Conversion - Corporate Bonds and Credit Agreement

Conversion

Copeland & Weston, Convertible Bonds

Pittsburgh Terminal v. Baltimore & O. Ry., 680 F.2d 933 (1982) (P. #1)

BMS Indenture, Section 2.10, 2.14, 11.01-11.03, Exhibit A, Section 7 and 10

Brightpoint Indenture, Exhibit A-2, Section 5, 6, 7, 9

Jamie Securities v. The Limited, 880 F.2d 1572 (1989) (P. #1)

Model Simplified Indenture, Section 10.01-10.05, Exhibit A, Section 9

Lennar Indenture, Section 11.1, 11.2, Exhibit A

Problem Set 5

Conversion: convert a certain principal amount to a certain amount of company shares

• Conversion rate/ conversion price

  • Fractional shares, e.g. 10k principal to 50 shares

• Economics of Conversion

  • Value if converted today what is the value of the stock will you get?

  • Waiting until last day more likely the value may change

    • + payments receivable if no conversion

    • - payments receivable if conversion

    • Longer time, the more valuable: because longer the time period, more changes will happen

    • Generally beneficial to wait

  • Option value = difference between value if one has to make the conversion decision now and value if one can wait to decide

  • What determines ‘optional value’

    • “Option Value” (as I use term) is the additional value of a conversion option that derives from fact that one does not have to decide now whether to convert.

      • How much you gain extra by not forcing to decide now

      • E.g. if value of stock is 20 + option to decide now unless value goes up 10 times (unlikely) option will have value of 0

      • If value of stock is 2000 + option to decide in a year would not want to convert unless the stock price goes 10 times higher than the value additional value of this option is not high

      • Option for a year to decide 50% that value of stock will decline keep bond and get 10K; 50% value will increase will make money

  • “In the money value” is value of conversion option if one had to decide NOW whether to convert

    • To convert now, option would have no value the longer the time period the more change can happen the more additional value because you don’t have to decide today

  • Also, If do not convert on a convertible bond, you get interest on the bond (if converted get dividend on stock) but for most convertible bonds, the interest is higher than dividend – so bondholder would not want to convert early

• Option value derives from possibility that one will make different decision

  • How much time to decide?

    • Longer time higher chance to change higher value

  • How close is the current stock price to breakeven point?

    • Closer to breakeven less additional value

  • How much does stock price fluctuate?

    • If stable won’t change much within a year less value

Consider the Lennar Indenture - Section 11.1, 11.2, Exhibit A

1. Assume that $10,000 principal amount of Lennar Notes are being converted, that the market price of Lennar stock is $30. What does the Holder of the Notes receive upon conversion?

2. Andrea is the holder of $50,000 principal amount of convertible Notes. The value of these Notes based solely on the right to receive interest and repayment of principal (i.e., the value absent the conversion right) is $50,000. If Andrea converts the Notes today, she would receive common stock with a market value of $53,000. Should Andrea convert? What facts, if any, would you like to know before giving advice to Andrea?

Consider Pittsburgh Terminal v. Baltimore & O. Ry

3. How and why did the dividend declaration hurt bondholders? How does the approach taken by Judge Gibbons and Judge Adams compare to the approach taken by the Van Gemert Court?

• B&O convertible bonds

• Company on 12/13/77 declares in-kind dividend with same date as Record Date

  • Why? So that holders cannot convert in time to receive dividend.

  • Why worry? If enough holders convert, B&O would have to file registration statement

• Holders sue for violating 10b-5. Question is whether company had duty to speak. Three opinions

  1. Duty under NYSE rules, Rule 10b-17, state law fiduciary duties, and good faith duty under NY contract law

  2. Duty under Rule 10b-17 – dividend “related to” bonds

  3. No duty since contract silent; no fiduciary duty; no breach of good faith; 10b-17 “related to” mean “on”

• C.f. Van Gemert Court aimed to fix the wrong If notice of the MAC transaction had been given to convertible debenture holders prior to the record date of the in-kind dividend, many of them might have elected to convert

Consider Jamie Securities. [1:07]

4. Which clauses does the court discuss? Which clause account for the outcome? How does the Circuit Court analysis differ from the District Court’s?

