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New JSE rules on hybrid financial instruments

31 January 2014 Yaniv Kleitman, Cliffe Dekker Hofmeyr

With effect from 2 January 2014, a new s20 has been inserted in the Johannesburg Stock Exchange (JSE) Listings Requirements which governs so-called "hybrid financial instruments" (HFIs) that are listed on the securities exchange operated by the JSE.

HFIs are instruments which have characteristics of both debt and equity. Typical examples of debt instruments would be debentures, bonds and notes, and typical equity instruments would be ordinary shares. Various factors and tests have been adopted to distinguish debt and equity, often in the context of tax law as the classification of an instrument as one or the other often has important fiscal consequences. For instance in the 2012 US case of Hewlett-Packard Co v Commissioner (139 T.C. 8 (2012)), the court outlined the following key factors, amongst others:
• The presence or absence of a maturity date on an instrument;
• The source of the payments;
• The right of the holder of the instrument to enforce payment;
• The right to participate in management;
• The status / ranking of the instrument as compared to regular corporate creditors of the company; and
• The intent of the parties to the instrument (ie issuer and holder).

In March 2011, new stand-alone rules for pure debt instruments were introduced by the JSE in its Debt Listings Requirements. Subsequently a number of companies have sought advice from the JSE on how to classify certain instruments that straddle the line between debt and equity. This has led to the new rules on HFIs.

The new s20 of the Listings Requirements defines HFIs as "securities that portray characteristics of both debt securities and equity securities". Under the JSE Listings Requirements, "equity securities" are equity shares, securities convertible into equity shares, and equity instruments. In turn, "equity share capital" is a company's issued share capital, excluding any convertible securities, equity instruments and any other securities which are regarded as debt instruments in terms of IFRS or the Companies Act, No 71 of 2008.

"Equity instruments" are securities with restricted voting rights but which participate in the distribution of profits in a manner directly linked to the profitability of the company.

As for "debt securities", these are defined in the Debt Listings Requirements as securities which are designated by the JSE as such from time to time, including, without limitation, debentures, debenture stock, loan stock, bonds, notes, certificates of deposit, preference shares or any other instrument creating or acknowledging indebtedness.

In this regard it is notable that certain preference shares would be likely candidates for characterisation as HFIs, as such shares very often exhibit characteristics of both debt and equity, and accordingly companies with preference shares listed on the JSE should certainly pay particular attention to the new regime introduced by the JSE. Each case however should be analysed on its own merits.

Against the above background, the following key points arise from the new HFI requirements:
• HFIs must be freely transferable.
• An existing issuer or an applicant issuer seeking a listing of HFIs on the JSE is required to comply with and satisfy all applicable JSE Listings Requirements in addition to the provisions set out in s20.
• The criteria for the listing of new HFIs are that the JSE must be satisfied with the structure of the HFI, the pricing of the HFI must be clearly determinable, and 20% of the HFIs must be held by the public and the number of public HFI holders must be at least 50.
• The issuer is required to comply with s3 of the JSE Listings Requirements which contains various continuing obligations pertaining to, inter alia, financial disclosures, rights of holders of securities, shareholder spreads, director dealings and communications with holders of securities. However, the following are important exclusions in respect of HFIs:
o S3.28: The requirement that voting rights within the same class of security are the same. Note however that if the instrument happens to be a "share" as defined in the Companies Act, s37 of that Act requires all shares in the same class to have identical rights.
o S3.29 to 3.31: These sections contain the requirement that all securities in a class shall rank pari passu. Further, they contain a general pre-emptive right in favour of existing holders of equity securities where the company proposes to issue fresh equity securities for cash. These requirements will not apply in respect of HFIs.
o S3.32 and 3.33: These provisions deal with the possibility of equity security holders waiving the abovementioned pre-emptive rights in a general meeting. Since the pre-emptive rights do not apply to HFIs in the first place, there is no need for the waiver provisions to apply.
• In the event that the issuer makes any changes that affect the terms and conditions of the HFI or the underlying guarantee of such HFI (if applicable), other than changes which are of a formal, minor or technical nature or are made to correct a manifest error or to comply with mandatory provisions of South African law, the issuer must obtain approval from the HFI holders holding not less than 66.67% of the value of a specific class of HFI. This would be in addition to, and not to the exclusion of, any other approvals required, for instance, to amend the company's memorandum of incorporation if needs be (which requires a special resolution of shareholders).
• An issuer of HFIs need not comply with the provisions of s5 of the JSE Listings Requirements regarding the methods and procedures of bringing securities to listing. However, on conversion of an HFI into listed equity securities of the issuer (if the HFI is convertible), s5 will in fact apply to such equity securities.
• The bulk of the new s20 relates to the content of the issuer's prospectus or pre-listing statement in instances where it applies to have HFIs listed on the exchange.

The new HFI requirements are no doubt an important measure taken by the JSE in fulfilling its mandate of investor protection particularly in the context of complex financial instruments.

Issuers of such instruments should ensure that they are au fait with the new requirements and should carefully consider their compliance obligations going forward, and where exactly their instruments stand in terms of the new s20 and the Debt Listings Requirements.

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