Anti Dilution - Corporate Bonds and Credit Agreement

Anti-Dilution

Lennar Indenture, Section 11.6, 11.7, 11.10, 11.13

Broad v. Rockwell, 642 F.2d 929 (1981) (P. #1)

Overview

• Anti-Dilution Adjustments

• Dividend Formula

• Ender Offer Formula

• Warrant Formula

• Partaking Adjustment

Stock split

• an issue of new shares in a company to existing shareholders in proportion to their current holdings simplest way to reduce stock price (no one cares for convertible bondholders – screwing convertible bondholders to benefit shareholders)

• Value of convertible bond conversion option is already ‘in the money’

Gap between the two lines option value

• Only need a Notice Provision so convertible bondholder can convert before stock split (easy and cheap remedy)

  • c.f. hard provision: need to identify the actions that reduce company value + right remedy difficult to construct effective contractual protection, as it is difficult to specify which actions the holders would care about

Problem Set 6

1. Assume that the "Current Market Price" of Lennar common stock is $30 a share and that 10 million shares of common stock are outstanding. How is the initial conversion price adjusted in each of the events? Do these adjustments fully protect the economic interests of Lennar noteholders?

1. Lennar effects a 2 for 1 stock split.

Anti-Dilution Provisions

• If company does act + convert afterwards get something different than what you would have gotten if you convert beforehand change formula that determines what you get

  • To effectively protect the convertible holders shares they get immediately after conversion should be identical to what they get immediately before stock split

• 2 for 1 stock split effect on convertible holders absent adjustment

  • Reduces stock price by 50%

  • Reduces value of stock received upon conversion by 50%

• Adjustment? 11.06(a)

  • Condition “If the Company issues [additional] shares of Class A Common Stock as a dividend or distribution on shares of Class A Common Stock, or if the Company effects a share split or share combination…”

  • Adjustment “the Conversion Rate will be adjusted based on the following formula:

CR’ = CR(0) x OS’

OS(0)

• CR(0) = Old Conversion Rate

• CR’ = new Conversion Rate

• OS(0) = no. of shares outstanding immediately prior stock split

• OS’ = no. of shares outstanding immediately after stock split

New conversion rate = Old conversion rate x no. of shares immediately after stock split 2

no. of shares immediately prior stock split 1

= 2 (Old Conversion Rate)

• After adjustment, shares received would be doubled keeps value of shares received the same as prior to stock split.

2. Lennar pays a stock dividend of 30 shares of newly-created Class B common stock for each 1,000 shares of common stock. (Class B is identical to regular common stock, except that it carries no voting rights.)

• Dividend Formula

  • Most important formula for thinking about anti-dilution provisions. Where does it come from?

  • Goal: value of stock (or other consideration) should be the same if you convert right before or right after diluting event

  • Assumption: dividend reduces shares value by amount of dividend

  • Let

    • V = face value of bond

    • OCR = conversion rate before adjustment

    • P = share price before dividend

    • D = value of dividend

  • Value received if converted before dividend

    • V * OCR * P (number of shares times share price)

    • Face value of bond x conversion rate before adjustment x share price before dividend

  • E.g. convert $10,000 bond at rate of 40 shares/$1000 with stock price $30: $10,000*40/$1000*$30=$12,000

  • Value received after conversion

    • V * NCR * (P – D) (new number of shares times share price)

  • Dividend Formula: NCR = OCR * P / (P - D)

New conversion rate = old conversion rage x market price / (market price – dividend)

• Value received if converted after dividend

  • V * [OCR * P / (P - D)] * (P – D)

  • = V * OCR *P same as if converted before

• Take $10,000 bond at rate of 40 shares/$1000 with stock price $30: $10,000*40/$1000*$30 = $12,000

• Assume dividend of $6

• NCR = 40 shares/$1000 * $30 / ($30 - $6) = 50 shares/$1000

• Assume dividend reduces share price to $24

• Take $10,000 bond at rate of 50 shares/$1000 with stock price $24: $10,000*50/$1000*$24 = $12,000

• Main Formula: SP(0) / SP(0) – FMV

• Subsidiary Formula: FMV(0) + MP(0) / PM (0)

• What is relationship? Why two formulas?

