Converts with Hedges and Warrants and Contingent Payment Debt Instruments

Converts with Hedges and Warrants and Contingent Payment Debt Instruments Eileen Marshall Wilson Sonsini Goodrich & Rosati, PC David L. Forst Fenwick & West LLP 1

I. Big Picture Issues A. Tax Treatment of Issuance of Conventional Convertible Debt Instrument No allocation of value to imbedded option, so no OID unless actually issued for less than face. See, e.g., Notice 2001-36, 2002-1 C.B. 1029. Compare issuance of note/warrant investment unit, with FMV allocation to warrant. Custom Chrome, 76 T.C.M. (CCH) 386, aff d in part and rev d in part, 217 F.3d 1117 (9 th Cir. 2000). Which reflects true cost of borrowing? 2

I. Big Picture Issues B. Background of Note/Hedge Integration Popular financing source for issuers, because less dilutive than typical convertible notes, although more expensive. Difference in tax and accounting treatment of hedge. Not integrated for accounting, so interest expense is lower. Recent accounting changes with respect to net share settlement makes transaction less appealing. Previously net share settled debt More or less expensive than straight debt? Hedging inefficiencies may increase cost. If more expensive, why bother? 3

I. Big Picture Issues C. Description of Transactions Three components to overall deal: Convertible note (non-cpdi), with conversion price in typical range for converts (up 25-35%); Purchased call option or note hedge, purchased from the lead bank (and sometimes more than one bank), which more or less exactly matches conversion feature of note; and Sold call option or warrant, sold to same bank or banks, with higher strike price and slightly longer term (typically 90 days longer). 4

I. Big Picture Issues C. Description of Transactions Transaction $1000 1 Issuer Holder Note $100 2 Issuer Counterparty Hedge $75 3 Issuer Counterparty Warrant Transactions 1 and 2 are integrated: Issuer has net cash/value flow of $900 in year one but at maturity pays out $1,000, resulting in $100 of deductible interest. Warrant is not intended to be integrated with convertible note and hedge; if it were, however, the interest deduction would be reduced by the amount of the premium paid for the warrant. 5

I. Big Picture Issues D. Description of Notes Unsecured obligations, sometimes senior, sometimes subordinated. Holders have option to convert under limited circumstances: Satisfaction of market price or trading price conditions, Occurrence of certain corporate transactions, or During the month prior to maturity. Upon conversion, holders will receive: cash, stock (full physical settlement), or combination of the two (typically cash equal to the principal and stock for the excess value net share settlement ). 6

I. Big Picture Issues E. Description of Hedge(s) Purchased call option(s) with respect to aggregate number of shares of issuer stock deliverable under notes. Issuer has no contractual right to terminate hedge(s). Exercise of hedge(s) is triggered by conversion of notes, American-style option. Hedge(s) will expire worthless if conversion right on notes has not been exercised. 7

I. Big Picture Issues F. Description of Warrant Sold call option typically European-style warrant covering shares of issuer stock. Exercise not tied to convertible. No or limited right to net or set off rights/obligations under warrant against obligations/rights under hedge. Premiums due to bank for hedge and to issuer for warrant should be negotiated using arm slength pricing. Hedge costs more than warrant given warrant s higher strike price. Net cost of transaction typically 10%-15% of face. 8

I. Big Picture Issues G. Principal Tax Consequences Taxpayer elects to integrate note and hedge (but not warrant) under Treas. Reg. 1.1275-6, creating synthetic debt instrument ( SDI ) with OID equal to the cost of hedge. OID deductible over term of SDI. Warrant not taxable under 1032. 9

I. Big Picture Issues H. Principal Tax Issues Blessed by IRS in generic legal advice AM 2007-0014. Accounting rules changed shortly thereafter. [OID Anti-Abuse Rule.] Treas. Reg. 1.1275-6(d)(1)(iii). Treas. Reg. 1.1275-2(g). [Integration of All Three.] What if? Risk of failed integration. Separateness of Hedge and Warrant. Is there a valid business purpose? For overall transaction? For purchase of hedge and sale of warrants? For separation of hedge from warrants? Does there need to be? Technical Noncompliance. Mismatched cash flows. Identification requirements. 10

