Debt-to-Equity Conversion Solutions Under Ukrainian Legal Framework
Inbound investments into Ukraine are critical not just for the purpose of maintaining and developing existing and future businesses, but also for rebuilding and modernizing the country, which has suffered severely because of the Russian aggression. In this regard, the importance of the legal framework as well as of the legal tools for investments cannot be underestimated.
Furthermore, certain investors, such as institutional investors, expect to have access to the instruments that these investors have in other countries. From Ukraine’s point of view, it is important to meet that expectation, as Ukraine continues to compete with other countries in the global world, while the war has not made this competition easier for the country.
One of the instruments that investors seek for, is debt-to-equity conversion. It is an instrument which is universally considered as an efficient debt management tool which, on the one hand, is enabling the indebted companies to free up cash, improve their balance sheet, and on the other hand, it allows investors, such as venture capital and private equity investors, to structure and implement their convertible loan transactions.
In a nutshell, if to look as to what is a debt-to-equity conversion under Ukrainian law and, specifically, under Ukrainian legal jargon, it can be defined as setting off an obligor’s debt obligations before the creditors using the equity in the company. These obligations may arise out of loans, including the shareholders’ loans as well as out of transactions with third parties (i.e. the parties which are not the shareholders of a company), including conventional loan facilities and convertible loans.
This article gives an insight into the development of debt-to-equity conversion under Ukrainian law and provides the details of the process through which it can be successfully implemented.
I. The Legal Framework Development Path
The history of regulatory development of debt-to-equity conversion is quite notable in the national legal framework. It was heavily demanded by the market first during the 2008 – 2009 global financial crisis, and then in the 2014 – 2016 turmoil, as a debt restructuring mechanism to overcome the dramatic depreciation of the national currency and lower debt obligations of Ukrainian companies. Despite those needs, the statutory limitations and prohibitions existing at the time did not allow debt-to-equity conversion transactions the way these transactions were allowed in many other countries.
Then came the needs related to growth: the booming Ukrainian tech sector and start-up projects demanded investments and financing. Convertible loans would be the instruments to use, particularly for venture capital funds, to finance and invest in Ukrainian companies and start-ups. While the debt-to-equity conversion remained unavailable, these investments were structured in offshore jurisdictions, with Ukraine, as the jurisdiction, losing for no good reason.
In order to try to change the status quo, the team of Wolf Theiss lawyers, acting under the auspices of the Ukrainian Venture Capital and Private Equity Association (“UVCA”), prepared the draft law that would enable debt-to-equity conversions in limited liability companies (“LLC”) which is the most common corporate form used to set up business in Ukraine.
For this purpose, the Draft Law On Amendments to Certain Legislative Acts of Ukraine to Ensure the Right to Convert Monetary Claims to the Company for Contribution to its Authorized Capital (registration No. 2764) (the “Draft Law”) was prepared and submitted to the Parliament of Ukraine in 2015. In 2016 the Draft Law successfully passed the first parliamentary hearing and gained the necessary votes for it to be considered further.
In brief, under the Draft Law, it was proposed to remove the statutory prohibition on capital contributions by setting off debt obligations, which prohibition was the principal obstacle for debt-to-equity conversions in LLCs. Also, the Draft Law framed the mechanisms for implementing debt-to-equity conversions, including the ones under convertible loan agreements.
Notably, during the parliamentary consideration, the Draft Law gained a great deal of attention from the market community and was actively discussed in parliamentary committees. These discussions involved the state regulators, such as the National Bank of Ukraine, and professional business associations, including the Independent Association of the Banks of Ukraine.
Ultimately, the idea of debt-to-equity conversion travelled from the Draft Law to another major Draft Law On Limited and Additional Liability Companies, which reformed the whole legal regime for LLCs, and was ultimately adopted in 2018 (the “LLC Law”).
When considering the matter of debt-to-equity conversion, the LLC Law eliminated the prohibition for setting off claims to LLCs in exchange for equity in them. However, the LLC Law, once originally passed, nevertheless omitted to provide the necessary procedural details for the implementation of the new possibility. That resulted in complexities at the stage of state registration of the capital increase, leaving that issue and the whole possibility in the loophole domain.
Ultimately, that loophole was addressed only in 2021, by supplementing Article 18 of the LLC Law to provide that additional capital contributions to an LLC can be made by setting off mutual correlative claims between an LLC and its participant (shareholder) and/or a third party. As a result, the implementation possibility of debt-to-equity conversions was given the green light.
II. Conditions for Debt-to-Equity Conversions
Under Article 601 of the Civil Code of Ukraine, in order to terminate the obligations by offsetting them, such obligations must meet a number of requirements. These requirements have been further interpreted and applied by judicial practice, and include the following:
- Being mutual, e. the obligations whereunder the claims arise must be between the same parties with each of them being both a creditor and an obligor;
- Being correlative (e. of the same kind). The law does not provide greater details as to what precise obligations may be considered as correlative. These criteria have been developed by court practice with courts’ position remaining quite uniform. The courts concluded that such obligations should concern the transfer of things of the same kind, such as money, and such obligations may arise out of different grounds (such as different agreements). Importantly, the obligations expressed in different currencies may not be considered as correlative and, therefore, cannot be terminated by offsetting.
