Demystifying Modern Convertible Notes

August 2019

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Table of Contents Introduction ...... 1 Basic Theory ...... 1 The Straight Note ...... 1 The Call Option — Intrinsic Value and Time Value ...... 2 Examining Time Value and Its Consequences ...... 3 Noteholders Will Not Necessarily Convert If the Notes Are in the Money ...... 3 Make-Whole Fundamental Change Provisions ...... 4 The Effect of Redemption Rights on Time Value and the Make-Whole Table ...... 6 Delta Hedging ...... 7 The Magnitude of the Short Position in a Delta-Neutral Hedge...... 8 Unwinding the Delta- Neutral Hedge ...... 9 Why Investors Employ a Delta Hedge ...... 11 Reducing Equity Dilution: Share Repurchases, Call Spreads, and Capped Calls ...... 13 Accounting for Convertible Notes ...... 13 Debt/Equity Bifurcation Under the “Cash Conversion Subsections” ...... 13 Diluted Earnings per Share Accounting: If-Converted Method vs. Treasury Method ...... 14 Current vs. Long-Term Liability Classification ...... 15 Equity Accounting vs. Mark-to-Market Derivative Accounting ...... 15 “Conventional Convertible Debt Instruments” ...... 16 The “Fixed-for-Fixed” and Related Requirements ...... 17 Beneficial Conversion Features ...... 17 Conversion Rate Adjustments ...... 18 Conversion Rates and Conversion Prices ...... 18 Conversion Rate Adjustment Factors ...... 18 Deferral Provisions ...... 19 Types of Conversion Rate Adjustments ...... 19 Anti-Dilution Provisions ...... 19 Value-Transfer Protection Provisions ...... 19 Distributions to Common Stockholders ...... 20 Self-Tender Offers ...... 23 When the Conversion Rate Adjustments Become Effective ...... 24 Readjustment Provisions ...... 25 Parity Maintenance ...... 25 Avoiding “Double Dips” and “Unfair Deprivations” ...... 26 Make-Whole Fundamental Change Provisions ...... 27 Price-Protection Provisions ...... 27 Reset Provisions ...... 27 Degressive Issuance Provisions ...... 28 Voluntary Adjustment Provisions ...... 28 Conversion Continuity Provisions ...... 28 Treatment of Dividend Thresholds ...... 29 Cash Mergers ...... 31 Conclusion ...... 31 Appendix A: Sample Make-Whole Table ...... A-1 Appendix B: Convexity and Volatility Trading ...... B-1 Appendix C: Value-Transfer Protection Conversion Rate Adjustment Formulas ...... C-1

Authors If you have questions about this primer, please contact one of the authors listed below or the Latham lawyer with whom you normally consult:

GREGORY P. RODGERS [email protected] +1.212.906.2918 New York

ARASH AMINIAN BAGHAI [email protected] +1.213.891.7809 Los Angeles

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The authors would like to thank Colyer Curtis, Joshua Murray, and David Puritz for their valuable insight over the years and for their constructive feedback during the preparation of this primer.

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Introduction Issuing convertible notes has long been an attractive capital-raising option for public companies. At its most basic essence, a convertible note is a debt instrument that pays interest and principal, but also carries the right to exchange the interest and principal cash streams into an equity interest, typically common stock, of the issuer. In that sense, a convertible note can be viewed as a debt inst