Thursday, 29 September 2011 / Michael Orimobi
The dearth of infrastructure in Nigeria has been attributed to various factors including but not limited to, lack of political will, corruption, bad maintenance culture and paucity of requisite funds. With regards to the paucity of funds, dwindling allocations from the Federal Government via the Federation Account, coupled with an ineffective internal revenue collection mechanism have led State Governments (Sub-nationals) to depend on alternative financing arrangements to fund their year-on-year budget deficit. For years, bank loans at high interest rates have played a significant role in funding the said deficit. However, with the re-emergence of the bond market in 2003, the issuance of same by sub-nationals has offered them a viable option to reducing the said deficit and investing in numerous long term capital projects at comparatively lower cost. Some of the State Governments that have taken this route of funding and the size of their respective bond issuance exercises are as follows: Lagos (Series 1- N50bn; Series II- N57.5bn; Imo (N18.5bn); Kwara (N17bn); Niger (N6bn); Bayelsa (N50bn); Kaduna (N8.5bn); Ebonyi (N16.5bn), etc.
The Legal Basis
The power of State Governments to issue registered bonds (and promissory notes) is enshrined in Section 223 of the Investment and Securities Act 2007 (“ISA”). Furthermore, before a state government can issue bonds to the investing public, it must obtain the approval of the Securities and Exchange Commission of Nigeria (“SEC”) having been accorded the status of apex regulatory body for the Nigerian capital market by Section 13 of the ISA.
In issuing a State Government bond, the requirements for obtaining the SEC’s approval are provided for in Section 224 of the ISA and Rule 307 of the Securities and Exchange Commission’s Rules and Regulations (“SEC Rules”) made pursuant to the ISA. Section 224(3)(a) of the ISA provides that an application to the SEC by a State Government to raise funds from the capital market shall be accompanied by such documents as may be prescribed by the SEC, from time to time, and shall include:
1. a Law authorizing the bond issuance exercise and creating a sinking fund to be fully funded from the consolidated revenue fund account of the issuer;
2. a Rating Report by an accredited Rating Agency registered with the SEC; and
3. an Irrevocable Letter of Authority (ILoA) from the Accountant General of the State, authorising the Accountant General of the Federation to deduct payment obligations due on the bond from the issuer’s statutory allocations in the event of a default by the Sub-national.
The Sinking Fund simply refers to a fund into which an issuer sets aside monies with a view to liquidating its debt instruments. The Sinking Fund can be funded through the Irrevocable Standing Payment Order (ISPO) and or any other source of repayment as discussed in the offer documents (in this case, the Bond Prospectus and the Trust Deed). The ISPO established by reason of the ILoA is a credit enhancement tool as it is backed by the full faith and credit of the Federal Government of Nigeria. In other words, it improves the credit rating of the instrument and enhances the attractiveness of the instrument to prospective investors. However, under Rule 107(6) of the SEC Rules, a State Government bond can be approved by the SEC without an ILoA/ISPO E.g. the Lagos State N57.5bn Series II Fixed Rate Bonds issued in April 2010 under the N275bn Debt Issuance Programme of the State Government, was issued via a book building process to investors without an ISPO. A fastidious examination of the provisions of Section 224(3)(a) of the ISA creates an impression that deductions from the statutory allocation (ISPO) should only crystallize when there is a default by the Sub-national in liquidating the bonds from other sources of repayment. In practice, this isn’t entirely correct. In fact, for most Sub-national bonds (if not all) that have hit the Nigerian capital market in the recent past, the ISPO is the only or major source of repayment. In other words, deductions from the statutory allocation of the State kick-off immediately the offer hits the market and in some cases, even before the offer hits the market.
In addition, the Resolutions of the State Government’s Executive Council and Legislative Assembly authorising the issuance of the bonds and published in the Official Gazette of the State and the Feasibility Reports on the projects to be funded by the proceeds of the bond issue are part of the documents that are sine qua non for the SEC’s approval to be obtained. Moreover, the funding from the bond issuance exercise and utilization of same should be captured in the provisions of the state’s yearly budget during the bond’s tenor.
There is a cap on the amount of debt a Sub-national can raise via bonds or any other means; the total loan portfolio of a State at any particular time must not exceed 50% of the revenue generated in the previous year - proviso to Section 223(1) of the ISA. Loans in this context include bank loans, external debts arrangements, bonds, etc. By way of example, if a Sub-national’s current outstanding loan portfolio is N20 billion and the preceding year’s income was N100 billion. The amount that can be raised via bonds cannot exceed N30 billion, as a N30 billion bond issuance exercise will bring the total loan portfolio to N50 billion, which is 50% of the previous year’s revenue.
