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CONVERSION CAPS MAY NOT PREVENT SHORT-SWING TRADING LIABILITY FOR HOLDERS OF CONVERTIBLE SECURITIES
 

By Daniel J. Kramer, a partner and James McBride, an associate at the New York City-based law firm of Schulte Roth & Zabel LLP.

Securities that are convertible into common stock at a floating conversion rate provide their holders with protection against a decline in value of the common stock, by giving the holder a greater number of shares upon conversion if the price of the comm

Securities that are convertible into common stock at a floating conversion rate provide their holders with protection against a decline in value of the common stock, by giving the holder a greater number of shares upon conversion if the price of the common stock declines. However, these floating rate convertible securities may also subject the holder to unintended consequences. For example, if the securities can be converted into more than ten percent of the common stock, the holder might run afoul of the short-swing profit rules of Section 16 of the Securities and Exchange Act of 1934. To avoid this result, many hedge funds have inserted conversion caps into their stock purchase agreements that prevent the funds from converting their securities into more than 9.9% of the issuer's common stock. The viability of this technique has been called into question by a recent judicial decision, which holds that a standard conversion cap will not prevent liability under Section 16.

Under Section 16(b), corporate insiders face strict liability for "short-swing" trading -- effecting purchases and sales (or sales and purchases) in their company's securities within a six-month period that result in a profit. Insiders under Section 16(b) include the issuer's officers and directors, as well as persons (including hedge funds) who directly or indirectly beneficially own more than ten percent of any class of any equity security. Section 16 compels insiders to disgorge all profits gained in short-swing transactions. With respect to convertible securities, a person is deemed to be a beneficial owner of the stock receivable upon conversion if he has the right to acquire such stock within 60 days through the exercise of any option, warrant or right, or through the conversion of a security.

These rules may prove to be a hidden trap for hedge funds that purchase convertible securities at a floating rate. Often, the initial conversion rate is high enough so that, if the fund fully converted its securities into common stock, it would acquire less than ten percent of the issuer's outstanding common stock. However, if, as often happens, the conversion rate falls, the fund may find itself in a position where, if it fully converted its position, it would own more than ten percent of the issuer's equity securities. Under these circumstances, the fund may be deemed to beneficially own more than ten percent of an issuer's stock and become a statutory insider under Section 16 and subject to the statute's short swing trading prohibitions.

To guard against this eventuality, many funds include clauses known as "blocker" provisions, or conversion caps, in their agreements. Typically, such provisions provide that the fund's securities shall not be convertible to the extent that, if converted, the fund would beneficially own in excess of 9.9% of the issuer's shares of common stock. The theory behind these provisions is that they prevent the fund from beneficially owning more than ten percent of the issuer's common stock, and thereby prevent the fund from becoming an insider under Section 16.

So far, only a handful of courts have considered whether blocker provisions are effective in precluding liability under Section 16. Until recently, all of the courts to consider this issue held that because conversion caps prevent holders from being able to acquire more than 10% of the issuer's common stock at any one time, the holder never becomes an "insider" and is not subject to Section 16(b)'s restrictions. One court, however, has refused to find a conversion cap provision effective to prevent short-swing trading liability. On September 13, 1999, in Schaffer v. Capital Ventures, Int'l, a federal district judge in New York held that, notwithstanding the presence of a conversion cap, a fund could beneficially own more than ten percent of the issuer's common stock (and therefore become a statutory insider). The court reasoned that the fund could dispose of more than 10% of the issuer's common stock, by converting its securities into as much as 9.9% of the issuer's common stock, selling some or all of the common stock it received, and then converting more of its securities into additional common stock. Thus, even though the fund could not hold more than 9.9% of the issuer's common stock at any one time, it nevertheless was deemed to be an insider because it had the power, in a relatively short period of time, to control more than 10% of the common stock.

The Schaffer decision casts some doubt on whether hedge funds can limit their conversion rights regarding floating rate convertible securities to prevent Section 16 liability. Until the law in this area is clarified, funds would be well-advised to restructure conversion caps to address the concerns of the Schaffer decision or avoid short-swing trading altogether.

 
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