Are convertibles really convertible?

Author: | Published: 1 Apr 2007
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Although the Turkish securities market has been organized since 1866, until the Turkish Capital Markets Law was enacted in 1981, the market was substantially dormant. The Capital Markets Board was established under the Capital Markets Law as a main regulatory body responsible for the supervision and regulation of the Turkish capital markets. The Capital Markets Board, as the regulator, assists the development of the Turkish securities market by issuing secondary legislation. When issuing the implementation legislation, the Capital Markets Board takes into account the mandatory rules of the Turkish law and the needs of the market. The Capital Markets Board also looks into the developments in the international arena to meet the expectations of foreign indirect investors investing in Turkish securities.

Since the beginning of nineties, there have been a number of global offerings of Turkish equity securities and, consequently, the Turkish equity market has been developed to meet international standards. In almost every equity offering (either global or purely domestic), the Capital Markets Board has issued new rules. Now, global equity offerings of Turkish securities are simultaneously effected without any hurdles because the capital markets rules of both markets (that is, the Turkish market and the international market) are compatible, or even identical.

The picture in debt securities is different and somewhat odd. The Capital Markets Board rules concerning the debt securities are very much domestic and contradict with rules applicable in the international debt markets. So it is difficult to issue debt securities in international markets simultaneously with domestic markets.

Convertible bonds, some of the most widely used debt securities in the international markets, are governed by the Communiqué on the Issuance of Convertible Bonds promulgated by the Capital Markets Board in 1992. Since then, a number of convertible bond deals structured according to the rules and practices of international debt markets were cancelled as a result of their incompatibility with the Turkish convertible bond rules. Contrary to precedents in equity market deals, the Capital Markets Board has not attempted to amend the Communiqué to harmonize its convertible bond rules with the international rules.

Turkish convertible bond rules

Maturity: The permitted maturity term of convertible bonds is two to seven years. Interest is payable on an annual basis.

Issuance limits: The total value of all debt securities issued by an issuer cannot exceed paid-up share capital and reserves less losses. The Council of Ministers has increased this limit to six times the shareholders' equity, if: (i) the issuer has made profit during the previous fiscal year; (ii) that fiscal year has been audited; and (iii) the proposed limit is approved by the Capital Markets Board.

Corporate authorizations required: The Communiqué states that companies are allowed to issue convertible bonds provided that this right is included in their articles of association. If there is no provision in the articles of association on convertible bonds, the issuer first must amend its articles of association to include such a provision. This would require: (i) the Capital Markets Board's prior approval of the amendments; (ii) the Ministry of Trade's prior approval of the amendments; (iii) the shareholders' approval of the amendments; and lastly, (iv) the registration of the amendment with the Trade Registry. The whole process would take at least a month.

The right to issue convertible bonds is vested in the shareholders, unless the issuer has adopted the authorized share capital structure. In companies with the authorized share capital structure, the board of directors is authorized to decide on the issuance of all types of securities, including convertible bonds.

External authorizations required: Under the Communiqué, the procedure relating to issuance of convertible bonds are as follows:

  • The authorized corporate body (shareholders or the board of directors, depending on the capital structure of the company) of the issuer should resolve for the issuance of convertible bonds.
  • The shareholders' resolution relating to the issuance of the convertible bonds should be registered with the Trade Registry where the issuer is headquartered and published in the Trade Registry Gazette.
  • The issuer should apply to the Capital Markets Board to register the bonds.
  • The Capital Markets Board issues a registration certificate.
  • A Turkish circular (izahname) should be registered with the Trade Registry within a week after the Capital Markets Board's registration certificate date and published in the Trade Registry Gazette.
  • A summary of the izahname should be published in dailies within seven days after the izahname registration.
  • The sale period cannot be less than six days and more than three months. At the end of the sale period, if there are unsold bonds, the issuer should cancel them and inform the Capital Markets Board of the sale results.

A Turkish underwriter must underwrite the whole tranche if the issuer or the bondholders are entitled to prepayments.

Conversion means capital increase: Under Turkish law, the treasury stock concept is not recognized. Each time a conversion takes place the issuer is required to go through a capital increase procedure to issue new shares to the bondholders. Capital increase of publicly held companies is a lengthy procedure, requiring a number of external and internal approvals.

