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Term Finance Certificates And

Pakistani Capital Markets:

An Overview

1993

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PTCL 1994 Jour, 33

Term Finance Certificates And Pakistani Capital Markets: An Overview

By: Khozem A. Haidermota

It is axiomatic that development of capital markets is sine qua non to the growth and prosperity of a country’s economy. This paper is an attempt to analyse a potential source of capital financing which has not heretofore taken in root in Pakistan. It focuses on commercial paper and debentures, with particular emphasis on term finance certificates (“TFCs”). This paper is organized as follows:

(A) Concept of Commercial Paper;

(B) Secured Debentures and Bottlenecks;

(C) TFC’s, Stamp Duty and the Structure for Private Placement with Investors;

(D) Capital Issues (Continuance of Control) Act, 1947 (the “Capital Issues Act”) and

Offering/Placement of TFC’s;

(E) Public Offering of TFC’s and Bottlenecks;

(F) Convertible TFC’s

(G) TFC’s and Islam; and

(H) Conclusions.

A. Concept of Commercial Paper:- In developed capital markets, commercial paper is commonly an unsecured promissory note for a specific amount maturing on a specific date. In the United States, the issuance of commercial paper is exempt from registration or prospectus requirements of the Securities and Exchange Commission, if the issuer utilizes the fund to finance current transactions and maturity of the paper is within 270 days. Such paper is usually issued to meet seasonal needs for funding and also as a means of bridge financing. i.e., to fund start-up projects that are later permanently funded through equity or long-term debenture issues. Commercial paper may be issued directly to an investor or may be placed through the intermediation of a financial institution.

B. Secured Debentures and Bottlenecks:- A debenture offering may be an attractive alternative to traditional bank financing especially if it is convertible into equity shares of the issuer company. It is a long-term instrument with interest-payments at specified intervals. The face value of the debenture is redeemed at maturity.

It is possible to secure a debenture issue by a company to the public at large through the

intermediation of a trustee which invariably is a financial institution. This may be done by a trust deed which contains or evidences creation of mortgage or charge to secure repayment of the debt to the debenture holders. The instrument of trust specifies that the trustee insures repayment of the interest as well as the principal advanced to the debenture holders. Repayment may also be guaranteed by a guarantor. The author of a debenture trust would also have to expressly transfer the secured properties in favour of the trustee.

The trust deed is rather a complex document and is carefully drafted so as to protect the

interests of the investors and also to achieve the objects of the denture issuer. For example, in Pakistan, it would be possible to create an equitable mortgage by the mere act of depositing of deeds of title with the trustees on immovable properties of the issuer company. It is not necessary to reduce to writing the transfer of interest in immovable properties by way of a security as in the case of other

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forms of mortgages. If reduced to writing, the creation of mortgage would attract compulsory registration under the Registration Act and stamp duty. The trust deed may also contain a “debenture redemption reserve”, which could provide for a sinking fund for the redemption of the debentures. Under the Companies Ordinance, 1984 (“Companies Ordinance”), debentures may not carry voting rights, bur if they are convertible into ordinary shares, then such shares, at the option of the issuer, may carry voting rights. Further, the proceeds raised by a debenture issue do not attract the provisions of the Companies (Invitation and Acceptance of Deposits) Rules, 1987.

From the point of view of the borrower, an adequately secured offering will have a lower cost

of borrowing than a partially secured or unsecured offering. Even though the Companies Ordinance, in Sections 113 to 120, extensively deals with

debenture issues providing various safeguards to investors, there has not been much activity in this regard in Pakistani capital markets, except with respect to primary issues of TFCs to financial institutions. The main bottlenecks appear to be: (a) incompatibility with Islamic injunctions; and (b) excessive stamp duty applicable on the instrument issuing such paper. Under the Sindh Stamp Act, debenture instruments would attract duty of about 3.5% or thereabouts depending upon the value of the issue.

C. Term Financing Certificates Stamp Duty and the Structure for Private Placement

with Investors:- TFCs, at least partially, offer a mechanism by which the above bottlenecks can be overcome because they are ostensibly Islamic instruments and under the circumstances discussed below, are exempt from stamp duty. TFCs are included within the definition of debentures in the Companies Ordinance and are “redeemable capital” instruments issued pursuant to Section 120 of the Companies Ordinance. Generally, and simply stated, a financial institution advances “redeemable capital” to a company for a fixed term and the company promises to repay the capital plus a specified profit at maturity. TFCs do not involve any loss participation. Further, their issuance may or may not be secured.

