Convertible Loans: U.S. Practice and Applicability in Russia


Authors: Vladislav Lurye, LL.M., Evgeny Melikhov, PhD in Business and Private International Law, MBA


The article continues the series of studies on "hybrid"[1] financing mechanisms widely used abroad but less known in Russia commenced by the authors in the mezzanine financing article[2]. This time, the research topic is the convertible loan. In the article, the key legal and financial aspects of convertible loans are reviewed through the prism of the U.S. practice where they are actively applied in raising funds both for startups and accomplished businesses and, therefore, developed well enough. Then, the applicability of and issues related to the use of that financial instrument in Russia are analyzed against the U.S. practice. The comparative analysis given in the article allows the understanding of the convertible loan mechanism, scope and applicability in the United States and Russia.

Key words: convertible loan, convertible debt, debt financing, venture financing, bridge financing, convertible notes, warrants, commercial papers, promissory note, convertible bonds.

Convertible Debt Notion and Advantages

In the world practice, convertible debt means debt financing where a creditor and a debtor are granted the opportunity to satisfy the creditor’s claims by transferring shares (participation interests) in the debtor to the creditor on the terms agreed upon in advance. There are two main forms of the convertible debt: 1) convertible loan/credit facility that is, in most cases, structured through the issuance, by the debtor in favor of the creditor, of convertible promissory notes and warrants analyzed in greater detail hereinafter, and 2) convertible bonds.

Convertible debt is actively used in the developed countries due to a number of benefits provided by that type of financing:

- opportunity for the creditor to gain a higher return from discharging its claims in exchange for shares in the debtor at a discount agreed upon in advance or by exercising special options to purchase shares in the debtor (warrants);

- funding that is cheaper for the debtor than equity investments on less stringent conditions in terms of security and financial ratios than in the case of bank lending as well as the opportunity to defer the debt service costs until its full repayment or not to pay the debt with money (in the event of conversion);

- availability of “tax arbitrage” under double tax treaties between the countries of the borrower and lender that may qualify convertible debt service payments as loan interest in the borrower’s jurisdiction excluded from taxable income and as dividends taxed at a low or zero rate in the lender’s jurisdiction;

- ability to overcome internal and statutory restrictions of the investor (credit rating of a convertible debt is higher than the one of equity investments because in the event that the debtor becomes insolvent the claims of creditors will prevail over the shareholders’ claims and directors and officers of the debtor company will owe fiduciary duties to the creditors and not to the shareholders)[3];

- hedging of risks related to impossibility to develop a reliable forecast of the debtor’s shares value (it is important at early, “seed” funding stages where monetary valuation of a startup that has neither financial history nor ready product is mainly based on assumptions and belief in the project and its team; and, therefore, it cannot be objective and reliable)[4];

- opportunity to use it as bridge financing to cover the company’s expenses until the next equity financing round.

Convertible debt should be distinguished from so called “exchangeable debt” where the creditor receives an option to exchange its claims for shares in a second company (covert firm) owned by the debtor. This scheme does not suggest debt conversion in the strict sense. It is similar to lending secured by a pledge of shares in favor of the creditor with the right to foreclose the pledged assets without recourse to a court. Within the exchangeable debt, the debtor deposits shares on an escrow account opened with a third company as the security under the above option. Simultaneously, the debtor provides a repurchase guarantee to the investor pursuant to which the debtor shall repurchase those shares at a price fixed in advance if the price of the shares which the debt can be exchanged for does not increase after raising the debt financing[5].

This article is devoted to the convertible loan, a simpler and cheaper and, therefore, more affordable form of convertible debt than convertible bonds, which loan is, in the authors’ opinion, paid insufficient attention in the Russian publications.

Convertible Loan in the U.S.

In the U.S., convertible loan has been traditionally used to finance startups at a medium or late development stage as bridge financing between equity investment rounds. Now, it is actively applied in the early, “seed” financing of venture projects[6]. In the U.S., debt created by such loan is deemed to be a deferred equity investment (debt to equity conversions happen in approximately 50% cases while within seed financing the conversion frequency reaches 80-90%[7]). Nevertheless, that mechanism is successfully used by large businesses as well that issue convertible promissory notes also; however, in the U.S., such use thereof is seen less often than in Europe where convertible debt is issued, mainly, by big and financially stable companies, and the conversion right plays the role of an additional sweetener for investors who, ultimately, take the borrower’s equity in approximately 27% cases[8].

Transaction Structure

The typical structure[9] of a non-bond convertible loan under the U.S. law[10] includes transaction term sheet based on which a framework Convertible Promissory Note [and Warrant] Purchase Agreement is drafted (“Framework Agreement”) that governs all the organizational and legal aspects of financing in detail. In pursuance of the Framework Agreement, the borrower issues convertible promissory notes and, in some cases, warrants to the creditor in consideration of the borrowed funds. The form and substance of convertible note and warrant certificates are agreed by the parties in appendices to the Framework Agreement that gives the note and warrant certificates the effect of a contract although the said certificates may bear the borrower’s signature only. If the borrower has unsecured obligations to other debt creditors the obligation of the new creditor to sign and deliver, to the existing creditors, a subordination agreement is included in the Framework Agreement which establishes the priority of the existing creditors’ claims over those of the new creditor. In such event, notes are called subordinated notes.

In rare cases[11], the term sheet provides for granting control rights in relation to the borrower to the convertible promissory note holder. In such situation, a small number of shares in the borrower is transferred to the creditor and the creditor and other shareholders enter into a shareholders’ agreement setting out the rights of the convertible promissory note holder to appoint its member to the borrower’s board of directors with the right of veto in making certain key decisions by the borrower such as, for instance, company reorganization or sale.

In the context of convertible loans, the term promissory note is often used along with a note. Nonetheless, they are not equivalent: the term “note” is a generic notion to promissory note. Although notes are included in the list of securities under §77b(a)(1), Section 15, US Code[12] и § 2(1), U.S. Securities Act of 1933[13] (hereinafter – “U.S. Securities Act of 1933”), they are not always recognized as securities in the case law. In determining whether an instrument is a security the decisive factor is not its name but the nature and aggregate of rights and interests that it sets forth: the holder’s intent to profit from the efforts of others (investment goal) or become a business partner of the issuer[14]. If this condition is not met notes are considered as common contracts[15].