II. Drilling Down A. Business Purpose Business purpose for buying hedge and selling warrants is to synthetically increase conversion threshold of notes, at cost equal to net cost of hedge and warrants. Tax benefits are based on gross cost of hedge, not net cost. If warrant strike price is too close to convertible strike price (so net cost is greatly reduced) Transaction may lack economic substance (extreme). May call into question stated business purpose. Value of tax benefits may outweigh net cost of hedge and warrants. May make transaction more vulnerable to an anti-abuse challenge. Must a line be drawn, and if so where? 11

II. Drilling Down B. Separateness of Hedges and Warrants The following factors influence whether hedges and warrants will be respected as separate: Difference in maturity; Separate transferability (but is there an economic compulsion to keep hedge and warrants together?); No or limited rights of set-off; No acceleration of warrant expiration in event of early termination of convertible and hedge (for example, cash merger); Settlement mechanics; Premiums separately determined. 12

II. Drilling Down C. Pricing of Hedges and Warrants Arm s length pricing for each option: Important because OID accruals on SDIs depend on amount of premium for hedges. How can tax advisors be sure pricing is arm s length and determined separately for each component? What if there are adjustments in warrant intended to affect economics of hedges (e.g., volatility adjustment). Auctions: Why do the prices often vary significantly in competitive bidding situations? Is assumed volatility the only variable? What s the best way to prepare a file that will withstand audit challenge? 13

II. Drilling Down D. Qualification for Integration In General Cash flows on the qualifying debt instrument and 1.1275-6 hedge must permit the calculation of a fixed yield to maturity. Convertible and hedge appear to qualify because hedge offsets conversion features, creating a synthetic fixedcoupon debt with OID. Features that could call integration into question include: Conversion features not fully or perfectly hedged; Potential early termination (increasing yield); Potential minor timing mismatches between issuer receipt and delivery of stock; Potential minor amount mismatches because of net share settlement or cash settlement features. 14

II. Drilling Down E. Specific Sources of Concern Early termination. Voluntary holder early conversion; Extraordinary events, including mergers. Physically settled convertible and net share settled hedge. Unhedged make-whole or volatility. adjustment feature of convertible. Staggered settlement of hedge. 15

II. Drilling Down F. Potential Sources of Comfort Remote contingencies. Incidental differences in value. Alternative payment schedule rules of Reg. 1.1272-1(c). If conversion feature not fully hedged, can ignore under Reg. 1.1272-1(e). But note, if SDIs are convertible, unaccrued OID may be disallowed under section 249 if SDIs are retired prior to maturity, unless issuer can prove premium is not attributable to conversion feature. It s not a problem unless it happens, and if it does, it s a legging out event. 16

III. Examples A. Unhedged Make-Whole Adjustment Facts: Notes include matrix adjustment to conversion rate if converted in connection with change of control, intended to make up for lost optionality. Prior to first put date; Purchase price is within certain range and at least 10% cash. Hedges do not have make-whole adjustment. Counterparty not able to hedge make-whole feature in market. Warrants have calculation agent adjustment to preserve value of deal to counterparty in event of change of control of issuer. Adjustment triggered if acquiror s stock is less volatile than issuer s; Amount of payment is not capped. 17

III. Examples A. Unhedged Make-Whole Adjustment Integrating make-whole adjustment: Convertible synthetic debt instruments? Only if make-whole is triggered? Ignored under 1.1272-1(e). 249 may result in disallowance of unaccrued OID if retired prior to maturity, unless issuer can prove premium is not attributable to conversion feature. Can hedge have volatility adjustment? Unknown cash flow from counterparty to issuer, so alternative payment schedule rules not available. Can t be ignored under 1.1272-1(e) because not option to convert into issuer stock or equivalent value. What if capped at cash outflow under make-whole adjustment? Makes hedge more complete; If less than make-whole, excess cash outflow still ignored under 1.1272-1(e); Cap results in economic issue for issuer. Can counterparty be made to pay over to issuer profits under its hedging activity as result of make-whole adjustment? Must payment be capped? 18

