With Ethiopia's Capital Market, Say Hello to Debt Instrument Financing

Jul 24 , 2021
By Yehualashet Tamiru Tegegn

With the establishment of a capital market, one of the financial instruments at play will be debenture, a complex but effective means of diversifying risk among creditors that nonetheless has never been used in the Ethiopian market, writes Yehualashet Tamiru Tegegn (yehuala5779@gmail.com), adjunct lecturer at Addis Abeba University and an associate at MTA.

In a bid to open up the economy, parliament recently revised Ethiopia’s Commercial Code, which had been in use for more than six decades. One of the areas of change is the rule and regulation on debenture. A company may finance itself not only by equity financing, which is by the issuance of shares in exchange for contribution, but also by issuing debt financing. One of the typical forms of debt financing is the issuance of a debenture.

The term originated from the Latin word debentur. It was first employed to refer to a form of acknowledgment of indebtedness in England to pay the wages of servants. Later, the same was given to soldiers to charge the government of England payment due upon computing the account of their arrears. The contemporary means of debenture is a document issued by a company as evidence of indebtedness and entitling its holder to a fixed interest rate until the principal amount is paid.

Debenture has benefits both for the issuing company and the lender. The main one is the distribution of risk among creditors. It is easier to get 100 people to buy 1,000 Br each in debentures rather than a single person to finance 100,000 Br.  Another benefit is that since the sale of a debenture does not confer voting rights to the lender, the original shareholders do not lose their power of control as a result of the issue of debentures.

Until today, no company has ever issued debenture in Ethiopia. One of the reasons is what J. Escarra (Prof.), who was the mastermind behind the Commercial Code, felt was the lack of sophistication of Ethiopia’s economy. The lack of familiarity with the concept in the legal and business communities did not help either. Perhaps the most compelling reason is the absence of a capital market to trade debentures in the secondary market. Now, with the introduction of the capital market proclamation, it could gain greater usage.

The recently revised Commercial Code defines debenture as a transferrable debt instrument where the issuing company pays a fixed interest to the lender (debenture holder) for a specified period of time and repays the loan upon maturity. This definition encompasses two key elements.

Arguably the most significant aspect is the recognition of debenture as a transferrable debt instrument, implying that it is a negotiable instrument. The Commercial Code recognises three categories of such instruments: commercial instruments, transferable securities, and documents of title to goods. Debenture as transferable security, therefore, is a document incorporating a right to entitlement in such a way that it is not possible to enforce or transfer the right separately from the instrument.

Because of this feature, the debenture can be pledged to guarantee the performance of an underlining contract. In the new movable property security right proclamation, a pledge is not restricted to corporate movable property but also extended to intangible goods, the latter of which could encompass debenture.

Fixed interest is also paid on the debenture for a specified period of time and the loan is repaid upon the date of the maturity date. This implies that companies are not entitled to issue non-conversion, perpetual debentures, and zero-coupon rate types of debentures. By implication, the issuance of perpetual or irredeemable debentures is prohibited in the revised Commercial Code. As the law requires a fixed interest rate, it in effect excludes debentures that do not carry a fixed interest rate (zero-coupon debentures).

However, there is no prohibition to a share company issuing both bearer and registered debentures. The main difference between the two is the manner of transfer. In the case of bearer debenture, there are only two requirements: endorsement and transfer. However, there is a third requirement of registration for effective transfer of registered debenture.

It is only share companies that are permitted by the law to issue debenture. A share company may do this if its capital is paid up fully and it has been in business for at least a year and has issued a balance sheet approved by its general assembly. As a matter of rule, the debenture issued by the company should not exceed the paid-up capital.

All too often, compared to shareholders, debenture holders are susceptible to exploitation. The shareholders of a company are regarded as owners as they have a defined interest in the company while the debenture holders are mere lenders or creditors. Unlike the shareholders who are regarded as insiders, the debenture holders are seen as outsiders, who can not attend and vote in a general assembly.

Thus, to mitigate this power imbalance, the law permits debenture holders to form and organise as a legal entity having a separate legal personality to protect and enforce the loan agreement. The general meeting of debenture holders, among other things, can consider proposals of the debtor company in relation to its structure, possibility of mergers, issuance of debenture with priority over the existing one, and terms of loan. A resolution of debenture holders is adopted by a simple majority.

The establishment of a capital market will likely increase the use of debentures within the private sector, especially as a way of raising money or as an investment opportunity for those with excess liquid assets. It is a complicated financial instrument, but it will be one of the tools at play in the gradually opening up and diversifying finance sector.

PUBLISHED ON Jul 24,2021 [ VOL 22 , NO 1108]

Yehualashet Tamiru (yehuala.t@ethioalliancelaw.com), partner at Ethio Alliance Advocates LLP.

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