Companies have many different ways to raise financing; either by way of equity financing or by way of debt financing.
Classic examples of equity financing are for corporations to increase their share capital by inviting existing shareholders or new strategic investors (i.e. private placement) to subscribe in newly issued shares, or through lunching a public offering to the general public to subscribe in its shares. The public offer process is internationally know as “IPO” or Initial Public Offering.
Alternatively, corporations may, instead of equity financing, decide to raise financing through debt financing. The commonly used debt financing means are:
(i) borrowing from one or a syndicate of banks against a set of securities and charges on the corporations’ assets, commercial establishment, and shares; or
(ii) issuing bonds to general or specific beneficiaries, known as “Bond Holders”.
What are “Bonds”?
As explained above, bonds are one of the most commonly used instruments by corporations to raise financing. Bonds can be a cost-effective but less flexible form of finance than equity shares. It is more cost-effective because lenders are entitled to only a fixed rate of interest, but less flexible because they are usually entitled to that interest, whether a company is doing well or badly, whereas the declaration of dividends on ordinary shares is usually a matter for the discretion of the Board whose recommendation must be ratified by shareholders. In this way, distribution of dividends is dependent upon and linked to the operational and financial performance of the company. Also, the financing cost a company must incur depends to a considerable extent on whether it can offer a lender security and the quality of the security offered.
The legal relationship between a company and its bond holders is a contractual relationship of a debtor and creditor. On the other hand, the legal relationship between a company and its shareholder(s) is a contractual relationship governed by the company’s articles and memorandum of association. In contrast, with a shareholder, the bond holder is in law not a member of the company having rights in it but a creditor with rights against the company. In other words, shareholders have rights in the company but bond holders have rights against the company.
Issuance of bonds is something that we can only expect from a large company of perceived creditworthiness. A bond in this context is a bearer security of certain nominal value issued for money by a company which promises payment of the nominal value at a certain date in the future and, usually, regular interest payments in the meantime. Some bonds are issued for much less than their nominal value and no interest is paid on them.
Another type of bonds is where a company issue bonds against a loan and grant the lender an option to convert the value of the bonds a lend holds into shares in the issuing company. The conversion terms and rate are to be set beforehand between the issuing company and the lender. As this article will explain, in the UAE this type of bond(namely convertible bonds) confers particular practical benefits and advantages to companies and investors who have particular interests to hold a significant stake in the issuing company.
Why Do Companies Issue convertible bonds?
The decision to issue new equity, convertible and fixed-income securities to raise capital funds is governed by a number of factors. One is the availability of internally generated funds relative to total financing needs. Such availability, in turn, is a function of a company’s profitability and dividend policy.
Another key factor is the current market price of the company’s stock, which determines the cost of equity financing. Further, the cost of alternative external sources of funds (i.e., interest rates, availability of securities) is of critical importance.
As we will see later on in this Article, sometimes UAE joint stock companies issue convertible bonds to facilitate bringing on board new strategic investors, but to do it is necessary to circumvent preemption rights of existing shareholders to subscribe to newly issued shares.
What are the Rules Governing Bonds Issue under the Local UAE Laws?
The Commercial Companies Law No. 8 of 1984 (“CCL”) sets out basic terms and conditions applying to the issuance of convertible bonds. Under the CCL, a public joint stock company may, following the approval of its EGM, enter into loan agreement(s) in consideration for negotiable loan debentures of equal value, i.e. convertible bonds (“CBs”).
As the case in all common and civil law jurisdictions, the UAE legislation designed to protect the best interest of the prospective holder(s) before the company in question issues the CBs and general public subscribe to it. The law seeks to ensure that the financial position and overall performance of the company allow it to issue CBs. On one hand, to ensure that the issuer of the CBs will be in a financial position to repay the face value of the CBs in addition to the applicable interest rate, and on the other hand, if the CBs holder decides to convert the CBs into shares in the issuer, the CBs holder will become a shareholder in a vibrant and lucrative entity. For this reason the CCL provides that a public joint stock company shall not be permitted to issue CBs before the publication of the company’s balance sheet and loss/profit accounts for at least one financial year following its incorporation.
Furthermore, the CCL indicates that the value of the CBs must not exceed the existing capital as disclosed the latest certified balance sheet of the public joint stock company, unless the CBs are guaranteed by a UAE Sovereign entity or by a UAE-licensed bank.
As the issue of CBs may diliute the existing shareholders of a public joint stock company, the CCL requires the shareholders of the issuing company to approve the isssue of CBs in a general assembly with special attendance and voting quorums.
Although, CBs grant its holder a right against the issuer of the CBs, the resolutions of the general assemblies of the shareholders of the issuer shall apply to CBs holders. However, the general assemblies may not alter the rights of the holders of such CBs except with the approval of the CB holders in a special meeting.
