Perpetual Bonds as a Tool for, in Principle, Indefinite Financing | Part 2

In the first part of this article, I discussed the principle under Polish law that continuous obligational relationships must remain terminable. The time has now come to consider an exception to that principle.

One financing instrument known in other legal systems and available in Poland since 2015, to which the legislature has attributed the feature of permanence (perpetuity), is the perpetual bond. Under Article 23 of the Polish Bonds Act, an issuer may issue bonds that are not redeemable and that entitle the bondholder to receive interest for an indefinite period. To make that possible, the Act expressly excludes the application of Article 365¹ of the Civil Code discussed in the first part of this study.

Perpetual bonds may, however, become due and payable. This will be the case upon the issuer being declared bankrupt or entering liquidation, as well as – subject to certain exceptions – upon the issuer defaulting on monetary payments due to bondholders under the bonds. In addition, the issuer may specify in the terms and conditions of issue further circumstances, beyond those described above, in which perpetual bonds become due and payable (although such circumstances may not depend on the discretionary decision of bondholders). The issuer may also reserve the right to redeem the bonds, without any corresponding right being granted to bondholders. In that event, such bonds may be described as “unilaterally perpetual.”

Redemption may take place no earlier than upon the expiry of five years from the date of issue of the perpetual bonds, unless one of the above events causing them to become due and payable occurs, in which case the protection of bondholders takes precedence over the durability of the legal relationship between them and the issuer.

The dates and manner of redemption of perpetual bonds should be specified in the terms and conditions of issue.

The provisions governing perpetual bonds therefore create a financing instrument for the issuer’s activities whose durability is protected so long as the issuer does not become bankrupt, enter liquidation, default on monetary payments due to bondholders, potentially breach other terms of issue, or decide to redeem the bonds where it has reserved such right. Unless and until one of those events occurs, the issuer may use the funds made available by bondholders without interruption, while bondholders may expect interest and, potentially, other benefits. This prospect is all the more attractive because bonds (including perpetual bonds) are not subject to the statutory limitations applicable to maximum interest.

The range of entities that may issue bonds (including perpetual bonds) is broad and includes not only companies but also, among others, local government units. It does not, however, include natural persons, even if they conduct business activity. The Act does not impose any restriction on the purposes for which perpetual bonds may be issued; such purposes may, but need not, be specified in the terms and conditions of issue.

Perpetual bonds may therefore be used by issuers to obtain stable financing for at least partly predictable cost. In some cases, they may be issued in order to qualify as own funds of financial institutions or as own-funds items of insurance or reinsurance undertakings. It appears that the structure of perpetual bonds – especially where the terms and conditions of issue do not provide for the issuer’s redemption right – could also be treated as a component of the own funds (equity) of other entities.

From that perspective, perpetual bonds may serve to improve an entity’s balance-sheet structure, for example through the restructuring of its liabilities – not only vis-à-vis partners, shareholders or entities within the same capital group, but also with the participation of a wider group of creditors. At the same time, however, the entity must be prepared to bear the cost of such financing in the form of interest, which may even exceed statutory maximum interest.

Key practical uses of perpetual bonds:

• • Stable financing of operations – issuers (e.g. companies or local government units) may raise capital without any obligation to repay it on a specified date, for example to finance long-term infrastructure projects while continuing to pay interest to bondholders. The requirements may also be less stringent than those applicable, for example, to bank financing.
• • Balance-sheet optimisation / quasi-equity treatment – perpetual bonds may be treated as an item akin to equity, making it possible to improve financial ratios (e.g. leverage ratios) and enhance creditworthiness.
• • Financing for regulated institutions (banks, insurers) – this instrument is sometimes used as a component of the own funds of financial institutions or insurance undertakings, in accordance with sector-specific regulations.
• • Debt restructuring – entities may convert existing indebtedness (e.g. owed to shareholders or other creditors) into perpetual bonds, thereby extending the financing horizon and stabilising cash flows.
• • Intra-group financing – perpetual bonds may be issued within a capital group (e.g. by an SPV), providing flexible, long-term financing without a classic obligation to repay principal.

Key benefits for issuers of perpetual bonds:

• • Indefinite financing – the absence of any obligation to repay principal on a specified date makes it possible to finance ongoing operations and long-term projects on a stable basis.
• • Improved balance-sheet structure – the instrument may be viewed as akin to equity, with a beneficial effect on leverage ratios and overall financial capacity.
• • Flexible issue structure – the issuer may define the events triggering maturity and reserve the right of early redemption, thereby retaining control over its obligations.
• • Relatively predictable financing costs – fixed interest payments make cash-flow planning easier.
• • Broad scope of use – the absence of restrictions as to the purpose of the issue and the broad range of eligible issuers make it possible to tailor the instrument to a variety of business and restructuring needs.

What are the risks? Certainly there are some – and on both sides. For the issuer, the principal risk – unless it has reserved a redemption right – lies in the potentially unlimited period over which payments to bondholders must be made, without any ability to interrupt that process and repay the principal. In addition, depending on the interest calculation mechanism specified in the terms and conditions of issue, there is a risk of a substantial increase in interest, the servicing of which may, in extreme cases, exceed the issuer’s current financial capacity.

For bondholders, the risk lies in the inability to recover the invested capital and, for example, redeploy it into more profitable or otherwise more desirable instruments from the perspective of the relevant entity’s policy, or to improve the bondholder’s own liquidity. In practice, the prospect of recovering those funds may prove illusory, as it will arise only when the issuer’s position has deteriorated at least to the point of defaulting on payments. An alternative may be to dispose of the bonds held, provided, of course, that a purchaser can be found.

For these reasons, especially where the issue is neither rescue-driven nor intra-group in nature, caution is advisable on both sides, together with careful analysis of the terms that may be offered and – from the investor’s perspective – those that may properly be accepted. Any decision should be taken with full awareness of the long-term, and potentially even indissoluble, nature of the contractual bond thereby created.