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Exchangeable securities, which often include terms that are similar to convertible securities, have likewise become a significant factor in the capital markets. Because these securities are exchangeable for the equity of a different issuer, these securities enable an issuer to

“monetize” a securities position that it holds in another issuer. In addition, such securities form a staple of the many structured notes programs adopted by various U.S. domestic investment banks and others. Structured notes are offered by investment banks as a means of providing purchasers with exposure to the equity security to which the note is linked when instruments providing the economic terms of the structured note have not been issued by the issuer of the underlying common equity.²

BASIC STRUCTURAL PROVISIONS

Securities that may be converted into, or exchanged for, common equity at the option of the holder are commonly referred to as optional convertible or optional exchangeable securities.

Securities that will automatically or at the option of the issuer be converted or exchanged for the underlying equity are commonly referred to as mandatory convertible or mandatory exchangeable securities.

Convertible and exchangeable securities are generally debt securities or preferred stock;

they may also take the form of trust preferred or other types of securities issued by special purpose vehicles. Regardless of the form, convertible and exchangeable securities generally provide:

• an income stream (which may be a fixed or floating interest rate and, in the case of zero coupon convertible securities, may have an accreting principal amount);

• anti-dilution protection; and

• takeover protection.

The conversion or exchange feature embedded in a convertible or exchangeable security is, in effect, an option to purchase the underlying equity at the conversion or exchange price of the security (i.e., the number of shares deliverable divided by the principal amount or liquidation value of the security). Since the embedded option has value to the investor, the investor effectively pays the issuer for this option by accepting a lower interest rate than for a comparable, non-convertible security.

Convertible and exchangeable securities generally protect against dilution of the underlying common equity from certain corporate actions or events that affect the underlying common equity. Some of the more standard events include stock splits or combinations, distributions of securities or assets, changes in the rate at which cash dividends are payable on the underlying equity, mergers and issuer tender offers.

2 See Chapter 7 (Structured Notes) of this volume.

In addition to anti-dilution adjustments, protection is often provided for change of control events, particularly a cash acquisition. Frequently a change of control will enable the holder to put the security to the issuer at its principal amount or liquidation value. However, because convertible securities contain an embedded option, a put right resulting from an event such as a cash acquisition that permanently impairs the value of the embedded option would not necessarily fully compensate the investor for the loss of this value. As a result, it has become standard for convertible securities issued in the U.S. capital markets to include a make-whole payment in connection with a cash acquisition. This make-whole often takes the form of an increase in the conversion rate.

1933 ACT CONSIDERATIONS³

At the time of offer and sale, convertible or exchangeable securities, like any other class of securities, must either be registered under the 1933 Act or offered and sold pursuant to an exemption from registration. The exemption provided by Rule 144A under the 1933 Act is the most common exemption from registration used by issuers in the U.S. capital markets.

Optional Convertible or Exchangeable Securities

Offerings of convertible or exchangeable securities that are immediately convertible or exchangeable are considered to be offers for the purchase of the underlying security as well as the convertible or exchangeable securities. This is because the definition of “offer” in Section 2(a)(3) of the 1933 Act includes a right to convert or exchange a security into another underlying security as an offer of the underlying security unless the conversion or exchange right cannot be exercised until a “future date.” The staff of the SEC (the “Staff”) has defined “future date” as any date that is beyond one year of the date in question. As a result, unless the conversion or exchange cannot occur prior to one year from the date of issue, in addition to the requirement for registration of the convertible or exchangeable security (or for there to be an applicable exemption from those requirements), the underlying equity must also be registered at the time of sale of the convertible or exchangeable security unless an exemption from registration is available. Where convertible or exchangeable securities are not convertible or exchangeable within one year from the date of issue, the issuer may choose not to register the underlying securities at the time of registering the convertible or exchangeable securities, but, in the absence of an available exemption, the underlying equity must be registered no later than the date the securities become convertible or exchangeable.

Securities underlying optional convertible or exchangeable securities are considered to be sold at the time the investors elect to convert or exchange. Therefore, the underlying securities must be registered at the time of conversion or exchange unless an exemption (such as Section 3(a)(9) discussed below) is available. If an exemption from such registration is not available, the issuer of the underlying security will be required to furnish a prospectus in connection with the conversion or exchange and, as a consequence, will be required to employ an “evergreen” shelf registration statement (i.e., a shelf registration statement that will be available at all times during

3 For recently updated interpretive guidance by the Staff on certain 1933 Act considerations, see http://www.sec.gov/divisions/corpfin/cfguidance.shtml#sas.

CHAPTER 3—CONVERTIBLE AND EXCHANGEABLE SECURITIES SIDLEY AUSTIN LLP

the optional conversion or exchange period). If an evergreen registration statement is not viable, the terms of the security may restrict the periods during which the holder may convert or exchange.⁴

Section 3(a)(9) Exemption for the Conversion or Exchange

Section 3(a)(9) of the 1933 Act provides an exemption for a security that is exchanged by the issuer with its existing securityholders where no commission or other remuneration is paid for soliciting such exchange. Provided the underlying securities are securities of the same issuer as the issuer of the convertible securities, Section 3(a)(9) would be available to exempt the issuance of the underlying equity upon conversion so no evergreen prospectus would need to be delivered upon conversion.

