their face value before all bondholders of the issue because the bondholders must carry out very specific actions to accept the said offers by the issuer. The bondholder actions required to accept the issuer's offer, as well as the order and the terms of their fulfillment, are prescribed in each public irrevocable offer by the issuer irrespective of whether such offer is fixed in the text of the decision to issue securities or it is issued as a separate document.

Bondholder's refusal to carry out these actions, or non-compliance with the order and the terms of fulfillment of those actions as provided by the issuer's offer does not create the issuer's obligation to buy the bonds from the bondholder.

As to the second bond default scenario as stipulated in item 9.7. of the decision to issue securities, it has its own weak points, too, which will probably be solved only at the judicial practice formation stage: whether the issuer's failure to honour its obligations under the public irrevocable offer before the bondholder accepting such offer results in occurrence with those bondholders of the same issue, who did not accept the offer by the issuer, of the right to claim an early repayment of the bond principal from the issuer (early redemption of the bonds of that issue).

There is no consensus with regard to this matter, either. Issuers insist that such right does not arise in respect of the bondholders, which did not accept the offer by the issuer, based on the following: according to Item 2, Article 811, the RF Civil Code, the lender's right to request early return of all remaining amount of the loan arises if the loan agreement provides for such loan repayment in parts (by installments), and the borrower has violated the repayment schedule as established by the loan agreement.

Provisions of the issuer's decision to issue securities establishing the issuer's obligation to forward to the bondholders its public irrevocable offer to buy the bonds of that issue or the issuer's public irrevocable offer included in the text of the issuer's decision to issue securities, despite their similar nature, are not the provision of the bonded loan agreement allowing such loan repayment in parts (by installments).

This conclusion is based on the notion that the issuer's decision to issue securities includes the issuer's obligation to buy the securities from the bondholder matching the right of the bondholder to present the bonds for early redemption.

Therefore, based on the counteractions by the bondholder accepting the issuer's offer only, an early redemption of the bondholder's securities by the issuer is possible, hence, the said provision cannot be considered as the provision stipulating loan repayment in parts (by installments), since without the appropriate actions by a particular bondholder accepting the issuer's offer in the order and on the conditions as provided by the issuer's offer, the issuer is not obliged to buy back any bonds of that issue from that particular bondholder early.

Moreover, the issuer's sending and the bondholder's accepting such public irrevocable offer transfers the parties from relations within the framework of the bonded loan agreement to relations associated with purchase/sale of the securities.

According to Articles 454 and 456 of the Russian Federation Civil Code, under a purchase and sale agreement, one party (seller) undertakes to transfer a thing (commodity) to the possession of the other party (buyer), while the buyer undertakes to accept that commodity and to pay a specified amount of money (price) for it. The seller must transfer to the buyer the commodity as specified by the purchase/sale agreement.

These provisions of the Russian Federation Civil Code mean that the bondholder's acceptance of the issuer's offer signifies conclusion of a bond's purchase and sale agreement between the latter and the issuer, correspondingly providing the bondholder with the right to request the issuer to pay money for the bonds, and the issuer with the right to request transfer of the bonds.

Based on this, we could draw a conclusion that the issuer's violation of its obligations under the public irrevocable offer is applicable only in respect of the issuer's obligations to buy bonds from the bondholder who accepted the offer and therefore has become the party to the agreement.

Those bondholders that did not accept the issuer's offer, to support their alleged right to claim early fulfillment by the issuer of its obligations under the bonded loan, can refer to Item 2, Article 450, RF Civil Code, containing provisions on material violation by the issuer of the terms and conditions of the bonded loan agreement.

The fact that the issuer has allowed violation of the terms and conditions of the bonded loan agreement only in respect of the bondholders that accepted the issuer's offer has no significance because the issuer's failure to fulfill its obligations before one bondholder constitutes, according to the issuer's decision to issue securities, a material breach of the terms and conditions of the bonded loan agreement (default), and such issuer's default is applicable to all the bondholders, including those who did not accept the issuer's offer, and such issuer's default provides any bondholder with the right to claim early fulfillment by the issuer of its obligations under the bonded loan agreement.

The position of the issuers in respect of this matter looks more defendable.

Absence of any economically strong point is a distinctive feature of a defaulted bonded loan. On the one hand, bondholders, as a rule, face the impossibility of satisfying their claims at the expense of the issuer due to absence of any monetary or other liquid funds in its assets. Therefore, any legal procedures that they may have at their disposal to press the issuer (including the court of law) are ineffective in advance.

On the other hand, the issuer is on the verge of bankruptcy, and its only reasonable way of rescue is to get an extension on its obligations under the bonds. Readiness of the issuer to struggle for its own existence and its desire to avoid bankruptcy are good signs of the issuer's aspiration to collaborate with the bondholders.

Unfortunately, the current bond market situation is such that not all issuers are ready to collaborate with the bondholders; many bonded loan issuers and guarantors are looking for and finding ways to avoid liability for their default on bonded loans.

Here are just a few of such methods: issuers and their owners use arbitration court to contest the existing public irrevocable offers with a view to get extension on bond payments; the issuer (guarantor) disposes of its assets and initiates procedure of voluntary dissolution with subsequent bankruptcy of the legal entity based on the simplified bankruptcy procedure as provided by the Federal Law On Insolvency (Bankruptcy).

Note that the Government is trying to participate in solving the defaulted bonds problem. For example, Vladimir Milovidov, the Head of the FFMS of Russia, has made a number of statements recently, including that the Government could go as far as buying out the defaulted bonds, but only in cases where it would be firmly assured that the issuer really could not serve the debt. In addition, the FFMS has sent letters to the Russian Federation Supreme Arbitration Court, the Russian Federation Supreme Court, and the Ministry of Internal Affairs of the Russian Federation requesting to give "special attention" to the problem of Russian issuers' defaults, and in its letter addressed to Anton Ivanov, Chairman of the Russian Federation Supreme Arbitration Court, the FFMS of Russia requests to pay attention to the general practice of legal proceeding in respect of "problem" issuers, and to develop the judicial position on this matter.

Author biography

Sorokin Sergey Sergeevich

Liniya Prava

Sergey Sorokin graduated from the Far East State University Law School. He was the Head of the Law Department of OAO New World and a legal adviser of the Rusal Global Management BV Moscow Office before joining Law Firm Liniya Prava in 2008.

He specialises in arbitration, civil and corporate law. His professional experience includes representation of client interests in arbitration courts of Russia, including En+, Rusal and SUAL on issues such as corporate matters, protection of proprietary rights, and others.He has worked on various projects associated with asset acquisition in Russia and abroad, and provided counsel to large Russian companies pertaining to civil law and arbitration practice.

He speaks English fluently.