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Toxic convertibles: catalysts of doom or financing of last resort?

I Introduction

Among numerous financial innovations spawned during the 1990s were an exotic variety of floating-priced convertible securities known as "toxic" or "death spiral" convertibles. (1) These securities, which have been around for nearly a decade now, were heavily used by many of the now-failed dot-com firms, with E-Toys and Excite@Home.com being among the more well-known examples (Wengroff, 2001). Toxic convertibles have gained notoriety mainly due to their ability to harm existing shareholders and their contribution to firm demise.

Despite the doom experienced by many issuers, these instruments have not disappeared. While the market for these securities slipped in 2002-03 (coinciding with the generally sluggish market for private placements), there is currently a remarkable revival of interest in these securities as financing vehicles among smaller firms, despite the recent spate of negative publicity. (2) Given their relative newness and excepting the just-published, comprehensive study by Hillion and Vermaelen (2004) on their use, these securities have been sparsely examined and remain relatively obscure on the academic radar screen. Accordingly, this paper seeks to contribute to the literature on toxic convertibles by attempting: (1) to provide a description of their particular features; (2) to examine the rationale for their use in the context of theories of agency and information asymmetry in the corporate finance literature; and (3) to evaluate possible corrections to design flaws that would mitigate their most pernicious effects on issuing firms and make them viable sources of financing for some firms.

A floating-priced convertible is either a convertible bond or a convertible preferred stock (Hillion and Vermaelen, 2004). The security allows the holder to convert at a discount from a reference price, defined as "the lowest stock price or the average of a series of past stock prices in a look-back period." Floating-priced convertibles have two notable features: (1) a typical contract specifies a lock-up period during which conversion is prohibited, and (2) once the lock-up period expires, most contracts specify the maximum number of newly issued shares that can be sold in the secondary market as a function of the stock trading volume. These two characteristics assure that conversion into stock takes place over a period of time, at least several months after the issue announcement.

As with its more traditional variant, the "straight convertible," a floating-priced convertible may also be viewed as a form of delayed equity financing. The major distinction between the two lies in their conversion terms. Whereas in conventional convertibles the conversion price from debt to equity is set in advance, in the case of toxic converts the conversion price can be reset downward if the market price falls below the conversion price set at the time of issuance. The reset feature allows the conversion point to decline if the stock falls, thus forcing the company to issue more shares, causing dilution. Beyond the dilution, the investors--which often include professional short sellers and hedge funds--frequently sell the shares they have converted, forcing the stock price to decline even more. For this reason, the securities are known as toxic or death spirals, and are used only by companies in dire need of cash. The pejorative appellation suggests that firms issuing these securities are candidates for doom, at least in part because of the design of these securities.

The rest of the paper is structured as follows. Section II describes the salient characteristics of toxic convertibles, section III examines the rationale for the place of toxics in firm capital structure, section IV examines the pros and cons of toxics in the light of theories of agency and capital structure in corporate finance, section V identifies the winners and losers in these deals and, suggests remedies for inherent design flaws. Section VI reports on the current state of the toxic convertible and concludes.

II Characteristics of Toxic Convertibles

Toxic convertibles are a particular class of instruments called private investment in public equities (PIPEs). A PIPE is the sale of equity by a public issuer, either in the form of common stock or a fixed-price convertible. PIPEs in the form of common stock are typically sold at a discount to the market price. Usually these shares are registered for resale after the closing. According to PlacementTracker, (3) since 1995, there have been 6,904 PIPE transactions of which 1,846 (27%) were "structured deals" or death spirals. In terms of amount of capital raised over the same period, all PIPE transactions cumulatively raised about $98.2 billion, of which about $12.5 billion (13%) were of the "toxic" or "structured" variety. In general, smaller, cash-intensive, high-growth companies in the high-tech or biotech sectors have been the most common users of PIPEs.

Elias (2001) delineates the chronology of events surrounding a toxic PIPE deal as follows:

1. An embryonic venture goes public.

2. The new venture burns through all of its IPO capital and desperately needs more cash.

3. With profitability prospects receding, mainstream capital markets rebuff the company's plea for cash.

4. Private equity firms offer to infuse cash, receive death spiral convertibles, obtain steep discounts--as high as 30%--on common stock purchases, and reserve the right to sell the stock short.