Issuers, through a shareholders' resolution (or, in the case of authorized share capital structure, a board of directors' decision) will increase their share capital and issue new shares. Pursuant to the Communiqué, bondholders have priority at the time of issue by the issuer of new shares upon the exercise of the conversion rights. So the shareholders (or, in an authorized share capital structure, the board of directors) are authorized to restrict the preemptive rights of the shareholders who are otherwise entitled to subscribe for the new shares. Neither the shareholders nor the board of directors are authorized to pass decisions restricting bondholders' rights. The total number of shares to be issued in connection with the capital increase must be enough to meet the bondholders' conversion rights. Also, the total number of shares after the conversion cannot exceed the authorized share capital level of the issuer. At the time of issuing convertible bonds, the issuer's authorized share capital level should be enough to cover the shares to be issued upon the conversion.

Conversion procedure:Under the provisions of the Communiqué, convertible bonds may be converted into shares at once on the maturity date. It is also possible to convert bonds into shares in different conversion periods, the first being at the end of the second year, the last being on the maturity date, and the others on a yearly basis. If the conversion is realized during different conversion periods, the names of the bondholders who would be entitled to convert their bonds into shares during each conversion period will be drawn before a notary public. Conversion principles should be stated on the back of the certificates representing convertible bonds. Conversion may be at the request of the issuer or at the request of the bondholders.

If the issuer is requesting the conversion, the conversion may be realized at the end of the second year or on each interest payment date. The issuer should make an announcement in two dailies distributed countrywide, one month in advance. In the announcement, the conversion period (which cannot be less than five business days or more than 10 business days), where the shares are to be distributed and other conditions relating to the conversion should be stated. During the conversion period, all bondholders who are entitled to conversion are expected to convert their bonds into shares. At the end of the conversion period, if there are bonds not converted, the issuer places the value of the bond with a bank. Whenever a bondholder presents its bonds, it receives the amount placed. Within six days after the conversion period, converted bonds and bonds not converted but whose value is placed with the bank are cancelled. The cancellation is announced to the public through two dailies distributed through Turkey.

If the bondholders are entitled to request the conversion, the conversion may be realized at the end of the second year or on each interest payment date. Any bondholder wishing to exercise its conversion right should inform the issuer of its request one month in advance. This one-month period is for the issuer to complete the capital increase procedure. During this period, the issuer will resolve for the capital increase and apply to the Capital Markets Board for the registration of the shares, get the shareholders' (or board of directors') approval and apply to the Istanbul Stock Exchange to listing the shares.

At the end of the conversion periods, the issuer will notify the Capital Markets Board and the Istanbul Stock Exchange of the conversion results.

At the end of the conversion periods, the issuer must apply to the relevant Trade Registry where its headquarters is based to complete the capital increase process and deliver the shares to the bondholders. If the issuer has the authorized share capital structure, then it must apply to the Capital Markets Board for the completion of the capital increase process and the Capital Markets Board issues a capital increase completion certificate, which should be registered with the Trade Registry of the issuer. If the issuer has authorized share capital, shares are distributed to the bondholders at the time of the conversion.

Dilution: Under the provisions of the Communiqué, if a dilution event occurs, that is, bonus issue or exercise of pre-emptive rights by the current shareholders (rights issue with a price under the market price, usually the nominal value), the conversion ratio must be adjusted and the adjustment method must be specified in the izahname.

Compatibility with international rules

One of the main hurdles in the Turkish convertible bond market is the requirement to increase share capital each time there is a conversion. The capital increase procedure is a lengthy process and takes at least one month. Secondly, the conversion may be on interest payment dates only (that is, on an annual basis), the first one being on the second anniversary of the issuance date. In the international markets, conversion may be carried out from time to time at the request of the bondholders and the issuers meet the demand through treasury stocks.

As a result of these structural obstacles, in most of the deals a special purpose vehicle to issue convertible bonds is introduced and the Turkish company is given a guarantor role.

A wholly owned special purpose company formed by the issuer, a publicly held Turkish company, abroad would issue convertible bonds and onlend the proceeds to the issuer. The issuer would guarantee the payment of principal and interests and performance of conversion obligations. The bonds would be convertible to the shares of the issuer (the Turkish parent company). Please see Figure 1.

Figure 1

Issues with the proposed structure

There are a number of issues associated with the above structure.

Under the Communiqué, convertible bond issuers are the ones who would be converting the bonds into shares. In other words, the bond issuer and the stock issuer are required to be the same entity. Accordingly, if the issuer of the convertible bonds is a foreign entity, the bondholders are entitled to receive the shares of that company, not shares of another company, even if the other company is the parent company of the issuer. The bondholders have no right to require the issuer of the shares to issue the shares to them. So the Turkish authorities do not consider securities issued by the special purpose company to be convertible bonds.

