Deemed dividends on convertible debt under sec. 305(c).

• Author: Velotta, Robert A.

Over the past decade or so, several public companies have issued convertible debt instruments that provide for a conversion rate adjustment (CRA) so that a conversion rate is changed if a distribution is made on corporate stock. One of the CRA's primary purposes is to prevent a convertible debt holder from being diluted upon a distribution to the shareholders by adjusting the conversion rate on the stock to increase the number of shares that the debt holder can obtain in a conversion of the bond to shares of the company.

To understand a CRA in its simplest form, consider the following.

Example: Bondholder holds $1 million of debt that is convertible into 20,000 common shares of Company A (20 shares of Company vis common stock per $1,000 of principal amount of the debenture, or an initial conversion rate of 20). Company vi pays a dividend to common shareholders of $0.25 per share. The company's share price immediately prior to the ex-dividend date is $40 per share. Under the formula prescribed in the debt instrument, the conversion rate is adjusted as follows: [old conversion rate (20) x share price immediately preceding the ex-dividend date ($40)] -r [share price--cash per share distributed ($40 - $0.25)]. Accordingly, the new conversion rate after the dividend is 20.1258 (20.1258 shares per $1,000 of principal). Assuming the share price remains at $40, the CRA's economic value to the convertible bondholder is $5.032 per $1,000 of bonds (CRA adjustment of 0.1258 x $40 per share), for a total increase in value to the bondholder of $5,032.

CRAs come in various forms. The convertible debt of a company may provide for a CRA for any distributions paid, whereas a company with a fairly steady distribution history may issue debt providing for a CRA only to the extent that the distributions exceed a specified threshold.

Under Sec. 305(c), a change in the conversion ratio or conversion price or a similar transaction is treated "as a distribution [by the corporation] with respect to any shareholder whose proportionate interest in the earnings and profits or assets of the corporation is increased by such change." Under Sec. 305(d), the term "shareholder" includes a holder of rights or convertible securities for Sec. 305(c) purposes.

Regs. Sec. 1.305-7(b)(1) states that an adjustment in the conversion ratio or price made under a bona fide, reasonable adjustment formula will not be considered to be a deemed distribution of stock. Examples of these types...