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Debt Conversion Program: Guidelines for Bulgaria


There are several reasons for considering some countries' programs as models for Bulgaria. First of all, Bulgaria is a late comer to the family of countries with such programs and it is an obligation and a privilege to learn the lessons of its predecessors. Secondly, some of the programs are reflecting accumulated experience or have specific features that are attractive to Bulgaria from legal, economic or other point of view. However, there still remains place for subjective choices. But nobody can argue against the programs of the following countries: Argentina, Brazil, Chile, and Mexico.

3.1. Argentina

The formal debt conversion scheme based on the restructuring agreement of August 1987 consisted of a debt-to-equity investment program and a capitalization mechanism for onlending funds. A third element was added later - the purchase of shares of existing companies if a Central Bank rediscount was canceled in the process. These three instruments resulted in the conversion of .5 bn in one year, with the debt equity conversions accounting for more than 50 % and the rediscount mechanism for 34 %.

The Argentine debt equity conversion program is relatively more structured and well-defined program, particularly, with regard to investment aspects (like Mexico and the Philippines). In order to set a ceiling for the conversions, a system of quotas has been set up through a public auction process rather than administrative decision to assign conversion quotas. There was a clear intention to adapt the swap scheme to the country's economic policies.

An important aspect is that all foreign direct investments associated with debt-for-equity conversions are regulated explicitly by the existing legislation. It did not impose any major restriction on foreign direct investment except in the real estate and finance sector. Argentina used the conversion program as a leverage to promote investment projects beyond the program parameters. Investments benefiting from it were ineligible for industrial promotion schemes, as well as tax or other special benefits. Invested resources could not be repatriated for ten years, they were immobilized for three years and profits cannot be remitted during the first four years.

Following the authorization of the investment by the Ministry of the Economy, the Central Bank puts the pre-set quota up for tender and redeems the debt instruments in Australes at the free exchange rate, less a conversion commission (discount). The exchange rate less the commission sets the effective cost of the swap. It is the public auction where only the discount offered by the investor in order to obtain a portion of the quota is formally taken into account. (In the course of the 5 public auctions the discount rose from 36 % nominal value of debt to about 72%).

In those cases where the holder of the paper (generally the foreign bank) becomes the investor in the Argentine company, there is no price attached to the debt instrument to be swapped. It will then have to make a fair valuation of the project to determine at what value it will be incorporated as an asset in its accounts.

With respect to the requirement for additional funds, 70% of an investment project may be financed by a swap deal, while the remaining 30% should be covered by fresh money. But the cost of imported equipment, the VAT and a percentage of the working capital or real estate are excluded from the capitalization program. From the point of view of the investor, the need for additional funds increases the cost of the project. Such additional funds may be paid up in foreign currency or Australes and contributed as a capital participation or a loan. The level of risks and the return on the investment will depend to a large extent on how this mix is structured.

There is a mechanism which slightly favors the development of small and medium enterprises. The program is also concentrating in agro-industry, tourism and the automotive sector. This might point to substituting normal foreign direct investment, but it has been quality investment that has created new productive capacity.

If the investor is the original holder of Argentine paper, the swap is tax free as it will be treated as a redemption of the debt instrument before maturity at less than nominal value. The investor becomes shareholder in Argentine company. However, if the investor purchased the paper in the market, income tax may be due on the difference between the purchase price and the Australes received from the Central Bank. Here are some taxes levied under the program:

An important aspect of the Argentine program is the Foreign Investment Law (FIL) Application. If the investor is foreign, the project falls under the terms of the FIL, which restricts the repatriation of investments and the remittance of profits. In the case of investments made under the Debt-for-equity swap program, the converted funds cannot be repatriated for a period of ten years and dividends may not be paid during the first four years.

Argentine's program is highly regulated one, where the Central bank controls the supply and demand by establishing quotas and discount rates. The financial and tax regulations in Argentina and abroad are critical factors to be taken into account.

The quota system sets a ceiling on the investments necessary for the restructuring of production.

If the component of imported equipment, working capital and real estate is significant, then the requirement for additional fund would be larger and consequently the project will have a lower rate of return. The real cost of the project will be lowered and the expected rate of return after taxes can be improved through a good combination of discounts, fresh funds and fiscal planning. Projects with better short term profitability are in the best position.

3.2. Brazil

Resolution No 1460 of February 1, 1988 with respect to public debts is considered here because it is most relevant to our objectives.

Debt for equity swap may cover all types of financing registered with the Central Bank including medium and long term loans and foreign currency deposits of matured installments of principal and of interest with the central bank covered by the Brazilian foreign debt restructuring agreements.

The assignment of loans and financing to third parties is expressly accepted. However, the proceeds of swaps must be applied in risk investments and cannot be used for operations that could be interpreted as credit transactions or for projects that guarantee a return of repurchase, directly or indirectly covered by public funds.

