Wang Jie explains core provisions and everything else you wanted to know about perpetual bonds in China
Perpetual bonds are a type of financial instrument that has been offered quite frequently in recent years. However, for the financial institutional investor, how to design terms that are binding on the debtor, whether it is possible to demand the provision of credit enhancement measures for perpetual bonds, and what impact the determination, accounting-wise, of the nature of perpetual bonds has on the commercial terms are all questions requiring particular attention at the product design stage.
Usually, perpetual bonds do not provide for a specific repayment term. Under specific conditions, they may be listed as an equity-type item, not a liability, in accounting accounts. For a debtor, perpetual bonds offer numerous advantages, such as improving its financial statements, reducing its asset-liability ratio, pre-tax deduction of the interest, etc. In mainland China, there remains a certain lack of legislation governing perpetual bond products, but, considering such features as the flexibility in the offering methods and the diversity in offering conditions, they are commonly deemed to be a financial instrument with great potential.
PRODUCT DESIGNS AND RISKS
As compared with ordinary claims, the biggest difference is that perpetual bonds do not have a fixed maturity date. This lack of a maturity clause usually needs to be remedied through the design of the commercial terms so as to heighten the debtors’ willingness to perform. This section will describe, from the perspective of a financial institution (as the perpetual bond investor), the arrangements for perpetual bond product terms in order of weaker to stronger binding force.
General terms. They refer to the arrangements that are generally selected for perpetual bonds. In such arrangements, the investor will forego default clauses as well as such measures as security, credit enhancement, etc., for the products, and pressure on the debtor to redeem the bonds will rely solely on hiking the interest rate. For the investor, legal protection under such arrangements is very weak. The following are some of the features of general terms:
1. Repayment sequence. Perpetual bonds may be set as subordinated debt that ranks after ordinary claims but before equity in the repayment sequence. Alternatively, it may be specified that they have the same ranking as other claims in the repayment sequence. Whether perpetual bonds rank after other ordinary claims is not statutorily mandated, but rather can be freely determined based on the Contract Law.
2. Term and redemption. Perpetual bonds generally do not have a fixed term and they give the debtor the right to redeem them at its discretion. However, in order to ensure steady returns for the investor, it will usually be specified in the terms that the debtor may redeem them in full only after a certain number of years.
3. Interest deferment and interest rate hikes. The debtor’s willingness to redeem perpetual bonds can be adjusted by hiking the interest rate. The debtor has the right to defer payment of interest indefinitely, without such deferral constituting a default or a debt owed by the debtor.
4. Mandatory redemption or payment of interest. The mandatory redemption or payment of interest clause is usually only triggered if the debtor carries out a distribution of profits, reduces its registered capital, or announces its going into liquidation. However, mandatory redemption of the bonds or payment of interest before a distribution of profits will put a certain amount of pressure only on the average listed company, or a public company whose shareholder structure is relatively thinly spread.
5. Foregoing of default clause. A default clause will usually be specified for a financial instrument, i.e., when a situation that affects the repayment of the perpetual bonds – such as a worsening in the debtor’s financial indicators, difficulties in its operations and management, or a change in its actual controller – arises, the investor will, in the great majority of circumstances, call in the debt. However, in order to facilitate the listing of certain default bonds as equity for the purposes of accounting treatment, a default clause as mentioned above will be obviated. Instead, it will be provided that the debtor is required to bear its obligation of repaying the principle and paying the interest only in the event that it is liquidated.
6. Foregoing of credit enhancement measures. This is mainly for the purpose of facilitating the entry of the perpetual bonds as equity in the accounts. Accordingly, it is necessary to avoid providing for credit enhancement measures or security terms that would point to their being a claim, failing which the perpetual bond product could be directly recognized as a debt.
