Convertible bonds may be an attractive financing instrument for listed companies, particularly for companies with a high growth potential. Creating a share lending facility may help issuers to increase the size and improve the pricing terms of their convertible bonds. This article aims to provide a brief overview of how such facilities may be structured and typical stumbling blocks that must be considered and addressed.
By Sandro Fehlmann (Reference: CapLaw-2024-19)
1) Introduction
Recently, a number of European companies looking to raise money in the convertible debt markets created “share borrow facilities” to improve the pricing terms of their convertible bonds and potentially allowing them to increase the size of the fundraising. While there are several ways of structuring such facilities, the most common approach involves share lending programs. Such a “share borrow facility” gives investors in the convertible offering the opportunity to hedge their convertible position through means other than a short sale of the issuer’s shares in the market. By facilitating hedging, the issuer may be able to obtain more favorable pricing terms on its convertible bonds through a lower coupon rate or higher conversion premium and significantly increase the level of investor interest in the convertible bond offering. This particularly holds true for situations where there is insufficient share borrow available for short sales. “Share borrow facilities” present a number of complex corporate, securities and regulatory issues – under Swiss law and the law of foreign jurisdictions – that must be considered and addressed as part of the offering process.
2) Background and Rationale
Investors in convertible debt securities are generally institutional investors. These institutional investors may be either “fundamental” buyers or hedge funds who are looking to hedge against changes in the value of the issuer’s shares. Convertible bond investors who wish to hedge their convertible bond position typically accomplish this by short-selling shares into the market. Because the value of a short position increases as the issuer’s share price declines, short positions allow investors to effectively offset a reduction in the value of their convertible bond holdings resulting from a decline in the value of the shares underlying their convertible bonds.
To affect a short sale of shares, an investor borrows outstanding shares and sells the borrowed shares into the market. Given the prevalence of hedge fund investors in the convertible bond market, often the number of shares available to be borrowed (commonly referred to as the issuer’s “available share borrow”) will impact the size of convertible bond offering. Depending on the circumstances, companies with little or no available share borrow may struggle to access the traditional convertible bond markets.
Recently, a number of announced convertible bond transactions by issuers have addressed inadequate available share borrow by creating a “share borrow facility” to allow investors in the convertible bonds to hedge their positions. The share borrow facility then allows the issuer to access the traditional convertible debt markets on (more) attractive terms. The mechanics of executing a convertible bond offering itself are generally the same whether or not the issuer is creating a share borrow facility.
3) Mechanics of the Share Borrow Facility
a) Overview
Share borrow facilities can be accomplished either (i) by means of the issuer entering into a share lending agreement with a stock lending agent (usually an affiliate of a member of the underwriter syndicate of the convertible bonds), whereby the issuer lends issued and/or unissued shares to the lending agent, or (ii) by means of the issuer entering into a prepaid forward contract with a member of the underwriter syndicate or an affiliate of such member, whereby the issuer agrees on the contract date to purchase shares at a fixed price on the maturity date of the convertible bonds. The purchase price of the shares is typically paid upfront from the proceeds of the convertible bond offering, which, as discussed further below, reduces the issuer’s net proceeds. In certain instances, however, it may be possible for the issuer to delay payment of the purchase price until the maturity of the convertible bonds, giving the issuer access to all the proceeds of the offering in the interim.
b) Share Lending Program
A number of recent convertible bond offerings with share borrow facilities have been completed using a share lending facility. To execute a share lending facility, the issuer lends shares to a lending agent concurrently with the offering and issuance of the convertible bonds. The lending agent is typically an affiliate of one of the underwriters of the convertible debt offering. The lent shares may be newly issued shares, treasury shares or a combination of both. The share lending is governed by a share lending agreement which requires the lending agent to return the shares once the bonds are converted, redeemed, repurchased or repaid. Once the shares are borrowed, the lending agent will sell some or all of the shares short into the market.
Once the lending agent has sold the shares short, the lending agent is in a position to transfer the short position to convertible bond holders, either through equity swap arrangements or directly, depending upon the legal requirements.
c) Prepaid Forward Contract to Repurchase Shares
As an alternative to implementing a share lending facility, an issuer can create a share borrow facility through a prepaid forward contract, which is entered into with a member of the underwriter syndicate (or an affiliate of a member) in lieu of a share lending agreement. A prepaid forward contract is an agreement between the issuer and the underwriter whereby the issuer agrees today to repurchase shares at a fixed price if the convertible bonds are converted, redeemed, repurchased or repaid. By entering into the prepaid forward contract, the underwriter (or its affiliate) is agreeing to deliver shares in the future that it does not own on the contract date. This agreement to deliver shares it does not own is effectively a “short” position in the issuer’s shares. The underwriter can transfer this short position to the convertible bond investors via a swap transaction, and thereby allow the investor to hedge its position in the convertible bonds. This enables the convertible bond investors to hedge their position without borrowing and selling shares into the market. From the issuer’s perspective, its agreement to repurchase its shares has the added benefits of mitigating the potential dilution from the convertible bond offering and reducing the amount of short selling into the market that would otherwise result from the offering.
