A Mechanism for Protecting Debenture Holders Rights

Maria Karpacheva Senior Lawyer of the Practice of Banking Activities Support  Yakovlev & Partners Law Offices

On Sept. 23, 2009 the State Duma of the Russian Federation passed the draft law “On amending the Federal Law ‘On the securities market’” (regarding the creation of mechanisms for protecting debenture holders’ rights) prepared by the Federal Service for Financial Markets of Russia based on the experience of foreign countries.

The mechanism for the protection of rights provided by the draft law, particularly the setup of the institutes of general meeting of debenture holders and the debenture holders’ representative (hereinafter – the “Representative”), is undoubtedly necessary for the Russian law at present. However, there are certain disadvantages to the draft law that should be mentioned.

The first disadvantage is that the role of the Representative is limited to a few people within the company. The Representative must be a broker, a manager or a legal entity, who has for at least 3 years provided accounting, advisory or legal services, with net assets of at least RUB 1 million, and be accredited by the Federal Service for the Financial Markets of Russia. In addition, the draft law allows the Representative to be the issuer and its affiliated persons, or the person who provided the security for the given debentures and its affiliated persons.

It is natural that the list of established formal requirements regarding licenses or accreditations, periods of activity and amount of assets is quite extensive, however the requirements aimed at prevention of conflict of interests are very few.

It should be noted that in the countries with the most developed institute of representation of the debenture holders’ interests (Great Britain and the US), the main criterion is the absence of conflict of interests between the debenture holders and their Representative. Thus, for instance, US law allows the Representative to be any company (except the issuer or a company that directly or indirectly controls, or is controlled by, the issuer). US law specifies that the Representative may simultaneously represent interests under another indenture with the same issue; represent interests of holders of other bond series under the same indenture, with the same issuer (except where such issues of debenture claims are not subordinate to each other); that the Representative is the underwriter of the issuer (company, which directly or indirectly controls, or is controlled by, the underwriter); that the Representative and the issuer are controlled through the same officials, members of the boards of directors, holders of shares (directly or indirectly) in the Representative’s or the issuer’s capital; and that the Representative is the issuer’s creditor.

These formal requirements to the Representative are few, however, the list of conditions, which may cause conflict of interests with the debenture holders, is quite large. This is lawfully reasoned, since the Representative should first of all be independent from the issuer, and not be the owner of certain licenses, assets and accreditations.

A further disadvantage is that subject to the draft law, the mechanism of the general meeting of debenture holders with their Representative does not apply to state and municipal bonds. In accordance with US law, the requirement of obligatory appointment of the bond’s Representative does not apply to the state and municipal bonds, nor to private placements.

However, the possibility of using this legal mechanism for such bonds is not ruled out. The given exclusion in the draft law is not justified and may entail a decrease of investors’ interest in state and municipal bonds since investors will be less protected.

The final disadvantage is the requirement of the draft law regarding the obligatory appointment of a Representative for placement by open subscription, which is an unreasonable limitation that may mean extra costs for the issuer (for investors of issues, which are not large in their amount and number).

Such requirements are established by the US legislation for public issues with a total value of above $10 million.

I would like to conclude that the absence of straightforward legislative rules does not mean that these forms of associations and activities are prohibited or impossible. The debenture holders may conclude agreements, subject to which they will either undertake to perform certain actions or refuse to do so. Such agreements may be valid at the present time, although the terms of the resolution on the issue of securities may not be changed. For example, all debenture holders and the issuer may conclude an agreement on taking recourse upon the property pledged or mortgaged in security of bond obligations in an extrajudicial order.