The struggles in meeting the new convertible bonds requirements

Author: | Published: 28 Jan 2003
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Many parts of the Japanese Commercial Code are being amended to meet the needs of Japanese companies. As a part of these amendments, stock rights and their restrictions were amended as of April 1 2002.

Before the amendments, issuers were able to issue various types of stock rights including stock options, warrants in warrant bonds and conversion rights in convertible bonds. However, many restrictions on these rights existed. Stock options could only be issued to an issuer's directors and employees. Stock options were not transferable and certificates representing the options could not be issued. In addition, the stock options had to be exercised within 10 years of the date of the special resolution approving the stock option plan. Even more limiting for the issuer was the requirement that the number of shares to be issued under all existing stock options, including the number of unissued shares under previous stock options, could not exceed 10% of the aggregate number of issued and outstanding shares. Warrants and conversion rights, on the other hand, had to be issued with certificates and attached to bonds. Warrants could be issued to any person. The aggregate issue price of the shares issuable upon exercise of the warrants could not exceed the face value of the warrant bonds.

The amendments abolished stock options, warrant bonds and convertible bonds. In their place a new concept was created that applies to general stock rights - stock acquisition rights (SARs). An SAR is a right requiring an issuer to either issue new shares or transfer shares held by the issuer to the holder of the right. SARs may be issued to any person in any number without an accompanying bond and there are no rules setting limits on the expiry date of the SAR.

However, the amendments require that an issuer must issue certificates representing the SAR either immediately after issuance or on the request of the holder of the SAR. SARs can be issued at the time of a loan drawdown or at the time of an issue of other securities such as bonds. The amendments also introduced a new concept of undetachable bonds with stock acquisition rights (BSARs). SARs contained in BSARs are similar to plain SARs. There is no limit on the aggregate issue price of the shares issuable or transferable upon exercise of SARs contained in BSARs. However, a bond and the SARs contained in a BSAR must be undetachable and certificates representing them must be issued in bearer form.

The amendments intended to create better-tailored financial products that would combine SARs with loans, bonds or various other types of securities. Issuers can now issue SARs not only to its own directors and employees but also to related company directors and employees, transaction parties and any third party. SARs can be issued for any purpose including performance incentives and compensation. SARs can also be created to control issuers in the future or on the occurrence of certain events and could be a useful tool for joint ventures and issuers defending hostile takeover bids. However, in spite of the intention of the drafters of the amendments, much confusion has resulted in the area of BSARs.

Amendments to convertible bonds

Under the amendments, convertible bonds were replaced by BSARs and are now classified as a type of BSAR. In the case of a convertible bond type of BSAR (CB Type BSAR), on the exercise by a right-holder of the SAR attached to the bond that triggers redemption of the bonds (in lieu of the full repayment of the principal amount of the bond to the bondholder), the issuer will treat the redemption of the bond as payment for the shares acquired under the exercised SAR. The deemed price to be paid to issue or deliver shares to the bondholder on exercise of the SAR will be equal to the issue price of the bond. The issuer can then either issue new shares or transfer its own treasury shares to the bondholders exercising the SARs contained in CB Type BSARs.

The main goal of the amendments to convertible bonds was to treat the conversion rights - the stock right element in the convertible bond - in a similar fashion to the SARs. It is believed that the drafters of the amendments did not intend to change the substance of the law regarding convertible bonds. However, since the nature of the conversion rights in convertible bonds is different from that of SARs, the amendments will likely bring much confusion to companies planning to issue CB Type BSARs.

Issuing convertible bonds has been a powerful method for Japanese companies to finance their businesses. Convertible bonds were popular among investors and resulted in the formation of a large bond market. Before the amendments, issuing or subscribing for convertible bonds was a fairly well established practice. After the amendments, many practitioners are worrying that the changes in the law will complicate the practice of issuing and subscribing for securities, impede the financing activities of companies and decrease the market for convertible bonds.

The Japan Securities Dealers Association found the following problems in relation to CB Type BSARs: (a) determining the issue price of the SARs contained in CB Type BSARs; (b) determining whether or not the issue of CB Type BSARs were specially favourable; (c) explaining the nature of CB Type BSARs to investors; and (d) drafting the terms and conditions of the CB Type BSARs. In February 2002, the Association published a report in the hope of providing a solution to many of these problems. However, after the release of the report, other commentaries have been published that provide different interpretations of the amendments relating to convertible bonds. This has resulted in greater confusion. Two points in particular need clarification.

Issue price of SARs
Before the amendments, there was no concept of an issue price of conversion rights contained in convertible bonds. There used to be only one issue price for one tranche of convertible bonds and no separate issue price for conversion rights or bonds without conversion rights.

The amendments introduced a new concept. The issue price of the SARs and the issue price of the bonds contained in one tranche of the BSARs must now be determined by the board of directors of the issuer. Thus, when issuing BSARs, the issue price for each of the bonds and the SARs must be separately set out and approved by the board of directors of the issuer. Most of the confusion has resulted from trying to calculate the issue price of the SARs contained in CB Type BSARs.