- Being matured, or without an established deadline for their performance, or payable on demand. As also clarified by the judicial practice, as of the moment of offsetting, the corresponding claims should be overdue, e. not fulfilled when due and, thus, becoming a debt for one of the parties (i.e. LLC). When it comes to convertible loans, they can meet an obligation by being in the payable on demand domain.
As, in theory, offsetting may be restricted contractually, in addition to the above requirements, the relevant agreements out of which the obligations arise, must not prohibit offsetting.
III. Implementation Steps and Actions
In general, under the LLC Law, the procedure for the capital increase with additional capital contributions includes the following principal stages: (1) a preliminary decision of the General Meeting of Shareholders (Participants) of the company (the “General Meeting”), (2) actual making of additional contributions (i.e. the obligation set off in case of debt-to-equity conversion), and (3) final approval by the General Meeting of the 2nd stage results.
A Preliminary Decision
The first step in the process of capital increase is taking a preliminary decision by the General Meeting with respect to additional contributions to the LLC’s capital, or as it is called in Ukrainian law – authorized capital.
According to Paragraph 3 of Article 18 of the LLC Law, at this General Meeting, the shareholders should take a decision on the following matters:
- The total amount of capital increase. Importantly, in order to comply with the correlation requirement for the obligation set-off, as discussed above, the amount of capital increase would need to be determined in the currency of debt obligation. Therefore, in the decision of the General Meeting, the amount of increase (additional contribution) should be determined in both (1) the currency of the obligation, which is subject to offsetting, as well as (2) in the national currency equivalent. For this purpose, the parties should use the exchange rate set forth by the National Bank of Ukraine;
- the ratio of the amount of increase to each participant’s share in the authorized capital;
- the planned total amount of the authorized capital upon the capital increase;
- deadlines for making additional contribution. This timing should be set taking into account the above-mentioned requirement that the obligation subject to offsetting should have materialized and become due;
- the right of a specific shareholder or a third party to make an additional contribution without exercising their pre-emptive rights by the existing shareholders. This decision would require either a unanimous vote by all shareholders of the LLC or a respective provision in the Charter (Articles of Association) of the LLC; and
- execution of an agreement with the shareholder (third party) on making an additional contribution. While having such an agreement is not strictly required by law, it is advisable to have it in place in order to document the actual terms of agreement of the parties on offsetting claims.
Exercising Pre-Emptive Rights
Unless exercising the pre-emptive rights by the existing shareholders has been clearly excluded by the preliminary decision of the General Meeting, each existing shareholder will be entitled to make an additional contribution within the amount of increase pro rata to its share in the capital.
A third party or a shareholder will be able to make an additional contribution (i.e. proceed with offsetting) only after the existing shareholders exercise or waive their pre-emptive right to make capital contributions.
Additional Capital Contributions – Obligations Offsetting
Generally, under the Civil Code of Ukraine (Article 602), a request by either party is sufficient to proceed with offsetting obligations. Therefore, either the company or its counterparty (under an obligation that is subject to offsetting) may deliver such a request to the other party.
In case of a cross-border debt-to-equity conversions it is advisable to execute a bilateral document between the parties (e.g. a termination agreement, reconciliation act, etc.) clearly stating the amount of obligation terminated, details of underlying obligations (i.e. details of the contract, resolution of the General Meeting, an agreement on making an additional contribution, if any), payment deadlines, etc.
General Meeting Approving Capital Increase
The results of the previous stage must then be approved by the shareholders at the General Meeting not later than one month after expiration of the deadline for making an additional contribution set at the initial General Meeting. Thus, at the next stage the General Meeting must approve the following decisions:
- results of additional contributions made by the shareholders and/or third parties;
- participation shares of the shareholders and their nominal value, considering their additional contributions; and
- increased amount of the authorized capital.
Apart from the above matters, it may be also required for this General Meeting to approve a restated version of the Charter (Articles of Association) of the LCC, in particular if the list of shareholders and their shares are provided for in the text of the Charter.
Please note that (1) a unanimous shareholders’ vote will be required in case of re-distribution of participation shares among the shareholders, and (2) at least ¾ of shareholders votes will be required for amending the Charter, unless the Charter provides for a different number of votes.
IV. Conversion under Cross-Border Arrangements
The parties in cross-border loan agreements or convertible loan agreements, in addition to Ukrainian corporate regulations, need to take into account the exchange control regulations.
Currently, due to the introduction of martial law, the National Bank of Ukraine, by its Resolution dated 24 February 2022 no.18, established limitations and restrictions on outbound transfers as well as other currency controls. These restrictions and limitations are updated from time to time, with a trend to gradually make them more liberal. Importantly, debt-to-equity conversions are allowed under the current exchange control regulations regime, including that the Ukrainian companies’ banks should be able to facilitate conversations to the extent banks’ involvement is required.
All financing agreements of Ukrainian borrowers with foreign lenders are recorded in the information system “Loan agreements with non-residents” of the National Bank of Ukraine to which banks have access. Therefore, as a practical recommendation, prior to moving with the capital increase by conversion of debt into equity, the borrower-company should approach its bank to discuss and pre-clear with the bank the relevant procedures and documentation implementing the conversion.
By Taras Dumych, partner at Wolf Theiss, and Oksana Volynets, senior associate at Wolf Theiss