The Regulators’ Roles & Impact
Though the Nigerian capital market has been marred by high level malpractices which have dampened investors’ confidence, the Federal Government and Regulators like the SEC, the Central Bank of Nigeria (“CBN”) and the Nigerian Stock Exchange (“NSE”) have amended and or issued several guidelines to shore up investors’ confidence, encourage domestic and foreign investments and deepen the capital market in its entirety. A robust, efficient and credible market is the sole target as the impact of same on Nigeria ’s Gross Domestic Product (“GDP”) can not be over-emphasized.
As elucidated earlier, the SEC being the apex regulatory body for the Nigerian capital market must approve any application by a State Government to raise funds/loans from the capital market- Section 224(2) of the ISA.
The role of the NSE in relation to Sub-national bonds, borders mainly on the listing of these bonds on the Floor of the Nigerian Stock Exchange. Currently, only seven (7) State Government bonds are listed on the bourse with their tenor ranging from 5 – 7 years, although they are not actively traded on the secondary market when compared to the Federal Government of Nigeria (FGN) Bonds. With the face value of bonds outstanding in the domestic market put at N3.26 trillion and the FGN Bonds accounting for 89% or N2.901 trillion, Sub-nationals N251 billion and Corporate bodies N111.75 billion, it is of little surprise that the Sub-national bonds market is illiquid.
The CBN in September 2010 issued the “Guidelines for Granting Liquid Asset Status to State Government Bonds”. The aforesaid Guidelines were issued, inter alia, with a view to boosting investors’ confidence (both domestic and foreign) in the Nigerian capital market. In tandem with the provisions of the ISA on sinking funds, the Guidelines require a Law authorizing the bond issuance exercise and also creating the sinking fund. Other requirements before granting liquid asset status to a State Government bond include; the establishment of a debt management office/department; a cap of seven (7) years on the tenor of the bonds; provision of an ILoA by the Accountant-General of the State to the Accountant General of the Federation or a SEC waiver of the ILoA; the bond being rated as investment grade by a Rating Agency accredited by the SEC at the inception and during the tenor of the bond, etc. As regards the tenor of the bonds, no State Government bond currently outstanding exceeds the aforesaid tenor. Banks and Discount Houses, in computing their capital adequacy ratio, shall assign a risk-weight of 20% to State Government bonds that qualify as liquid assets while sub-national bonds that do not qualify as liquid assets shall be assigned a risk-weight of 50%. Furthermore, Sub-national bonds that qualify as liquid assets are eligible for “repo” transactions. By implication, most Sub-nationals would endeavour to meet the aforesaid liquid status requirements as such would make the bonds more attractive to prospective investors. For the Sub-national bonds that have issued in Nigeria in the recent past, a large portion of the subscription for these bonds can be attributed to Qualified Institutional Investors (“QIIs”), such as Pension Fund Administrators (“PFAs”), Fund Mangers, Insurance Companies, Staff Schemes, etc- See Rule 78© of the SEC Rules for the definition of QIIs. In view of the aforesaid, since these entities are deemed to be financially sophisticated investors, only a properly structured instrument (with regards to, inter alia, pricing, security and status) will garner their consideration for investment.
Structuring a State Government bond
For a typical Sub-national bond issuance exercise, several professional parties are involved. Pivotal of these parties are the Financial Advisers/Issuing Houses/Book Runners (if the bond is issued via a book building process- a process of price discovery by which an issuing house/book runner, attempts to determine at what price a public offer should be made, based on demand and bid prices from qualified institutional and high net worth investors). The Issuing Houses, led by the Lead Issuing House, coordinate the entire bond issuance exercise from start to finish. Other professional parties include; the Underwriters (if applicable), Trustees, Solicitors to the Bond/Offer, Solicitors to the Trustees, Reporting Accountants, Stockbrokers, Registrars, Rating Agencies and Receiving Banks/Paying Agents. The aforementioned professional parties must be registered with the SEC and their Fidelity Bond should be valid. It is also important to note that the members of the Executive Council, Attorney General, Accountant General and Auditor General of the State, perform important roles to the successful closing of a Sub-national bond issuance exercise.