The “same issuer” requirement means that the exemption provided by Section 3(a)(9) of the 1933 Act is generally not available for exchangeable securities. When a trust or other special purpose vehicle issues securities that are exchangeable for securities of its parent, and the parent guarantees the securities of the special purpose vehicle such that the ultimate credit relied upon by investors is that of the parent, SEC no-action letters have permitted reliance upon the Section 3(a)(9) exemption.⁵

Section 4(1) Exemption for the Conversion or Exchange

Where the Section 3(a)(9) exemption is not available for the issuance of the underlying securities upon conversion or exchange, the underlying securities must be registered and a prospectus must be delivered upon conversion or exchange unless another exemption is available (e.g., Rule 144A, Section 4(1), etc.).

• Exchangeable Securities. An exemption pursuant to Section 4(1) of the 1933 Act will be available if there is no involvement by the issuer of the underlying security or if no underwriter or dealer is involved. As such, under many circumstances, issuers of an exchangeable security may be able to avail themselves of this exemption from registration.

• Affiliate Relationships. If there is a control or affiliate relationship between the issuer of the exchangeable security and the issuer of the underlying security (as would be the case where an issuer issues notes that are exchangeable for the equity of another entity that the issuer controls), the Section 4(1) exemption would not be available because the transaction would be deemed to involve the issuer. In addition, even where the issuer of the exchangeable security is not affiliated with the issuer of the underlying security, the exemption provided by Section 4(1) may nevertheless be

4 Some issuers are reluctant to obligate themselves to provide an “evergreen” shelf registration statement given the potential for material corporate developments to arise at any time. Depending on the facts and circumstances, a development of this nature might not be ripe for public disclosure. However, the non-disclosure of a material development would constitute a material omission from the related prospectus.

5 See SEC No-Action Letters The Timken Company, available January 20, 1986, and Svenska Cellulosa Aktiebolaget SCA, available December 15, 1988.

deemed to be a distribution of the underlying security by the issuer. For example, if the issuer of the exchangeable security were to enter into a forward agreement or other hedging arrangement in respect of its delivery obligations under the exchangeable security with the issuer of the underlying security or an affiliate of that issuer, the issuance of the exchangeable security would be viewed as a distribution of the underlying securities on behalf of the issuer or affiliate.

• Disclosure Issues. Even if Section 4(1) of the 1933 Act provides the issuer of the exchangeable security with an exemption from registration, the issuer of the exchangeable security must also consider whether it has provided adequate disclosure about the underlying security.⁶

Mandatory Convertible or Exchangeable Securities

Where securities are convertible or exchangeable on a mandatory basis, the underlying securities must be registered or exempt at the time the convertible or exchangeable securities are initially sold since the investment decision with respect to the underlying securities is being made at that time, regardless of when the securities actually convert into, or are exchanged for, the underlying securities. That is, by making an investment decision to purchase the mandatorily convertible or exchangeable security, the investor is viewed to be concurrently making an investment decision to own the underlying security. Consequently, in the case of mandatorily convertible or exchangeable securities, there is a current sale of the convertible or exchangeable security and the underlying security. There is no separate sale of the underlying security upon conversion or exchange unless at that time the holder is required to make an additional investment or an investment decision. As such, the mandatory conversion or exchange is not a registrable event and no prospectus need be delivered (or an exemption from such requirements required) in connection with the mandatory conversion or exchange.

Shelf Registration for an Offering of Convertible or Exchangeable Securities

If an issuer has a pre-existing effective shelf registration statement, each of the convertible or exchangeable securities and the underlying securities must have been included in the shelf registration statement at the time of effectiveness (or at such later date as described above if the securities are not immediately convertible). If either class was not included in the shelf registration statement, the issuer must file a new registration statement or, if the issuer is a

“WKSI,” file a post-effective amendment to add the securities to the shelf registration statement or proceed with the offering in reliance upon an exemption from registration.

If the issuer is a WKSI, the requirement to file a shelf registration statement or a post-effective amendment to a WKSI shelf to add the convertible or exchangeable securities and underlying securities should not be burdensome. Such registration statements or post-effective amendments automatically become effective upon filing with the SEC. Accordingly, any execution risk caused by the potential for the SEC to review the filing is minimized.

6 For further information on disclosure issues, see the discussion in this chapter below under the heading “—

Documentation and Liability Issues Relating to Exchangeable Securities.”

CHAPTER 3—CONVERTIBLE AND EXCHANGEABLE SECURITIES SIDLEY AUSTIN LLP

Exemptions from Registration for an Offering of Convertible or Exchangeable Securities

Rule 144A

Rule 144A under the 1933 Act is only available for securities that, when issued, are not of the same class as securities listed on a national securities exchange or quoted in a U.S.

automated interdealer quotation system.

