New Twists in Convertible Note Financings August 1, 2003 As the capital markets have begun to open, several investment banking firms have assisted their clients by offering convertible notes with novel features. Based on our experience with these transactions, we believe these features can afford issuers interesting financing opportunities. This law flash outlines several of the features we consider to be most notable. 1. “True Zeros” or “No-nos”
Several issuers have sold “true zero” convertible notes. “True zero” notes have both zero coupon and zero yield to maturity, and thus are sometimes called “no-nos.” These notes differ from traditional zero coupon bonds in that “true zeros” are sold at 100% of their face amount and no interest is paid on the notes. This feature is achieved by reducing slightly the conversion premium of the notes to, in effect, “buy down” the relatively low market interest rate to zero. The reduction of the conversion price compensates the note purchasers for the elimination of interest and yield. Of course, if the notes are sold in a 144A offering, the conversion premium cannot be less than 10%. 2. “High Premium” Conversion Prices
While the “true zero” feature appears, at least initially, unattractive to many issuers, several investment banks have sought to ameliorate the lowered conversion premium by offering to their clients a convertible note hedging strategy that is designed to increase the conversion premium to a level that can be selected by the issuer. These strategies have two key elements. The first element – the sale to the issuer of a convertible note hedge – essentially fully hedges for the issuer the conversion feature of the notes. Under the convertible note hedge, each time a holder of notes elects to convert, the issuer’s counterparty (e.g., an affiliate of the investment bank offering the strategy) typically will go into the market and purchase the number of shares the issuer is required to issue upon conversion of the notes (if it does not already own the shares as a result of its own hedging activities) and will deliver those shares to the issuer at the stated conversion price. Alternatively, the issuer can settle with the counterparty on a net basis, in cash or in shares, as described below. Thus, the counterparty essentially becomes obligated to deliver shares upon the conversion of notes – regardless of what the price of the shares at the time of conversion. As a result, the issuance of shares upon conversion of the notes is designed to be a “nonevent” for the issuer.
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Typically, the convertible note hedge allows the issuer to elect to settle with the counterparty by purchasing the shares from the counterparty or, on a net basis, by having the counterparty pay the issuer, in cash or in shares, the spread between the strike price and the prevailing market price for the issuer’s shares. If the issuer elects to settle the counterparty’s obligations on a net basis in cash, the counterparty pays the issuer an amount equal to the number of shares to be issued on conversion of the notes multiplied by the difference between the current market price of the underlying shares and the conversion price of the notes. If the issuer elects to settle the counterparty’s obligations on a net basis in shares, the counterparty delivers to the issuer the number of shares equal to the quotient of the amount required for the counterparty to settle on a net basis in cash divided by the current market price of the underlying shares. In a net settlement, the issuer is not required to expend cash in either case. Conversely, if the issuer purchases from the counterparty the shares issuable upon conversion of the notes, the economic effect for the issuer is similar to redeeming the notes. The possibility that the share price may increase substantially amplifies the risk to the counterparty in the strategy and will result in a high purchase price for the hedge. The volatility of the issuer’s stock and the duration of the hedge (i.e., the time until maturity or put/call of the notes) could cause the purchase price for the hedge to be quite high. Indeed, the cost could be 30% to 40% of the principal amount of the notes if the issuer seeks a 50% conversion premium. However, the effect of the convertible note hedge is to approximate for the issuer the features of nonconvertible debt. The counterparty is responsible for delivering to the issuer shares equal in number to the conversion shares. The second element of the strategy is designed to reduce the aggregate cost to the issuer of the convertible note hedging strategy by reducing the risk to the counterparty. By selling to the counterparty a call option (essentially equivalent to a warrant) exercisable at a price selected by the issuer, the issuer mitigates the counterparty’s risk of greatly increased share prices. If the share price exceeds the strike price of the call option, rather than going into the market to purchase shares to satisfy its obligation to deliver shares under the convertible note hedge (or delivering shares it owns as a result of its own hedging activities), the counterparty merely exercises the call option to the extent of its sharedelivery obligation. Because the first element of the strategy eliminates from the issuer’s point of view the conversion feature of the notes, the issuer’s outstanding share balance will increase on account of the convertible notes only to the extent the call option is exercised. Thus, when the issuer selects the cost of the strategy (which in turn affects the risk to the counterparty), the issuer, in effect, selects the synthetic conversion premium for the notes. Several issuers have selected the strike price of the call option to achieve, from the issuer’s point of view, a 50% conversion premium for the notes. As with the convertible note hedge, the potential for the share price to increase substantially will result generally in a high purchase price for the call option, thus offsetting a significant portion of the purchase price the issuer pays to the counterparty for the convertible note hedge. Depending significantly on the conversion premium sought by the issuer, the volatility of the issuer’s stock and the expiration date of the call option (i.e., the time until maturity or put/call of the notes), the purchase price for the call option could range from 20% to 30% of the principal amount of the notes. The income tax treatment of “true zeros” or “no-nos” can be tricky and depends on the economics of the particular transaction selected by the issuer as well as the elections the issuer makes with respect to the notes, the convertible note hedge and the call option in reporting its income taxes. When viewed in isolation, the notes generate no interest deduction for the issuer because they are issued at their face
