Sunday, January 10, 2016

Regulatory strategy for convertibles

by Bhargavi Zaveri, Radhika Pandey and Shivangi Tyagi.

Convertible securities (such as convertible bonds and preference shares) are interesting to issuers as well as investors. They are attractive to issuers because (a) when compared to debt which cannot be converted into equity, they involve lower coupon rates; and (b) when compared to equity, they postpone the dilution of existing shareholders to a later date, with the possibility that the holder may not convert her debt at all. They are attractive to investors because (a) they give a possible upside by conversion into equity if the issuer does well; and (b) in a country with poor bankruptcy outcomes, they allow the holders of quasi-debt to convert it into the equity of an asset-heavy company, own the assets and sell them to recover their money.

Currently, the Indian securities regulatory framework governing issuance and listing of convertible securities, does not comprehensively govern convertible securities.1 Motivated by this concern, on December 1, 2015, SEBI issued a discussion paper inviting comments on the regulatory framework governing the issuance and listing of convertible securities. The Discussion Paper, among other things, raises the following questions:

  1. Should the price of convertible securities be pre-fixed or market-linked? Alternately, should the price be fixed or based on bids received under a book building process?
  2. Should offer for sale of convertible securities be permitted?
  3. Should convertible securities be treated as debt or equity?

At NIPFP, we have written a response to the discussion paper, where we recommend:

  1. That a regulatory framework governing issuance and listing of securities must be agnostic to the nature of the security; and
  2. That convertible securities are not debt.

    Regulatory framework for issuance and listing of securities.

    State intervention in this field, in the form of prescribing a maximum or minimum tenure for a kind of security and pricing methods of securities, cannot be traced to any failure in the market for securities. However, given the nature of convertible securities, a market failure that that can arise is based on the information asymmetry between:

    1. The issuer and subscribers of such securities, where the subscribers are not clear about the terms and conditions of conversion; and
    2. The issuer and the shareholders, where the shareholders of the issuer are not aware of the extent to which they will be diluted upon conversion of the securities.

    This market failure can be resolved by mandating appropriate disclosure standards for convertible securities, which may be different from those mandated for equity and pure debt securities. Issuers are best placed to determine the terms and conditions on which they will borrow money, and subscribers are best placed to decide what price to pay for securities with the given terms and conditions. Hence, the regulatory framework for issuance and listing of convertible securities must not seek to regulate the terms and conditions of such securities.

    Regulatory frameworks of mature financial jurisdictions (including EU, UK and Korea) do not treat convertible securities as a special class of securities and apply different rules to them. These frameworks do not dictate the terms and conditions for their issuance or conversion.

    Are convertible securities debt or equity?

    Convertible securities must not be treated as debt securities, since their price depends on the price of the equity shares into which they may be converted.

    A convertible security is a combination of a bond and a warrant. The price of the convertible security is dependent on the price of the warrant, which is, in turn, dependent on the price of the underlying shares that are created when the warrant is exercised on the company.

    When a person subscribes to a convertible security, he factors in a return that he will get upon converting or not converting the security into equity shares of the issuer. Thus, the return on the security is not fixed, which is one of the inherent features of a debt instrument. The return is intrinsically linked to the performance of the issuer, which determines the decision to convert or not convert.

    Our response to the Discussion Paper explains the mathematics for determining the price of a convertible security, showing that the price of such a security is dependent on the price of the warrant, which, in turn, is dependent on the price of the underlying shares. This is standard material which is covered in graduate level finance textbooks. Convertible securities are akin to equity and not to debt.

    The authors are researchers at the National Institute for Public Finance and Policy.

    1. The SEBI (Issue and Listing of Debt Securities) Regulations, 2008 do not apply to convertible debt. The SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 restrict the tenure of convertible instruments to 18 months (a) where the proceeds of such instruments are to be used for financing of group companies or (b) where the securities are issued through a preferential allotment. The regulations restrict the tenure of convertible instruments to 5 years in case of qualified institutional placements. Back

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