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...the now-failed dot-com firms, with E-Toys and Excite@Home.com being among the more well-known examples (Wengroff, 2001). Toxic convertibles have gained notoriety mainly due to their ability to harm existing shareholders and their contribution to firm demise.
Despite the doom experienced by many issuers, these instruments have not disappeared. While the market for these securities slipped in 2002-03 (coinciding with the generally sluggish market for private placements), there is currently a remarkable revival of interest in these securities as financing vehicles among smaller firms, despite the recent spate of negative publicity. (2) Given their relative newness and excepting the just-published, comprehensive study by Hillion and Vermaelen (2004) on their use, these securities have been sparsely examined and remain relatively obscure on the academic radar screen. Accordingly, this paper seeks to contribute to the literature on toxic convertibles by attempting: (1) to provide a description of their particular features; (2) to examine the rationale for their use in the context of theories of agency and information asymmetry in the corporate finance literature; and (3) to evaluate possible corrections to design flaws that would mitigate their most pernicious effects on issuing firms and make them viable sources of financing for some firms.
A floating-priced convertible is either a convertible bond or a convertible preferred stock (Hillion and Vermaelen, 2004). The security allows the holder to convert at a discount from a reference price, defined as "the lowest stock price or the average of a series of past stock prices in a look-back period." Floating-priced convertibles have two notable features: (1) a typical contract specifies a lock-up period during which conversion is prohibited, and (2) once the lock-up period expires, most contracts specify the maximum number of newly issued shares that can be sold in the secondary market as a function of the stock trading volume. These two characteristics assure that conversion into stock takes place over a period of time, at least several months after the issue announcement.
As with its more traditional variant, the "straight convertible," a floating-priced convertible may also be viewed as a form of delayed equity financing. The major distinction between the two lies in their conversion terms. Whereas in conventional convertibles the conversion price from debt to equity is set in advance, in the case of toxic converts the conversion price can be reset downward if the market price falls below the conversion price set at the time of issuance. The reset feature allows the conversion point to decline if the stock falls, thus forcing the company to issue more shares, causing dilution. Beyond the dilution, the investors--which often include professional short sellers and hedge funds--frequently sell the shares they have converted, forcing the stock price to decline even more. For this reason, the securities are known as toxic or death spirals, and are used only by companies in dire need of cash. The pejorative appellation suggests that firms issuing these securities are candidates for doom, at least in part because of the design of these securities.
The rest of the paper is structured as follows. Section II describes the salient characteristics of toxic convertibles, section III examines the rationale for the place of toxics in firm capital structure, section IV examines the pros and cons of toxics in the light of theories of agency and capital structure in corporate finance, section V identifies the winners and losers in these deals and, suggests remedies for inherent design flaws. Section VI reports on the...
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