Promissory notes, in contrast, due to their nature and intended purpose are always securities[16]. Under certain conditions (unconditional promise to pay a certain amount of money on demand or upon expiry of a certain period of time and some others) that are generally met when executing convertible loans they are classified as so called “negotiable instruments” (section 3 of the U.S. Unified Commercial Code[17]). As a negotiable instrument, promissory notes differ little from promissory notes («простые векселя» in Russian) under Russian law. This conclusion is also confirmed by the fact that the term “promissory note” is directly translated in the text of the Convention Providing a Uniform Law for Bills of Exchange and Promissory Notes of 1930 being in effect in Russia as a “promissory note” («простой вексель» in Russian). However, because a promissory note is reviewed in this article in the context of the U.S. law, for the avoidance of concept confusion, the term “promissory note” («простая нота» in Russian) is used as its Russian equivalent.

In the U.S. and English corporate and investment law, a warrant means a security by which the person issuing the warrant (issuer) grants, to its holder, a special call option in respect of the issuer’s shares, i.e. the right and not the obligation to purchase issuer’s shares at a determined price during the exercise period set forth in advance. A warrant may also provide for additional exercise conditions that may relate to both the company issued the warrant and warrant holder. Unlike a common option that may be executed by any holder of the issuer’s shares, a warrant may be issued by the issuer only in respect of its unissued shares.

To perform obligations under a warrant the issuer thereof issues additional shares resulting in its equity dilution. Therefore, the value of a warrant is lower than the value of a regular call option.  An exception is the situation when the value of the company’s shares is calculated on a fully diluted basis, i.e. including the total number of shares in the company both actually issued and those which all valid and in-money options, warrants and convertible securities can be converted into[18].

The implementation of a scheme involving warrants is more complex and expensive and makes it more difficult to structure a sale of the borrower company or its merger with another company in the future because in such cases it is necessary to take into account the interests of the warrant holders that may not coincide with the interests of the other parties to the transaction. Therefore, they are mainly used in bridge financing and very rarely in “seed” investments[19]. The advantage of warrants is that they enable the issuer to raise additional funds upon their exercise if it has been developing successfully. Furthermore, unlike convertible notes, especially in the event that they set forth a valuation cap, warrants do not adversely affect the valuation of the borrower’s shares within the next financing round[20]. On the other hand, warrants provide more flexibility to the creditors in exercising their rights as they are separated from the principal convertible debt.

Because convertible promissory notes and warrants issued when structuring convertible loans are classified as securities in the U.S. they are subject to registration requirements. The U.S. Securities Act of 1933 requires to register all offers and sales of any instruments that are recognized as securities by the U.S. federal laws unless exempt from registration[21].

One of the grounds of such exemption in executing convertible loans in the U.S. is private placement[22], i.e. placement among pre-determined qualified investors who have access to the type of information normally provided in a prospectus for a registered securities offering and agree not to resell or distribute them to the public[23]. A number of rules promulgated by the U.S. Securities and Exchange Commission (SEC) specify the conditions of private placement that should be met to confidently assert that registration is not required. Such conditions include, for instance, limitation of the maximum amount of funds raised during any 12-month period with a gap between such periods of not shorter than 6 months (1 m dollars with no restrictions on investors’ status, 5 m dollars provided that the number of so called “non-accredited” investors does not exceed 35), and filing a notice with SEC[24]. Non-accredited are any investors except for institutional investors and high net worth or high income individuals[25].

In addition, it is not required to register so called “commercial papers” or “very short-term notes”, i.e. promissory notes placed privately with the maturity term at the time of issue not exceeding 9 months, high par value to exclude regular individuals from potential purchasers of such papers (in practice, the par value amounts to 100 thousand US dollars or more) and premium quality pursuant to the rating from a recognized rating agency (for instance, S&P or Moody’s). A necessary condition of exemption from the registration requirement is applying the revenues from such securities placement to finance current operations or repayment under other short-term papers of the borrower[26]. Commercial papers can be issued with the security in the form of a standby bond (standby commitment or backstop facility), standby letter of credit or revolving credit facility) that guarantee payments to the note holders in the event of a default by the issuer thereof[27]. If the issue is arranged for by a bank the transaction documentation includes, in addition, a dealership agreement with the bank for carrying out trading transactions with promissory notes (however, the dealer bank is not an underwriter and does not guarantee the placement of notes) and agency agreement with the bank to arrange for the issuance  and payments[28].

A plus of a private placement is that exemption from the registration requirement simplifies paper work related to the transaction expediting actual provision of borrowed funds, relieves the issuer of the need to comply with the stringent disclosure requirements, and, thus, reduces overall transaction costs. Furthermore, an issue of commercial papers makes lower adverse effect on the value of the company’s shares and provides some flexibility (it is possible to attract funds as soon as they become necessary optimizing interest payments)[29]. However, the transaction terms may provide for the borrower’s duty to register securities placed privately during a particular period of time after their placement[30].

A minus of private placement is that notes and warrants so placed as well as shares which they can be converted into are “restricted securities” that may not be traded on a stock exchange; until registration thereof or obtainment of a legal counsel opinion that such registration is not required, any dealings with them are permitted in strictly limited cases only. However, to determine whether a transaction with such securities is lawful or not, Rule 144 or 144А is used that is aimed at qualified institutional buyers (QIBs). Rule 144 requires meeting the conditions regarding the minimum holding period (no shorter than 1 year after placement and full payment and, in some cases, – 6 month), issuer’s public reporting, maximum permitted transaction amount, broker participation, and notice to SEC[31]. In this connection, the certificates of convertible promissory notes and warrants issued in the US without registration must bear special clauses (legends) indicating that the securities certified by them are restricted and explaining the essence of the relevant restrictions.

Also, it should be taken into account that each state has its own securities laws that may differ from the federal laws[32]; therefore, registration of a convertible note and warrant issue may be required both at the federal and state level at the borrower’s place of residence and location where transactions with them are effected.

The framework agreement and convertible note (warrant) certificates may set forth additional restrictions on the assignment of rights to the notes and warrants, for example, minimum permitted assignment amount, right to transfer notes and warrants to persons who can be the shareholders of the borrower company only given the restrictions provided for in the borrower’s articles of association. Also, framework agreements provide for conditions precedent to the creditors’ commitments to purchase the borrower’s convertible notes coming into legal force that may include the compliance by the borrower with the representations and warranties given to the creditors, obtainment by the borrower of all required consents, authorizations and decisions required to issue the convertible notes and warrants, settlement of anti-dilution rights conferred upon the existing preferred shareholders of the borrower.

