Perpetual securities are debts, not equity. Here’s why.

This article first appeared in Capital, The Edge Malaysia Weekly, on April 1, 2019 - April 07, 2019.
Perpetual securities are debts, not equity. Here’s why.
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If it walks like a duck, quacks like a duck, looks like a duck, swims like a duck, then it probably is a duck. Why are companies so intent on classifying perpetual securities (perps) as equity, instead of what they really are: financial liabilities or debts? Looking at a simplified balance sheet and profit-and-loss statement of a hypothetical company (see Table 1) provides the reason.

With perps recognised as equity, the gearing of this company is 5%, giving the impression that it has almost no debts and is therefore totally safe. In reality, it would be a hugely leveraged and risky company at 567% gearing.

It would also be able to present itself as a hugely profitable company, making an after-tax profit of $28 million and an impressive after-tax return to ordinary shareholders of 18.7%. On the other hand, had the perps been accounted for as debt, the company would have reported an after-tax loss of $20 million.

In both circumstances, the facts do not differ. Their cash flows are identical. The balance of cash outstanding and amount it owes others, along with net assets, are exactly the same. It would be worse if the accounting earnings and return on equity were used to compensate management for a job well done.

So, how is it possible for perps to be accounted for as equity (that is, as capital) instead of debts in the financial accounts, approved by auditors?

Over the past three weeks, I have written on accounting standards and articulating how these standards may have caused greater difficulties in understanding the accounting numbers and could — indeed, in some circumstances — have led to misleading results.

However, on this recognition of perps as equity instead of what it should be — finan­cial liabilities — the fault lies squarely on practising accountants, not the standards.

The justification used by all companies to recognise perps as equity is referencing IAS 32 (MFRS 132). In particular, it is asserted that perps are classified as equity when there is no contractual obligation to deliver cash or other financial assets to another person or entity or to exchange financial assets or liabilities with another person or entity that are potentially unfavourable to the entity. Consequently, distribution on perps is recognised in equity in the period in which they are declared. That is, coupon interest paid is not interest expense but a dividend payment.

Perps are crafted to enable them to meet the above two conditions under the IAS 32 to facilitate their recognition as equity. The argument is that there is no contractual obligation to redeem these perps and to pay periodic distribution.

Here is why I believe that argument is wrong and intentionally misrepresented.

First, interpreting anything requires understanding the context of the entirety and not just drawing upon a limited and specific section of the statement or facts. In fact, IAS 32, section 18 specifically states that “the substance of a financial instrument, rather than its legal form, governs its classification in the entity’s statement of financial position”. This statement was specifically to address the question of no contractual obligation to deliver cash or another financial asset.

Let us look at the substance of perps.

  •     They have a tenure, usually five years, whereby it is callable by the issuer although not a maturity;
  •     In the event that they are not called by the issuer, there are consequences. In one case, the coupon rate is stepped up from 6.9% to 15% a year. Is this not effectively forcing a repayment?
  •     Interest rate or dividend rate is specified, and there is a time interval to pay, usually semi-annually;
  •     The redemption price is spelled out in the prospectus, including for early redemption;
  •     Some perps are secured against the entity’s assets, with an imposed security cover. Some even come with an unconditional and irrevocable guarantee by the issuer;
  •     Some perps have a sinking fund to pay on callable dates; and
  •     There are consequences if “dividends” on perps are not paid, including stopping the entity from paying dividends to shareholders.

Are these not similar to the terms as would be expected for issuance of debts such as bonds? It does not look like a financial instrument without obligation to repay or to make periodic interest payments. The penalties imposed in effect forces repayments, even if the legal language says otherwise.

And some perps are secured against the entity’s assets. How can these perps be equity? Can equity holders (shareholders) have security over its own net equity? Or, for that matter, a company giving unconditional and irrevocable guarantee to its own shareholders?

This leads to the second point. IAS 32 says two conditions must be met for the financial instrument to be classified as equity. Condition 2 states that there must be no contractual obligations to exchange financial assets under conditions that are potentially unfavourable to the issuer. How can this condition be met when dividends to shareholders are stopped, assets of entity are pledged, and money to be deposited into a sinking fund and interest rates are stepped up, where the only way not to repay is for the entity to become bankrupt?

Third, that a specific statement could be found to assert that a financial instrument is not a financial liability does not mean it is necessarily equity. A negation of an observation does not imply a confirmation of the opposite. If I say it is not a negative number, it does not necessarily mean it is a positive number (it can be zero).

Fourth, to classify perps as equity requires that they meet the characteristics of equities. Section 11 of IAS 32 and FRS 9 defines equity. An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. Perps do not have a share of the residual interests.

IAS 32 further clarifies that equity is in the class of financial instruments that are subordinated to all other classes. Perps rank ahead of holders of ordinary shares.

