Take the twist out of ‘death spiral’ convertibles
The so-called “death spiral” convertible bonds that lie at
the heart of the proxy battle at Magnus Energy may be a wake-up call for all
stakeholders.
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Kenneth Lim
28 April 2016
The so-called “death spiral” convertible bonds that lie at the heart of the proxy battle at Magnus Energy may be a wake-up call for all stakeholders.
Regulators must ensure that the holders of such instruments are not skirting rules about control of a company; independent directors must ensure that disclosures to shareholders are explicit about the risks of such instruments and be transparent about why the bonds are necessary in the first place; and shareholders must learn to recognise death spiral convertibles as bad news.
What are death spiral convertibles? In a typical convertible, the conversion price is fixed, which means that the potential dilutive impact of the convertibles is known and limited. In death spiral convertibles, however, the conversion price is based on a formula that assures a discount to market. This not only protects the bondholder against a tanking stock price, but it also creates an increasingly dilutive effect with each round of conversion. When such convertibles are issued in large amounts by a company, or when the conversion prices are set at large discounts to market, the transactions can be devastating for the underlying stock price. Hence the “death spiral”.
Magnus Energy entered into a deal in 2014 to issue up to S$35 million of such instruments to a little known investment firm called Value Capital Asset Management. In Magnus’s case, Value Capital gets to turn the bonds into stock at a 10 per cent discount - the maximum allowable under Singapore rules when conversion prices are not fixed.
A group of Magnus minority shareholders want to stop Magnus from issuing any more of those convertibles. The company has an option to require Value Capital to buy the remaining S$15 million of convertibles not yet issued, and the shareholders want to make sure that the option is not exercised. So they have requisitioned an extraordinary general meeting to remove all of the current directors of Magnus and to appoint their own nominees. The shareholders’ meeting takes place on Friday.
The grumbling about the convertibles is not without cause. Value Capital converts some of its bonds into shares many times a week and invariably sells them. The dilution from issuing new shares at a discount plus the selling pressure have weighed heavily on Magnus’s share price. Before the convertible deal was announced on Sept 3, 2014, Magnus’s shares were trading at the equivalent of 65 Singapore cents, adjusted for a 2015 consolidation. The shares were last traded at 0.2 Singapore cent on Wednesday.
Proceeds
Death spiral convertibles are fundamentally tilted against existing shareholders, but they exist for a reason. Typically, companies that issue such instruments are in urgent need of funds and have few better alternatives, so the convertibles do provide last-resort funds.
But it is not obvious that Magnus was in such dire straits when it agreed to the convertible deal, or even if it were, whether it is still in that position today.
In all of its disclosures since 2014, Magnus has consistently declared that it has sufficient working capital for “present requirements”. Indeed, as at end-December 2015, the company had S$7.4 million of cash and bank deposits.
Magnus has instead used most of the proceeds from the convertible deal to make investments. As at Feb 3, 2016, about S$8.3 million of the S$14.5 million of convertibles issued had been used for strategic investments. The high cost of financing should be considered when analysing the returns on those investments. Magnus may want to reconsider whether it makes sense to use such expensive funds for those purposes. The company’s directors should address this point with shareholders.
Impact
That just one transaction by Value Capital could have such a large impact on key shareholder decisions raises questions about whether Value Capital should have been considered a substantial shareholder in the first place. Although Value Capital and Mr Lee have been careful not to cross the 30 per cent trigger for a mandatory general offer for the rest of the company, the fact remains that the convertibles held by Value Capital give it an incredible amount of sway should it choose to exercise its well-in-the-money conversion options.
By law, option holders are not considered shareholders until they actually exercise their options, but regulators should consider whether existing rules provide enough safeguards for minority investors. The issue is not confined to Magnus. Value Capital has also entered into similar convertible deals with Annica Holdings, ISR Capital and LionGold Corp.
Another major player in the space, Advance Capital Partners, has offered similar financing deals with Attilan Group (the former Asiasons Capital) and Elektromotive Group. Many of these companies were involved in the 2013 penny stock crash.
SGX head of listing compliance June Sim told The Business Times that convertibles “are a source of funding available to companies depending on their needs”.
The listing rules essentially provide protection by making sure that significant issuances receive shareholder approval and that companies provide enough information for shareholders to make an informed decision.
It may be worth seeing if more can be done. After all, Magnus’s shareholders approved the deal two years ago.
Lawyer Adrian Chan of Lee & Lee said of such structures in general: “These ‘death spiral’ convertibles that force the issuer to take on share price risk rather than the bondholder may be so dilutive to minority shareholders that there may need to be some safeguards built into our regulatory framework to protect the interest of the minorities. Although shareholders have to approve the issuance of such convertibles in the first place, it is doubtful that the real effect and downside risk is completely appreciated by the investors.”