• Dividend formula satisfies goal that holder gets same value if she converts before or after dividend given assumption

• Is this enough for full protection of value of conversion right? No

  • For full protection, one would also have to sure that future variability in what one converts into is unaffected

  • E.g., in (c), if LNC stock is much more variable than remaining assets, variability will decline

  • The higher the variability of what you convert into, the greater the value of a conversion right

  • Also, board has discretion in setting FMV

Lennar

• Stock Dividend (30 on 1000)

• Effect on convertible holders absent adjustment

  • Ignoring difference in classes, reduces stock price by about 2.91%

  • Lack of voting rights means reduction is smaller

  • Dividend Formula (see above)

    • 11.06(a) is applicable to stock split and stock dividends, consisting of Class A Common Stock

    • New conversion rate = Old conversion rate x (no. of shares after stock split)

(no. of shares prior stock split)

• This formula is simpler and better: no discretion or evaluation that can be abused

• All Class A Common Stock would have the same value

• 11.06(c) If company distribute shares of capital stock, evidence of Company’s indebtness or other assets or property or right, options or warrants to acquire the Company’s capital stock or other securities

  • This describe all types of dividends all subject to this formula

  • Except for what is taken out from the formula

    • (i) dividends, distributions, rights or warrant as to which such an adjustment was effected pursuant to s.11.6(a) and 11.6(b)

    • (ii) cash dividend subject to s.11.6(d)

    • (iii) spin-offs which the provision set forth below in this s.11.6(c)

CR'= CR(O) x SP(O) _ market price before

SP(O)-FMV market price after (market price before – dividend)

New Conversion Rate = Old Conversion Rate x (average sale price 10 days prior stock split)

fair market value of the shares

• Market price before - Dividend Payment = fair market value of shares

• SP(O) = market price beforehand

  • Average of the Last Reported Sale Prices of the Stock over 10 consecutive Trading Day period ending on and including the Trading Day immediately preceding the event that triggers adjustment

  • FMV = the fair market value (as determined in good faith by the Board of Directors) of the shares of capital stock, evidences of indebtedness, assets, property, rights or warrants distributed with respect to each outstanding share of the Class A Common Stock on the Ex-Dividend Date for such distribution

    • Value is determined in good faith by the Board of Directors, enemies of the converting bondholder, may want to pick a lower value for adjustment

    • Evaluation of dividend that will systematically produce an evaluation that is too low

3. Lennar pays a dividend per share consisting of 1 share of LNC common stock. Prior to the distribution, LNC was a wholly-owned subsidiary of Lennar and after the distribution, LNC will be traded on the New York Stock Exchange.

• 11.6(c) Spin Off Dividend

  • “Excluding spin-offs to which the provision set forth below in this section 11.5(c) shall apply”

  • Spinoffs (shares of subsidiary distributed to its shareholder the spun-off company would also be publicly traded – if you have a certain amount of shareholders, need to be publicly registered)

  • Effect on convertible holders absent adjustment

    • Reduces stock price by value of dividend

    • Corresponding reduction in shares received upon conversion

  • Adjustment Formula for spin-offs:

CR'= CR(O) x FMV(0) + MP(0) market price before (market price after + dividend)

MP(0) market price after

• FMV(O) = the average of the Last Reported Sale Prices of the capital stock or similar equity interest distributed to holders of the Class A Common Stock applicable to one share of the Class A Common Stock over the first ten consecutive Trading Day period immediately following, and including, the effective date of the spin-off; and

  • measure of value of dividend

• MP(O) = the average of the Last Reported Sale Prices of the Class A Common Stock over the first ten consecutive Trading Day period immediately following, and including, the effective date of the spin-off.

  • Not calculating something but looking at the actual market price after

• Why is the method of valuation of dividend are calculated differently in these two formulae?

  • Other than giving board of director’s discretion second formula is a more scientific way of determining amount of dividend than the first

  • Giving the board discretion may not be so ideal better to look at market price instead

  • Other ways of valuing dividend, e.g. cash dividend

    • E.g. a $5 dividend would worth $5, no need evaluation by directors

• Goal: keep value received upon conversion the same if you convert right before or right after the diluting event

  • formulae are aiming to protect the additional value you get from having another year or two to decide

  • whether would be worst off if you convert a year after the diluting event

• What generates the extra value?

  • Possibility that the stock price will change

  • If stock price will go up will make more money if you convert

  • If stock price goes down won’t convert and won’t lose a lot of money

• The extra value is determined on

  • How long a period do we have?

  • How much does the stock price change...