Public sector debt is exempted from the auction process and ceilings but investment must be made in public sector companies or used to liquidate their debt. Such investments must have the prior approval of the Special secretariat for the Control of State Companies and the Secretariat of the national Treasury. Investments may also be made in foreign capital conversion funds which may hold in their portfolio more than 5% of the voting capital or 20% of the total capital of any company. The Securities and Exchange Commission (SEC) may establish provisions for their transfer abroad.

Funds invested in Brazil must remain in the country for a period of 12 years from the date of capitalization and the remittance of profits and dividends is as defined for foreign investment under Law No 4131.

Swaps that result, directly or indirectly, in the transfer of control from Brazilian to foreign ownership are not permitted. Proceeds may not be invested in the total or partial acquisition of foreign owned company unless the product of the sale is reinvested in Brazil, by the foreign seller.

Swaps are not permitted where repatriation of capital with or without capital gains have been made in the preceding 36 months unless these funds are brought back. Any remittance abroad of capital repatriation with or without capital gains by companies that already have a foreign capital registration is subject to a deposit with the central bank, for a period of 12 years in an amount equivalent to the funds swapped. Proposals for swaps are examined and decided by the Central bank.

The Brazilian Securities and Exchange Commission has authorized the creation of several Debt/Equity Swap funds:

  1. FCCE 0 million conversion fund set up by Banco;
  2. Bozano Simonsen de Investimento, managed by Morgan Grenfell of the UK;
  3. The Safra conversion fund, managed by Banco Safra;
  4. The million Factor conversion fund, by Factor brokerage house;
  5. The Boston/Sodril Conversion Fund by Bank of Boston and the Sodril brokerage house;
  6. The Chase Conversion fund by Chase Manhattan group.

3.3. Chile

Debt conversion in Chile is governed by Chapter XVIII and XIX of the Compendium of Rules on International Exchange. Short term maturities, official and multinational loans have been excluded from the program.

3.3.1. Chapter XIX rules for foreign investors

This regulation authorizes natural and juridical persons, Chileans or foreigners, with residence and domicile abroad, to invest in Chile using eligible external debt instruments. Prospective investors must apply for authorization to the International Directorate of the central bank. If the investor is other than the original creditor, the application must also include a request to change the instrument's creditor.

If the Central Bank (CB) is the debtor, local currency redemption will be made indexed or dollar denominated financial instruments to be exchanged for the external debt at the debt instrument's face value as follows:

  •  A dollar denominated promissory note to be paid in pesos, with maturity of principal as of ten years from date of substitution of the debt instrument and semi-annual interest payment in pesos at an interest rate based on LIBOR, fixed by the CB, from time to time.
  •  An indexed peso denominated promissory note issued in Unidades de Fomento (inflation indexed development units), with maturity of principal as of fifteen years from the date of substitution and semi-annual interest payments in pesos at an average rate based on local market conditions fixed by the CB, from time to time.
  •  The holders of the dollar denominated promissory notes may exchange them for peso denominated promissory notes any time during the first 18 months. Both kinds of promissory notes may be sold on the secondary market at a discount through a local bank acting as agent for the transaction under the authorization of the CB. The proceeds of such sale must be applied to the authorized investment or deposited with the agent bank until disbursement is required according to the authorized investment.

There are no limits imposed on the volume of transactions that can be undertaken over a given period, since approval of applications by the CB is on case-by-case basis. The CB can refuse the proposal without expression of cause. Although there is no official guideline on favored sectors, investment in export activities are preferred.

Once approval of investment has been granted, the investor is given access to the foreign exchange market for the purpose of repatriation of profits, subject to the following conditions:

  • a) capital invested cannot be remitted for ten years from the date on which the investment or capital contribution was made;
  • b) profits generated during the first four years can only be remitted from the fifth year, in installments that do not exceed 25% of the total accumulated profits. Profits generated from the fifth year onwards are not subject to restrictions.

Reinvestments are allowed subject to the restrictions imposed on the original investment.

An important amendment was introduced in 1987, to allow natural and juridical persons (owned by foreigners) with residence and domicile abroad, to invest in shares of local open corporations (sociedades anonimas) through Chilean Investment Corporations (sociedades de inversion) specially created for this purpose. The foreign investor (Chileans are not allowed) eligible for such investments may be private, government or multinationals with a net worth of not less than US$ 5 million.

There are a number of requirements which apply to the "sociedades de inversiones". the minimum subscribed capital must be US million and each share a minimum of US0,000. No shareholder may hold more than 25% of the shares. The shares, once subscribed and paid, could be transferred abroad and traded amongst foreign investors qualified to make such investments.

The life of the sociedades de inversiones cannot be less than 12 years, which is equivalent to a minimum permanence of the initial investment for such a period. It may not remit any profits until the end of the fifth accounting year, and thereafter remit up to 90% of net profits every year plus up to 20% of the profits accumulated over the first five years period. These sociedades are under the control of the Superintendencia de Valores y Seguros (controlling agency for public corporations) and the CB.