Creditor’s Income

The creditor’s income under a convertible loan is composed of the two components: 1) interest for using borrowed funds (5-12% per annum that are generally fixed and paid upon redemption of the promissory notes but may be compounded at certain intervals) and 2) participation in the possible increase of the borrower’s value (equity kicker). The latter is compensation to the creditor for an increased risk and implemented through a discount from the borrower’s share value that is given to the creditor upon the conversion of the promissory notes (the amount of the discount accounts for 10 to 30%[33] and may vary depending on the conversion grounds and time). The above components are inversely related: the higher is the loan utilization interest rate the less is the discount. The second way to ensure creditor’s participation in the borrower’s value appreciation is to issue a warrant to the creditor that confers, upon the creditor, the right to purchase shares in the borrower in a certain quantity or for a certain amount representing a percentage of the loan amount provided by the creditor. Discounts may be granted upon exercising the warrants also. It should be, however, noted that promissory note conversion and warrant exercise prices as well as the discount conditions are set forth taking into account all aspects of the transaction and aligned so that no party receives excessive benefits.

A note conversion discount enables the creditor to covert its claims, within the next equity financing round, into a bigger number of shares in the borrower than the creditor would have received if it had been one of the subsequent investors. For instance, if, within the next financing round, one share provided to investors was valued at 1 dollar a regular investor would receive 100,000 shares in the borrower for investment of 100,000 dollars while the creditor under a convertible promissory note providing for a 20% discount would receive 125,000 (100,000/0.8) shares in the borrower[34] in exchange for waiving its claims against the borrower in the amount of 100,000 dollars, i.e. the creditor’s income would account for 25,000 dollars.

In the case of privately placed warrants, the aggregate income of the warrant holder from exercising thereof can be calculated based on the simplified formula:

                  V current – Debt current + P exercise * nw

Ew = nw * (-------------------------------------------------------------  – P exercise)

                                                   n + nw


V current – current market value of the borrower

Debt current – current debt amount of the borrower

P exercise – warrant exercise price per one share in the borrower (it may be equal to a fixed amount set forth in the warrant or fair value of a share in the borrower at the time of exercising the warrant whether at a discount or not (depending on the warrant’s terms and conditions); it is paid with money or by waving a portion of the indebtedness under the notes being converted)

n – number of shares in the borrower that has  been issued prior to exercising the warrant

nw – number of additional shares in the borrower issued in exercising the warrant[35]

The net income from exercising a warrant is determined by deducting the price of the warrant itself that is generally established at the level of two or three dollar decimals to avoid creditor’s liability to pay tax on the warrant rights value prior to the exercise thereof[36] as well as taxes and creditor’s expenses related to purchasing and exercising the warrant from the total earnings from exercising the warrant.

In addition to exercising the warrant in exchange for payment by the creditor of the exercise price, a warrant may set out the creditor’s right to so called “net exercise”. In the case of such exercise, the warrant exercise price is not paid and creditor receives shares in the borrower company for the positive difference between the fair market value of shares in the borrower company and warrant exercise price.

The interest income of the creditor is guaranteed while equity kicker is not guaranteed because it depends on the value of shares in the borrower, borrower’s future actions as well as factors that may be beyond control of the parties to the financial transaction. In this connection, special mechanisms protecting creditor’s interests related to the total expected return on investment have been developed, a particular set of which may vary depending on the specifics of the case. Some of them are mentioned below:

- Valuation cap, i.e. terms that establish the maximum conversion price to protect the creditor from dilution of its participation interest when debt is converted into the borrower’s shares within the next financing round if at the conversion time the shares in the borrower have been valuated significantly higher than it was expected initially. This term is advantageous to the creditor but disadvantageous to the borrower because in the equity investment round following the provision of the convertible loan the borrower will receive less investment due to the valuation cap itself and, in addition, future investors can use such a cap as an argument to substantially reduce the borrower’s value as a whole. In this connection, it is used most often at the seed financing stage as an extra compensation for risk to the first investors[37]

- Protective put option, i.e. creditor’s right to sell its shares to the other shareholders of the borrower at a pre-determined price immediately after converting promissory notes and/or exercising warrants. This right protects the creditor in a situation where the price of the borrower’s shares at the time when debt is converted or warrant is exercised turns out to be lower than the minimum price set forth in advance.

- Acceleration and multiple payout, i.e. terms providing for that the borrower’s obligations under convertible promissory notes become immediately due to the creditor with the borrower’s obligation to pay the principal amount increased by a certain multiple and interest accrued. Such terms guarantee the receipt by the creditor of additional return in the case of the borrower’s default under obligations arising out of the convertible debt, change in the borrower’s control that has not been consented to by the creditor, sale or liquidation of the borrower company prior to raising the next equity financing round and convertible promissory notes’ becoming mature[38].   

- Call protection, i.e. a term allowing the early redemption of notes upon creditor’s consent only.

- Warrant exercise price adjustment provisions preventing alteration of potential rights volume of the warrant holder in respect of the borrower company that it would have received when exercising the warrant in the event that actions making impact on the borrower’s share value   are undertaken (reorganization, issue of additional shares by the borrower, cancellation, purchase or redemption, or reduction of the number, split or combination of the borrower’s shares, etc.).

Redemption and Conversion of Notes, Exercise of Warrants

The borrower’s obligations under convertible promissory notes terminate by the performance thereof (redemption of notes) or by issuing shares to the creditor in consideration of the debt forbearance or promissory note counterclaim setoff (conversion of promissory notes). Such obligations may, also and with the consent of creditors, be restructured by exchanging old notes for the new ones that may be accompanied by the payment of interest accrued on the old notes by way of issuing additional notes called “toggle notes”[39] (pay-in-kind interest).

There are two types of promissory note conversion – automatic and upon creditor’s demand.

In the case of an automatic conversion, all the creditor’s claims to the borrower are converted into the borrower’s shares with no participation of the creditor. An automatic conversion is effected by the borrower company in the events specified in advance. Generally, they include raising equity financing by the borrower (prior to IPO) where the borrower’s revenues reach the minimum agreed amount (so called “qualified financing”). In such a situation, debt is converted into shares of the type that is issued to the other investors within the qualified financing. An automatic conversion happens also in the case of the borrower’s IPO (prior to the qualified financing) but in ordinary shares in the borrower. In both cases, the number of shares which the debt is converted into is calculated by dividing the amount of the claims under the notes owned by the relevant creditor by the price at which the shares are placed within the qualified financing or IPO taking into account discounts and other conversion conditions pre-agreed by the creditor and borrower.

