Making Sense of “Death Spiral” Convertibles

Focus on “death spiral” convertibles – which are essentially convertibles without a fixed conversion price – sharpened recently after a bondholder triggered unusual volume movements in the shares of LionGold and Magnus Energy by converting its bonds into shares below market price and selling huge quantities of these converted shares thereafter. In response to the situation, the Singapore Exchange (“SGX”) has released an article to highlight the risks of such convertible instruments, as well as the disclosure requirements expected of a listed company intending to employ such method of financing.

Due to their hybrid nature, convertible instruments are an attractive form of financing and investment for companies and investors, respectively. Companies can typically raise relatively large amounts of financing at the outset since subscribers will pay a principal amount upfront for the convertibles. Over the term of the convertible, subscribers may earn interest and can be entitled to “exercise” the convertible in accordance with its terms, thereby converting all, or a portion of it, into ordinary shares. It is relatively common for the conversion price to be paid to be fixed throughout the term of the convertible. As such, subscribers will probably be inclined to “exercise” the convertible when the market price of the shares exceeds the conversion price as this raises the underlying value of the convertible.

However, there exists a type of convertible in which the conversion price is not fixed, and is instead, “floating”. Unlike a typical convertible instrument, the conversion price of such convertibles is pegged to, and is almost always lower than, the prevailing market price of the shares at the time of conversion. Consequently, the subscriber is essentially insulated from any decrease in the market price of the shares – any decrease in market price causes a corresponding decrease in the conversion price which results in an increase in the number of shares that the subscriber will obtain upon conversion. Where there is a sustained decline in the market price of the company’s shares, it can become appealing to the subscriber to keep “exercising” his convertibles and selling the shares thereby received to lock in a profit. The influx of new shares dilutes the share price, which then gets further eroded with each round of conversion and share sale by the subscriber. Thus, such convertibles are known as “death spiral” convertibles.

Risks of “death spiral” Convertibles

There are several risk factors a company should consider when contemplating the issuance of “death spiral” convertibles. For one, the continual erosion of the share price due to repeated rounds of conversion and share sale may accentuate the company’s difficulty in obtaining other forms of financing or carrying out further fund-raising. Additionally, companies normally have to bear significant upfront fees for the structuring of such convertibles, and may also incur huge break fees for any termination of the convertible agreement.

Why Issue Convertibles with a “floating” Conversion Price?

Despite the risks associated with “death spiral” convertibles, there are several strategic factors a company may take into account when considering whether to issue such convertibles. For cash-strapped companies, convertibles with a “floating” conversion price may sometimes be the fastest way of raising funds, or even be the only viable source of financing. Even for companies with relatively healthy profiles, the increasing challenge of gaining access to capital can mean that issuing such convertibles, which are arguably more enticing to investors due to the protection they offer against price fluctuations, becomes discussion-worthy. Further, for companies with low liquidity, the relevant risks associated with “death spiral” convertibles may be less acute. The “death spiral” could also be tempered by setting a “floor”, or minimum conversion price.

SGX’s Disclosure Requirements

In its recent regulator’s column, SGX sets out several disclosure requirements expected of listed companies intending to raise financing through the issuance of convertibles with a “floating” conversion price.

In particular, if a company intends to issue such convertibles with a conversion price at a discount of more than 10% of the market price of the shares at the time of exercise, or if the maximum number of shares to be issued exceeds the prescribed limits under the general share issuance mandate, the company will not be able to issue such “death spiral” convertibles by way of a general mandate. The company must convene a shareholders’ meeting to specifically vote on such convertibles and the related new share issuance.

In the circular to be issued to all shareholders, the following disclosures shall need to be made:

1. the minimum conversion price and the maximum number of shares which can be issued upon the “exercise” of such convertibles;
2. a warning at the front of the circular to draw shareholders’ attention to:
   • the features and risks associated with the issuance of the convertibles;
   • the rationale for the issuance of the convertibles as a form of financing and the use of proceeds;
   • the basis for the discount to the market price at the time of the conversion;
   • whether the board of directors of the company had sought alternative sources of financing and the outcome of these exercises; and
   • the opinion by the board of directors of the company that the issuance of the convertibles is in the interest of the company and its shareholders; and
3. the terms of the convertible agreement, including any restrictions and pre-emptive rights, as well as the upfront fees and possible break fees.

Concluding Remarks

While the risks associated with “death spiral” convertibles should not be discounted, a company’s source of financing is ultimately a commercial decision best made by the company after considering the various sources of funding, its business needs and financial circumstances. Although risky, issuing convertibles with a “floating” conversion price remains a viable source of financing which companies might want to consider if the situation fits.

This article is written by Wong Gang from Shook Lin & Bok LLP.

This article does not constitute legal advice or a legal opinion on any matter discussed and, accordingly, it should not be relied upon. It should not be regarded as a comprehensive statement of the law and practice in this area. If you require any advice or information, please speak to practicing lawyer in your jurisdiction. No individual who is a member, partner, shareholder or consultant of, in or to any constituent part of Interstellar Group Pte. Ltd. accepts or assumes responsibility, or has any liability, to any person in respect of this article.