COVID-19: Stock volatility and your convertible notes (United States)

The coronavirus disease (COVID-19) outbreak has had and continues to have significant human, commercial and financial impacts all over the world. One undeniable impact is the economic uncertainty created by COVID-19 and the related historic volatility in global securities markets. While the impact of this volatility on a company’s common stock may be clear, the impact on a company’s equity-linked securities, like convertible bonds, may be less apparent. 

This alert is intended to assist companies in thinking about how the market volatility could impact their outstanding convertible notes and the accompanying call-spread overlay equity derivatives. Convertible note indentures and bond hedge and warrant confirmations vary from deal to deal, sometimes significantly, so the concepts addressed below are general considerations. The actual terms of these securities are very complex, so companies are encouraged to reach out to their DLA Piper relationship partner or a member of DLA Piper’s equity-linked team to assist in the review of the relevant documentation.

Disruption events: market closures and circuit breaker triggers

If a convertible bond is maturing or otherwise subject to conversion in the near future, the issuing company is encouraged to remain aware of “market disruption events,” whether caused by a suspension of trading on an applicable stock exchange or the market-wide “circuit breakers” triggered by precipitous declines in prices. In short, when a convertible note is being settled in cash or a combination of cash and common stock, a daily volume-weighted average price of the relevant common stock over a measurement period is required to determine what amount of cash and/or shares are to be deliver to converting holders of the notes. If a “market disruption event” occurs on a given day, the measurement period is pushed out an additional day.

A typical definition under a convertible note indenture for “market disruption event” is (a) the failure to open the applicable market where the underlying common stock is listed, whether The New York Stock Exchange (NYSE), the various Nasdaq markets (collectively Nasdaq) or (b) the occurrence of a suspension in trading in the underlying common stock (or any options or futures contracts for the common stock) for more than one half-hour period in the aggregate during regular trading hours. Call-spread confirmations (as discussed in more detail below) typically have an analogous “Market Disruption Event” definition, although without the half hour threshold for trading disruptions (an important difference).

An example of a “market disruption event” is the total shutdown of the NYSE or Nasdaq, as occurred in the aftermath of the September 11, 2001 terrorist attacks and during Hurricane Sandy. If COVID-19 was to cause a market shutdown and trading did not resume electronically (such as occurred during Hurricane Sandy), a “market disruption event” would be deemed to have occurred and any measurement period under the indenture would need to be adjusted to give effect to the loss of the trading day(s) during which the market disruption event occurred.  The NYSE’s recent announcement of its movement to all electronic trading would not, by itself, constitute a “market disruption event” under this definition.

Market disruption events could also occur upon the triggering of market-wide circuit breakers due to market price declines. Such circuit breakers have already been triggered multiple times during the COVID-19 pandemic. However in order for these circuit breakers to cause a market disruption event under the typical definition in convertible bond indentures, the relevant stock market would need to fall by at least 20 percent, such as occurred on the “Black Monday” crash in 1987. This is because both the NYSE and Nasdaq follow the three level circuit breaker system, with Level 1 occurring at a 7 percent decline, Level 2 occurring at a 13 percent decline, and Level 3 at a 20 percent decline. Tripping Level 1 and Level 2 of the market circuit breaker generally triggers a 15 minute pause in trading. As a result, in order for the circuit breaker system to trigger a “market disruption event” of more than 30 minutes of trading inactivity under the typical definition, a Level 3 trigger, or 20 percent decline, would be required, resulting in suspension of trading for the remainder of the scheduled trading day. 

It is important to understand that the definitions of “market disruption event” under indentures or call spread confirmations may vary on this point. As mentioned above, the standard definition in call-spread confirmations does not include the 30 minute lower threshold, so any triggering of the circuit breakers would push out the measurement period under the confirmation at issue, creating a mismatch to measurement period for the related convertible notes.

Fundamental change

Indentures governing convertible notes typically contain a provision requiring issuers to repurchase the notes at par upon a “fundamental change.” What constitutes a “fundamental change” is defined in the indenture and generally includes:

(a) a person or group acquiring 50 percent of the voting stock; 
(b) a recapitalization; 
(c) a share exchange, consolidation, or merger under which the common stock gets converted into other assets; or
(d) a sale of substantially all of the assets of the issuer. 

The fundamental change definition typically also contains an element relating to the listing and quotation of underlying shares on the NYSE, Nasdaq, or any successor (the “Exchange Listing Prong”). The intent of the Exchange Listing Prong is generally understood to address the situation in which shares underlying the notes are delisted, such as when the trading price of an issuer’s common stock falls below the listing thresholds for the applicable exchange. 