A conversion under creditor’s demand may be effected upon the expiry of a period of time set forth in the convertible notes in all cases where there are no grounds for automatic conversion. In the event that there are several creditors the terms and conditions of notes usually provide for that to effect a conversion under creditors’ demand the approval by the holders of the majority or qualified majority of the convertible notes is required.

As per the warrant exercise, the commonly accepted practice is to grant the warrant holder the right to make claim against the borrower to have the relevant number of borrower’s shares transferred at any time during the warrant exercise period set forth therein. Like in the case of convertible promissory notes, warrants may provide for an automatic exercise on the terms and conditions agreed upon therein (usually, in the event of the borrower’s IPO). If the creditor fails to exercise a warrant during its exercise period and it has not been exercised automatically the warrant-based share option is terminated but the warrant holder retains the right to claim so called warrant’s “intrinsic value” or asset value payment (AVP) from the borrower[40], i.e. the difference between the current value of the borrower’s shares the right to which is established by the warrant and warrant exercise price taking into account the taxes and expenses related to exercising the warrant.

Technically, note conversion or warrant exercise is implemented by adopting a resolution, by the borrower company’s  directors or shareholders, to issue the corresponding number of fully paid shares of the relevant category and type to the note or warrant holders and issue share certificates to them in exchange for surrender of their convertible promissory note or warrant certificates to the borrower and, in the case of warrants, in exchange also for the warrant exercise price payment under borrower’s own initiative or creditor’s demand save that relevant grounds exist. In the event that such certificates have been lost the holder thereof must provide the borrower company with an indemnity in the form and substance satisfactory to the borrower for a situation where a lost certificate is found thereafter.

In order to ensure that debt is converted into shares, the Framework Agreement often includes the borrower’s obligations to provide in its articles of association and maintain during the period when the obligations under the convertible loan remain  in effect the required number of authorized and unissued shares of the relevant category and type, not to amend the articles of associations in a way that may adversely affect the rights of the convertible note and warrant holders, procure making by its directors of all resolutions required to redeem the promissory notes or issue shares when they are converted or warrants are exercised according to the terms and conditions of the Framework Agreement.

Subject to conversion are the principal amount and interest accrued on the convertible notes at the time of conversion. Fractional shares are generally not issued upon conversion or warrant exercise; instead the creditor is paid a monetary compensation equivalent to the size of a fractional share.

Opportunities and Drawbacks of Structuring a Convertible Loan Pursuant to the U.S. Model in Russia

In the Russian law, there is no a “convertible note” or “convertible loan” notion; however, the term “conversion” is used in the Russian legislation. In particular, Federal Law dated 26.12.1995 No.208-FZ on Joint-Stock Companies  (as amended and supplemented, hereinafter – FL on Joint Stock Companies) and Regulations on the Securities Issue Standards, Procedure of Registering an Registrable Securities Issue (Additional Issue), State Registration of Reports on the Results of an Registrable Securities Issue (Additional Issue) and Registration of Securities Prospectus, adopted by the Bank of Russia on 11.08.2014 No. 428-P[41] (hereinafter – the Issue Standards) provide the opportunity to issue bonds and preferred stock convertible into a company’s ordinary or preferred stock of other type, opportunity to convert shares into shares of the same category when shares are combined or split, their par value or shareholder rights are modified as well as in the case of joint-stock companies reorganization (sections  V, XI, and XII of the Issue Standards). In the Russian legislation, there is also found such type of registrable securities as issuer’s options convertible into the issuer’s shares[42].

It should be noted that in all the cases mentioned above the talk was about converting one security into another, i.e., in the Russian law, conversion implies acquiring ownership right to the securities being placed in exchange for alienating ownership right to other securities. Therefore, we have to agree with the statement that, pursuant to the Russian laws, only persons having ownership right to securities that have already been placed prior to a conversion may participate in it[43]. Not incidentally, Federal Law dated 08.02.1998 No.14-FZ on Limited Liability Companies  (as amended and supplemented, hereinafter – FL on Limited Liability Companies), in articles 52 and 56, uses the term “exchange of participation interests for shares” in the event of reorganization of companies; and in doing so it does not treat exchange of corporate rights for securities as a conversion.

Based on such understanding of conversion in the national law, it seems that the only instrument allowing for conversion of a debt obligation into shares provided for in the Russian laws is convertible bonds. In terms of their legal nature and effectuation mechanism, convertible bonds are similar to convertible promissory notes utilized in the U.S. to structure convertible loans. Like convertible promissory notes, Russian convertible bonds may be converted into shares: 1) under a demand of the bond holders and/or 2) within a period of time that is indicated in the bond placement resolution (or determined pursuant to the procedure set forth therein), and/or 3) in the circumstances indicated in the bond placement resolution that is, in fact, an analogue of an automatic conversion (see clause 20.4 of Issue Standards).

The difference between the Russian convertible bonds and U.S. convertible promissory notes is that the said notes are not registrable securities and, in certain conditions not requiring significant expenses to be met the issue thereof is exempt from registration. An issue of the Russian convertible bonds is subject to registration that requires completing rather complex formalities which make such form of convertible debt acceptable for large Russian companies that are able to bear costs related to bond placement and not for small or medium businesses that usually need small financing fast and at a minimum cost.

An alternative to issuing convertible bonds might be 1) issuing a promissory note or several promissory notes (in Russian – «векселя») by the borrower to the lender that are also qualified as securities in Russia but do not require issue registration (if a special agreement is entered into between the lender and borrower at the same time providing for conditions of satisfying claims under the promissory notes by issuing (transferring) a certain number of shares in (interest in the share capital of) the borrower to the creditor, the promissory note scheme would have not fewer common traits with a convertible loan under the U.S. Law than convertible bonds) or 2) including such terms directly in the loan agreement without issuing promissory notes. Moreover, the authors of this article are aware of examples where convertible loan agreements entered into under the law of Cyrus or Switzerland did not contemplate issuance of any securities convertible into the borrower’s shares. In those cases, the conversion mechanism was implemented through contractual obligations of the parties only.