III. Examples B. Convertible with Longer Term than Hedge Some deals involve a convertible with a longer term (typically 20 years), with put and call rights after say 7 years. Hedge is for the term up to the put/call date. To integrate, SDI must have a fixed term of 7 years, for otherwise yield isn t fixed. Most deals use a put right at a premium, or a drop in stated interest rate on the QDI, so the put is presumed exercised under Reg. 1.1272-1(c)(5). Does this work? Does the yield presumption work for convertibles? Why bother with a long-term convertible in a hedge situation? If conversion feature is in-the-money the hedge forces the issuer to call the notes, and if the conversion feature is out-of-the-money, the holders will put. 19

IV. Identification Statement Issues A. Timing To meet identification requirements, taxpayer must enter and retain as part of its books and records (1) date QDI was issued or acquired (or is expected to be issued or acquired) and date hedge was entered into by taxpayer, (2) description of QDI and hedge, and (3) summary of cash flows and accruals on SDI. 1.1275-6(e). Identification requirements must be satisfied on or before date hedge is entered into. 1.1275-6(c)(1)(i). Is the hedge entered into when signed, priced (if different) or closed? Closing makes the most sense, but absent specific guidance, only the earliest date is safe. 20

IV. Identification Statement Issues B. Divisibility If one holder converts early, that triggers an acceleration of the hedge and an early retirement of a portion of the SDI. Could this be considered a legging out? Reg. 1.1275-6(d)(2) talks in terms of terminating all or a part of the QDI or hedge. If so, it arguably kills the integration for the entire issue, because you can t leg back in within 30 days. Many tax advisors address this issue by drafting the ID statements to integrate each $1,000 unit of the convertible with a pro rata slice of the hedge, thereby creating as many SDIs as there are units of convertible. Is this technique sufficient to solve the problem, if there is one? Necessary? 21

IV. Identification Statement Issues C. Hedging the Shoe If initial purchasers are granted option to purchase additional notes, sometimes greenshoe notes are hedged on different terms than base notes, or may close on a different date. If each QDI is integrated with separate hedge or slice of hedge to form multiple SDIs, it should be possible to hedge greenshoe notes on different terms from firm notes, or not at all. However, greenshoe notes and firm notes are designed to be entirely fungible with each other. If terms of hedge are different, resulting SDIs will be different. Even if identification requirements of particular QDI with particular hedge can be satisfied at issuance, will issuer know which SDIs a transaction in QDIs affects (e.g., early conversion)? Pro rata? If government were to aggregate notes and treat as single QDI that is integrated with one bond hedge (rather than the slices approach), having some of the notes not covered by the hedge would be problematic. Under 1.1275-2(c)(2)(ii), however, the QDIs should not be aggregated. 22

V. Contingent Payment Debt Instruments A. The Basics CPDI rules under Treas. Reg. 1.1275-4 apply to debt instruments with one or more contingent payments, unless: the contingent payments are remote or incidental; the alternative payment schedule rules of Treas. Reg. 1.1272-1(c) apply; the notes are VRDIs; or the OID anti-abuse rule of Treas. Reg. 1.1275-2(g) applies. Beware debt/equity issues that might make the purported CPDIs equity for tax purposes. 23

V. Contingent Payment Debt Instruments A. The Basics If the CPDI rules apply, and note is issued for cash or publicly traded property, non-contingent bond method is used to determine yield. Generally, interest accrues on the note using the comparable yield at which issuer would issue fixed rate, non-contingent, non-convertible note with terms and conditions otherwise similar to CPDI (i.e., higher straight debt yield). Intended to approximate actual cost of borrowing. 24

V. Contingent Payment Debt Instruments B. Terms of CIDECS $1,000 face amount, issued at par. Stated term of 30 years. General unsecured, subordinated notes - junior in right of payment to all other debt, pari passu with trade creditors, senior to equity. Convertible at 15-25% (or less?) conversion premium at holder s option into cash and/or stock (at issuer s option) under limited circumstances: If trading price of common stock is 130% of conversion price for 20 of 30 consecutive trading days; If trading price of notes is less than 98% of trading price of common stock times conversion rate for 10 consecutive trading days; If issuer calls notes for redemption; Upon occurrence of certain fundamental corporate transactions; or During month preceding maturity. Contingent interest after year seven: 0.50% during any semi-annual period if average trading price of notes (not common stock) is at least 150% of face ( Upside Trigger ); 0.25% during any semi-annual period if average trading price is less than 50% (increasing over time to 95%) of face ( Downside Trigger ); and Amount of extraordinary cash dividend. Deferral of interest payments for 5 years if not in default (but not beyond maturity or redemption). After year ten, issuer may call for redemption if common stock trading price exceeds 150% of conversion price for 20 of 30 consecutive trading days. Holder put in event of certain fundamental corporate transactions. No other puts. 25

