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Ukraine’s New Most Favored Creditor Provision Likely Excludes Kyiv’s GDP Warrants Albeit With Some Uncertainties

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Relevant Documents:
Exchange Offer Memorandum
Warrant Prospectus

Investors holding Ukraine’s $19.7 billion sovereign eurobonds have two days left to vote (before the Aug. 23 early consent deadline) on a deal that will impose a 37% haircut on their $19.7 billion of existing bonds and $3.7 billion of unpaid interest.

Kyiv is offering investors to swap $1,000 of existing bonds and all their past due interest for $400 of new bond A bonds and $230 of new bond B securities (“New Notes”).

Ukraine’s proposed eight new eurobonds all contain a most favored creditor provision (“MFC Provision”) under which Ukraine pledged not to give other sovereign creditors, including Ukrenergo bondholders, a greater recovery rate than the eurobond exchange recovery rate, without offering the same terms (or consideration of equivalent value) on a ratable basis to holders of Ukraine’s new bonds.

It does not mention a potential recovery cap on Ukraine’s GDP warrants, which the government is due to address later this year. The contingent instrument has soared 20 points in the past month to 68/69, according to Solve, as Ukraine and its advisors have so-far adopted a light-touch approach to the GDP-linked security.

Ukraine states in the eurobond memorandum that it is committed to “ensure the fair and equitable treatment of holders of the warrants having regard to the concessions made to date by holders of the warrants.” Kyiv added that it is committed to ensure that the “restructuring burden is shared across all commercial claims within the restructuring perimeter, including the Additional Perimeter Claims.”

This article looks at whether Ukraine’s $3.239 billion of GDP-linked securities (ISIN: XS1303929894; US903724AW28) (“Warrants”) come within the scope of the MFC Provision for the New Notes as described in the exchange offer and consent solicitation memorandum dated Aug. 9, 2024, as amended and restated on Aug. 12, 2024 (“Exchange Offer Memorandum”).

Page references are to pdf pages of the Exchange Offer Memorandum unless otherwise stated.

Summary
 

  • The New Notes’ MFC Provision requires the New Notes’ recovery rate to be increased if the recovery rate of certain other debt of the issuer is more than a specified amount above that for the New Notes, that is, the other debt has less than a 35% “grant element.”
  • The $3.2 billion Warrants come within the MFC Provision if they are “Specified Indebtedness.”
  • The “Specified Indebtedness” definition does not specifically reference the Warrants. We assume because the issuer does not regard them as Indebtedness at all. After working through the five other debt definitions the Warrants are unlikely to be Specified Indebtedness and so will lie outside the MFC Provision – whatever return is payable on the Warrants will not trigger any uplift in the New Notes return – but some doubt remains.
  • Key is whether the Warrants are “Indebtedness” as defined, and if so, whether they are carved out from the Specified Indebtedness definition because they are:
  • Dollar notes or similar traded outside the Ukraine (“Relevant Indebtedness”); or
  • Non-hryvnia debt that has more than a 35% grant element (“Concessional External Indebtedness”).
  • We set out below several ways that the Warrants could be argued to be Non-Specified Indebtedness (and alternative views); only one of these need apply to carve the Warrants out of the MFC Provision. We set the stronger arguments for the Warrants not being Specified Indebtedness first to the weaker ones last.
  • Arguably, Warrants are not “Indebtedness” because they do not have payment obligations for borrowed money; no principal has been lent to the issuer thereunder. They are more like an equity kicker – the sovereign state equivalent of shares issued to creditors by companies in debt restructurings – and the Ukraine MinFin does not list the Warrants as a debt liability in their reporting.
  • On the other hand, the Warrants’ payment obligations remain linked to an underlying repayment obligation and so are “Indebtedness”; they have a “put” option whereby upon an event of default, the Warrantholders can claim back the “haircut” (the “forgiven” principal on the money initially lent to the issuer under notes) given to the issuer as part of the 2015 refinancing plan.
  • If the Warrants are Indebtedness, being English law governed dollar debt instruments traded outside the Ukraine makes them fit almost perfectly into the Relevant Indebtedness definition and so carved out of the MFC Provision. The sticking point is that they have to be “notes or similar” to be Relevant Indebtedness and they are dissimilar to notes in material ways, for example the lack of principal and interest payments. However, “notes or similar” could be interpreted to mean any negotiable instrument containing a promise to pay, which would include the Warrants.
  • Warrants being Relevant Indebtedness seems to contradict the issuer’s statement that the New Notes will not cross-default to the Warrants; an event of default under the New Notes is triggered if Relevant Indebtedness over $50 million is accelerated prior to maturity. We presume the issuer does not regard the Warrants as Indebtedness at all so there is no internal inconsistency regarding this in the Exchange Offer Memorandum.
  • A “grant element” is the difference between nominal “face” value of a loan and its present value, calculated using the interest rate on the underlying debt and a discount rate. The Warrants do not have an interest rate to calculate a “grant element” so cannot be “Non-Concessional External Indebtedness” where the 35% grant element is required to determine this. If correct, the MFC provision would not apply to the Warrants.
  • The New Notes have not been marketed as clearly including or excluding the Warrants in the MFC Provision; their inclusion would be attractive to New Noteholders but not to Warrantholders who would view this as a constraint on the issuer in any future renegotiation of the terms of the Warrants.
  • The issuer names the instruments as “warrants” and “securities” and not notes or bonds. It also uses a term (Relevant Indebtedness) that appears to include the Warrants in the cross-default provision, when the Exchange Offer Memorandum states they are excluded from it. The MFC Provision is based on making returns between different debts equivalent to each other based on an interest rate and the Warrants do not have one. These suggest the issuer does not view the Warrants as indebtedness or included in the MFC Provision. Given this and the arguments above, investors may wish to assume the New Notes do not include the Warrants in the MFC Provision.