5. In exchange for their cash infusion, these private equity investors receive preferred stock that can be converted to the discounted common stock, usually within 90 days. Notably, there is no "floor" on this provision, so that the more the price of the stock drops, the more common stock the company must issue to satisfy its obligation to the original investors in the "toxic."

6. The private investors begin to sell the company's stock short. As the stock price falls, their ownership stake increases.

7. Others, such as professional short sellers and individual investors, alerted by a volume increase in the thinly traded stock, jump on the selling bandwagon, thereby driving down the price even further.

8. The stock hits a low of $5, triggering sales by institutional investors and causing brokerages to stop research coverage.

9. The stock continues to plummet, and delisting appears inevitable.

10. The company converts the private investors' preferred stock into common stock at the current market rate, less an agreed upon discount of between 20% and 30%.

11. The private investors use newly converted common stock to cover their short positions, earning considerable profits.

12. The same investors sell off any remaining common stock they hold, or hold the shares for the inevitable liquidation or takeover.

13. In some cases, the private investors end up with enough stock to have a majority position in the company.

An example depicts the magnitude of gain that accrues to the toxic investor. (4) An institutional investor owns and is entitled to convert a debenture into $1.5 million worth of common stock. If the holder were entitled to convert the debenture into a fixed number of shares--say 500,000--he or she would have no incentive to see the stock price decline. If anything, the value of those 500,000 shares would increase if the stock price increased. The holder's motivations, however, might change if he or she receives more shares as the stock price decreases.

If the company's shares were trading at $5 at the time of issuance, the debenture holder might start by selling short 500,000 shares and realizing proceeds of $2.5 million. If, as with many micro-cap firms, the stock is not heavily traded, those sales could help drive the price of the stock downward. As prices fall to $3, the debenture holder can short another 500,000 shares and realize $1.5 million more. It need not stop there. When the stock decreases to $2 per share the debenture holder can short 500,000 more shares for another $1 million. At that point, this investor will have generated cumulative proceeds of $5 million from the short sale.

In this hypothetical situation, when the stock reaches $1, the debenture can be converted into 1.5 million shares. The debenture holder may then deliver those shares to cover the outstanding short position. For a $1.5 million investment, the investor winds up with proceeds of $5 million, for a $3.5 million, or 233%, profit. (5) "Companies would be very ill-advised to take this type of loan," according to David Beim at Columbia University's Graduate School of Business. "A death spiral precipitates a crisis." (Wengroff, 2001).

III Rationale for PIPE Issuance

The structure of PIPES offers public companies and investors a number of advantages over registered public offerings, including:

* Confidentiality and lower susceptibility to market volatility. Because PIPEs involve sales to a small number of sophisticated investors in private offerings and are not announced to the public until they are completed, the offerings are confidential and less subject to the general volatility of the public market than are registered public offerings.

* Offered discount vis-a-vis public offering price drop. Although PIPEs are typically offered at a discount to the current market price, the discount may still be less than the drop in the market price after a secondary registered offering is announced to the public, especially in an unpredictable market.

* Speed, absence of SEC review, and lower cost. PIPEs are faster and less expensive to complete than registered public offerings. A standard PIPE can be completed in two to four weeks, while a registered offering can take up to three months or longer if the SEC elects to review the filing.

* Savings on issuance costs. PIPEs eliminate the need for a road show to attract investors and avoid various out-of-pocket issue costs.

Some of the benefits to the PIPE investors include:

* Discount pricing. In a PIPE transaction, issuers often offer securities at a discount of 10% to 20% to the current market price, so investors may view this as a way to buy equity at a discount and potentially reap an immediate gain upon conversion.

* Public market liquidity. Once the resale registration statement is declared effective by the SEC, investors can resell the securities in the public market. To ensure immediate liquidity, investors will often insist on penalty provisions that require an issuer to make payments if the resale registration statement does not become effective within a prescribed period (typically 60 to 120 days after the closing of the PIPE transaction).