Hedging disruption events

If the Securities and Exchange Commission (the SEC” bans short selling, dealer counterparties may be able to terminate their commitments due to a “hedging disruption” under the call-spread confirmations designed to mitigate the dilutive impact of convertible notes. In 2008, the SEC adopted an emergency order that temporarily halted short selling in nearly 1,000 financial stocks. Companies with outstanding call spread confirmations should consider the impact to their capped calls, bond hedges and warrants if the SEC limits short selling in US markets.

Call spread overlays, whether by capped-call or bond hedge and warrant, also are intended to mitigate the dilutive impact of the convertible notes. These products are documented by “confirmations” that supplement, and are governed by, an International Swaps and Derivatives Association, Inc. (ISDA) Master Agreement. The ISDA Master Agreement will contain a number of definitions that are defined in the ISDA Equity Derivatives Definitions and those definitions are supplemented in the confirmations for a given deal.

“Hedging disruption” under the ISDA Equity Derivative Definitions is a regularly negotiated point within confirmations and is relevant to the analysis here. Under the Equity Derivative Definitions, a “hedging disruption” means that the dealer counterparty is unable, after using commercially reasonable efforts, to hedge the equity price risk of entering into and performing its obligations under the confirmations, or realize, recover or remit the proceeds of any hedging activities related to the confirmations. If the SEC bans short selling in a given company’s stock that is underlying a convertible note that was issued with a call-spread overlay, the dealer counterparties to the confirmations related to that convertible note issuance will be able to terminate their obligations under those confirmations. They would be able to do so because they would be unable to hedge the price risk of the underlying common stock. If a dealer terminates its obligations under a bond hedge confirmation, the issuing company would be unable to have that dealer counterparty deliver the settlement amount intended to be provided to holders of convertible notes upon conversion, thus losing the benefit of the call-spread overlay’s dilution protection.

In addition, to the extent that call spread confirmations elect the application of one or more of “Loss of Stock Borrow,” “Increased Cost of Stock Borrow” or “Increased Cost of Hedging,” and a dealer is unable to borrow shares, is able to borrow them only at a level greater than the rate specified in the confirmation, or would occur materially increased costs in establishing or maintaining its hedge positions, that dealer could have rights to modify trade terms or unwind the transaction at the dealer’s side of the market.

We should note that we are unaware of any dealers terminating call spread confirmations during the SEC’s 2008 order suspending short selling. To the extent, a dealer counterparty reaches out to you in connection with terminating its obligations under a call-spread confirmation, please contact a member of the DLA Piper equity-linked products team or the DLA Piper attorney who assisted you in the creation and entering into of the call spread confirmations.

Force majeure event

It is theoretically possible that there will be a “Force Majeure Event” (FME )under the ISDA Master Agreement, which requires a payment or delivery failure by reason of force majeure or act of state beyond the parties’ reasonable control. FMEs under ISDA Master Agreements are rare events and typically only have been invoked in cases in which natural disasters or sovereign related events have prevented parties from making payments or deliveries. Given the lack of specificity in the FME clause, there could be a dispute as to whether a failure to make a payment or delivery arose by reason of an FME. In that case, there could be an issue as to whether the failure to pay or deliver will be an Event of Default, which is subject to a 1 business day grace period under the 2002 form ISDA Master Agreement, or an FME, which carries an 8-day waiting period under that form. If a FME clearly has occurred, the failure to pay or deliver will be an FME subject to the waiting period and not an Event of Default.

Good news

Convertible note investors include traditional institutional “long-only” investors, as well as hedge fund investors that utilize the convertible notes to monetize the volatility of the underlying common stock. For companies with high hedge fund investor participation, the hedge fund trading in the convertible note is beneficial to the stability of underlying stock in times of high volatility, as the hedge fund investors buy the underlying stock on down days and sell on days in which the stock goes up. Thus, companies in the market with outstanding convertible notes may see less volatility, or dampened volatility, as compared to those companies that do not have a convertible note in the market.

Concluding thoughts

The uncertainty of the economic impacts of COVID-19 is causing extreme volatility in the capital markets. This volatility may have practical impacts on your outstanding convertible notes, particularly in connection with any near term settlement in cash or a combination of cash and common shares. 

As the impact of COVID-19 continues to evolve, DLA Piper is available to assist in helping companies manage the various legal implications of the outbreak. Should you have any questions about the impact of COVID-19 on your outstanding convertible notes or the related call-spread overlay, or other matters related to the COVID-19 outbreak and related market volatility, please do not hesitate to reach out to your DLA Piper contact or a member of the DLA Piper equity-linked team.

Please contact a member of the DLA Piper Equity-Linked Products team:

John Gilluly
Jamie Knox
Marc Horwitz
Larry Nishnick
Drew Valentine

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