Detailed Analysis

Below is a detailed analysis of the points summarized above.

The Warrants

The Warrants were issued in 2016 together with nine separate series of notes as part of a restructuring under a four-year $17.5 billion Extended Fund Facility program for Ukraine approved by the IMF in 2015. The Warrants, issued with an aggregate notional amount of $3.12 billion, are unsecured, do not bear interest and have no maturity date when the notional amount becomes due. The notional amount is used to determine the amount of any annual payments to be made under the Warrants until they expire on May 31, 2041. On May 31 of each year commencing May 31, 2021, holders of the Warrants are entitled to receive an amount calculated based upon the prior year’s real GDP growth rate, capped at 1% of GDP for the year, provided that (i) the real GDP growth rate exceeds 3% and (ii) GDP is at least $125.4 billion. The Warrants have no events of default, but if Ukraine breaches any of the covenants in the warrants, the holders will have a right to put their Warrants at the nominal amount.

The Most Favored Creditor Provision in the New Notes

The New Notes will have a most favored creditor provision (“MFC Provision”) that states the issuer cannot:
 

  • Pay “Specified Indebtedness,” “Existing Guarantee Indebtedness” or the existing notes subject to the exchange offer in accordance with their terms; or
  • Enter into any arrangement in respect thereof (“Settlement”),

In each case where:
 

  • The aggregate Settlement consideration received by creditors consists of notes, a cash consent fee or cash, which gives them a greater recovery rate (very briefly, the sum of the present value of principal as well as historical and future cash fees, divided by the outstanding amount) than the New Notes, without offering the same terms (or equivalent consideration) on a rateable basis to the New Noteholders; and
  • Delivery of any other Settlement consideration is provided without the consent of at least 50% (by value) of all New Noteholders.
(cl. 3(b) in the terms for each series of the New Notes, pdf pgs. 124 and 151).

Existing Guarantee Indebtedness refers to the $700 million 6.25% guaranteed notes due 2030 issued by Ukravtodor (“Existing Ukravtodor Guaranteed Notes”) and the $825 million 6.875% guaranteed sustainability-linked green notes due 2026 issued by Ukrenergo.

So the Warrants can only come within the MFC Provision if they are Specified Indebtedness.

Are the Warrants Specified Indebtedness?

Specified Indebtedness is not simply defined, you have to jump through five other debt definitions to arrive at an answer and there is no specific reference in any of the definitions to the Warrants.

Below is a table summarizing these definitions, with the top of the column stating the definition and below, the drafting for the definition.
 