IV Toxic-Convertible Issuance and Corporate Finance Theory

The finance literature is replete with studies that show why convertible securities, as alternatives to both straight debt and equity securities, are appropriate vehicles for capital raising for risky, high-growth firms. Jen, Choi, and Lee (1997) document positive market reaction to convertible issues by highly levered and high-growth firms. Additionally, Jensen and Meckling (1976), Myers (1977), and Myers and Majluf (1984), show that convertible debt issuance is one way of reducing the conflict between debt holders and equity holders in a firm. Equity investors, due to incentives to take on riskier projects with new straight debt, can make existing bondholders worse off. However, if they do so with convertible debt, the convertible debt holders can always exercise their conversion options and become equity investors, thus arresting such distortionary incentives.

In the above light, floating-rate convertibles should represent a valuable innovation for highly risky growth firms, characterized by high agency costs of debt and high levels of information asymmetry. However, floating priced convertibles have received scathing criticism in the financial press as several companies that issued them have experienced spectacular price declines, averaging 34% following issuance. (6) The argument is that convertible investors have an incentive to short the stock prior to conversion. The resulting short-selling may push the stock below "fair value," especially since the typical issuer is a relatively small, thinly traded firm. As conversions take place at prices below fair value, the resulting dilution lowers the underlying value per share. Furthermore, the mere potential to lower the fundamental value of the stock when conversions take place below "fair value" attracts professional short sellers and hedge funds.

Investment bankers and others, on the other hand, who defend the use of the floating-priced convertibles, argue that the issuers have no other alternative. They argue that managers are unable to raise equity or sell traditional, fixed-price convertibles because the stock is overvalued given the firm's financial prospects. The subsequent price decline shows that the market gradually discovers the issuer's poor operating performance. So, it is the issuing firm, rather than the instrument, that should be the source of concern. Floating-priced convertibles offer a new lease on life and help companies survive in difficult times. Because the stock is overvalued at the time of issue, this argument holds that issuing firms experience negative abnormal returns after the announcement date. Empirical evidence in the Hillion-Vermaelen (2004) paper seems to be consistent with both explanations.

V Managerial Motivations, Winners, Losers, and Remedies to Contract Design

Table II shows the largest investors in floating-priced convertibles. While the obvious gains from the issuance of death spiral convertibles accrue to the holders themselves, the losses are dispersed over multiple stakeholders. The biggest losers are usually the company's original creditors. If most of the issuing companies are destined for business demise anyway, then the company should probably terminate its life while assets remain to pay off existing debts. In reality, however, after the "death ride" is over, there is usually nothing left, and the creditors are left with nothing. The common shareholders also lose. In addition to the often calamitous amount of dilution they suffer, the possibility that their stock will be worthless is very real. Unfortunately, most companies do not inform their common shareholders of such deals until long after they have been struck and the toxics issued. There is no regulatory requirement that issuing companies must warn their shareholders of such deals beyond their regular SEC filings, particularly if the issuing company's shares are traded on the OTCBB or the Pink Sheets. Therefore, when a company issues toxics immediately after completing its regular filing, shareholders may well remain unaware until the firm's next filing, which could be three to five months later. By then, the stock price may have plummeted.

A question that naturally arises in connection with the issuance of these toxic securities is that if management understands what happens with these "death rides," why do they sell them in the first place? As a conjecture, management may truly believe that the capital raised through a toxic convertible will be enough to save the company ("prettiest baby syndrome"). This is when the management thinks that their company is such a good investment that the toxic buyer will not (want to) short the stock but instead hold it through conversion. Evidence suggests that such expectations are in vain.

Based on agency theory, one can argue that if the managers of an issuing company genuinely believe that the issuance of toxic convertibles was the company's only hope, then there may be ways to "bond" themselves to their firm. One possibility is for management to either accept no salary or benefits or cap them to pre-issuance levels, until the convertibles are extinguished. Company management could also "lock-up" every share, warrant, and option they hold, directly and indirectly, to prevent themselves from cashing in until the convertibles are extinguished. Finally, if management is convinced of the wisdom of seeking such financing, they should actively seek shareholder approval of the terms before the issuance. However, there seems to be no real call by shareholder groups to eliminate toxic convertible sales. (7)

Those who plan to issue adjustable convertible securities and are interested in avoiding the resultant wealth transfer from these sales may avoid falling into the death-spiral trap by using one or more of the following techniques:

* Restricting investors' and in particular purchasers,' ability to short-sell the stock. (8) Mere closing of this opportunity can significantly stem the downward spiral in prices, as short sales by professional investors tend to follow and not precede those by private, well-informed investors.