To substantiate as equity (AG14E), its attributed cash flows over its life must be based substantially on the profit and loss, changes in the recognised net assets or fair value of the recognised and unrecognised net assets of the entity over the life of the instrument.

Perps are not equity, and no amount of legalistic manoeuvring can change facts.

Fifth, IAS 32 (AG6) actually defines perpetual debt instruments, such as perpetual bonds, debentures and capital notes. It provides the holder with contractual rights to receive payments on account of interest at fixed dates extending into the indefinite future, either with no right to receive a return of principal or a right to a return of principal under terms that make it very unlikely or very far into the future.

It goes on to say that the ability to exercise a contractual right or the requirement to satisfy a contractual obligation may be absolute, or it may be contingent on the occurrence of a future event. A contingent right and obligation meets the definition of a financial asset and a financial liability (debts), even though such assets and liabilities are not always recognised in the financial statements.

Changing the name “perpetual debts” to “perpetual securities” does not make it equity. It appears to me under the very same standards (IAS 32) that accountants claim perps are equity, the very same characteristics are articulated as a perpetual debt, a financial liability. To argue that perps are equity because they lack an “absolute contractual obligation” is wrong and was anticipated in IAS 32.

It is not just the abstract, theoretical, economic and legal arguments that clearly favour classifying perps as a financial liability, but the practice and behaviour of market participants too.

In all cases where perps are used by companies, there is a clause in the prospectus that allows the issuers to redeem under the following conditions:

  •     Accounting event — If the perps are or will no longer be recorded as equity as a result of changes to accounting standards;
  •     Tax event — If the company is or will become obliged to pay an additional amount, owing to changes in tax laws and regulations;
  •     Tax-deductible event — If distributions made would not be fully deductible for income-tax purposes; and
  •     Rating event — If the equity credit is lower than initially assigned as a result of changes in equity credit criteria, guidelines or methodology of rating agency.

Why would there be a need to so clearly spell out such a default event — one based on an interpretation of recognising a financial liability as equity? Because these companies, their bankers, lawyers and accountants are clearly aware that they may be wrong (intentional or otherwise).

Or take the case of Singapore-listed Ezion unitholders who supported refinancing of notes and perps at end-2017. Unitholders of Series 3 to 7 and Series 8 perps voted 93.5% and 98.2% respectively to push out maturity of these securities and cut coupon rates on them. It succeeded, as the proposal required a majority vote that met the required 75% quorum under Singapore’s debt restructuring regime. Yes, it fulfils the conditions of a debt restructuring regime.

Incidentally, Ezion has, again, requested for voluntary suspension of trade in its shares as the company searches for a white knight. Its financials had continued to deteriorate after the debt restructuring, further underscoring the risks of perps.

When I asked the banker who structured and placed out many of these perps who they placed to, the answer was these bonds were placed to both institutions and retail.

It seems to me that perps are presented differently to different stakeholders, depending on what best suits the promoters’ interests.

The tax authorities are told they are “debts”. This allows the “dividend”, which is really interest expense on the perps, to be added as a cost of doing business, and therefore it is tax-deductible.

For the credit rating agencies that are more sophisticated, it is half debt and half equity.

To their own shareholders, it is debt, as these perp holders are paid a fixed interest rate and have no share in the net asset or profits of the company.

To the public investors of these perps, they are bonds with a fixed coupon rate, to be paid semi-annually and redeemed at the end of five years.

Shareholders of companies that issue perps and investors of perps need to fully understand the financial implications of perps. We have listed all Bursa Malaysia and Singapore Exchange companies with perps outstanding and to show the financial effects of recognising perps as a financial liability rather than as equity (see Table 2). There is real danger that some companies are using perps to misrepresent the state of their financial strength.

As regulators, the Securities Commission Malaysia and the Monetary Authority of Singapore should consider the possibility that individual investors may lack the sophistication in comparison to a concerted effort of senior corporate management, accountants, lawyers and bankers.

The Global Portfolio fell 0.7% last week, slightly better than the benchmark index. I disposed of my entire holdings in DIP Corp and China Sunsine Chemical Holdings. I also bought an additional 18,000 shares in Ausnutria Dairy and 44,000 shares in Harta­lega Holdings. I will articulate the reasons behind these transactions next week.

Cash holdings amount to some US$33,534, or roughly 6.9% of total portfolio value. Total returns now stand at -2.5% since inception. By comparison, the benchmark MSCI World Net Return Index is up 2%, over the same period.

Stocks on the Bursa Malaysia continued to drift lower amid weaker sentiment in global markets. The Malaysian Portfolio fell 2.2% last week, paring returns since inception to 49.5%. I acquired 11,000 shares in Hartalega. Nevertheless, this portfolio continues to outperform the benchmark index, FBM KLCI, which is still down 10.3% over the same period.

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.