Both alternative options imply entering into a convertible loan agreement between the creditor and the borrower as a separate document or agreeing upon special terms of the loan agreement that describe in detail all the conversion conditions like in the framework agreements used in the U.S. practice. Based on the contract liberty principle enshrined in article 421 of the Civil Code of the Russian Federation (hereinafter – CC RF), entering into such agreement is possible. Let us remind that article 421 of the CC RF permits entering into agreements that are not provided for by law or other regulations and enables the parties to determine the terms and conditions of an agreement at their own discretion within the limits of mandatory statutory requirements. In Decree of the Plenum of the Supreme Arbitration Court of the Russian Federation dated 14.03.2014 No. 16 on Contract Liberty and Limits Thereof, it is indicated that, in applying the said provision, courts should take into consideration that a rule establishing rights and duties of the parties to an agreement shall be construed by a court on the basis of its essence and statutory regulation goals; and a court has to take into account both literal meaning of the words and expressions contained therein and goals pursued by the legislator when establishing that rule. Moreover, because the talk is about entering into agreements that arise out of business activities of the parties in the prevailing majority of cases, in relation to them a rule of law, unless otherwise required by its restrictive teleological construction, must always be treated as a dispositive one[44]

Based on that, an agreement between the parties that one of them shall provide an interest-bearing loan to the other with the borrower’s obligation to issue, upon the lender’s request made if the pre-agreed grounds exist, a certain number of shares and transfer them to the lender (increase its share capital) in consideration of terminating the obligations to the latter under the loan agreement must not contradict Russian laws. In the meantime, in the Russian law perspective, such obligation will be terminated by actions made by the borrower and its shareholders (members) to issue additional shares in the company to the creditor (increase the company’s share capital)[45] and setting off the borrower’s and creditor’s counterclaims or providing a termination compensation if at the time of performance the shares (participation interest) to be transferred to the creditor are already owned by the borrower which is also possible rather than by a “conversion” of debt into shares in (interest in the share capital of) the borrower.

The above statement does not necessarily mean that such arrangements are invalid. Moreover, FL on Joint Stock Companies expressly provides for the opportunity to pay a company’s debt  to its creditor by an additional issue of the borrower’s shares which shall be paid by means of setting off the creditor’s rights under the borrower’s obligations (see clause 2 of article 34 of Federal Law on Joint Stock Companies); however, it sets forth certain restrictions at the same time: such offset is possible in the case of a private subscription for shares only and must be provided for by the resolution on issuing the company’s shares. The same rule is also contained in clause 4 of article 19 of Federal Law on Limited Liability Companies pursuant to which, by a decision of the company’s general member meeting adopted by all the company’s members unanimously, the company’s members and/or third parties may set off monetary claims to the company against their additional contributions or, in the case of third parties, against their contributions. Transfer of shares (participation interest) already owned by the company constitutes a secondary alienation thereof; therefore, it may be effected in exchange for any consideration not prohibited by law.

At the same time, it should be admitted that the goals pursued by the Russian legislator in introducing those rules to the laws on business companies were different from the economic nature of a convertible loan agreement reviewed by us. Those rules appeared in the laws during 2008-2009 financial crisis; and they were aimed to enable the parties to settle existing debts by modifying the manner of obligation performance[46]. Due to this fact, those rules are talking about issuing a certain number of shares by an agreement between the parties (and, as a consequence, at a price determined at the time of issue thereof) to the creditor. In the case of a classic convertible loan mechanism, there should be variability in the manner of obligation performance (as soon as the opportunity to convert is, except for an automatic conversion, the creditor’s right and the number of shares which the debt will be converted into is unknown at the time of entering into the agreement. Otherwise, economic reason of the instrument would be lost. In this connection, there is a question whether the following provisions inherent in a classical convertible loan scheme are compliant with the Russian laws: a) ability to confer upon the creditor and not the debtor the right to choose the manner of performing an obligation by the debtor; b) ability to determine, in the agreement, the number of shares to be placed in favor of the creditor in the case of conversion as a description of determination procedure rather than as a precise number; c) ability to condition the occurrence of the creditor’s right to request conversion to circumstances that are partially dependent on the will of the borrower (and in some cases, of the lender – for instance, approval by the lender of the next financing round in accordance with its rights granted by a shareholders’ agreement, etc.).

a) Pursuant to article 320 of the CC FR (“Performance of an Alternative Obligation”) the right to select consideration belongs to the debtor unless otherwise required by law, other regulation or terms and conditions of the obligation. Therefore, given the dispositive nature of that rule, it follows that the right to select the manner of obligation performance under a convertible loan agreement may be granted to the creditor and not to the debtor[47]. At the same time, there is an open issue what such selection procedure should be like where there is more than one person on the creditor’s part to ensure recognition and protection by the Russian courts. In particular, whether certain creditors may demand that their claims be converted into stock and the others claim for cash repayment of the loan; and if the decision of the creditors must be made collectively, then, whether it may be adopted by a majority vote or must be made unanimously.

b) The issue of determining the number of shares in the agreement is important as well because as it seems to us a convertible loan agreement may be construed by the Russian court as a mixed agreement containing elements of a loan agreement and share sale and purchase agreement (section 3 of article 421 of the CC RF). Pursuant to section 3 of article 455 of the CC RF, the terms of a sale and purchase agreement regarding the goods shall be deemed to have been agreed if the agreement allows the determination of the goods name and quantity. The risk is that in the event that the term on the goods quantity is found to be not agreed by a court, such agreement will be held to have not been entered into in its entirety; as a consequence, there will be impossible to compel the borrower to transfer shares in favor of the lender and pay penalty to the latter[48]

As mentioned above, the standard practice for convertible loan transactions is that the number of shares to be placed to the lender is determined by applying a particular discount to the market value of the borrower’s shares at the time when the debt is converted into shares. In our opinion, such method of establishing the provision regarding the quantity of goods by the parties is, in general, compliant with the requirements of law and case law that the essential terms and conditions of a sale and purchase agreement have to be agreed upon by the parties, and one can find the conclusions that the goods quantity provision may be agreed upon by setting forth a procedure of its determination in the agreement[49]. In the meantime, it should be noted that in each case a court will assess the agreement as a whole given the other circumstances of the transaction.