One theory is that the issue price of each of the SAR and bond as contained in a CB Type BSAR should be the estimated value of the SAR and bond respectively. This theory assumes that a model analysis, such as the Black-Scholes Pricing Model, can be used to determine the value of any SAR contained in a BSAR. This understanding is consistent with the natural interpretation of the amendments. However, at least in respect of CB Type BSARs, this theory may not be practical. Pricing models are based on the premise that each of the bond and the SAR can be separated from the other and individually valued. This may not be true for CB Type BSARs.

A CB Type BSAR is an integrated financial product that includes both a bond and a SAR. It is packaged and distributed as one financial product, indivisible between the bond and the SAR. The CB Type BSAR certificate represents both the bond and the SAR. The rights contained in the CB Type BSAR can never be detached in normal cases. Where the SARs contained in the CB Type BSAR are exercised, the payment upon exercise of the SARs is deemed to take the place of the full redemption of the bonds. Where the bonds are redeemed before the exercise of the SARs, the SARs will usually expire several banking days before the redemption date. The individual rights contained in the CB Type BSARs cannot exist independently and, because of this indivisible nature, the value of SARs contained in CB Type BSARs is difficult to determine.

For this reason, it is arguably more practical to price a CB Type BSAR as if it were one single security. Valuing CB Type BSARs as if they were one security is consistent with Japanese accounting practices. With respect to the previous concept of the convertible bond under the Commercial Code, the practice of recording the acquisition value of the convertible bond did not recognize the individual values of the conversion right and the bond without the conversion right. Under current accounting practices, even after the Commercial Code amendments, the recorded acquisition value of a CB Type BSAR is calculated based on the value of the whole CB Type BSAR in general, similar to the convertible bond practice before the amendments.

The other theory is that the issue price of the SAR contained in a CB Type BSAR should be nil and the issue price of the bond should represent the total issue price of the CB Type BSAR. Since this theory does not require theoretically estimating the value of the SARs, this understanding provides a more practical, workable solution. Moreover, this theory is consistent with Japanese accounting practices. Since the Commercial Code amendments took effect, there have been more than 30 transactions involving the issuance of CB Type BSARs. In most cases, the value of the SARs has been set at nil. However, even though the second view appears to be more accepted within the industry, it could lead to a problem with respect to CB Type BSARs being subject to preferential issue restrictions under the Commercial Code if the terms of the SARs contained in BSARs are deemed specially favourable.

Specially favourable
The Commercial Code provides that where the terms of the SARs contained in BSARs are specially favourable, the issuer must obtain a special resolution from a general meeting of shareholders in addition to a directors' resolution approving the issuance. Where the issue price of the SARs contained in the CB Type BSARs is nil, one may argue that under the Commercial Code the terms of the SARs contained in such CB Type BSARs are specially favourable and that the issuance of the CB Type BSARs is also specially favourable. An issuer might therefore be required to obtain the relevant special resolutions.

Under the Commercial Code, preferential issue restrictions attach to shares or equity-linked securities if the issue is specially favourable. The aim of the preferential issue restrictions is to limit devaluation of shares. The restrictions prevent issuers from devaluating the issued shares without obtaining approval from existing shareholders. Before the amendments, the restrictions applied to the issuance of shares, warrant bonds and convertible bonds. After the amendments, the restriction applies to the issuance of shares, SARs and BSARs. If a specially favourable issuance is not approved by a super majority resolution of shareholders, the issuance may be suspended at any time before the issue at the request of existing shareholders.

The test for a specially favourable issuance depends on the type of securities. Issues of shares are specially favourable if the issue price of shares is specially favourable. Conversely, issues of SARs are specially favourable if the terms of the SARs are specially favourable. The drafters of the amendments expect that whether or not the terms of the SARs are specially favourable will be determined based on the theoretical value of the SARs using pricing models such as the Black-Scholes Pricing Model, compared with the consideration for SARs to be received by the issuer.

Issues of BSARs will be viewed as specially favourable if the terms of the SARs contained in BSARs are specially favourable. Like plain SARs, whether or not the terms of SARs contained in BSARs are specially favourable seems likely to be determined based on the theoretical value of the SARs contained in the BSARs calculated using pricing models such as the Black-Scholes Pricing Model, compared with the consideration for SARs contained in BSARs to be received by the issuer.

However, as mentioned above, it is difficult to estimate the value of SARs contained in CB Type BSARs using theoretical pricing models, since CB Type BSARs are not detachable securities. To resolve this problem, we believe that the test for determining whether a CB Type BSAR issuance is specially favourable should be modeled after the same test that applies to plain SARs, with the some modifications.