TABLE OF DEFINITIONS
Specified Indebtedness Commercial Debt Claims Non-Concessional External Indebtedness External Indebtedness Relevant Indebtedness  Indebtedness
Commercial Debt Claims

(pdf pgs. 127 and 154)

 Non-Concessional External Indebtedness EXCLUDING obligations guaranteed by international or development financial institution or insured by an export credit agency or other public sector institution

(pdf pgs. 125 and 152)

 External Indebtedness,EXCLUDING Relevant Indebtedness, with less than a 35% grant element

(pdf pgs. 126 and 153)

 Indebtedness that is denominated or payable, or at the option of the relevant creditor may be payable, in any currency other than … of UkraineEXCLUDING Indebtedness governed by Ukraine law placed solely in Ukrainian capital markets

(pdf pgs. 123 and 150)

 External Indebtedness (principal, premium, interest or other amounts), present or future, of Ukraine in the form of or represented by notes, bonds or similar, whether or not issued directly by Ukraine, capable of being traded on any stock exchange or other securities market

(pdf pgs. 124 and 151)

 Any obligation (present, future, actual or contingent) for the payment or repayment of money that has been borrowed or raised (incl. (i) money raised by acceptances and leasing and (ii) guarantee, indemnity or similar assurance provided against financial loss)

(pdf pgs. 123 and 150)
Existing Notes except Existing Ukravtodor Guaranteed Notes  

Are the Warrants Indebtedness?

Before deciding if the Warrants are a particular kind of indebtedness (Specified Indebtedness) the first question that needs to be asked is “is it indebtedness at all”?

This is trickier to answer than you might expect. We set out arguments for and against below.

Arguments That the Warrants Are Not Indebtedness

The “Specified Indebtedness” definition is ultimately based on the definition of “Indebtedness.” If the Warrants do not come within the “Indebtedness” definition then they do not come within the MFC Provision.

“Indebtedness” means any obligation (present, future, actual or contingent) for the payment or repayment of money, which has been borrowed or raised including money raised by acceptances and leasing and a guarantee, indemnity or similar assurance provided against financial loss).

It could be argued the Warrants are not Indebtedness on the following grounds:
 

  • Warrants and notes are separate: The Warrants were part of a 2015 debt restructuring plan. That plan included issuing new bonds for existing ones; a simple case of a replacement of existing “Indebtedness” for new “Indebtedness.” The notes’ “Indebtedness” obligations are deliberately separate from the obligations in the Warrants because they are of a different order – obligations are separate from the “borrowed money” payment and repayment obligations under the notes;
  • No money has been borrowed or raised under the Warrants: The Warrants do not have an obligation for the issuer to repay borrowed money. There is no principal that has been lent to Warrants’ issuer, there is a notional amount. A “notional” amount is “notional” because the amount referenced has neither been paid to the issuer and so does not need to be repaid to Warrantholders. There was not a $3.2 billion cash movement when the Warrants were issued and will not be when the Warrants expire;
  • The Warrants are not loans or notes: The Warrants do not evidence a loan or a note/bond, which is how payment or repayment obligations for borrowed money or money raised is typically evidenced;
  • Issuer payments are not “for” money borrowed or raised: The scheduled payments under the Warrants are not for money raised; there is no interest paid on the notional amount, payments are made only if certain thresholds related to GDP are met. The payment obligation could be argued to exist in relation to money raised under a related but different transaction – the 2015 refinancing notes – but does not constitute a payment directly related – “for” – the money raised;
  • The Warrants are in effect an equity “kicker”: The nature of the Warrants must be considered in the context in which they were issued. When a private company restructures its debt, it sometimes gives its creditors equity (in the form of shares, warrants or otherwise) as partial compensation for the hit they took in the restructured debt, so that the creditors will benefit from any future increase in the value of the equity. A sovereign has no shareholders and so can’t issue equity in a restructuring, but the Warrants were intended to play a similar role, where the holders benefit from future increases in Ukraine’s GDP and GDP growth rate; and
  • The Warrants are not reported as debt: Ukraine MinFin does not list the Warrants as debt or debt liability in their reporting.