Section 9A of the Stamp Act (II of 1899) read with a modification in Sindh (PA/DS(B)-Misc-I/84,

dated 1st January 1985) provides that no stamp duty would be applicable on the issuance of TFCs nor on any instrument of transfer by or in favour of banking companies, as defined in the Banking Tribunals Ordinance, 1984. TFCs , however, under Section 120 of the Companies Ordinance may only be issued by a company in favour of scheduled banks and financial institutions (as defined in the Companies Ordinance) and other notified parties which, pursuant to a modification (S.R.O. 1142(I)/91, dates 3rd November, 1991), includes investment finance companies (institutions which are both banking companies for purpose of the aforesaid exemption from stamp duty and are also institutions to whom TFCs may be issued under Section 120 are hereafter collectively referred to as the “financial institution”).

A possible structure, therefore, to the issue of TFCs to investors is as follows: a company would issue TFCs to a financial institution who would in turn privately place the TFCs with its clients and contacts. (The considerations relating to public offering of TFCs are separately dealt with in this paper).

It should be noted that the company could not have placed TFCs directly with investors as it would not have been permitted to do so under Section 120 of the Companies Ordinance. It is possible to interpret Section 120 to imply that TFCs may not be transferred/placed with investors who are not scheduled banks, financial institutions (as contemplated under Section 120) or other notified parties because Section 120 merely states that TFCs may be issued by a company to the foregoing entities. In my opinion, however, such an interpretation is untenable for the following, among other, reasons: (i) Section 120 does not expressly restrict any transfer/placement of TFCs, and (ii) Sections 76-81 of the Companies Ordinance contemplate transfers of debentures, which include TFCs.

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Continuing with the above structure, it needs to be pointed out that offerees who purchase the TFCs from the financial institution may have to pay the stamp duty at the time such offerees wish to sell the TFCs. This is so because the notification exempting stamp duty on TFCs only applies to the issue of TFCs and to the transfers to or by a banking company. As such, under existing laws, due to its illiquidity, a secondary market for trading TFCs cannot develop.

Transfers (but not the issue to the financial institution) of TFCs in bearer form would not attract stamp duty. Surprisingly, however, a notification (No. F.I. (I)-EF/49, dated 9th April 1949) under the Foreign Exchange Regulation Act, prohibits the issuance of bearer securities without State Bank’s consent. This notification, apparently, remains operative till this date. On the positive side, however, the State Bank vide a circular dated 23rd January 1994 permits, without its prior consent, the issue and transfer of TFCs in favour of foreign residents on a repatriable basis, provided the purchase price is paid in foreign exchange.

Interestingly, by a notification in September 1993 (No. 8(5)/B & A. 91. Vol. III dated 15th September 1993) stamp duty on “bonds traded within the capital territory of Islamabad” has been considerably reduced. There is stamp duty on the first issue of bonds at .15% and stamp duty on subsequent transactions at .1%. Unfortunately, the term “traded within capital territory of Islamabad” has not been elaborated. Does it mean that if the issuer or transferor is registered/resident of Islamabad, the lower rate would apply? Or does it mean that the physical transfer of shares has to be executed within Islamabad? In addition, whether TFCs would fall within purview of bonds as used in the above notification is a debatable point.

A legally permissible and dependable mechanism can, however, be designed by which stamp duty is not attracted for onward transactions, but detailed discussion of it is beyond the scope of this paper.

D. Capital Issues Act Offerings/Placement of TFCs with Investors:- The next regulatory hurdle discussed is the archaic, anti-market statute, the Capital Issues Act. Under the Act, generally speaking, the consent of the Controller of Capital Issues would be required to make (a) “an issue of capital” (unless an exemption is available), or (b) any “public offer of securities for sale”. The Controller has wide discretion in making its consent conditional on various factors affecting the pricing of the securities.

With respect to the issuance of TFCs by the company to the financial institution, there is an

escape route from the rigours of the Capital Issues Act and the Companies Ordinance. Section 120 of the Companies Ordinance specifically states, that the provision of the Companies Ordinance and the Capital Issues Act relating to creation, issue, increase or decrease of capital shall not apply to redeemable capital, which includes TFCs.

