Why issue preference shares?

A company can finance its projects either from internal or external sources. External financing normally involves a third party loan or corporate bonds or issuance of ordinary shares. Preference shares are rarely used in Vietnam. This may be due to a lack of awareness of the versatility of this funding option. Nguyen Huu Hoai of Russin & Vecchi looks at the financing possibilities available through preference shares, and discusses the types of preference shares available under Vietnamese law, and the advantages and disadvantages of preference shares. His article also analyses preference shares as a tool to avoid the limitations on foreign ownership.
Preference shares We discuss the various types of preference shares that Vietnamese law permits. Under the new Law on Enterprises¹, only a joint stock company (JSC) may issue preference shares. Preference shares can be converted to ordinary shares, but there is no mandatory requirement to convert unless otherwise agreed by the issuing company and holders of preference shares. The Law on Enterprises permits a JSC to issue the following types of preference shares: voting preference shares; redeemable preference shares; dividend preference shares; and other preference shares provided for in the company’s charter (articles of association).

‘Voting preference shares’ can be issued only to founding shareholders and the rights attached to these shares are forfeited after three years from the date of incorporation. Because of these limitations, we do not discuss voting preference shares.

‘Redeemable preference shares’ can be redeemed by the issuing company upon the holder’s demand or under terms and conditions set forth in the share certificate. A redeemable preference shareholder has all the rights of an ordinary shareholder (including the right to receive dividends as distributed to ordinary shareholders, except for voting rights, the right to attend general meetings of shareholders, and the right to nominate a person to the board of directors and to the board of controllers). Redeemable preference shares can be converted to ordinary shares.

‘Dividend preference shares’ are shares on which a dividend is paid at a rate that is greater than the rate that applies to ordinary shares or at an annual fixed rate. In the case of an annual fixed rate, dividends are paid to dividend preference shareholders regardless of the company’s operating result. Like a redeemable preference shareholder, a dividend preference shareholder has no voting rights, is not entitled to attend general meetings of shareholders and cannot nominate a person to the board of directors or the board of controllers. Like redeemable preference shares, dividend preference shares can be converted to ordinary shares.

In addition to these preference shares, the Enterprise Law permits a JSC to issue hybrid preference shares that are not stipulated in the Law on Enterprises, provided that they are stipulated in the company’s charter or that ordinary shareholders agree to issue such hybrid preference shares.

We consider some of advantages and disadvantages of issuing preference shares:

Advantages
From the investor’s perspective, there are a number of advantages:

• There is no corporate income tax on dividends from preference shares, if the dividends come from after-tax profits;
• A holder of preference shares paying a fixed rate is entitled to receive dividends (regardless of the company’s operating result²).

Preference shares also give the issuing company some advantages:

• They are highly versatile and can be tailored to meet the issuer’s needs;
• There are no restrictions nor conditions for a JSC to issue preference shares;
• Voting rights of existing shareholders are not diluted;
• Most preference shares have no maturity date nor encumbrances;
• Preference shares permit the company’s shareholders to share their risks with other investors;
• As preference shares can be issued only in Vietnamese dong, there is no foreign exchange risk for the issuing company; and
• The issuance of preference shares can help the issuing company overcome legal limitations on foreign ownership.

The last advantage is a very large benefit although there are some limitations. Although Vietnam committed to open its market to foreign investors when it became a WTO member, a number of sectors and industries remain restricted or limited to foreign investors. The limitation on foreign ownership in some particular areas is subject to industry-specific legislation, such as the Publishing Law, the Law on Credit Institutions, Law on Civil Aviation, Law on Education, Law on Securities, Law on Insurance Business, Law on Petroleum, Law on Prevention and Control of Tobacco etc.

Most of these laws do not specify limitations, but generally refer to Vietnam’s international undertakings. Sometimes, the limitations are set out in implementing decrees issued by the government. For example, the government has recently issued Decree 60³ in which, since September 1, 2015⁴ foreign ownership in a public company can be increased. The maximum ratio of foreign ownership in a public company⁵ may vary. It depends on Vietnam’s WTO commitments, bilateral commitments between Vietnam and other countries or on investment legislation and industry-specific laws or on restrictions set out in the company’s charter. Under Decree 60, for example, foreign ownership in a public company remains limited to 49 percent if the public company engages in a conditional business⁶ and if there is no other specific regulation on foreign ownership.

It is important to understand the concept of foreign ownership and how the foreign ownership ratio is calculated. Under Decree 60, the concept of foreign ownership in a public company means the aggregate ratio of voting shares held by all foreign investors in that public company. A holder of preference shares is not entitled to vote pursuant to the new Law on Enterprises. There is room for an existing public company in which there is a foreign ownership limitation to restructure its existing shareholding in such a way that foreign investors hold preference shares, and that such preference shares are not counted for the purpose of measuring foreign ownership. The issue that relates to the limitation on foreign ownership will arise only once preference shares are converted to ordinary shares. As the new Law on Enterprises has a concept of foreign ownership similar to that in Decree 60, this discussion can also be applied to a non-public company in which foreign ownership is limited or restricted.

Disadvantages
From the investor’s perspective, there are a number of disadvantages:

• An ordinary shareholder is entitled to vote on important matters, attend the general meetings of shareholders or nominate a person to the board of directors or to the board of controllers. A holder of preference shares has no such rights.
• The possibility to trade preference share is more difficult than the possibility to trade ordinary shares. That is, ordinary shares of a listed company can be traded on a stock exchange whereas preference shares cannot.
• Preference shares can be issued only in Vietnamese dong. The risk may arise for an investor if the Vietnamese dong is significantly devalued during the investment term.
• Preference shares (in case of paying dividends at a fixed rate) may be unattractive when the market interest rates are increasing. In addition, loans are usually secured by encumbrances or are guaranteed, whereas preference shares are neither secured nor guaranteed⁷.
  From the issuing company’s perspective, there are two disadvantages:
• A holder of preference shares (other than dividend preference shares in which dividends are paid at a fixed rate (regardless of the company’s operating result)) has the same right to receive dividends as an ordinary shareholder does. Therefore, the dividends of ordinary shareholders are diluted;
• In the case of dividend preference shares in which dividends are paid at a fixed rate (regardless of the company’s operating result), the rate is often higher than the market rate, because the issuing company wants to attract investors to buy its dividend preference shares.