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amount. However, issuers typically elect to report the notes and the convertible note hedge together, as a single instrument, and to report the call option separately. In so doing, the issuer treats the note and the convertible note hedge, for income tax purposes, as a synthetic zero coupon note sold at a discount equal to the purchase price paid by the issuer for the convertible note hedge. Thus, for federal income tax purposes, the issuer reports deductions for interest equal to the cost of the convertible note hedge amortized over the period to maturity. In addition, the issuer takes the position that there is no taxable income associated with the grant, exercise or lapse of the call option. In most cases, the issuer’s interest deductions resulting from the convertible note hedge being bundled with the notes more than offsets the actual aggregate cost of the convertible note hedging strategy to the issuer. In structuring these arrangements, it is important to navigate carefully the tax rules that limit deductibility of interest with respect to convertible and discount obligations. Further, the tax treatment of the elections made with respect to the hedge may be subject to challenge. For financial reporting purposes, other than the income tax expense which is affected by the strategy as described in the preceding paragraph and earnings per share which is affected by the shares issuable upon conversion of the notes, the issuer’s income statement is unaffected by the notes and the note hedging strategy. When the convertible note hedge and the call option are settled and when the notes convert, the stockholders’ equity portion of the balance sheet, however, is affected. 3. Restricted Convertibility
Although less novel than the features described above, notes with a restricted convertibility feature are becoming more prevalent. This feature does not affect the conversion price of the notes but, instead, restricts convertibility of the notes. Sometimes this feature is referred to as “contingent convertibility,” and thus notes issued with this feature are called “co-cos.” Different investment banking firms tend to sell notes with slightly different conversion restrictions. However, all of the conversion restrictions are designed recognizing that most holders of convertible notes generally will not convert unless it becomes necessary for them to do so. As a result, a typical conversion restriction will be relaxed only if: • the notes are called for redemption, • the issuer enters into a merger or similar corporate transaction or plans a significant distribution to shareholders, • the underlying shares are trading at a significant premium (e.g., 20%) over the conversion price of the notes or • there is a market aberration resulting in a dislocation between the trading prices for the notes and the underlying shares. The restricted convertibility feature is designed to enable the issuer to report, for financial reporting purposes, net income per share without giving effect to the dilution from the notes until the share price exceeds the trading premium or another event occurs that relaxes the conversion restrictions.
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4.
Contingent Interest
Notes with a restricted convertibility feature, or “co-cos,” sometimes provide for additional interest payments. Additional interest payment features can take various forms. In one of the more common forms, beginning on the date the notes are first putable/callable, if the underlying shares are trading above the price at which the conversion restriction is relaxed, the holder becomes entitled to additional interest together with the regular, semiannual interest payments. This feature may motivate the issuer to call the notes in order to avoid paying the contingent interest and may deter holders from putting their notes to the issuer or converting them in order to continue receiving the contingent interest. As a tax matter, the right to receive additional interest payments upon the occurrence of specified events generally causes the debt obligation to be considered a “contingent debt obligation.” The issuer of a contingent debt obligation is required to accrue interest expense, and the holder of a contingent debt obligation is required to recognize income, for tax purposes, at an interest rate equivalent to the interest rate of comparable debt of the issuer. (The amount of interest accrued and income recognized will be adjusted based on a determination of true imputed interest at the time of conversion or maturity of the notes, or their earlier retirement.) Further, gain to the holder upon conversion, maturity or earlier retirement of the notes is taxed as ordinary income. As with notes with high premium conversion prices, it is important to navigate carefully the tax rules that limit the deductibility of interest. In addition, the tax characterization of the notes as contingent debt obligations may be subject to challenge. It is important to note that these features are not suitable for all issuers. A variety of considerations must be addressed for each issuer, including its income tax and financial reporting positions as well as its overall business and financial strategies. Nevertheless, these features can be useful tools in considering the financing options that may be available given the current state of the capital markets. For more information, please contact the Morgan Lewis attorney with whom you usually consult or Richard A. Silfen at 215.963.5024 (rsilfen@morganlewis.com).
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