Arguments That the Warrants Are Indebtedness

It could be argued the Warrants are Indebtedness on the following grounds:
 

  • Warrants have payment obligations for money raised: The Warrants were issued as an integral part of the 2015 refinancing. As such, the Warrants require the payment of money – the GDP-related payments by the issuer – in consideration for money raised – the refinancing notes. “In consideration for” has the same meaning as “for”;
  • Warrants contain a “put” option for the return of the original principal amount borrowed: A direct aspect of the same point above is that the Warrantholders can “put” the Warrants back to the issuer at the price of the notional amount. The “put” can be exercised if a final judgment is made against Ukraine for breach of the covenants (unless arising solely due to a moratorium) (cl. 5.2 on pg. 72 of the listing prospectus, summarized on pg. 12). The notional amount represents the original amount lent to the issuer that Warrantholders agreed to forego, that is, the “haircut” under the 2015 refinancing. This “put” is a contingent payment for borrowed money and so is “Indebtedness”; and
  • The Warrants listing prospectus describes them as External Indebtedness: The listing prospectus for the Warrants states they “rank pari passu in right of payment with all other unsecured External Indebtedness” (our emphasis) (pg. 69 thereof). By describing the Warrants in relation to “other unsecured External Indebtedness” means they themselves are External Indebtedness, which is defined as all non-hryvnia “indebtedness” (not defined). What matters is how the Warrants are defined in the Exchange Offer Memorandum, not the Warrant prospectus, but at least it describes them as debt.

Even if the Warrants Are Indebtedness, Are They Specified Indebtedness?

Whether or not the Warrants are Indebtedness is irrelevant if they do not satisfy the other conditions for being Specified Indebtedness.

We go through the definitions step-by-step below to answer this.
 

  • Are the Warrants “Commercial Debt Claims”?
Yes, if they are (a) Non-Concessional External Indebtedness that are (b) without government-level support. The listing prospectus of the Warrants does not describe them as being guaranteed (the issuer’s other notes have “guaranteed” in the title when they are) and public insurance is also not described. So we presume the condition in (b) is satisfied.

 

  • Are the Warrants “Non-Concessional External Indebtedness”?
Yes, if they are (a) External Indebtedness (b) that is not Relevant Indebtedness with (c) less than a 35% grant element.
The “grant element” is a way to assess the “concessionality” of a loan; the difference between nominal “face” value of a loan and its present value. When the interest rate for a loan is lower than the discount rate used to calculate its present value, the present value is smaller than face value. The higher the percentage value for the grant element, the less interest charged under the loan compared to the discount rate, and so the more “concession,” or more compromise, the creditor gives to the borrower.
 
However, the Warrants do not have an interest rate so can a “grant element” be calculated? The calculation is required to be done using the methodology of the OECD Development Assistance Committee as adopted by the IMF and the World Bank (see the definition of “Non-Concessional External Indebtedness,” pdf pgs. 126 and 153). The working paper for this (dated May 2017) describes the method as a comparison of the expected cash flow under the loan in question compared to the expected cash flow under a loan at market rates, calculated at the time the loan is extended and on the basis of an explicit repayment schedule. Given that the Warrants do not have an explicit repayment schedule and that all payments under the Warrants are conditional on future GDP and GDP growth, they arguably don’t have a grant element.

 

The consequences for the Warrants not having a “grant element” for a Specified Indebtedness characterization is unclear.

Arguably, if the Warrants do not have a “grant element” to assess their concessionality then they cannot be “Non-Concessional External Indebtedness” where some percentage of grant element is required to determine this, that is, debt with “no grant element” is neither “non-concessional” nor “concessional” External Indebtedness and so they cannot be “Non-Concessional External Indebtedness.” If correct, the Warrants (if Indebtedness) are not Specified Indebtedness and lie outside the scope of the MFC Provisions.

Even if wrong, the Warrants still have to be External Indebtedness, and must not be Relevant Indebtedness, for them to be Non-Concessional External Indebtedness that triggers the MFC Provision.

 

  • Are the Warrants “External Indebtedness”?
“External Indebtedness” is “Indebtedness” that is in any currency other than hryvnia. Warrant payments are in dollars.
However, excluded from “External Indebtedness” is Indebtedness governed by Ukraine law placed solely in Ukrainian capital markets but the Warrants are governed by English law (cl. 16 on pg. 81 of the listing prospectus) and listed on the Irish stock exchange.