The net result to the issuer from a prepaid forward contract is similar to a share lending facility, since both create a short position that can be transferred to the convertible bond investors, thereby allowing them to hedge their positions without borrowing shares in the market. The prepaid forward contract, however, will typically result in the issuer receiving lower proceeds from the convertible offering since a portion of the proceeds is used to repurchase shares under the prepaid forward contract. This contrasts to the share lending facility, for which the issuer is not required to use any of the proceeds in connection with the lending of the shares. For this reason, we have seen more share lending facilities in order to create a share borrow facility (though in certain circumstances, for prepaid forward contracts it may also be possible for the issuer to finance the cost of the repurchase either by upsizing the convertible transaction or implementing a loan agreement with a commercial bank).
4) Swiss Regulatory Considerations
a) Disclosure Duty of Major Shareholdings
According to article 17 (2) (a) of the Financial Market Infrastructure Ordinance FINMA (“FinMIO-FINMA“), the disclosure duty in a securities lending facility is incumbent on the borrower. Hence, the lending agent as borrower must notify a purchase position due to his right to borrow and receive shares under the share lending facility.
The lender, however, must not make any corresponding disclosure notification (by way of disclosing a selling position). However, since the lender remains the beneficial owner of the shares to be on-lent (to the extent such shares have already been created), the lender and the borrower will both disclose a purchase position resulting in a “double notification”. This applies irrespective of whether the shares are actually lent or not. Neither the lending agent as borrower nor the lender will, however, disclose a selling position.
b) Technicalities of the Reporting of Major Shareholdings
The positions requiring notification must be calculated based on the total number of shares in accordance with the entry in the respective commercial register (article 14 (2) FinMIO-FINMA). This also applies for shares created out of conditional share capital. Hence, the number of shares in the denominator (to determine the relevant shareholdings and thresholds) must always be the number of shares in accordance with the entry in the commercial register.
c) Considerations from a public takeover perspective
Article 135 of the Financial Market Infrastructure Act (“FinMIA“) requires any who directly, indirectly or acting in concert with third parties acquires equity securities which exceed the threshold of 33⅓% of the voting rights of a target company to make a tender offer. For the calculation of the 33⅓% threshold for mandatory public takeover purposes, only shares (i) which are owned by a shareholder or (ii) for which it may exercise voting rights in other ways are counted (see BSK FinFraG – Kuhn, Article 135 N 13). “Acquisition” within the meaning of article 135 (1) FinMIA applies, however, not only to the acquisition of ownership of shares, but also to the acquisition of usufructus (article 34 (2) FinMIO-FINMA in conjunction with article 690 (2) of the Swiss Code of Obligations). Securities lending and so-called repo transactions are to be treated as transfers of ownership if the borrower or buyer also acquires the right to exercise voting rights (see TOB, Recommendation, June 27, 2005, Unaxis Holding AG, E. 5.1; BSK FinFraG – Kuhn, Article 135 N 31).
As long as the shares remain on the client account with the lending agent, such lent shares are not counted towards the 33⅓% threshold of article 135 FinMIA. Only once the lending agent borrows the shares and thereby becomes the legal owner, such shares would, in theory, be counted towards the threshold of article 135 FinMIA (subject to any applicable statutory exception or exemption from the Swiss Takeover Board). However, according to legal scholars and an older recommendation issued by the Swiss Takeover Board in 2005 (see TOB, Recommendation, 27 June 2005, Unaxis Holding AG, E. 5.1), for banks (as lending agents) such rule only applies if the bank not only acquires naked ownership, but also the corresponding voting rights. In addition, whenever such shares are on-sold or on-borrowed by the lending agent to a third party (such as a hedge fund), these shares would not count anymore towards the 33⅓% threshold.
Hence, shares on the lender’s securities account with a bank as lending agent available under a securities lending facility do not count towards the 33⅓% threshold as long as no transfer of legal title has occurred and the lending agent has no other means of exercising the voting rights. In light of this general rule, securities lending agreements often contain a contractual provision where the lending agent waives any rights to exercise the voting rights of any shares received under the securities lending facility.
5) Conclusion
By allowing convertible bond holders to hedge their positions, share borrow facilities have the potential to significantly enhance the terms of a convertible bond offering, and may give companies access to the convertible debt markets when they would not otherwise be able to do so, absent the borrow facility. Convertible debt offerings containing a share borrow facility present a number of challenging corporate, securities and regulatory issues and, hence, must be carefully structured.
Sandro Fehlmann (sandro.fehlmann@advestra.ch)