The Financial Advisers/Issuing Houses structure the instrument and prepare the Bond Prospectus, with inputs from other professional parties. The Bond Prospectus is the document that offers the securities (bonds) to the investing public. The Prospectus and the securities that it offers must be approved and registered by the SEC. In structuring a Sub-national bond, a typical term sheet will address issues such as the bond size; method of issue; coupon rate; coupon payment dates; tenor of the bonds; issuer and bond rating; security for the bonds; sinking fund; use of proceeds; quotation (admission of the bonds on the Daily Official List of the NSE); tax qualification (grossing-up); status of the bonds (whether or not they qualify as liquid assets or securities in which PFAs may invest under the Pension Reform Act, Cap P4, LFN 2004 or securities in which Trustees may invest under Trustees Investments Act Cap T22 LFN 2004, etc.
If the bonds are to be issued via a book building process, the initial term sheet will not include a definite bond size and coupon rate but only an indicative bond size and a coupon band within which investors are to bid for the bonds.
The Trustees to the bond are key to a Sub-national bond issuance exercise. Section 224(5) of the ISA provides that the sinking fund in a Sub-national bond issuance exercise shall be managed by a corporate trustee registered with the SEC.
The Trustees act as the representatives of the bondholders until the redemption of the bonds and also hold on their behalf, the security for the repayment of the principal and coupon in relation to the bond. The Trustees are appointed under the Trust Deed prepared by the Solicitors to the Trustees. The Trust Deed will contain clauses bordering on the powers, rights, duties and reliefs of the trustees, creation and funding of the sinking fund, terms of the bonds, redemption of the bonds, investment of monies in the sinking fund, obligations of the issuer, events of default, etc.
Since the ISA permits registered bonds as the only type of the bonds that can be issued by a Sub-national, the importance of a Registrar cannot be over emphasized. The Registrar will, inter alia, maintain the register of bondholders until the redemption of the bonds- Section 227 of the ISA.
The Solicitors to the Bond/Offer act as Transaction Counsel and thus, protect the interest of the investing public. They are expected to conduct a sort of due-diligence on the issuer (State) and issue a detailed report bordering on issues such as the claims & litigation and the material contracts entered into by the State. Furthermore, they draft the Vending Agreement, Joint Issuing Houses Agreement (if applicable), Underwriting Agreement (if applicable) and also review other transaction documents such as the Bond Prospectus, Trust Deed, etc.
The Rating Agency as the name suggests, rates the issuer and the bond; the Reporting Accountants report on the historical financial statements and financial projections of the issuer; the Stockbrokers are in-charge of the entire process of applying to the NSE for admission of the bonds to the Daily Official List of the NSE and the subsequent listing of same and the Receiving Banks/Paying Agents receive the proceeds of the issue and upon the instruction of the Trustees, remit the requisite coupons and principal payments to the bondholders. However, the Receiving Banks and the Paying Agents may also be separate entities depending on the structure adopted by the Financial Advisers.
Compliance with the provisions of the Laws, Regulations and Directives on the issuance of bonds by Sub-Nationals can be mandatory or voluntary. Generally, the provisions of the ISA and SEC Rules are mandatory, whilst the provisions of the aforementioned CBN Guidelines can be optional, but will inevitably affect the attractiveness of the instrument to prospective investors especially in the face of other competing investment alternatives in the capital and money markets.
With the Presidential tax waiver granted on March 16, 2010 on a range of debt securities (i.e. Federal, Sub-national, Corporate and Supra-national bonds, mortgage-backed securities and asset-backed securities) and short term securities issued by the Federal Government of Nigeria, such as Nigerian Treasury Bills and the 2011 general elections now behind us, the remaining quarters of 2011 and beyond are bound to experience a spate of Sub-national bonds issuance exercises. A total of eight (8) Sub-national bonds valued at about N460 billion are said to be awaiting approval at the SEC and there is a likelihood of more applications before the end of the year. The aforesaid tax waivers allow for a level playing field between Sovereign and Sub-national bonds vis-a-viz prospective investors. The Lagos State Series II Bond issued in 2010 was oversubscribed by 249%; the highest level of participation rate in any bond issue in the Nigerian capital market. The steady increase in the number of Sub-national bond issues would gradually enhance the issuance of other bespoke/structured bonds, asides from the plain vanilla bonds that currently dominate the market. This growth would encourage bonds with embedded options and possibly, bond issuance exercises for the purpose of liquidating debt to government contractors.
About the Author
Michael Orimobi is the Managing Partner of the Nigerian Commercial Law Firm of Tokunbo Orimobi & Co.
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