c) The matter whether the standard grounds for converting debt into shares (such as raising the next financing round, achieving certain financial ratios by the borrower or market value of its shares) are complaint with the Russian law is covered in substantial detail in the national legal literature devoted to the possibility of using the western analogues of shareholders’ agreements, options and other investment agreements in the context of Russian law. The point is that such circumstances are in general more or less dependent on the will of the parties and the Russian courts still construe the rule of article 157 of the CC RF ambiguously and, generally, we see negative case law on transactions and obligations the performance of which is conditioned in part or in full to the will of one of the parties (potestative or mixed terms). Thus, for instance, in Judgment of the Nineteens Arbitration Court of Appeals dated 27.01.2014 in case No. А08-3097/2011, it is indicated that it follows from the analysis of article 157 of the CC RF that 1) a condition precedent is applicable to a transaction as a whole rather than to separate parts thereof, 2) the fact that a transaction is executed with a condition precedent does not itself create rights and obligations of the parties because rights and obligations appear when there is another legal fact only – the occurrence of the event that is mentioned in the condition precedent, and 3) a condition precedent must be tied to a circumstance that does not depend on the will of the parties. Based on the above mentioned interpretation of article 157 of the CC RF, there is a risk that a lender may face difficulties in the Russian court in enforcing the terms and conditions of a convertible loan agreement regarding the satisfaction of the lender’s claims by transferring shares in (interest in the share capital of) the borrower to it.

In addition to those issues, when implementing a convertible loan transaction under the Russian law, the issue whether it is possible to claim from the borrower the specific performance of the obligation to issue and transfer shares in favor of the lender in a court. It seems that in the event that a share issue is caused by making a decision on issuing and placing shares by the company’s general shareholder meeting, then, such award is impossible because the court cannot predetermine the will of the shareholders in a certain way or make such decision in lieu of them. Having said that it should be noted that the issue of the performance of conversion obligation being dependent on the debtor’s will is inherent in convertible bonds issued under the Russian laws also[50] and convertible notes issued under the U.S. law.

Thus, entering into a convertible loan agreement and subjecting it to the Russian law is related to significant legal risks because recognition and practical implementation of the terms regarding the conversion of the lender’s claims under a promissory note, loan agreement or credit agreement executed pursuant to the Russian law, into the shares in (interest in the share capital of) a Russian company-debtor, in the absence of established case law on the key issues, cannot be guaranteed. Mitigation of this risk can eliminate one of the main advantages of that instrument, namely: simple execution and minimum expenses that are so important for starting and fast growing companies; this fact forces Russian entrepreneurs and investors to look at more predictable international schemes of structuring convertible loan transactions one of which is reviewed below.

At the same time, let us note that the Government of the Russian Federation, in the 2014 - 2020 Information Technology Industry Development Strategy for 2014 – 2020 and for the perspective through to 2025 adopted by it, emphasized the need, inter alia, of incorporating convertible loans and other world standard investment mechanisms in the Russian law[51]. Agreeing with the fairness of that provision, we have to note that, in our opinion, to enable entering into convertible loan transactions under the Russian law as well as using other investment mechanisms known in the foreign practice there is, first of all, the need of acknowledgement on the legislator part and in the case law that there is no an exhaustive list of legal structures to attract investments in the business[52]. It is necessary to reinstate, in case law, the priority of the arrangements between the parties over general rules of law and maximum contract liberty in relationship between entrepreneurs. In particular, the Russian legislation and case law have to recognize transactions and separate obligations executed on a condition the occurrence of which is more or less dependent on the will of one of the parties as being subject to judicial protection.

Entering into an agreement on the provision of a convertible loan (with or without issuing convertible promissory notes and warrants) under English or U.S. law with a foreign holding company directly or indirectly controlling the Russian company that receives the financing

This option implies that 100% of the shares/interests in the share capital of the Russian company that is the ultimate beneficiary of the financing are directly or indirectly owned by a company incorporated in an English or American law jurisdiction. This might be Delaware, Cyprus, B.V.I. or Great Britain (hereinafter – the Holding Company).

In such a case, a convertible loan transaction may be implemented through either issuing convertible promissory notes or warrants by the Holding Company in favor of the lender in exchange for funding obtained from it or, without issuing convertible notes, by entering into an agreement or agreements (Convertible Loan Agreement and Shareholders Agreement) between the lender, borrower company and its shareholders where all the terms and conditions as well as the procedure of loan provision and its conversion into the Holding Company’s shares are stipulated. In both cases, funds received from the Holding Company are, then, provided by it to its Russian subsidiary as a loan or contribution in the share capital.

The apparent advantage of the above option is that the parties use the verified legal instruments to implement a convertible loan being sure that they will be able to enforce such instruments in the relevant foreign court. However, this variant has also an objective flaw because the lender acquires shares in the Holding Company that does not carry on any operating activity and does not generally have any assets other than participation in the operating company which makes the valuation of its shares more difficult. Furthermore, in the event that the debt is converted into shares the investor will not be able to participate in the corporate management of the operating company unless such rights are arising out of the Holding Company shareholders’ agreement. As a consequence, the originally risky investments in the company at an early stage becomes even more risky for the investor and such investments would be hardly possible without obtaining some security from the operating company or its beneficiaries.

As an alternative to that option, one could consider a situation where the borrower is a Russian operating company and the loan obligations are performed pursuant to the above mentioned “exchangeable debt” model with debt being “exchanged” for shares not in the borrower but in its foreign holding company. Such structure makes the loan agreement less risky because the repayment of the loan is guaranteed by the assets and activities of the operating company; however, in that case, the standard convertible note and warrant purchase agreements are not a good fit. As an alternative, the parties may enter into a call option agreement in respect of the holding company shares under English or U.S. law simultaneously with entering into the loan agreement.