* Setting a floor on the conversion price. Given the propensity among toxic holders to realize quick, low-to no-risk profits, post-conversion, this measure caps the maximum gain from opportunistic behavior.

* Restricting the number of securities an investor can convert during any one period. An additional mechanism by which the problem of post-conversion short covering can be discouraged is to limit the number of securities an investor can convert in any given time period.

* Offering reduced discounts relative to the reference price. This measure seems to have significantly improved the long-term survival of issuers (Hillion and Vermaelen, 2004).

* Conducting due diligence on (or requiring disclosure of) prospective investors to determine whether they have participated in toxic financings. Given the extent of damage caused by private equity investors, experience with toxic financing should be required as part of due diligence on investors in these private placements.

Finally, recent investigations, by the Securities and Exchange Commission (SEC) into toxic convertibles helps to alleviate malfeasance associated with trading toxic convertibles. On February 27, 2003, the SEC announced a settlement agreement with Thomas Badian of New York-based Rhino Advisors. The settlement called for Badian to pay a fine of $1 million to settle claims that he had fraudulently engaged in large scale short selling designed to force down the price of publicly traded Sedona Corporation.

Thomas C. Newkirk, Associate Director for the Division of Enforcement, is quoted as saying, toxic convertibles "present the temptations for persons holding the convertible securities to engage in manipulative short-selling of the issuer's stock in order to receive more shares at the time of conversion," and said the $1 million penalty "shows the Commission's determination to address these abuses." (9) The SEC's aggressive action, while delayed and arguably isolated except in this instance, points to regulators' steps to curb excesses designed to manipulate stock prices. Therefore, increased regulatory oversight, accompanied by significant penalties associated with stock price manipulation, generally seems to follow excesses or weaknesses in the marketplace.

VI State of the Toxic Convertible and Conclusion

As reported on the finance.yahoo.com Web site under the headline "Sagient Research Reports Robust U.S. PIPE Market in 2004," (10) the prospects for PIPEs appear to have improved dramatically since mid-2003. The article quotes Robert F. Kyle, executive vice president of Sagient Research, as follows:
 "We are encouraged to see that the high
 activity rate in the PIPE market that began
 in the second half of the year is continuing
 into 2004. Should we continue at this pace,
 2004 will likely end up being the most
 active year for U.S. PIPE issuances since
 we started tracking this market in 1995. We
 believe that a combination of events is
 causing this high level of activity, including
 a recovering market for capital dependent
 companies in the technology and biotechnology
 sectors, increased liquidity in the
 micro, small and mid-cap markets, and
 institutional efficiency of PIPE market
 pricing and closing procedures that make
 completing a PIPE transaction faster,
 cheaper, and easier than current alternatives."


To the extent these comments relate to toxic convertibles, in particular, Hillion and Vermaelen (2004) attest to the same development. Some of the most egregious provisions that contribute to the toxicity of these instruments, such as the conversion discount, are beginning to fade. Investors should pay particular heed to contract design, and, in particular, to the size of the discount. On the other hand, Hillion and Vermaelen (2004) show that restrictive measures such as floors on the conversion price or short-sale restrictions, while removing one deficiency in contract design, appear not to be significantly associated with long-term improvement in issuers' operating performance. This may offer additional insight into why shareholders have not placed such restrictions on managers.

In summary, toxic convertibles represent a financial innovation that, through an iterative and--unfortunately, for many investors--costly process, has improved its design but is still used by the same types of firms as in the past. A study of characteristics of issuing firms reveals that they are small, risky, firms strapped for cash. The rationale for use of toxics appears to be driven by despair, ignorance, or both. However, with improvements in contract design, as outlined earlier, smaller firms in need of capital that cannot access the market for traditional securities are better positioned to consider issuing these securities; stripped of their most harmful characteristics, floating-price convertibles can be a legitimate financing source.
Table I Annual Floating Convertible Deals
(U.S. Based Companies)

Year Deals Amount

2004 121 $628,287,500
2003 74 $270,959,250
2002 129 $567,816,583
2001 233 $1,309,861,913
2000 394 $3,169,622,316
1999 194 $1,368,770,242
1998 243 $1,295,397,247
1997 261 $2,034,499,290
1996 162 $1,538,937,555
1995 35 $259,949,000
Total 1,738 $12,034,738,897

