PRINT THIS PAGE Re-introduction of the Participating Debenture in Sweden16/01/2006. Source: Hamilton Advokatbyrå. Niclas Högström
The new Swedish Companies Act, which entered into effect on January 1st, 2006, includes some noteable new features, a few of which are likely to be of interest for buyout firms investing in Sweden. Of particular interest is the re-introduction into Swedish law of the participating debenture (Sw. kapitalandelslån) which will allow Swedish companies increased flexibility when raising debt. The participating debenture was a common feature in Sweden in the late 1920's when it was utilised to a considerable extent internationally by the Swedish financier Ivar Kreuger and his investment company Kreuger & Toll. Following the collapse of Kreuger & Toll in the early 1930's and the numerous and lengthy lawsuits that followed during a decade or two thereafter, participating debentures became outlawed as a means of raising debt for Swedish companies. Although participating debentures were no longer an alternative, so called profit-sharing debentures (Sw. vinstandelslån) have remained a permiss-ible alternative and such will now from January 1st exist alongside participating debentures.
A participating debenture, as it will exist under Swedish law, is a debt instrument in which the underlying obligation to repay the capital amount of the loan, in whole or in part, is made dependent upon economical factors such as dividend distributions, the share price at a particular time, the issuer's profit level or its financial position taken as a whole. Up until now, Swedish companies have been prohibited from issuing debt instruments pursuant to which the debt to be repaid is determined other than in amounts corresponding to the nominal value of the underlying loan.
The opportunity to once again issue participating debentures will enable Swedish companies to issue an instrument which from a financial perspective in all material respects can be made to resemble an equity related instrument (e g shares etc.), however, with the very important exception that the participating debenture will not allow its holder any administrative rights (e g voting rights and other shareholder rights). Accordingly, Swedish companies will from January 1st technically be able to issue "shares" without voting rights. For the future this is likely to have an impact on the way in which buy-out firms are able to structure their management incentive programs in Swedish portfolio companies.
The current practice in Sweden with regard to such programs is to offer key management to participate in investments by acquiring shares, convertible bonds or warrants, or in some cases a mixture of these instruments. Due to the nature of such incentive programs, being directly or indirectly equity-related, the lead investor - wishing to retain control of the target - will require participating management to enter into management ownership agreements pursuant to which management investors e g will (a) undertake to follow the instructions of the lead investor as to a future sale of their investments (drag-along/tag-along), (b) accept a vesting period during which they may be obliged to sell their investments at a loss (bad-leaver/good-leaver provisions) and (c) in the case of an investment in shares agree to forsake their statutory rights as minority shareholders.
The principal aim of these agreements, on an overall level, is to ensure that management shall remain passive investors. Although these types of agreements are often captioned shareholder agreements it is almost without exception the case that they resemble such agreements only to a very limited extent. Instead the whole idea is to relieve the investors of any statutory rights they may have under the Companies Act as equity holders. As such it may well prove to be a questionable matter in some instances to what extent they are valid if put to the ultimate test of a court of law or an arbitral tribunal.
The importance of retaining absolute control over the share capital in a portfolio company can hardly be overstated. This aspect is vital in the event of an IPO, but is clearly also essential in the event of a trade sale. A disenchanted management shareholder would accordingly in the context of an exit be able to cause considerable havoc and it is not unlikely that the lead investor in such an instance would have to agree to a settlement outside of the framework of any management ownership agreement. This in turn could cause frustration with other management investors.
To sum up, it is clear that the nature of current equity based incentive programs encompass considerable, albeit in most cases theoretical, threats to the lead investor. A further issue of a more practical nature, is the burden of ensuring fulfilment of the formal requirements in the Companies Act (e g summons for shareholder meetings) which increases by the number of shareholders, and which if not acceded to may result in invalid resolutions.
With effect from January 1st it will accordingly be possible to use participating debentures (alone or in combination with profit-sharing debentures) as the basis for the managements' participation in Swedish portfolio investments. This we believe will alleviate many, if not all, of the problems associated with equity linked instruments of the past. By issuing instruments that combine the features of the participating debenture with those of the profit-sharing debenture, the lead investor will be able to create an investment which for all purposes resembles that of an equity investment. However, without also giving the management investors any statutory rights equivalent to those possessed by the shareholders.
As the profit-sharing debenture allows for the interest rate on the underlying debt to be tied for example to the size of the dividend distributions, an instrument combining the features of the participating debenture with those of the profit-sharing debenture could be made to resemble a preferential share in a portfolio company. This would mean that the instrument could generate accumulated interest ("dividends") during the holding period and on exit result in a repayment of the underlying debt in an amount corresponding to the share price received on exit.
Although this paper does not deal with tax implications of participating debentures, it is understood, however, that these instruments due to their nature of being debt, may possess certain tax advantages. The existence and potential advantage of any such features will need to be investigated separately by qualified tax counsel in each specific case.
Hamilton law firm is principally active within the spheres of Swedish and international business and financial law. As legal advisors to Swedish and foreign companies, banks and public enterprises, the firm has, over the years, built up a comprehensive and thorough competence within the entire area of business law. Hamilton law firm is represented in Stockholm, Gothenburg, Malmö, Karlstad, Falun, Växjö, and London.
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