If they are “Indebtedness,” the Warrants are External Indebtedness.

 

  • Are The Warrants “Relevant Indebtedness”?
“Relevant Indebtedness” is Indebtedness of Ukraine in the form of or represented by notes, bonds or similar, whether or not issued directly by Ukraine, capable of being traded on any stock exchange or other securities market.

There are various articles available that conflate GDP-linked bonds with GDP-linked warrants and on a superficial view the Warrants could be said to be similar to notes, the similarities between the two are described in Arguments for the Warrants Being Indebtedness above. However, there is also commentary that notes and warrants are different and so support an argument that the Warrants are not “notes or similar,” and so are not Relevant Indebtedness. Benford, Ostry and Shillerin in their book Sovereign GDP-Linked Bonds: Rationale and Design describe the difference as follows:
 

Warrants are issued in the context of debt restructurings and provide only an upside, never a downside. Their intent is to compensate investors who saw part of their principal disappear in a restructuring by promising a share of the ‘better days to come’. … By contrast, GDP-linked bonds … have a principal amount that fluctuates with GDP movements according to an identical formula across the universe of this new asset class. They carry a coupon that also fluctuates in accordance with the same formula.1
1 Sovereign GDP-Linked Bonds: Rationale and Design, edited by James Benford, Jonathan D. Ostry, and Robert Shiller (CEPR Press) 2018
If the Warrants are Indebtedness, then by being English law governed dollar debt instruments traded outside the Ukraine makes them fit almost perfectly into the Relevant Indebtedness definition and so carved out of the MFC Provision. The sticking point is that they have to be “notes or similar” to be Relevant Indebtedness and they are dissimilar to notes in material ways, for example, the lack of principal and interest payments. However, notes are arguably any negotiable instrument containing a promise to pay, which would include the Warrants.

Nevertheless, if it is accepted that the Warrants are similar to notes, then they are Relevant Indebtedness and so carved out of the MFC Provision. But this characterization would contradict the events of default. The Exchange Offer Memorandum states “New Securities [that is, the New Notes] will include no covenants, events of default or other provisions related to or referencing the Warrants” (pdf pg. 45) and the events of default are linked to Relevant Indebtedness. For example, the cross-default event of default begins “Any Relevant Indebtedness shall become due and payable prior to the stated maturity thereof following a default… .”

We assume the events of default refer to “Relevant Indebtedness” to ensure the New Notes cross-default only to dollar capital markets debt traded outside the Ukraine and that Ukraine and the issuer do not consider the Warrants to be Indebtedness at all, so from their perspective there is no contradiction.

Tentative Conclusion – The Warrants Do Not Come With The MFC Provision

The Warrants come within the MFC Provision if they are Specified Indebtedness. However, there are three conditions that would prevent the Warrants from being Specified Indebtedness:
 

  • The Warrants are not Indebtedness as defined; or
  • Even if they were, they are not Non-Concessional External Indebtedness because:
  • They are Relevant Indebtedness (that is, English law governed dollar notes traded outside the Ukraine); or
  • Even if they are not Relevant Indebtedness (because they are not notes or similar), they are unable to be “concessional” in nature at all and so cannot be concessional or non-concessional in nature.

The New Notes have not been marketed as clearly including or excluding the Warrants in the MFC Provision; their inclusion would be attractive to New Noteholders but not to Warrantholders who would view this as a constraint on the issuer in any future renegotiation of the Warrants’ terms.

The issuer names the instruments as “warrants” and “securities” and not notes or bonds. It also uses a term (Relevant Indebtedness), which appears to include the Warrants in the cross-default provision, when the Exchange Offer Memorandum states they are excluded from it. These suggest the issuer does not view the Warrants as indebtedness or included in the MFC Provision. Given this and the arguments above, investors may wish to assume the New Notes do not include the Warrants in the MFC Provision.

Reorg reached out to Ukraine’s Ministry of Finance and its legal advisor White & Case to clarify the MFC Provision with regard to the Warrants but did not receive a response.

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