Firstly, a CB Type BSAR is an integrated financial product that includes a bond and an SAR, both of which are inseparably related such that neither the bond nor SAR may be distributed apart from each other. In addition, the terms and conditions of both the bonds and SARs can be interrelated and inseparable. Therefore, even in the event that the issue price of the SAR itself is determined to be specially favourable, existing shareholders will arguably suffer no damage if the issuer obtains another value by issuing the CB Type BSARs where the favourable degree of the issue price of SARs itself is nearly equal to the value that the issuer obtains from the non-SAR parts of the CB Type BSAR.

For instance, in the event that the issue price of the SAR contained in a CB Type BSAR is set at nil, if the difference between nil and the value of the SAR contained in the CB Type BSAR at the time of issuance is nearly equal to the value that the issuer obtains from the non-SAR parts of the CB Type BSAR (for example, lower interest rate of the bond), then by issuing such CB Type BSAR at that price, the existing shareholders will not incur any losses. Consequently, it is reasonable to assume that such an issue will not be viewed as specially favourable.

Secondly, if one adopts the above valuation method, another problem presents itself: how does one determine whether the difference between nil and the value of the SAR contained in the CB Type BSAR at the time of issuance is nearly equal to the value that the issuer obtains from the non-SAR parts when issuing a CB Type BSAR? By adopting the Black-Scholes Pricing Model as the calculation method for valuing the SAR contained in the CB Type BSAR, the value of the SAR would have to be determined by applying the pricing model, but also considering whether the value of the SAR is nearly equal to the value that the issuer obtains from the non-SAR parts of the CB Type BSAR.

However, it is not useful calculating the value of the SARs contained in CB Type BSARs using the theoretical pricing model, because the SARs are just one part of the integrated financial product. To determine the aggregate value of the rights that make up the SAR within the CB Type BSAR, many of the following factors would have to be valued, or at least taken into consideration: (a) the number of CB Type BSARs to be issued; (b) the length of the CB Type BSAR's maturity period; (c) the lack of liquidity of plain SARs; (d) the exercise price adjustment terms of SARs; and (e) any early redemption terms of the bonds.

If one considers all these elements in calculating the value of SARs contained in CB Type BSARs, it is likely the resulting value will vary greatly from the estimated value determined using only theoretical pricing models such as the Black-Scholes Pricing Model. Therefore, unless valuation specialists of financial products make appropriate modifications to the theoretical pricing models, it may be meaningless to use existing theoretical pricing models that have traditionally been used to price options.

If one can determine that the value of SARs is nearly equal to the value that the issuer obtains from the non-SAR parts of the CB Type BSARs using another pricing method, then it may not be necessary to use such theoretical pricing models.

There could be more practical ways to determine whether the value of SARs is nearly equal to the value that the issuer obtains from the non-SAR parts of CB Type BSARs. For instance, if the issue price of the entire CB Type BSAR is determined fairly by an appropriate book-building pricing process, then it is likely that the SARs contained in the CB Type BSARs will be seen as having a fair value and, consequently, such an issuance of the CB Type BSARs at this price would unlikely be seen as being specially favourable. In short, the value of SARs granted by issuers to investors should not be much larger than the value the issuer receives from other non-SAR parts of CB Type BSARs.

If one adopts a valuation method that takes into consideration the actual sale and demand relationship, for example, the book-building pricing process, it is inevitable that not only existing shareholders' interests but also the issuer's interest will be better served. Such a valuation method would produce a different price from the theoretical pricing models where an issuer issues JPY1 billion ($800 million) of CB Type BSARs and where it issues JPY100 billion ($800 million) of CB Type BSARs. To market larger amounts of securities in the market, the pricing of the latter will be favourable to investors and less favourable to the issuer and existing shareholders. However, the courts have held that in determining whether or not a share issuance is specially favourable, an issuer can consider its own financing needs in setting the issue price. This should also apply when issuing CB Type BSARs. However, because there is no further guidance on this matter, it is still unclear whether the book-building pricing process in connection with an offering of BSARs is suitable for this valuation purpose.

Until further guidance is given, valuers should at least be aware that different methods exist for determining whether the value of SARs contained in CB Type BSARs is nearly equal to the value that the issuer obtains from the non-SAR parts.

Conclusion

Besides the two main practical problems in issuing CB Type BSARs, other concerns exist. For example, BSARs can be issued only in bearer form and this may cause problems in relation to US tax treatment when these securities are placed or offered in the US.

Before the introduction of the amendments, issuing convertible bonds was one of the most important financing measures used in Japan - and this trend continues. After the amendments came into force, the aggregate issue price of the CB Type BSARs was at least JPY800 billion ($6.7 billion). Viewed in this light, it is hoped that the influence of the amendments on the economy will be prudently considered, and that laws and regulations relating to CB Type BSARs will be further amended.


Nagashima Ohno & Tsunematsu
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3-12 Kioicho,
Chiyoda-ku
Tokyo 102-0094
Japan
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