In addition to preference shares, a company has other funding options (e.g. corporate bonds, an outside loan or issuance of ordinary shares).

We discuss these options and compare them with the preference share option. First, we discuss the corporate bond option.

Corporate bonds Issuance of corporate bonds is conditional. A company that has failed to pay principal and interest on its existing bonds or to pay debts that have come due within the three preceding years, may not issue corporate bonds8. There are no similar conditions to the issuance of preference shares. A corporate bond holder is a creditor and is entitled only to the interest specified in the coupons (normally a fixed interest rate). This funding option may be unattractive to investors that want not only fixed interest income, but also want to participate in dividends. Because of the obligation to pay interest, corporate bonds pose a financial burden if its project does not generate revenue at the initial stage. The same company is not required to pay interest to a holder of preference shares (other than dividend preference share holders whereby dividends are paid at a fixed rate, regardless of the operating result). This can help the issuing company to avoid financial burdens and to focus on the project. A corporate bond has a maturity date whereas there is no maturity date on preference shares. The issuance of preference shares (other than redeemable preference shares) can delay the payment of principal and improve its debt-equity ratio. Tax benefits are another factor for an investor that is an entity. Interest income is taxed at 5 percent (in case of an offshore lender) and at 20 percent9 (in case of an onshore lender) whereas there is no corporate income tax on dividends if a shareholder of preference shares is an entity10.Ordinary shares The issuance of ordinary shares to existing shareholders is another funding option. This option is straightforward. Existing shareholders, however, may be unable to contribute due to limited financial capacity or they may not want to increase their exposure to the business. Private placement to new shareholders is an alternative, but this alternative may be unwelcomed by existing shareholders because their ownership will be diluted. A more complex problem exists if some shareholders are prepared to invest but others are not. The legal limitation on foreign ownership is another hurdle to overcome in many types of business11. Outside loans It is common for a company to seek outside loans. This funding option is easier for a company that has a long-term relationship with its banks and has assets to pledge, but it may be difficult for a newly-formed company that has no track record of good credit. Interest income is taxed. Also, in most loan arrangements, lenders often require personal guarantees by owners or an encumbrance of existing assets. Commercial banks in Vietnam are also subject to regulatory control by the State Bank of Vietnam (SBV). The SBV imposes restrictions on commercial banks from time to time that may affect their ability to lend or increase exposure. For example, loans for real estate projects may be restricted if the SBV wants to mitigate risks to the industry or to the economy caused by real estate projects. In certain circumstances or during certain periods of time, therefore, real estate loans may be unworkable due to SBV restrictions. Convertible loans provided by an offshore lender (e.g. an investment bank) have become more popular in Vietnam. In addition to interest income, the offshore lenders have the option to participate in profits when they convert their loans to ordinary shares and subsequently sell the shares. In case loans are converted to ordinary shares, share-dilution and limitation on foreign ownership must be dealt with. Share-dilution can be commercially resolved, but the legal limitation on foreign ownership may prevent the offshore lender from achieving its objectives. Although loan expenses can be deducted from taxable income as in the case of corporate bonds, there is a cost to the issuing company if there is no income at the initial stage or if the forecast of the project’s revenue is inaccurate. In extreme cases, the issuing company can become insolvent or even bankrupt if it is unable to pay interest or to repay principal. Personal guarantees or granting security interest over a solvent business asset can introduce a profound risk. All of these issues can be avoided or mitigated if the company can issue preference shares. Although preference shares are still new in Vietnam, they are a good instrument for a JSC to use, to address many types of financial issues: mobilisation of capital, improvement of the company’s debt-equity ratio, deferral of repayment of debts. More importantly, a JSC may, through preference shares, overcome the legal limitation on foreign ownership. There are choices that depend on business circumstances. A JSC company may issue dividend preference shares or redeemable preference shares or other types of preference shares that it creates. The choice is broad and preference shares are a clear complement or alternative.

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Footnotes:

• Law no. 68/2014/QH 13 adopted by the National Assembly on November 26, 2014. The law came into effect on July 1, 2015.
• It is unclear whether dividends can be deducted from taxable income if dividends are paid regardless of the operating result.
• Decree 60/2015/ND-CP of the Government dated June 26, 2015 (“Decree 60”).
• The effective date of Decree 60.
• The concept of a “public company” is broad in Vietnam. It is a joint stock company that falls into one of the following circumstances: (i) a company that has offered and issued its shares to the public; (ii) a listed company; or (iii) a company that has charter capital of VND 10 billion or more, and in which 100 investors or more (excluding professional investors) invest.
• There are about 200 conditional businesses. Particular conditional business can be found in the Investment Law.
• Holders of preference shares may want to oblige the issuing company to provide a third party guarantee in order to secure its payment obligation (eg, obligation to pay dividends or its obligation to redeem shares).
• These conditions do not apply if the company issues corporate bonds to a financial institution.
• The rate applied from January 1, 2016.
• An individual shareholder is still taxed on his dividends.
• For the purpose of measuring foreign ownership, only ordinary shares are calculated.
• Email: lawyers@russinvecchi.com.vn
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