Place your debts
17 July 2006
Lottomatica’s subordinated bond issue looks likely to herald a new wave of finance in Italy. Andrea Novarese reports
In May Italian blue-chip company and lottery operator Lottomatica became the first Italian corporate issuer of a perpetual subordinated bond, the Subordinated Interest Deferrable Capital Securities, due in 2066. Lottomatica intends to use the proceeds from the issue of the securities to finance part of the costs of the acquisition of gaming and technology solutions provider GTECH Corporation.
The securities have been issued and placed only with institutional investors, in accordance with the applicable Italian laws and regulations. Even though the terms and conditions of the securities are governed by English law, the securities constitute bonds (obbligazioni) issued by an Italian joint stock corporation pursuant to Article 2410 of the Italian Civil Code.
The securities have been expressly subordinated, ranking junior to all the other subordinated and unsubordinated creditors of Lottomatica and ranking in priority to the rights of the equity holders (shareholders and holders of other equity-like financial instruments issued pursuant to Article 2349 of the Italian Civil Code) in the event of the commencement of a voluntary or involuntary liquidation, dissolution or winding-up of the issuer, or the occurrence of any insolvency proceeding.
The securities exist for 60 years in line with the duration of the corporate entity, as provided by the current bylaws of the issuer. Due to their subordinated treatment and other features, including the related interest deferral mechanism, the securities have been partially treated and rated by the rating agencies as a stable component of the equity structure of the issuer, and therefore are regarded as pure additional indebtedness of the issuer for the full amount of the issue; thus such treatment allows the issuer to maintain and enjoy an investment grade rating.
Subordination is a legal principle that has been expressly recognised recently in Italian commercial law, even though it was largely accepted and favoured under legal doctrine before such recognition. The subordination principle was first expressly set out by the 1993 Banking Act, which provides that the banks can issue subordinated debt and raise funds by way of perpetual loans (prestiti irredimibili) or issues of subordinated notes or certificates of deposits (the so-called subordinazione assoluta).
Both the Basle Accord of 1998 and the various European Directives in the banking field influenced the subordinated debt principle. In 1989, the European Commission reached an agreement on the Solvency Ratio Directive and on the Own Funds Directive for credit institutions. In order to comply with this regulation, and following the mandate of the Interministerial Credit Committee’s resolution of 23 December 1986, the Bank of Italy introduced the risk-assets ratio relating to the different activities and counterparts involved.
In addition, the Bank of Italy guidelines set out the definition of bank capital for regulatory purposes by distinguishing the different components of bank capital, from share capital to subordinated debt. The guidelines determine which funding instruments count as bank capital and divide the eligible instruments into two tiers: tier 1 is composed mainly of share capital, reserves, funds for general banking risks and the lower tier 1 instruments (strumenti innovativi di capitale); tier 2 is the secondary capital and includes revaluation reserves, reserves for credit risks, hybrid instruments, also known as upper tier 2 (strumenti ibridi di patrimonializzazione), subordinated term debt, also known as lower tier 2 (passività subordinate), and longer-term subordinated debt. For the calculation of regulatory capital, tier 2 instruments can be included as a component of the bank capital only as long as they do not exceed the total value of the tier 1 instruments. Moreover, the subordinated debt may not exceed 50 per cent of the level of tier I capital.
Tier 2 instruments
Leaving aside the tier 1 and the lower tier 1 instruments, it is worth focusing only on upper tier 2 instruments and lower tier 2 instruments.
According to the provisions of the Bank of Italy guidelines, upper tier 2 instruments are calculated in the secondary capital as long as the relevant instrument provides that:
#in case of losses suffered by the issuer, followed by a reduction of its capital below the minimum required for the maintenance of the Bank of Italy’s authorisation to carry on banking activities, the capital and accrued interest may be used to cover the losses;
#the issuer will not be required to pay interest on the notes in case of negative results from the business operations (andamenti negativi della gestione);
#in the event of winding up, dissolution, liquidation or bankruptcy of the issuer, the payment of the debt will rank after unsubordinated unsecured creditors; the debt instruments must have a maturity of either at least 10 years or be indeterminate and they may not be reimbursed without the prior agreement of the supervisory authority.
The Bank of Italy guidelines also provide for specific criteria for the inclusion of lower tier 2 instruments in the calculation of bank capital. The three main criteria are as follows: the debt instrument shall have an original maturity of at least five years; the debt may not be reimbursed on the bearer’s initiative or without the prior agreement of the supervisory authority; and in the event of the winding up, dissolution, liquidation or bankruptcy of the issuer, the payment of the debt will rank after unsubordinated unsecured creditors.
The Corporate Law Reform
Most recently, the 2003 Corporate Law Reform has provided that the right of repayment of the principal and interest to holders of bonds issued by a joint stock company (società per azioni) may be, in whole or in part, subordinated to the right of other creditors of the issuer (Article 2411 of the Italian Civil Code).
Under this provision, the bondholders agree and accept to rank junior in their rights of payment vis-à-vis the other creditors of the issuer, thus waiving the application of the general legal principle entitling creditors to equal treatment (par condicio creditorum). Thus such contractual subordination will be enforceable also in case of winding up, dissolution, liquidation or bankruptcy of the relevant issuer. In addition, the subordinated note holders usually waive some of their rights and protections normally provided by the Civil Code, such as Article 1819 (repayment of the debt in one installment if the debtor is in default), Article 1820 (default of the debtor in case of non payment of interest) and Article 1186 (right of prepayment in case of insolvency of the debtor).
The subordination principle introduced by Article 2411 provides that the issuer may also subordinate only repayment of principal, while the obligation of paying interest will be honored; the issuer can also undertake to pay interest only if certain objective ratios relating to the issuer’s business performances are satisfied. In the case of the Lottomatica securities, the issuer has reserved the option to defer at its discretion payment of interest (for a period of up to five years) unless dividends are paid. Conversely, the issuer does not have to pay any interest if certain financial ratios are not satisfied at a certain date.
It is clear that the new rules have introduced a concept of risk participation, which was previously unavailable and unknown as a concept to debt investors. The market seems to have accepted and integrated this legal approach. In addition, this subordination arrangement, now available to corporate entities, seems more extreme compared with the ones utilised for the perpetual notes (prestiti irridimibili) issued by banks, where the payment of interest to the noteholders can be suspended or deferred only in an insolvency scenario, but not in relation to the economic results of the relevant company. n
Andrea Novarese is co-head of banking and finance at Bonelli Erede Pappalardo