A Supreme Court decision has delivered a hefty blow to holders of HIH Holdings (NZ) convertible notes leaving them with little hope of recovering any of their investment.
The decision brings into sharp focus the risks of convertible notes for both investors and issuers. In particular, the way in which the notes are structured can leave investors unable to claim against an issuer if it becomes insolvent. This has relevance in all sectors, particularly in the mid cap mining sector where single asset entities struggle to raise bank debt and so have increased their reliance on convertible notes significantly.
Convertible notes are “hybrid” securities with both debt and equity characteristics. Like ordinary bonds, convertible notes have an issue size, maturity date, face value and coupon. What makes them different is that noteholders can typically choose to redeem the notes for an agreed cash value at maturity or convert them into shares in the issuing company.
The treatment of convertible notes as either debt or equity has important consequences for investors and issuers, from both a tax perspective as well as the claims that may be made against the issuer on its insolvency.
The recent New South Wales Supreme Court decision in Perpetual Trustee Company Ltd v HIH Holdings (NZ) Ltd (In Liq) highlights why issuers need to be clear on the nature of convertible notes at the time they are issued.
HIH NZ issued 42,620,000 unsecured convertible notes having a face value of $A213 million. The Notes were issued on the basis that if HIH NZ did not elect to redeem them in cash by a certain date, they would “automatically” be converted into ordinary shares in HIH NZ’s parent company, HIH Insurance Ltd.
This conversion process involved two discrete steps, which in the courts’ view could not be collapsed into a single process:
- HIH NZ would redeem the notes for an amount equal to their face value; and
- HIH NZ was automatically directed to use the money payable to it on redemption to subscribe to shares in HIH.
HIH NZ did not elect to redeem the Notes for cash prior to going into liquidation in 2001and in 2007 Perpetual Trustee Company successfully sought to terminate the subscription agreement.
In 2009, the noteholders made a creditor’s claim with HIH NZ’s liquidators, alleging that the company was indebted to the noteholders and obliged to redeem the Notes for an amount equal to their face value.
The claim was rejected by the liquidators, who declared that all the noteholders had was a right against HIH NZ for damages for breach of its obligation to convert the Notes to HIH shares. It was common ground that this right was worthless as by 2009 HIH was insolvent.
In his judgment, Macfarlan JA brought into focus that a debt can take many forms, and that the obligation to repay may not sound in money. He likened the convertible note structure to that of a limited recourse financing, in which the right to recover is limited to specific assets.
While subscription agreements frequently provide for redemption upon the issuer’s insolvency, in the HIH NZ case the obligation to redeem the Notes for their face value was not regarded as the primary liability, but rather the direction for HIH NZ to utilise the funds to subscribe for shares in HIH.
For noteholders, this meant the difference between being a creditor who would receive 24 cents in the dollar, versus being an equity holder whose claims are generally subordinated to those of creditors.
HIH shares are worthless of course, leaving noteholders with nothing.
We don’t know why the HIH NZ Notes were structured in this way, but it may have been to ensure they were treated as equity rather than debt for tax purposes.
The resounding lesson is that prior to issuing a convertible note, it is essential issuers consider not only their own financial needs, but also the impact of the structure on investors. How will the notes be treated for tax purposes and what are ramifications in the face of any potential insolvency?