• Conversion was in the money (i.e. call option's strike price is below the market price of the underlying asset; or that the strike price of a put option is above the market price of the underlying asset make sense to convert)

• Convertible bond called for redemption on a date between interest record date and interest payment date (the ‘window’ period) and the Holders need to decide whether to convert

• Timeline: Interest record date conversion date redemption date (didn’t happen as converted) interest payment date

• Converted prior to redemption date (payment date) do record holders get interest?

Court looked at 3 provisions:

1. Wash clause implies recordholder gets interest

   • “Absent redemption, if holder converts in window, converting holder must pay interest to company”

   • i.e. If there is no redemption, and the holder convert between record date and redemption/payment date, the holder must pay interest to the company

   • implies if converted before redemption date (no more redemption date), the record holder gets interest

2. No payment clause record holder doesn’t get interest

   • “No payment or adjustment will be made for accrued interest on converted security”

3. Cancellation clause record holder gets interest

   • “Interest must be paid to record holders despite cancellation before payment date”

   • 2.12 cancellation includes conversion or payment (which includes redemption) between record date and payment date

• District Court: record holders get interest

  1. Wash clause does not apply here [since it only applies without redemption], though consistent

  2. No payment clause only relates to calculation of conversion rate (and payment for fractional shares)

     • Prof: not convincing to only look at principal amount and not accrued interest when determining how many shares you get when you convert

  3. Cancellation clause controls

• Circuit Court: record holders do not get interest

  1. Wash clause does not directly apply;

     • No notice for redemption + without redemption, would get interest if you convert

     • In any case, it was inserted at last minute, perhaps by mistake

       • [Prof: not convincing]

     • Prof: What if there is conversion in window and no redemption?

       • Wash clause implies holders get interest.

       • There is no redemption, so cancellation clause should apply. But no payment clause does not differentiate and suggests no interest is paid.

  2. No payment clause controls

  3. Cancellation clause is inapplicable

     • Redemption notice eliminates all subsequent record dates, so cancellation clause is inapplicable

     • Once Securities is called for redemption, notice of redemption makes securities payable on redemption date eliminates all subsequent record dates

     • Prof: never heard of this idea, doesn’t make sense

       • Court thinks the timeline is: notice of redemption record date redemption date

       • Should be: Notice of redemption date record date (15 days later) interest payment date redemption date (30-60 days after redemption date)

       • What if redemption date is after interest payment date (e.g. Notice 1/10, record date 1/15, payment date 2/1, redemption date, 3/10). Does company not have to pay interest on 2/1?

Wash clause is common in indentures, added from a different indenture

• Why do we have the wash clause (absent redemption, holder pay interest, implying you get interest and pay it back but why not just say holders don’t get interest?)

  • Because bonds may be sold between record date and Conversion Date

  • Record holder gets interest sells bond to Converting holder (taking into account the interest when deciding the price of the bond)

  • To facilitate transaction, need to know for sure whether you get interest on record date

  • Without redemption (wash clause applies) if bond is converted, record holder would get interest

    • Converting holder must pay interest to the record date holders, but it also must be returned on a conversion occurring between record and conversion date

    • Money A1 B A2 (but A2 holder may not be identical to A1)

  • 2 Options:

    1. Co. pays interest to record holder converting holder doesn’t get interest wash clause not required

    2. If conversion between record and payment date co. need not pay interest if record holder sells the bonds record holder will not know if buyer will convert

       • If buyer convert, they would do not get interest;

       • if buyer did not convert and they would get interest

Record holder don’t know price wash clause required Company doesn’t have to pay interest preserving recordholder’s entitlement to interest

• Wash clause preserve record holder’s entitlement to interest: by

  • (1) record holder gets interest; or

  • (2) record gets interest + wash clause

Cannot just say: company doesn’t pay interest if converted

• 4 possibilities:

  1. No conversion, no redemption record holder gets interest

  2. Conversion, no redemption record holder gets interest

  3. Redemption and no conversion interest goes to holder on redemption date or

  4. Redemption and conversion Jamie Securities

[March 06]

5. Assume the same fact pattern as in Jamie (call and conversion in the period between the record...