In the event that the aggregate consideration involved in the issue of TFCs by a company does

not exceed Rs 100 million, even the onward private placement by the financial institution, in my opinion, is exempted from the application of the Capital Issues Act; provided the issuing company, broadly stated, is not involved in the financial services sector nor is it a company with foreign capital that is involved in a security sensitive sector.

E. Public Offering of TFCs and Bottlenecks:- Next we consider the regulatory obstacles

that confront a public offering of TFCs. Firstly, every public offering of securities requires the consent of the Controller of Capital Issues. Though the definition of the word “securities” in Capital Issues Act does not expressly include “term finance certificates”, it includes the world debentures. Under the Companies Ordinance, debentures include TFCs. Even otherwise, the definition of “securities” is so wide that it would be untenable to contend that TFCs are not included.

Exemptions mentioned above with respect to the issue of securities are not applicable for

public offerings of securities. Moreover, under Section 120 of Companies Ordinance, TFCs, as already

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discussed, may not be offered directly to the public. As such, intermediation of a financial institution becomes essential.

A tenable argument can, however, be advanced that notwithstanding the provisions of Section 120, the Corporate Law Authority (the “CLA”) has the power to permit a company to issue TFCs directly to the public, even if the company is not a financial institution. As in the case of private placement, in Sindh, there would be no stamp duty on the public offer of TFCs by the company, provided that such offer is specifically permitted by the CLA. But onward transactions, not involving a financial institution would attract the duty.

Conventional thinking presumes that consent of the CLA would be required in the event the financial institutions make an offering to the public for the sale of TFCs acquired by them. However, there appears to be an anomaly in the law which suggest otherwise. Specifically, Section 62(5) of the Companies Ordinance states;-

“(5) A notice, circular, advertisement or other document soliciting bids, offers, proposals or tenders for sale of shares or other securities acquired in the course of normal business or for negotiating sale thereof or expressing an intention to disinvest such shares or other securities issued by a scheduled bank or a financial institution shall not be deemed to be a prospectus or an offer for sale to the public for the purposes of sections 61 and 62.”

A plain reading of this Section makes it clear that the TFCs (which are included within the definition of “securities” under the Companies Ordinance) acquired by a scheduled bank or financial institution in its normal course of business may be sold by offering them to investors in practically any manner, yet the bank or financial institution would not be required to prepare a prospectus. Presently, TFCs are acquired by many banks as part of their normal business.

The above interpretation will vehemently be challenged on grounds, inter alia, that the object and spirit of the Companies Ordinance requires that disclosures, as stated in the prospectus, be made when securities are sold to the public. However, under the law where terms of statutes are clear and unambiguous, it has to be given effect, notwithstanding its consequences. This is an established principle of statutory construction.

F. Convertible TFCs:- In most developed market economies, a debt instrument may be packaged with such terms that may be changed at the option of the issuing company, the holder of such instruments or both. One of the two of the most basic of such options is a convertible debt instrument which would give the holder the right to swap/convert the instrument into a prescribed number of equity shares of the issuing company. The other is a debt instrument which may be packaged with a warrant, i.e., the holder of the instrument can, at its option, purchase a set number of equity shares of the issuing company at a set price on or before a set date. The main difference between warrant and a convertible is that the owners of a convertible when they exercise their option to buy shares do not pay cash – they simply give up the debt instrument.

Under the present regulatory scheme in Pakistan, the development of any market for options in the nature stated above is improbable. The first problem is Section 86 of the Companies Ordinance which gives pre-emptive rights to existing shareholders to subscribe to any new issue of the company’s shares. As such, a company would be restrained from issuing new shares as the time a derivate debenture holder would want to exercise the option to purchase new shares of the company. It may be noted, however, that the Controller of Capital Issues has very broad powers to override the provisions of Companies Ordinance pursuant to sub-sections 4 and 4(A) of Section 3 of the Capital Issues Act. Prima facie, therefore, if the Controller of Capital Issues consents to the issue of derivative securities, then such issues may be legal, notwithstanding the fact that the existing shareholders are deprived from exercising their pre-emptive rights. This proposition is supported by a Judgement of the Lahore High Court, Abdul Malik vs. Janana De Maluche Textile Mills Limited (PLD 1973 Note 116). I,

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however, have serious doubts as a to the: (a) constitutional validity of sub-sections 4 and 4(A) of Section 3 of the Capital Issues Act; and (b) correctness of the interpretations given to the aforesaid sub-sections by the Lahore High Court.

