Settlement Methods

This choice is typically driven by accounting considerations/implications. Standard options include:

  • Full physical settlement (the issuers delivers shares upon conversion);

  • Cash Settlement (the issuer delivers the value of the shares in cash);

  • Flexible Settlement (“instrument X”) - the issuer can choose to deliver physical shares, cash, or a combination thereof;

  • Net Share Settlement (“instrument C”) - the issuer must deliver the principal amount in cash and may use cash, shares or a combination thereof for the remainder.

SEC-Registered Issues vs. Rule 144A

“Well-known Seasoned Issuers” (“WKSIs”) - public companies with a market cap in excess of $700m may use an automatically effective SEC shelf registration statement to issue convertible securities. There is no delay in SEC review.

If a non-WKSI does not have an effective SEC shelf registration statement covering convertible securities, the issuer can use Rule 144A, allowing for fast execution and to avoid SEC review. Rule 144A also exempts issuers from Regulation M, which can be helpful in managing dilution and offsets short selling by hedged investors, because it allows issuers to buyback shares concurrent to the issue.

Fundamental Changes

Fundamental changes language, included in convertible bond prospectuses/indentures, allow investors to put their convertible securities to the issuer at par or greater, based on a “make whole” provision or table.

Fundamental changes include a change of control, disposition of “all or substantially all” assets of the issuer, or a transaction in which the existing stock is replaced by consideration that consists of less than 90% exchange traded securities, to give some examples.

Generally, owing to the loss of time-value-of-money, expressed as Theta, the further from maturity a change of control event occurs, the greater the premium paid to convertible investors.

Call Spreads

Issuers can offset their obligations under convertible security offerings - and manage equity dilution - by entering into over-the-counter derivative transactions, “call spreads”, with banks.

  • A call spread involved buying a call option on the underlying shares at the conversion price, offsetting the obligation to deliver shares or cash upon conversion.

  • The call option is subject to a cap price, hence “capped call transactions”, as commonly referred to in the US. The dealer does not deliver additional value to the issuer if the share price at conversion is above the cap price.

  • The issuer has synthetically increased the conversion price to the higher cap price, mitigation the dilution impact if notes are converted.