The foreign funds may be invested in predetermined financial instruments. These include shares of Chilean public corporations, debt instruments issued by the CB and the public sector, mortgage bonds (issued by banks), bonds issued by public corporations and other authorized instruments. Investments may not exceed 10%, and in some cases 15%, of the issuing company. Investment in one issuer may not exceed 10% of the total assets of the sociedades de inversiones. By the end of the fourth year of operation, at least 60% of total assets must be invested in shares of Chilean public corporations and not less than 80% in shares plus long term financial instruments.The "normal" foreign investment law allows operation of foreign investment funds. But such funds are eligible for Debt for Equity conversion mechanisms

3.3.2. Chapter XVIII rules

These rules authorize nationals and foreigners, resident or non-resident of Chile, to acquire eligible external debt instruments and to use them to obtain local liquidity.

Prior to acquisition of the debt instruments, the debtor or prospective investor must agree to one of the following alternatives:

  • a) that the instrument shall be paid immediately upon delivery, in cash, with or without discount, in Chilean pesos; or
  • b) that the instrument will be substituted for one or more instruments denominated in Chilean pesos, in indexed "Unidades de Fomento" or foreign currency payable in Chilean currency.

The CB imposes limits on the number of conversions that can take place every month according to monetary and exchange rate policies. The CB sells the right to buy discounted debt (called cupos) to banks, authorized to operate in international exchange transactions, at auctions, usually held twice monthly. These awards are transferable between banks during a given month. These rules were modified in 1986 to put Chilean nationals on more equal footing with foreign investors with the so called Annex 4.

It allows Chilean corporations and banks and financial institutions to substitute their own external debt for equity as a result of a new share issue, without being subject to the auction of rights (cupos) for the peso prepayment. The private corporations which apply for such procedure be heavily indebted and draw a direct benefit from the D/E conversion. These operations are also approved by the CB.

Unlike Chapter XIX, conversions through Chapter XVIII do not have to be applied to a specific use, previously approved by the CB, except for conversions made under Annex 4. The scheme has mainly be used by Chilean banks to retire their own external debt by taking advantage of the secondary market where it is traded at deep discounts. After adding the cost of the debt (around 60%), the commission to the CB and the effect of the foreign exchange gap, the effective cost of debt retirement is approx. 90%.

The success of the Chilean program stems from its clear cut rules and the government's commitment to the objectives it was seeking: to reduce or maintain the level of its external debt and to attract foreign investment. It was helpful to increase savings in Chile in order to facilitate the capitalization of private sector companies and banks.

These government objectives were translated into a liberal and relatively easy to use Debt for Equity conversion program.

3.4. Mexico

Mexico's program objective is the promotion of new investments that increase productive capacity and export earnings. It is highly structured. It reflects the thrust of the program to ensure the bona fide use of the funds generated through conversion and to channel investment towards priority sectors. The program was initiated in the legal framework governing foreign investment and only foreigners were allowed to participate.

The program is administered by the Ministry of Finance (MoF). But authorization for all foreign investment comes from the National Commission on Foreign Investments. An operating manual has been produced jointly to set out the specific guidelines and procedures for using the program. Conversions are subject to a monthly ceiling in order to control monetary expansion.

The Mexican companies eligible for investment under the program (in order of preference) are:

  • companies already 100% foreign owned;
  • companies with foreign owned majority;
  • companies which are to be converted into majority or minority foreign ownership.

Preference is also given to those companies that are export oriented and produce surplus in their BOP; with high technology; with higher degree of Mexican content; small and medium sized companies.

The funds acquired after the conversion may be utilized in the following ways:

  • for acquisition of fixed assets for expansion, new lines of products or new economic activities which result in exports;
  • for payment of the following liabilities in pesos: due to Mexican banks, due to Mexican suppliers of Mexican capital goods, obligations placed with the general investing public in Mexico.

The rules specifically prohibit that funds to be used for the following purposes:

  • investment in working capital, except when needed for the development of an approved project, provided payments outside Mexico are not involved;
  • payments of foreign liabilities to banks, affiliated companies or suppliers.

The discount applicable on redemption of public debt in local currency is decided on case-by-case basis by the Ministry of Finance. The decision is made on the basis of a set of pre-established percentage discounts contained in the operating manual for nine different categories of benefits expected from the investment.

The gain on redemption in local currency is subject to tax to the foreign investor at 20% of the redemption payment net of discount or 30% of the gain. Remittance of dividends and capital are subject to the normal tax rules governing foreign investment.

Capital generated through debt conversion cannot be repatriated for 12 years. Dividends resulting from the approved investment can be remitted when available. Under the restructuring agreement with the creditor banks, investment redemption cannot take place on a basis more favorable than the amortization of the original credit.


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