Because the convertible bonds issued by the special purpose company would not be deemed convertible bonds under Turkish law, bondholders would not be entitled to the benefits granted to them under the Communiqué. Specifically, the shareholders (or, in an authorized share capital structure, the board of directors) are not required to apply the Communiqué and so they are not required to increase the share capital if a conversion takes place. Also, because the Communiqué would not apply, the shareholders may challenge any decisions restricting their preemption rights to subscribe for the new shares and allocating shares to the special purpose company to meet the bondholders' requests.

Convertible bonds issued by an entity residing abroad would be regarded as foreign instruments and so their registration with the Capital Markets Board and listing with the Istanbul Stock Exchange would be subject to different sets of rules (not those applicable to Turkish convertible bonds). These bonds would not be traded on the Istanbul Stock Exchange National Market but be traded in a specific market in which only foreign securities are traded. This is not a well-developed market.

Foreign-originated loans with a tenor of 365 days must be registered in the External Debt Log kept at the central bank. By virtue of this registration, the borrower may freely repatriate all amounts due and payable by a borrower to the lender in the currency specified in the loan agreement.

Loans extended to Turkish residents from abroad are subject to RUSF (resource utilization support fund) in the amount of 6%. There are, however, a number of exemptions.

Under the Turkish exchange control regulations, companies are required to obtain the prior approval of the government if the capital transfer amount to establish a business outside Turkey exceeds $5 million. So if the share capital amount of the special purpose vehicle exceeds the stated amount, the government's approval needs to be secured in advance.

Guarantees given by the issuer must be notified to the Treasury within 30 days after the execution of the guarantee agreement. However, the Capital Markets Board, through a principle published in March 1997, restricted publicly held companies, excluding holding companies, from executing guarantee or suretyship agreements regarding third parties' obligations. This rule has been changed by the Capital Markets Board and, under the current rules, listed companies can guarantee third parties' obligations.

Author biography

Esin Taboglu

Taboglu Ates & Demirhan

Esin Taboglu graduated from Istanbul University, School of Law in 1986 and received her LLM degree from Harvard University in 1990. She was admitted to the Istanbul Bar Association in 1987. She is also a member of the Istanbul Bar Association, the Harvard Alumni Club (Istanbul), the Association of Fellows and Legal Scholars of the Centre For International Legal Studies (honorary member) and the Turkish Women Entrepreneurs Association (founding member). She teaches on the Sabanci University MBA programme.

Taboglu Ates & Demirhan

Taboglu, Ates & Demirhan is a full-service law firm, advising Turkish and overseas clients from corporate, commercial and financial matters to complex international transactions including, securities, structured financing, government procurements and privatizations. The Firms represents clients in public and private sectors including local and foreign investors. The Firm's corporate practice involves establishment of companies, corporate governance issues, shareholders' rights and directors' liabilities and responsibilities. Our practice also covers business acquisitions, private equity, public takeovers, venture capital investments, mergers, de-mergers, spin-offs and reorganizations and joint ventures. We have been actively involved in representing issuers and underwriters in the full range of securities offerings. These include initial public offerings, private placements of securities, global equity offerings for Turkish issuers, listings in major exchanges, convertible bonds, exchangeable bonds, high yield bonds and asset-backed offerings. The Firm represents borrowers as well as financial institutions in all types of financial products and transactions, which often involve multiple jurisdictions. The Firm has an unparalleled experience in privatization projects, including but not limited to the privatization of banks, telecommunications, airlines, tobacco production, steel, fertilizer, petro-chemical and cement production companies advising either the state entity in charge of privatization or the investors. The Firm also advises in areas such as power, mining, transportation and other infrastructure sectors and represent project participants, including sponsors, project companies, lenders and governmental organizations and provides regulatory advice on all aspects of the telecommunications industry including all aspects of voice and data carriage, the mobile and value added services. We are active in all categories of real estate practice, including financings, development, acquisitions and dispositions. We represent all of the various parties involved in real estate transactions, including lenders, borrowers, sellers, buyers, developers, investors, landlords and tenants. We advise clients on a broad spectrum of antitrust issues, such as structuring of joint ventures, mergers and acquisitions, creation and operation of distribution systems, negotiation and drafting of intellectual property licensing arrangements. We provide services to football players and technical directors with respect to their disagreements with their clubs and the Turkish Football Federation. We also have experience in employment contracts and consultancy agreements, dismissal issues and work permits. The members of the firm have also allocated a considerable amount of time for teaching in private universities, legal training and pro bono services.