Good News and Bad
Following the standstill caused by the financial crisis of late 2008 through early 2010, Ukrainian businesses, inspired by apparent recovery from the recent economic downturn, resumed looking at international capital markets to overhaul their old assets and further expand operations structurally and geographically. A number of success stories, including share placements by Industrial Milk Company, KSG Agro, Westa, Coal Energy and Ovostar and Eurobond offerings by Mriya, Metinvest, Ferrexpo and Agroton proved viability of global finance markets. However, the window of optimism closed at the end of summer when approaching prospects of the US sovereign default and Europe's financial challenges triggered fears of a global "double-dip" recession. These fears proved to be enough to make international investors cautious about investing in Ukrainian stock. Although it is difficult to predict how soon international capital markets will warm up again, issuers keep looking for market opportunities as they mature.
Adopted on 2 December 2010 and effective in major parts from 1 January 2011, the Tax Code of Ukraine (the Tax Code) compiled scattered tax regulations and introduced a wide range of changes in the existing tax system. One of the key new issues in the Tax Code is introduction of the concept of beneficial ownership, i.e. a non-resident acting as agent, nominee holder or intermediary in respect of Ukrainian-sourced income (including dividends and interest under the loan) would not qualify as the beneficial owner of such income and, consequently, is not entitled to double tax treaty benefits, if any. Notably, the concept targets application of the reduced rates of the withholding tax.
These changes have a profound impact on Eurobond projects traditionally structured as limited recourse loan participation notes (LPN) with reliance on Rule 144A and/ or Regulation S under the US Securities Act of 1993, where proceeds from the offering are channeled to Ukraine under a loan agreement. The principal and interest repaid by the borrower are further transferred by the issuer (loan grantor) to the wide range of bondholders (ultimate recipients of funds) located in different jurisdictions.
The concept of beneficial owner is rather underdeveloped in Ukraine. Despite the fact that similar provisions regarding beneficial owner are contained in double tax treaties concluded by Ukraine years ago before adoption of the Tax Code, tax authorities usually did not apply this concept in practice and there is no available interpretation of this provision, which results in uncertainty in the application of double tax treaty benefits.
Discovering New Opportunities
Credit-linked notes (CLNs) have been often discussed as an alternative to traditional Eurobond LPN structure. CLNs are tailor-made securities with an embedded credit default swap (CDS) that allow the issuer to transfer credit risk to specific investors. Payment of coupon and principal under the CLN is linked to the performance of a particular reference credit. The issuer is not obliged to repay the debt if a default occurs. This eliminates a swap counterparty providing credit protection for an ongoing premium.
Credit-linked notes have several advantages in comparison with traditional Eurobonds, e.g., credit rating is not mandatory,
listing of notes and registration of issuance is not required, disclosure requirements are limited. In terms of legal costs CLNs are cheaper than LPNs.
Catalyst — New Market for Ukrainian Issuers
On 30 September 2009, the Warsaw Stock Exchange launched the first organized bond market in Poland called Catalyst. Catalyst consists of four trading platforms. Two platforms operated by the WSE are dedicated to retail investors while two BondSpot markets are dedicated to wholesale investors. Ukrainian entities have not issued debt securities in Poland yet, but several major industrial groups have already expressed their interest to make a debut on Catalyst with a private listed offering of PLN-denominated bonds.
From Cyprus to Luxemburg
There are a number of different ways in which local businesses seeking floatation on the foreign stock exchange can consider entering the ECM: (a) direct share placement by Ukrainian issuer; (b) placement of depositary receipts representing shares in Ukrainian issuer; (c) placement of depositary receipts representing shares in a foreign holding company that owns the majority of shares in a Ukrainian issuer; and (d) placement of shares in a holding SPV.
Given an unequivocal prohibition of denomination of Ukrainian stock in foreign currencies and oppressive applicable regulations by Ukrainian securities supervisors a direct IPO of Ukrainian shares on international markets remains a legal dream rather than established reality for a common issuer (although there has been a controversial exceptional direct placement of Naftogaz Ukraine discussed below) while depository receipts have become an everyday practice and indirect issues through a holding SPV are ready to be launched by many.
In 2011 most of the Ukrainian issuers entered the ECM through a listing vehicle incorporated in Luxemburg, while in 2010, as in previous years, Cyprus led the list. The rise of Luxemburg is not logical at the first glance given a still not ratified double tax treaty between Ukraine and Luxemburg leaving local businesses without tax preferences. According to the European regulations a prospectus may be approved by the issuer's home competent authority in the EU and "passported" to another EU member state as the basis of a public offer or admission of securities to a regulated market. Currently approval of the prospectus in Cyprus may take up to 4 months, while Luxemburg's securities regulator recently completed its mission within 3 weeks. It is not surprising that volatile markets made timing crucial for businesses looking for a window of opportunity to have a successful placement. To bypass pitfalls of the tax regime transaction structurers place a Cypriot sub-holding between an issuer and Ukrainian companies of the group.
To facilitate restructuring of Naftogaz Ukraine's debt the Ukrainian SEC took the position in its letter in September 2009 that a direct placement of foreign (i.e. denominated in foreign currency) securities by Ukrainian issuers is possible and does not require SEC's approval. Based on this clarification in November 2009 Naftogaz made direct issuance of Eurobonds. There is still absence of clarity whether SEC's letter provides sufficient authority for direct Eurobond placements by Ukrainian issuers absent express relevant statement of law, not allowed denomination of bonds issued by Ukrainian entities in foreign currency and prevailing perception of experts that the new concept is legally vulnerable. Nevertheless, in 2011 SEC officials again reiterated the SEC's intention to ease restrictions on issuances of securities abroad by Ukrainian companies. The final solution of these good intensions, however, may be found only in the relevant legislative amendments, including in the first place the Commercial Codes' bond denomination rules, similar to permission in December 2011 of denomination of government domestic loan bonds in foreign currency. Most of Ukrainian
Eurobond LPN issuances prior to and following the 2009 Naftogaz transaction involved a non-Ukrainian SPV/issuer on-lending proceeds raised from the sale of bonds to Ukrainian fund raiser. This structure apparently remains the only risk-free approach from the legal perspective.
For the majority of Ukrainian companies international capital markets were essentially closed in the second half of 2011 and only solid and well prepared businesses were able to make debut issues in the beginning of the year. Analysts expect that first offerings will come from mature companies since investors are going to be very conservative in investment strategies unwilling to pay for future growth as much as for stable cash flows. There is a hope that stagnation of the capital markets will not last long both internationally and in Ukraine. The downtime appears to be used by many businesses for getting better prepared for finance opportunities in the next year.