Medium binding force terms. The binding force of general terms on debtors is limited. Therefore, changes will sometimes be made to certain terms, e.g., the addition of credit enhancement measures with relatively mild legal effectiveness, counterbalanced however by the investor compromising on the interest rate hikes, and so mitigating the pressure on the debtor to a certain extent, or increasing the confidence of the financial institutional investor, without affecting the recognition of the perpetual bonds as equity instruments. Medium binding force terms have the following features:
1. Adjustment of the interest deferral and interest rate hiking mechanisms. Although general terms permit indefinite deferral of the payment of interest, they will provide for an interest rate hiking mechanism to increase the possibility of prepayment by the debtor and compensate the investor for the potential risks it faces. However, from another perspective, as the debtor could be compelled to redeem the bonds that it issued because it is unable to bear the exceedingly high interest rate, an increasing number of accountants feel that this method causes perpetual bonds to constitute to a certain extent an enterprise liability, and cease to be equity. To avoid this from occurring, the debtor and investor may consider agreeing on a ceiling for the interest rate hikes, so that after the passage of a certain number of financing years, the interest rate will remain at the ceiling level, without further increases, even if the debtor defers payment of the principal and interest. The setting of the interest rate is something that the debtor must take into consideration, but in situations where interest rates are expected to rise, this would be detrimental to the investor.
2. Credit enhancement measures. Similar to asset securitization products, the terms of certain perpetual bonds may require an affiliate, or the controlling shareholder, to provide a liquidity support undertaking for the debtor. However, under such a measure, the funds are not directly paid to the creditor, and there is no express fund payment obligation. Accordingly, its legal binding force is relatively weak, but it will not affect the classification of the perpetual bonds as equity for the purposes of accounting treatment.
Strong binding force terms. These refer to terms that offer greater protection to investors than the two preceding ones, e.g., adding a cross-default clause, default clause and statutory security measures to protect the interests of the investor to the greatest extent possible. Strong binding force terms will usually have the following features:
1. Addition of a cross-default clause and a default clause. The term “cross-default clause” means that where the debtor is in default under a financing contract executed with another financial institution, or is in default under other bonds that it has issued, the calling in of the perpetual bond product will be triggered simultaneously. Such clauses are provided mainly to avoid default risk contagion and ensure the realization of the claims as soon as possible. Additionally, the investor will also require the corresponding addition of a default clause. The addition of the above-mentioned clauses is helpful in allowing the investor to judge risks in advance and take legal measures to avoid having to demand discharge of its claim only when the company is facing bankruptcy. However, the requirements in respect of the financial institution’s post-investment due diligence, and the adequacy of the debtor’s information disclosures, are also stringent.
2. Credit enhancement measures. To ensure the interests of the investor, early perpetual bond products set strict statutory security measures, mainly mortgages of real estate or the provision of joint and several guarantees by shareholders. Such statutory security measures are the most effective and legally recognized credit enhancement methods. In recent years, credit enhancement for products is more commonly done by requiring the shareholders or a connected party to provide directly to the creditor an undertaking to make up any shortfall, so enhancing the protection of the investor.
However, the addition of the two above-mentioned credit enhancement measures is not without certain shortcomings:
1. Both statutory security and the making up of a shortfall are rights subordinate to the master claim, and due to the nature of master claims the perpetual bonds will, as a result of the above-mentioned credit enhancement measures, be deemed a debt financing instrument;
2. The investor may exercise its statutory security rights, placing under seal, seizing or freezing the debtor’s assets, only if the master debt obligation is not performed. However, if the contract specifies that the debtor has the right to opt to defer the payment of interest without constituting a default, the investor cannot exercise its security rights by claiming a default under the master claim.
3. Additionally, given that the debtor has the right to opt to defer payment without constituting a default, the demand by the investor that the shareholders or a connected party (a third party) provide funds to make up the shortfall clearly makes the obligation borne by the third party exceed the obligation borne by the debtor. If a dispute arises, the third party could refuse to pay the make-up funds on the grounds that the master debt had not arisen, giving rise to a certain uncertainty as to the performance of the contract.
Accordingly, the provision of credit enhancement measures requires comprehensive consideration of their compatibility with the other terms to avoid a conflict between the arrangements under the various terms that would greatly reduce their expected legal effect.