As a matter of contract, CBs may not be converted into shares unless this was provided for in the loan agreement(s) and the conversion must be implemented in accordance with the terms and conditions stated in the loan agreement(s). CB holders will still have the right under the CCL to choose between either the conversion of the CBs into shares, or repayment, unless the CBs were issued on terms such that conversion is mandatory.
The CCL sets out specific conditions which a company must fulfill to issue CBs.
In a more specific piece of regulation, the Securities and Commodities Authority (“SCA”) has issued the Resolution No. 94R of 2005 (“Resolution”) in respect of “debt securities”, i.e. bonds. In this regard, the Resolution provides that every issuer of CBs offered through public subscription must apply to SCA to list such CBs with one of the Stock Exchanges licensed by the SCA, i.e. Dubai Financial Market or Abu Dhabi Stock Exchange. The Resolution defines “Public Subscription” as follows:
“any subscription where Debt Securities are offered in the State to the publicpursuant to a public invitation but does not include debt securities or certificates of deposit or any other debt instruments which are not offered for public subscription and which are issued by banks and specialised financial and investment institutions on behalf of their customers and where such debt instruments are subject to special regulations to be issued by the Central Bank”
If, however, a company issues CBs that are not offered through a Public Subscription it may apply to SCA to list all such CBs with one of the stock exchanges. In such event the provisions of the Resolution will apply to the issuer of the CBs and the CBs sought to be listed.
In principle, the provisions of the Resolution shall not apply to those CBs or certificates of deposit or any other debt instruments which are not offered to the public through a Public Subscription that are issued by banks and specialised financial and investment institutions on behalf of their customers, such debt instruments are subject to special regulations to be issued by the Central Bank.
Can the Issue of CBs Circumvent the Preemption Rights of Existing Shareholders?
Article 204 of the CCL states that:
“Shareholders shall have priority [preemption right] to subscribe to the new shares. Any condition to the contrary in the company articles or in the resolution adopted to increase the capital shall be void.”
As clearly indicated in the above Article, existing shareholders of public joint stock companies have a preemption right to subscribe in shares that will be issued as a result of a capital increase. This is a mandatory rule, so the company’s memorandum of association may not deprive the shareholders of this right. Therefore, if a public company wishes to invite a strategic investor to invest in the company by way of a capital increase, such invitation will always be subject to with the preemption rights conferred to the existing shareholders by the CCL making commercial negotiation of placement terms problematic.
The only way out is for the existing shareholders to waive their rights to subscribe to the capital fresh shares, which is cumbersome and impractical. Alternatively, the company in question may circumvent the preemption rights of the existing shareholders by issuing CBs to the strategic investor, offering him the right, or the option, to convert such CBs into equity in the issuing company. The strategic investor in can convert the CBs into equity, and in which case the existing shareholders will have no option to tab in and exercise their preemption rights.
By law, CBs should be issued against an underlying loan from the CBs holder to the CBs issuer. The value of the underlying loan will be the consideration for the newly issued capital increase shares which will be subscribed for by the strategic investor.
In practice, the structure is commonly used in the UAE. However, there is a residual legal problem under Article 174 of the CCL, which states that:
“Any resolution adopted by the ordinary or extraordinary general assemblies that might affect the rights of shareholders derived from the provisions of this law or from the company’s articles or increasing their liabilities shall be void.”,
The argument based on this provision would be that an extraordinary general assembly of the issuing company which approved the issuance of CBs might be void because it impliedly deprives the existing shareholder from one of their rights granted to them by the law, being their right to have priority to subscribe in new capital increase shares that will be allotted to the CBs holder(s).
The likelihood of having a successful claim made on the above argument is relatively remote unless someone can establish undisputable evidence that the underlying rational of the resolution of the extraordinary general assembly is to deprive the existing shareholders from their preemption rights. In practice, this is less likely to happen.
How To Determine CB Pricing and What Is Its Term?
The law is silent as to the pricing of CBs or its term or the maturity period. Although, parties are at liberty to determine the conversion rate and the term of the CBs, such determination is always subject to SCA’s approval. Typically, the conversion of CBs takes from eight to twelve months. However, there are exceptional cases where conversation took place in six months or less.
Can limited liability companies issue CBs?
Article 221 of the CCl prevents any limited liability companies from carrying on or offering for public subscription any shares or negotiable stocks or securities, i.e. CBs.
Used wisely, a policy of selling differentiated securities (including convertible bonds) to take advantage of market conditions can lower a company’s overall cost of capital below what it would be if it issued only one class of debt and common stock. However, there are pros and cons to the use of convertible bonds for financing; investors should consider what the issue means from a corporate standpoint before buying in.