Denis Vodnev of Alfa Bank -
The practice of issuing ruble-denominated bonds through special purpose vehicles (SPVs) is widespread in Russia, as they are very attractive for issuers. Such SPV issues are required to have guarantees from major operating and holding companies. However, investors in ruble bonds issued via SPVs should know that they are exposed to a large degree of risk as a result of poor implementation of the guarantee mechanism.
Until the end of 2007, the practice of using SPV finance to issue ruble bonds was widespread and used in more than three-quarters of third-tier ruble bonds and half of second-tier bonds.
But the guarantees on ruble bonds are limited. In the event of a default, the guarantee is valid for 30-90 days, during which time investors must file a claim with the guarantor. Otherwise, the investor will end up with only the SPV-financed bonds. The guarantee can be challenged on the grounds that there was a violation of corporate procedure in the approval process. Furthermore, the amount of the guarantee may be less than the amount of the bond, and the guarantee does not carry the obligation to pay interest and penalties. On top of all this, the guarantor usually has a low level of transparency, which prevents investors from reacting in the event that its financial conditions deteriorate.
Advantages and disadvantages
If the issuer is a specially created financial company guaranteed by the parent company, the legal risks of investing increase significantly. Therefore, investors who wish to participate in such schemes should carry out a thorough legal examination and demand a significant premium to compensate for the legal risks involved. Until recently, this type of lending was widespread because of the weakness of the legislative framework for the securities market.
Entities issue bonds through an SPV to avoid having to disclose financials on a quarterly basis and other important information, as these requirements apply only to the issuer itself and not the guarantor, ie. the parent company. This allows banks to issue "corporate" rather than "bank" bonds, which changes the regulatory framework applied to information on the issue and expands the range of investors who can participate. In particular, corporate bonds do not carry reserve requirements, which lowers the cost of borrowing.
At times, issuing ruble bonds through SPVs is the only way banks can attract funds from the ruble debt market, as reserve requirements make the cost of borrowing so high that it is not longer practical. For companies, SPVs increase the amount of funds that can be attracted. When an issuer sells bonds in its own name, the amount of authorized capital is restricted. When bonds are issued through an SPV with a guarantee from a parent company, there are no restrictions on the authorized capital of the guarantor.
To explain the first risk, we will use as an example AiRUnion's debut bond issue. At the time of the placement, the issuer was a financial company of a specially created holding. KrasAir was the guarantor and received the funds from the bond issue. Subsequently, the guarantee was deemed invalid owing to violations of corporate procedure. As a result, investors were left holding bonds of a shell company. Even though in this particular case it is unlikely that the guarantee would have protected investors even if it had been valid, they would at least have had the right to file a claim against KrasAir to redeem their bonds. Under the actual circumstances, we think the chances of a court even considering a case against KrasAir are very low: investors have the right to sue only OOO AiRUnion.
Under current regulations, only the issuer is obliged to release quarterly financial statements. Therefore, investors may not be able to monitor the financial situation of the guarantor.
Moreover, the guarantee might not apply to the entire amount of the placement, ie. it may only cover a coupon or a portion of the face value paid on maturity. As a rule, this limitation also applies to state guarantees (at both the federal and regional levels). Traditionally, such guarantees apply only to the principal, not interest or put options. Although the guarantee covers the bonds' entire term, the mechanism for its implementation is only short term. The requirement for the guarantor is often limited to 30-90 days after a default by the issuer. Therefore, during bond placements by issuers using SPVs, claims must be filed against the guarantor even if a restructuring has been proposed, and the issuer may delay the restructuring process until the expiration of the period during which claims may be filed.
Currently, unscrupulous issuers are using loopholes in Russian legislation and investors' ignorance of the legal system.
We believe that in the interests of investors, the regulator needs to more fully develop the regulatory framework of bond issues done through SPV-finance companies. The government should also pass legislation establishing regulatory requirements for the guarantee of bonds (eg. legal records of cross-default on bonds with a defaulted/bankrupt guarantor, requiring guarantors to report financial statements, etc.). That is, there should be mechanisms to prevent investors from buying unsecured securities in a shell company. Encouragingly, the Russian government's recent measures to improve insolvency legislation are steps in the right direction, in our view.
Denis Vodnev is Senior Analyst at Alfa Bank in Russia
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