Convertible Debt Financings: Fixed Conversion Prices and Downward Turns in Market ValueWednesday, April 22, 2020
Read online or download the full update here.
Convertible debt financings in both the private and public markets have become increasingly common in recent years. One of the key characteristics of a convertible debt financing, determined at the outset of the deal, is the price at which the debt will be convertible into equity or the “Conversion Price”, which may be: (i) fixed, (ii) floating, or (iii) a combination of fixed and floating.
The ongoing comprehensive study conducted by Wildeboer Dellelce LLP of convertible debt deals completed in Canada over the past 21 months (the “Study”) provides insight into the relative use of fixed versus floating Conversion Prices.
Private companies typically either use a conversion price based on a negotiated “valuation” (given the lack of transparent market for their equity) or use a floating conversion price that is tied to a discount to the pricing of a “qualified financing” the company expects to complete in the future.
This article focuses on publicly-traded corporations which, as you will see, typically favour a fixed Conversion Price (presumably, at least partly due to restrictions contained in the policies of certain stock exchanges).
Convertible debt deals with a fixed Conversion Price set a static dollar value at which the debt may be converted into equity, which is set at a premium to the trading price of the underlying equity securities at the time the deal is announced. The Study shows that the median premium by which the conversion price exceeds the share price at the time of issuance of the convertible debt is 25%, but premiums range widely. Any incentive on the part of the holder to convert is contingent on the value of the underlying equity securities increasing from the date of announcement beyond the premium pegged as the fixed Conversion Price. If the trading price of the underlying equity securities remains stagnant or decreases over the term of the convertible debt, the conversion feature will be out of the money and the holder would simply hold the debt to maturity.
By contrast, when the conversion rate “floats”, the Conversion Price is not set at the outset. Rather, these instruments provide for a Conversion Price equal to a future price; typically, a discount to the volume weighted average price (“VWAP”) of the underlying equity securities in effect at the time of conversion— and, in some cases, with a floor price.
The third mechanism that may be used in setting a Conversion Price is a hybrid of fixed and floating, often predicated on the lesser of (or, in some instances, the greater of): (i) a fixed dollar value, typically representing a certain premium to the VWAP at the time of issuance of the convertible debt; and (ii) a floating dollar value, based on the VWAP at the time of conversion.
Depending on the applicable stock exchange on which the equity securities of the relevant issuer are listed for trading, applicable exchange policies may preclude a Conversion Price that floats downwards and/or a hybrid Conversion Price based on a “lesser of” formula.
What Happens if the Stock Trades Down?
As mentioned above, the Study revealed that the vast majority of reporting issuers (or “issuers”) that have pursued convertible debt offerings in the past 21 months have opted to (or been required to) fix the Conversion Price, with only approximately 15% of those issuers using a floating Conversion Price. The implication of this statistic is that many issuers are, or will soon be, facing a problem; that is, where the value of the underlying equity securities has decreased following the issuance of the convertible debt instrument, leaving holders out of the money. Unfortunately, share price declines have been a pervasive trend with cannabis issuers—frequent users of convertible debt instruments as a financing tool—over the latter part of 2019 and into 2020 and now, with the onset of the COVID-19 pandemic, this is something that issuers across all industries are facing. The result is that “underwater” convertible debt instruments will likely run to maturity, at which point in time the issuer will need to pay the debentureholders out (assuming it has the liquid resources to do so) or seek to restructure or refinance the debt.
To compound the problem, it is not typically a simple process to amend the Conversion Price down to reflect the new market reality. In some circumstances, the amendment of the terms of a convertible security may be considered to be a distribution of a new security under applicable securities laws, and thus require a prospectus exemption. Further, most convertible debt instruments, particularly convertible debenture indentures where there is a broad base of holders, provide a somewhat cumbersome process for any proposed amendment to the Conversion Price. This is in contrast to the amendment mechanisms that are often provided under warrant indentures, which typically allow for a simpler modification process (importantly, without the requirement of the approval of holders) in the event that, in the opinion of legal counsel, the modification to the indenture does not prejudice any of the rights of the holders. Such a provision allows issuers to relatively painlessly amend down the exercise price of outstanding warrants if the market price of the underlying securities has decreased, subject to stock exchange approval.
However, an equivalent provision is noticeably absent from the vast majority of convertible debenture indentures. This is understandable, given the nature of the instrument; holders of debt are typically less willing than warrantholders to allow for a fairly open-ended amendment provision that the issuer can utilize absent holder consent. The upshot is that most convertible debenture indentures require the passing of an “extraordinary resolution”—generally being the approval by holders of not less than 66⅔% of the aggregate outstanding obligations—in order for a fixed Conversion Price to be amended down. While debentureholders are unlikely to object to a downward adjustment to the Conversion Price, the process of obtaining the requisite approval can be time consuming and costly.
In addition, the relevant stock exchange on which the underlying equity securities (and/or the debt securities themselves) trade will have its own set of rules and regulations pertaining to the amendment of convertible securities. For instance, the Toronto Stock Exchange (“TSX”) Company Manual provides that a decrease in the Conversion Price of a previously issued convertible security must be submitted to the TSX for approval and will be reviewed as a new private placement, and the TSX Venture Exchange Corporate Finance Manual sets out a number of preconditions that must be met in order for an issuer to be able to amend the terms of a convertible security.
Issuers (and their advisors) would do well to take a somewhat cynical view and contemplate a potential downturn in the price of their underlying equity securities when structuring a convertible debt instrument. If the trading price falls below the fixed Conversion Price, absent an amendment to the Conversion Price, issuers will be forced to either: (i) pay out the debt at maturity, which the issuer may not be able to do, (ii) restructure, or (iii) refinance. The process that must be followed by an issuer to amend the Conversion Price can be cumbersome and complex, typically requiring both the requisite debentureholder approval, as determined by the convertible debt instrument, and approval from the relevant stock exchange on which the underlying equity securities are listed for trading.
Some of these complications can be avoided by opting for a floating or hybrid Conversion Price at the outset of a deal, and/or allowing greater flexibility in the amendment provisions, but this may not be permitted by the applicable stock exchange. Naturally, a Conversion Price that floats will cap the upside of investors (though this can be avoided by going the hybrid, “lesser of” route, if permitted by the applicable stock exchange) and would result in greater dilution to existing shareholders in the event of a market price decline.
As well, providing greater latitude to amend the instrument comes with its own set of risks, and doing so may be moot if the policies of the relevant stock exchange preclude, or impose significant hurdles to, amendments to the Conversion Price in any event.
Finally, issuers will need to consider the securities law implications of any proposed amendment, including whether insiders of the issuer hold an interest in the debt instrument, and whether the amendment could be considered to be a distribution of a new security, and thus require a prospectus exemption.
All to say, various competing interests, as well as applicable securities laws and the policies of the relevant stock exchange, will need to be considered in the specific context.
The Study conducted by Wildeboer Dellelce LLP situates the firm in a unique position to be able to provide clients with the benefit of readily available statistical analyses to determine what terms and provisions are “market” for a convertible debt deal, as well as how to mitigate against the potential challenges inherent in a convertible debt financing, both pre-closing and as maturity approaches. We would be happy to help you work through the structuring of a proposed debt instrument at the outset of a deal, and/or discuss your options as related to amending an already outstanding instrument due to changes in circumstances that may have occurred since issuance.
This update is intended as a summary only and should not be regarded or relied upon as advice to any specific client or regarding any specific situation.