V. Contingent Payment Debt Instruments C. Remote and Incidental Test Conversion right alone cannot cause CPDI rules to apply. Treas. Reg. 1.1275-4(a)(4). See slide 2. CPDI rules will not apply if likelihood of contingent payments is remote or amount is incidental based on payment expectations as of issue date. Notice 2002-36 acknowledges that remote and incidental test is pretty low bar. 26

V. Contingent Payment Debt Instruments C. Remote and Incidental Test What is remote? Probability of occurrence of less than 5%? Less than that? Evidence provided by investment bank based on probability of Upside Trigger being reached. What s the point of Downside Trigger? 27

V. Contingent Payment Debt Instruments C. Remote and Incidental Test Payment treated as incidental if under all reasonably expected market conditions, the potential amount of the payment is insignificant relative to the total expected amount of the remaining payments on the debt instrument. Treas. Reg. 1.1275-2(h)(3). What is incidental? 1% or 2% of something? Evidence provided by investment bank based on a compound annual stock growth rate assumption (usually that predicted by comparable yield analysis). 1001 Test. With/without contingent interest. Yield with exceeds yield without by greater of 25 basis points or 5% of yield. Present Value Test. NPV of contingent interest as percentage of NPV of all payments (including conversion value). Gross Payment Test. Amount of contingent interest as percentage of all payments (excluding conversion value). 28

V. Contingent Payment Debt Instruments D. Comparable Yield Comparable yield is yield at which issuer would issue fixed rate, non-contingent, non-convertible (See Rev. Rul. 2002-31) note with terms and conditions otherwise similar to CPDI (i.e., higher straight debt yield). Relevant terms and conditions include level of subordination, term (what about puts/calls?), timing of payments and general market conditions. No adjustments made for riskiness of contingencies or liquidity of debt instrument. CY must be reasonable and not less than AFR, although presumed to be AFR if marketed or sold in substantial part to tax insensitive investors. Treas. Reg. 1.1275-4(b)(4)(i). 29

V. Contingent Payment Debt Instruments D. Comparable Yield AFR presumption can be overcome only with clear and convincing evidence that CY should be specific yield in excess of AFR. Evidence specific to issuer, may not rely on evidence pertaining to comparable issuers or general market conditions. Treas. Reg. 1.1275-4(b)(4)(i)(B). But issuer usually has no straight debt outstanding, maybe no convertible debt either. Evidence provided by investment bank: Option pricing model for convertible debt of issuer; Comparable issuers of unsecured debt; Integration hypothetical under Treas. Reg. 1.1275-6; Other CIDECS; and Trust preferreds and convertible preferred by issuers with comparable debt ratings. What if comparable yield is AHYDO? 30

V. Contingent Payment Debt Instruments E. Section 163(l) Sec. 163(l) disallows an interest deduction on corporate debt payable in equity of the issuer or a related person Indebtedness is payable in equity only if a substantial amount of the principal or interest is required to be paid or converted (or payable in or convertible into) such equity or determined by reference to the value of such equity The conference report states that it is not expected that 163(l) will affect debt with a conversion feature if the conversion price is significantly higher than the market price of the stock on the issue date of the debt The Service has stated that a projected payment schedule under the noncontingent bond method is not determinative in applying 163(l). Rev. Rul. 2002-31. 31

V. Contingent Payment Debt Instruments F. Section 249 Under 249 no deduction is allowed to the issuing corporation for a premium paid or incurred upon the repurchase of a convertible debt to the extent the repurchase price exceeds the adjusted issue price plus a normal call premium on nonconvertible bonds. However, 249 does not apply to the extent the corporation can demonstrate that such excess is attributable to the cost of borrowing and is not attributable to the conversion feature. Section 249 should not affect an issuer s ability to deduct accruals of interest based on a comparable yield. Rev. Rul. 2002-31. 32

IRS Circular 230 Disclosure To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under federal, state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. 33