This method of executing a convertible loan can be illustrated with a recent example of raising financing by a Russian chain of pizzerias that has been actively discussed on the Internet. Based on the publicly available information, in the above case, financing was structured as follows: 1) one of the Russian legal entities of the borrower’s group raised funds for business development from a wide range of Russian legal entities and individuals by means of an interest-bearing loan; 2) the loan amount was determined in dollars but a private investor remitted money in rubles based on the Bank of Russia’s current exchange rate. The repayment of the loan and payment of the interest would be also made in rubles based on the Bank of Russia’s rate in 3.5 years; 3) together with the loan agreement the investor entered into a call option to purchase shares in the foreign holding company owning 100% of interest in the share capitals of the borrower’s group Russian operating companies and trade mark. The option may be exercised in 2 years and 8 months as of the date of entering into the loan agreement for the principal amount and the amount of interest accrued. The option exercise period is 4 months upon expiration of which a lender that has not exercised the option shall be entitled to the repayment of loan amount and interest only[53]

As it follows from the company’s owner blog[54], the Russian borrower company has been successfully attracting investments under this scheme and plans to increase the amount of funds raised up to 80 m rubles by the end of 2017. In our view, the described scheme is, in general, a pretty successful method of structuring investments in a Russian company under the convertible loan model combined, in fact, with crowdfunding. Nonetheless, such scheme is not a typical one in the western practice perspective.

First, it is remarkable that the number of shares in which investors may “convert” their rights of claim under the loans is fixed at the time of entering into the loan agreement and call option and it is based on the forecast assessment of the borrower’s group value as of the loan conversion. Similar terms are found in the western practice of structuring convertible loan transactions; however, it does not happen in a company growth financing because, as indicated above, one of the advantages and distinguishing traits of a convertible loans is the absence of the need to forecast the value of a growing company at the stage where investment is raised when, as it is expressly stated in the owner’s blog as well[55], the valuation is based mostly on belief in the business and its team.

Another important distinguishing feature of such financing scheme is that the time of conversion is tied to a date determined by the borrower company at its sole discretion meaning that, as far as we can infer from the open data posted on the Internet, the legal documentation in relation to the transaction does not contemplate the conversion grounds typical for the western practice reviewed above such as raising the next financing round by the borrower, change of control, making a decision on the company’s dissolution or reorganization, implementation of an M&A transaction, etc.

It should be also noted that, pursuant to the blog of the borrower company’s owner[56], the loan agreement and call option to purchase shares in the holding company are not legally related in any manner, i.e., here, the conversion mechanism is secured by the fact that the investor, in the event that it decides to exercise its option, will be offered by the company to assign its rights to the Russian LLC in exchange for the foreign company shares. Based on this, it is not clear how the company can compel the investor to assign the rights under the loan agreement in the event that it decides to exercise its option rights and pay for the shares with cash and not by waiving claims under the loan agreement.

In addition, the specific of a foreign holding company acting as the issuer of the shares which the convertible loans will be converted into is that the borrower and its investors have to be sure that there will be the opportunity to implement the next investment rounds under the same scheme, i.e. that the subsequent investors (they will likely be equity funds, venture investors or IPO purchasers of shares) will agree to purchase the shares in the holding company and not in the operating one.

Finally, as far as we can judge based on the publicly available information, the terms of the transaction in question do not provide for standard behavioral and financial covenants that must be complied with by the borrower company. Perhaps, this specific is caused by the fact that the financing is raised through crowdfunding because if there had been one or more big investors the issue of documenting such covenants and other conditions that are standard for financial deals of such kind would have been inevitably raised.


The U.S. experience shows that convertible loan is a useful and powerful seed and bridge financing tool which, if applied correctly and if there is a stable law-enforcement practice, ensures an optimal balance of debtor’s and lender’s interests. In Russia, there is demand for such financing mechanisms that will inevitably increase along with the development of the national economy; the country has general law institutes allowing for the use of the convertible loan. At the same time, the lack of specific rules devoted to such loans and unclearness in relation to the application limits of the contract liberty principle as well as restrictive case law developed by the Russian courts in respect of potestative transaction conditions make utilization of the English and U.S. convertible loan models or particular elements thereof in the national legal environment a very risky undertaking. As a consequence, Russian businessmen are forced to resort to more predictable international schemes well tested in practice and implemented pursuant to foreign law.


[1] Various financial instruments that are classified as hybrid combine the elements of debt and equity investments.

[2] See: V. Lurye, E. Melikhov. Mezzanine Financing: International Experience and Russian Practice // Mergers and Acquisitions. 2013. No. 4 (4).

[3] См.: Frank J. Fabozzi, Richard S. Wilson. Corporate Bonds: Structure and Analysis: Alpina Publisher, 2005. P. 208; Brad Feld, Jason Mendelson. Venture Deals: Be Smarter than your Lawyer and Venture Capitalist. - Second Edition. - John Wiley & Sons, Inc. 2013. P. 112; Carolyn E.C. Paris. Drafting for Corporate Finance. What Law School Doesn’t Teach You / Practising Law Institute. New York City. 2007 (Kindle Edition). Loc. 2003.

[4] See: Brad Feld, Jason Mendelson. Op. cit. Ch. 8; Paul Gram Has Presented Safe – Like Convertible Loan but Better: [Electronic document] (

[5] See: Brad M. Barber. Exchangeable Debt. Financial Management / Summer. 1993: [Electronic document] ( P. 48-49.

[6] See: Brad Feld, Jason Mendelson. Op. cit. P. 111.

[7] See: Barry J. Kramer, Steven S. Levine. 2012 Seed Financing Survey. Internet/Digital Media and Software Industries: [Electronic document] (

[8] See: Marie Dutordoir, Linda Van de Gucht. Why Do Western European Firms Issue Convertibles Instead of Straight Debt or Equity? European Financial Management, Vol. 15, No. 3, 2009. P. 564-565, 570.

[9] The description is illustrative because the details of transactions can vary significantly.

[10] Here, the U.S. law means federal rules in effect in the territory of the United States of America as well as the laws of a particular state which the agreements are subject to. Generally, the law of states with developed regulation of corporate and investment relationship such as Delaware, California, or New-York is selected as the applicable law. The state rules may differ from each other in some nuances; however, the conceptual scheme remains substantially the same.

[11] Pursuant to 2012 Seed Financing Survey of Silicon Valley companies prepared by Fenwick & West LLP, the convertible note holders were granted a place in the debtor’s board of directors and right of veto in 8.3% of cases in 2010, 4% of cases in 2011 and 0% of cases in 2012. See: Barry J. Kramer, Steven S. Levine. 2012 Seed Financing Survey. Internet/Digital Media and Software Industries: [Electronic document] ( 

[12] See: 15 U.S. Code § 77b - Definitions; promotion of efficiency, competition, and capital formation: [Electronic document] (

[13] Securities Act of 1933 [as amended through P.L. 112-106,  approved April 5, 2012]: [Electronic document] (

[14] The U.S. courts indicate that a regular commercial paper the holder of which does not act as an investor or business partner of the debtor is not a security even though it is designated as a “note”. See: Edward X. Clinton, Jr. What Is A Security Under The Federal Securities Laws?: [Electronic document] (

[15] See: Promissory Note: [Electronic document] (

[16] See: Headman A. O. Is Our Promissory Note A Security? [Electronic document] (

[17] See: Negotiable instrument: [Electronic document] (; the text of the U.S. Unified Commercial Code is found at: The key provisions of this code have been enacted in all the U.S. states and territories.

