New Regs for Deadly Convertibles?
Turbulent markets are creating a chilly capital environment for some small growth companies, especially cash-poor enterprises in turnaround situations. So, more of them are turning to a complex type of convertible preferred shares that is starting to raise eyebrows at the National Association of Securities Dealers (NASD).
In these deals, preferred shares are issued to investors, who may convert the shares into an unspecified number of newly issued shares that depend on the stock’s market price at the time of conversion. The securities are considered by many a financing tool of last resort for troubled firms, which find these deals can attract the capital of risk-tolerant investors looking to make a quick killing in the market.
But the deals can ultimately destroy a company’s stock, which has earned them such epithets as “death spirals” and “toxic convertibles.” That’s because if the common price at conversion is lower than at the issue date, the company must issue additional stock to cover the deals-sometimes significantly diluting the stock’s market value, attracting short-sellers, and straining the stability of already shaky issuers.
Enter the NASD. “We’re looking at these securities and trying to decide what, if any, regulatory action is warranted,” says David Irwin, director of listing-qualification hearings at Nasdaq. He says the regulatory body might increase the amount of disclosure related to the securities or simply notify the issuers of their dangers.
But many defend floating convertible preferreds. “Properly structured, they can be a great way for a company that has good prospects coupled with a liquid stock to raise capital,” says Alexander Cappello, CEO of Cappello Group Inc., a Santa Monica, Calif., merchant bank. He argues that with the right restrictions and protections-such as stipulations against short-selling, restrictions on conversions and sales, and the ability to substitute cash for stock at conversion- issuers can avoid many of the problems associated with floating convertibles.
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