NATURE OF PERPETUAL BONDS
Whether perpetual bonds can be recognized as equity instruments is mainly dependent on whether the structural design of the financing terms can cause the enterprise’s rights and obligations to more closely comply with the criteria for recognizing equity capital.
Recognition as a financial liability. Pursuant to the Provisions for the Differentiation and the Related Accounting Treatment of Financial Liabilities and Equity Instruments, issued by the Ministry of Finance, the approach to determining whether perpetual bonds are equity instruments or financial liabilities requires, on the whole, a tracing back to the recognition of financial liabilities. In addition to contractual obligations requiring the delivery of cash or other financial assets being defined as liabilities, perpetual bonds may also be recognized as liabilities under the following circumstances:
- Where, under potential adverse conditions, contractual obligations relating to financial assets or financial liabilities are exchanged with a third party;
- Where an enterprise cannot unconditionally avoid performing a contractual obligation without delivering cash or other financial assets; or
- Where, although there are no terms or conditions expressly containing an obligation to deliver cash or other financial asset, a contractual obligation may nevertheless indirectly arise by way of other terms or conditions.
However, what specific conditions constitute “potential adverse conditions”, “unconditionally avoid” or “obligation that arises indirectly”? The provisions do not provide a clear explanation of these, leaving room for interpretation when applying the same. With more and more perpetual bond-type financial instruments being offered, the basis for recognition is also gradually becoming stricter.
Recognition as an equity instrument. Where a perpetual bond product has a settlement clause, it may be deemed to fall into the equity category under the following circumstances:
- Where it is required that settlement be carried out in cash, with other financial assets or by other means where the instrument becomes a financial liability;
- Where there is a settlement clause but the chance of the same arising is extremely slim, namely the relevant circumstance is exceedingly rare, markedly unusual or nearly impossible; or
- Where the issuer is required to carry out settlement in cash, with other financial assets, or by other means where the instrument becomes a financial liability only in the event that it is liquidated.
If, pursuant to the product terms, repayment of the perpetual bonds is only triggered when the company is liquidated, the author would first recommend that the investor strictly review the company’s articles of association, shareholder relationships and operational and management circumstances before investing, failing which it might find itself without any recourse when a risk arises after the investment is made.
Second, the sequence for repayment of the perpetual bonds when the company is liquidated must be carried out in accordance with article 186 of the Company Law, namely, “the company’s property remaining after the payment of the liquidation expenses, the wages, social insurance premiums and statutory compensation of the employees, taxes owed, and the discharge of the company’s debts shall be distributed to the shareholders in proportion to their capital contributions, in the case of limited liability companies, or in proportion to the shares held by the shareholders, in the case of joint stock limited companies”.
Although perpetual bonds are to be repaid before the distribution of equity, their repayment sequence may be affected for other reasons, including a previous undertaking by the creditor accepting a lower repayment priority or other claims having priority due to being secured.
Commercial arrangements that could affect the determination of the nature of perpetual bonds. For perpetual bond projects, the following commercial arrangements could affect the recognition of the perpetual bonds as equity or as liabilities. An increasing number of perpetual bond products are being offered on the market, accounting recognition is increasingly strict and project structures are increasingly complex, all of which increase the difficulties the investor faces in identifying risks.
1. Interest rate hike mechanism. The unlimited hiking of interest rates in past projects drew questioning from accountants. They were of the opinion that, under potential adverse conditions, the unlimited hiking of interest rates resulted in financial liabilities that debtors were required to promptly perform.
2. Credit enhancement measures. Although perpetual bonds provide for unlimited delay, they in fact remain claims, and creditors have the right to demand payment. Accordingly, if acceptable to both parties, security or credit enhancement measures can be added. With respect to the major credit enhancement measures on the market, the author believes that they differ in the following ways:
First, liquidity support letters are a commonly used form of credit enhancement measure. They generally do not have an express fund payment undertaking and do not impact the recognition of perpetual bonds as equity instruments. However, as the funds are not paid directly to the investor, they do not provide security and are unenforceable at the judicial level. Accordingly, they do not constitute a claim-debt relationship, only providing comfort and a moral binding force. They are not recommended as a principal credit enhancement measure.