There is some reprieve found, however, in Section 87 which under very limited circumstances

states that notwithstanding the pre-emptive rights under Section 86, certain securities, including TFCs, may be converted into equity shares of the company. This section does not, however, apply to the issue of warrants.

Section 87 is in my view, one of the most poorly drafted sections of the Companies Ordinance and also appears to be devoid of any rational or practical purpose. Generally stated, under Section 87, convertible TFCs may only be issued: (a) if TFCs have a term of three or more years; (b) conversion would be restricted to only 20% of the outstanding balance; and (c) option to convert may not be exercised by a company that has a profitable track record (this clause (c) is a simple interpretation of an otherwise convoluted proviso in Section 87).

Pakistani capital markets are thus deprived of various advantages of packaging debentures with options, which have been borne out by the experience of developed market economies. Some such advantages in the Pakistani context, are as follows (a) a TFC placement or offering would have a cheaper cost of capital with the conversion option; and (b) the convertibility would also give the investor a chance to participate in the issuing companies’ successes as well as its failures (if the company does well, its equity shares may be acquired at rates cheaper than market). Incidentally, such participation is also more compatible with Islamic injunctions.

With a massive overhaul of Sections 86 and 87, however, an options market in Pakistan will not develop.

G. TFCs and Islam:- Finally, sections 120 of the Companies Ordinance, inter alia, provides the rights of the holders of instruments of “redeemable capital” cannot be challenged by the company or its shareholders as repugnant to any provisions of the Companies Ordinance or any other law or memorandum or articles of the company. These protections are applicable to any instrument in the nature of “redeemable capital”. If TFCs are held by a court of law as interest-bearing instruments, they may not be considered “redeemable capital” as defined in the Companies Ordinance. Once these instruments are found to be outside Section 120, statutory protection will not be available. Care, therefore needs to be taken in formulating terms of the TFCs.

H. Conclusion:- A company may privately place TFCs with investors via the intermediation of a financial institution. Under existing laws, TFCs may not be directly placed with investors. In addition, in Sindh, the instrument issuing the TFCs to the financial institution and its subsequent placement to investors by the latter, would not attract stamp duty. Onward transactions would, prima facie attract stamp duty but there is a dependable and legal mechanism to get around such imposition of duty. In addition, in case of the above scenario, consent of the CLA, in most cases, would not be required where the value of the issue does not exceed Rs. 100 million.

It is possible to secure the issuance of TFCs. A company can grant the security to a trustee. In turn, the investor would look to the trustee in case of a default by the company. As the TFCs, under Section 120 of the Companies Ordinance, cannot be offered directly to the public, the financial institutions may issue the TFCs acquired from the company to the public, but consents of relevant regulatory authorities would be required. In addition, it appears to be an open question whether the CLA- independent of Section 120 – would consent to issuance of TFCs directly to the public.

It may be noted, however, that Section 62(5) of the Companies Ordinance is an anomaly in the law which suggests that the offer of TFCs may-if the financial institution acquires TFCs as part of its normal business - be made by the financial institution in practically any manner without preparing a prospectus.

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Under the present regulatory scheme, convertible TFCs can only be issued under very restricted circumstances. If an options market in Pakistan is to develop, certain statutes need massive overhaul. Options packaged with debentures offer the holder the opportunity to participate in a company’s fortunes. As such, it may also be favoured by Islamic jurists.

Manmohan’s India is on the way to becoming a new Asian Tiger, thanks to the development of a dynamic capital market. In India, the Capital Issues Act has been abolished; there is no stamp duty on the issue or transfer of debenture instruments where they are secured by a registered deed; explicit statutory provisions permit the issuance of debentures which are convertible and/or packaged with a warrant; and public offerings of debentures are an integral part of its capital market. None of the foregoing is presently true in Pakistan. Let’s hope our leaders and regulators permit us to grow and prosper.

Author(s)

If you would like further information on any issue raised in this note please contact:

Khozem A. Haidermota HaiderMotaBNR

Senior Partner,

[email protected]

+92 (021) 111-520-000

www.hmcobnr.com

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