[18] See, e.g..: Joshua Rosenbaum, Joshua Pearl. Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions. Second Edition. John Wiley & Sons, Inc., Hoboken, New Jersey (Kindle Edition). 2013. Loc. 1002.

[19] See: Brad Feld, Jason Mendelson. Op. cit. P. 108.

[20] See: I bid. P. 110.

[21] See, e.g.: David H. Pankey, LaTisha O. Chatman, Meredith Sanderlin Thrower. Overview of SEC Amendments to Rules 144 and 145: Limits on Sales of Securities: [Electronic document] (

[22] See. e.g.: Rule 144: Selling Restricted and Control Securities: [Electronic document] (

[23] See: Non-public offering (private placement) exemption: [Electronic document] (

[24] For details refer to: Regulation D Offerings: [Electronic document] (

[25] See: Investor Bulletin. Accredited Investors: [Electronic document] (

[26] See: James M. Bartos. United States Securities Law: A Practical Guide. Kluwer Law International. 2006. P. 61-64;  Thomas K. Hahn. Commercial Paper: [Electronic document] ( P. 106-107.

[27] See: Carolyn E.C. Paris. Drafting for Corporate Finance. What Law School Doesn’t Teach You / Practising Law Institute. New York City. 2007 (Kindle Edition). Ch. 2, Loc. 785, 790;

[28] I bid. Loc. 921, 1018, 1365, 1432.

[29] Thomas W. Albrecht, Sarah J. Smith. Corporate Loan Securitization: Selected Legal and Regulatory Issues. Duke Journal of Comparative and International Law. Vol. 8:411. P. 415.

[30] Joshua Rosenbaum, Joshua Pearl. Op. Cit. Loc. 2726, 4501.

[31] For details refer to: Rule 144: Selling Restricted and Control Securities: [Electronic document] (

[32] Known as “Blue Sky Laws”. See, e.g.: Headman A. O. Is Our Promissory Note A Security? [Electronic document] (; Don’t Run Afoul of Securities Laws [Electronic document] (; Richard I. Alvarez, Esq., Mark J. Astarita, Esq. Introduction to the Blue Sky Laws [Electronic document] (

[33] See: Brad Feld, Jason Mendelson. Op. cit. P. 104-105.

[34] I bid. P. 103.

[35] See:  Stephen Ross, David Hillier, Randolph Westerfield, Jeffrey Jaffe, Bradford Jordan. Corporate Finance, 2nd European Edition. McGraw-Hill Education. 2013. §24-3 “Warrant Pricing and Black-Sholes Model”.

[36] See: Brad Feld, Jason Mendelson. Op. cit. P. 109-110.

[37] I bid. P. 101-104.

[38] I bid. P. 107.

[39] Carolyn E.C. Paris. Op. cit. Loc. 1282.

[40]Warrants. Understanding Trading and Investment Warrants. ASX. 2010: [Electronic document] ( P. 25.

[41] Registered in the Russia’s Ministry of Justice on 09.09.2014 No. 34005, effective from 16.10.2014. Similar provisions were contained in the Securities Issue and Securities Prospectus Registration Standards adopted by the Order of the Russia’s Federal Service for Financial Markets dated 04.07.2013 No. 13-55/pz-n that were previously in effect.

[42] See, e.g., clause 20.5 of the Issue Standards. An issuer’s option has a function similar to that of an English and U.S. warrant. Like a warrant, an issuer’s option is a security that enshrines its holder’s right to buy a certain number of shares in the issuer of such option within a period of time set forth and/or in the circumstances indicated therein at a price determined in the issuer’s option (art. 2 of Federal Law dated 22.04.1996 No. 39-FZ on Securities Market). However, Russian issuer’s options are less flexible instruments: they are registrable securities; therefore, any issue thereof is subject to registration, they may be issued in respect of shares only, they are exercised under a demand of their holders only and if such demand is not made within an established period of time, the option rights are terminated and such options are cancelled with no option holder’s right to any compensation from the issuer (clauses 20.6 and 20.7  of the Issue Standards).

[43] Filimoshin, F.M. Conversion: [Electronic document] (

[44] For details refer to: D. Stepanov. Such a Sweet Word “Liberty” // Corporate Lawyer. 2014. No. 6.

[45] See, e.g.: Agapov S.V. Issuing Additional Shares to Creditors as a Means of Settling Accounts with Creditors with Own Stock // Joint Stock Company: Corporate management Issues. 2012. No. 3(94). P. 48-49.

[46] See: I bid.

[47] The authors of bill no. 47538-6 of Federal Law on Amending the Civil Code of the Russian Federation, Certain Statutory Acts of the Russian Federation and on Holding Certain Statutory Acts (Provisions of Statutory Acts) of the Russian Federation Ineffective ( think that it is necessary to grant this right to a creditor and third parties in a clearer manner.

[48] See, e.g.: Judgment of the First Arbitration Court of Appeals dated 26.09.2008 in case No. А79-1838/2008.

[49] See, e.g.: Judgment of the Thirteenth Arbitration Court of Appeals dated 01.08.2011 in case No. А56-47214/2010.

[50] See: Malchikov A.S. Ability to Enforce Specific Performance under an Obligation to Convert Bonds // Legal World. 2008. No. 1.

[51] Resolution of the Government of the Russian Federation dated 01.11.2013 No. 2036-r.

[52] Some positive steps toward that direction are already seen, see: The Ice Broke Up. Courts Began Recognizing Members Right Implementation Agreement in LLCs: [Electronic document] (; Decision of the Arbitration Court of Novosibirsk Region in case No. А45-1845/2013.

[53] Fedor Ovchinnikov (Dodo Pizza): Why I am Looking for Money from Private Investors Only: [Electronic document] (

[54] FAQ. investments in Dodo Pizza: [Electronic document] (

[55] I bid.

[56] I bid.