Source: PlacementTracker, September, 2004

Table II Largest Investors and Amount Invested
(Floating Convertibles--Since 1995)

Rank Investment Advisor Deals Amount Invested

1. Cornell Capital Partners, L.P. 106 $197,471,366
2. Fusion Capital Partners 41 $79,799,000
3. Dutchess Capital Management, LLC 36 $39,581,842
4. NIR Group, LLC 15 $25,500,000
5. Global Capital Advisors Ltd. 13 $24,030,000
6. Mercator Group (The) 11 $23,600,000

Source: PlacementTracker, September, 2004


(1) Other common, and mostly negative, ways of describing these securities include "floorless convertibles," "structured PIPEs (private investment in public equities)," "discounted convertibles," "lesser-of-convertibles," "junk equity," corporate loan-sharking," "payday advances," and "pawnshops for dot coms." See Friese and Raisi (1999).

(2) As Table I shows, the number of structured PIPEs in eight months of 2004 has already exceeded that for the entire calendar year 2003 and is nearing the volume in 2002. In terms of dollar volume, the amount raised in 2004 is already nearly two- and-half times the amount raised in 2003.

(3) PlacementTracker is "the preeminent provider of market data, research, and analysis on the PIPE (Private Investment in Public Entity) market. Launched in 1999 as a service of PCS Research Technology, Inc., PlacementTracker has become nationally recognized for its coverage of the PIPE market." It is a part of Sagient Research Systems. Source:// www.sagientresearch.com/pt/

(4) Source: "At Death's Door", March 12, 2002, StockPatrol.Com.

(5) Little wonder then that James O'Brien, founder and president of prominent death-spiral institutional investor, Promethean Asset Management, declared in the pages of a conference agenda that his $140 million fund has returned 126% since 1996, when it first began investing in this financing vehicle, (Elias, 2001).

(6) The Hillion-Vermaelen (2004) study reports this statistic for a sample of 467 firms during the 1994-1998 sample period, with 85% of the firms experiencing negative one-year post-issuance returns.

(7) This may not be as surprising as one might initially expect. The embedded option in these convertibles and the additional lease on life they offer the firm may be viewed favorably by shareholders, given the firm's highly risky pre-issue status that may be teetering towards bankruptcy. The author gratefully credits this argument to Professor Mark O. Tengesdal, paper discussant, at the 2003 SAM Annual Conference.

(8) In a recent example, Electric City Corp., in its 8-K SEC filing of convertible bond sale on September 11, 2003, included the following "No-shorting" clause: "The Purchaser or any of its affiliates and investment partners will not and will not cause any person or entity, directly or indirectly, to engage in "short sales" of the Company's Common Stock or any other hedging strategies."

(9) Source: OTC Journal, Volume VI, Issue 37, April 19, 2003.

(10) Source: Sagient Research Systems Press Release. Friday March 5, 8:00 am ET.

REFERENCES

Elias, P. (2001, April 1). Death by finance. Red Herring.

Elias, P. (2001, April 11). Toxic convert: A desperate, dangerous instrument. Red Herring.

Friese, R. C., and Raisi, J. P. (1999, February 15). Junk equity deals can harm stock. National Tax Journal.

Hillion, P., and Vermaelen, T. (2004, February). Death spiral convertibles. Journal of Financial Economics, 71(2), 381-415.

Jen, F. C., Choi, D., and Lee, S. (1997). Some new evidence on why companies use convertible bonds. Journal of Applied Corporate Finance, 10(1), 44-53.

Jensen, M., and Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs, and ownership structure. Journal of Financial Economics, 3,305-360.

Myers, S. (1977). The determinants of corporate borrowing. Journal of Financial Economics, 5, 147-175.

Myers, S., and Majluf, N. (1984). Corporate financing and investment decisions when firms have information that investors do not have. Journal of Financial Economics, 13, 453-476.

Wengroff, J. (2001, March 01). Floorless debt: The devil's candy. CFO Staff, CFO Magazine.

Dr Singh is the author or co-author of several articles on finance. He is co-director of Frostburg State University's Financial Planning Certificate Program, which prepares students to sit for the certified financial planner exam.

Sudhir Singh, Frostburg State University
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