Second, an undertaking to make up a shortfall is not a statutory security measure and, in theory, such a contractual provision is deemed to run the risk of being revoked. However, judicial practice leans towards supporting the validity of such undertakings. However, where payment of interest is deferred, whether such an undertaking will be accepted by a judge still requires the test of a judicial trial.
3. Cross-default clause. If a certain circumstance involving the debtor arises, triggering the provision in the cross-default clause on the accelerated maturity of the debt, this could constitute a “potential adverse condition” or result in the enterprise being “unable to unconditionally avoid” performing its fund payment obligation, so not satisfying the condition of “payment at the time of liquidation”. Based on the regulations of the regulator, the perpetual bonds could be deemed to be a debt instrument.
PERPETUAL BONDS V PREFERRED STOCKS
Perpetual bonds without a cross-default clause and no clear maturity date closely resemble preferred stocks, and their return rate levels are also extremely close. At the time of investment, they are often compared one to the other.
Although perpetual bonds may be acknowledged as long-term equity instruments, there nevertheless remains a major difference in the difficulty in disposing of them as compared to private equity investments or preferred stocks. Perpetual bonds offered as bonds on the open market are tradable, but if offered through a private offering, they do not enjoy any advantages over equity in the course of a transfer.
At the liquidation stage, preferred stocks have priority over ordinary equity in the repayment sequence, but rank behind ordinary claims. Perpetual bonds usually enjoy the same priority as ordinary claims at the liquidation stage. Accordingly, in terms of repayment sequence, perpetual bonds do enjoy a certain advantage.
Furthermore, with respect to the issuing entity, perpetual bonds may be offered as a nested financial product and both unlisted companies and listed companies can be debtors. In contrast, only listed companies are permitted to offer preferred stocks, restricting the available financing channels to a certain extent.
RECOMMENDATIONS FOR INVESTORS
First, it is necessary to focus on whether the purpose of the proceeds requires a penetrative review. In the past few years, asset management companies have often invested in perpetual bond projects by first establishing a dedicated asset management plan (i.e., a special purpose vehicle) and then appointing a bank to extend the loan. The reason for proceeding in this manner was to circumvent the strict regulatory requirements faced by project financing under the trust loan model. However, under current regulatory approaches, such circumvention schemes have become entirely ineffective.
Furthermore, from the perspective of products offered under the current bank and insurance regulatory regime, the regulators subject the purpose of the proceeds to a stringent review. Therefore, for the sake of prudence, a financial institution serving as an investor needs to substantively review whether the proceeds will ultimately be used for a lawful and compliant project, so as to avoid the financial institution being exposed to compliance risks.
Second, if, pursuant to the contract, the perpetual bonds rank behind ordinary claims in the repayment sequence, the security received by these bonds is extremely weak, and strong security and credit enhancement measures must be provided for them. The enterprise must provide credit enhancement measures such as an real estate mortgage, equity pledge, legal person security or liquidity support, in order to ensure the exercise of claim security liability in the event of a default.
Where the nature of the perpetual bonds is difficult to determine, the investor should, at minimum, duly carry out a credit investigation before the investment and endeavour to avoid accepting a clause that ranks the perpetual bonds behind ordinary claims in priority, in order to seek a balance between the rights/obligations of the debtor and those of the investor.
Third, at the commercial negotiation stage, the investor should endeavour not to lightly forego negotiations on an accelerated maturity clause. Such a clause must specify under which circumstances a default is constituted, and defaults must be quantifiable and enforceable. Whether the definition of various defaults is clear will affect the effectiveness of claim recovery, and the clarity of the provisions could also have a determinative effect at the time of litigation and preservation.
Finally, when assessing whether to invest in or offer perpetual bonds, it is necessary to comprehensively consider various factors such as the nature of the proceeds, the product return rate, liquidity, safety of the product, whether the credit enhancement is solid, risk handling measures, etc., to arrive at a rational determination.
Wang Jie is a senior legal counsel at Ping An Pension, and a legal expert at the Insurance Asset Management Association of China