Optional Convertible or Exchangeable Securities

With respect to convertible or exchangeable securities, Rule 144A specifies that the convertible or exchangeable securities will be deemed to be of the same class as the securities into or for which the exchangeable or convertible securities are convertible or exchangeable unless the convertible or exchangeable securities are issued with an effective conversion premium of at least 10%.

Because of the depth of liquidity for securities issued in reliance upon Rule 144A, Rule 144A has become the dominant exemption used in connection with the issuance of unregistered optional convertible securities.

Mandatory Convertible or Exchangeable Securities

The SEC views the offer and sale of a mandatory convertible or exchangeable security as an immediate sale of the underlying security. Accordingly, the exemption provided by Rule 144A is not available for mandatory convertible or exchangeable securities unless the underlying securities are otherwise unrestricted securities within the meaning of the 1933 Act or otherwise when issued were not of the same class as securities listed on a national securities exchange or quoted in a U.S. automated interdealer quotation system.⁷

• Mandatory Convertible Securities. In the absence of registration, the underlying securities, like the convertible securities, are by definition restricted securities within the meaning of the 1933 Act. Accordingly, in the absence of registration under the 1933 Act, mandatory convertible securities must be issued in reliance upon the exemption provided by Section 4(2) of the 1933 Act or another available exemption.

• Mandatory Exchangeable Securities. Because the issuer of the exchangeable security is not the issuer of the underlying security, depending on the facts and circumstances and the structure of the particular transaction, the underlying securities may or may not be restricted securities within the meaning of the 1933 Act. Where the underlying securities are themselves eligible for resale in reliance upon Rule 144A (as in the case of founder’s shares) or are otherwise unrestricted (as in the case of an issuer of an exchangeable security that has no hedging or other similar arrangements in place with the issuer of the underlying securities and that is not an affiliate of such issuer), the

7 See SEC No-Action Letters Shearman & Sterling, available December 21, 1998, and Cravath, Swaine & Moore, available October 25, 1999.

exchangeable security would be eligible for resale in reliance upon Rule 144A provided it otherwise meets the eligibility criteria of Rule 144A.⁸

Regulation S

Pursuant to Rule 405 under the 1933 Act and certain no-action letters issued by the SEC, convertible and exchangeable debt securities are treated as “equity securities” for purposes of Regulation S.

Convertible or Exchangeable Securities in Global Form

Where convertible securities issued in global form in reliance on Regulation S are eligible for resale pursuant to Rule 144A, the SEC will not require the implementation of the stop transfer provisions set forth in Rule 903(b)(3)(iii)(B)(4) of Regulation S provided that the transaction requirements comply with the requirements set forth in the SEC No-Action Letter Cravath, Swaine & Moore, available August 26, 1998.

Listing Issues

The issuer may be required to list the common stock issuable upon conversion of the convertible instruments pursuant to a listing application with the relevant exchange. In addition, if the convertible or exchangeable securities are not being sold pursuant to an effective registration statement, under DTC’s rules, DTC will only accept the convertible or exchangeable debt securities if they are eligible for resale pursuant to Rule 144A and included in an SEC-approved self-regulatory organization (“SRO”) transfer system like NASDAQ’s institutional market called “PORTAL.” PORTAL has become the SRO transfer system of choice for these listings. If a PORTAL listing is required, the lead underwriter for the offering will need to apply for the PORTAL listing on behalf of the issuer and deliver to DTC and the issuer confirmation from PORTAL that the convertible or exchangeable debt securities have been approved for trading on PORTAL.

REGISTRATION RIGHTS

Where convertible or exchangeable securities are issued in reliance upon an exemption from the registration requirements of the 1933 Act, an issuer may enter into a registration rights agreement with the underwriters of the securities for the benefit of the holders of the securities in which the issuer agrees to set up and maintain a resale shelf with the SEC that will allow the holders to sell the securities pursuant to an effective registration statement or, in some cases, to exchange the securities for 1933 Act-registered securities.

The registration rights agreement contains a series of milestones, discussed in further detail below, that, if not achieved, result in the issuer paying liquidated damages (typically in the form of an increase in the interest rate payable on the convertible or exchangeable security) until such requirements are satisfied.

8 Id.

CHAPTER 3—CONVERTIBLE AND EXCHANGEABLE SECURITIES SIDLEY AUSTIN LLP

Resale Registration

Resale registration rights agreements typically require the issuer to file and to cause to become effective a registration statement and related prospectus relating to the resale of the securities issued in the non-registered offering. Such agreements generally also require the issuer to maintain the effectiveness of the shelf registration statement and usability of the related resale prospectus during the period in which the unregistered securities are ineligible for resale without restriction in the absence of an exemption from registration.

The filing and effectiveness deadlines have varied from deal to deal but typically have been within three to six months, respectively, from the closing. However, amendments to Rule 144 under the 1933 Act adopted by the SEC in December 2007, which liberalized the resale provisions of Rule 144, have resulted in changes to these deadlines and have also called into question the necessity in any event of such agreements. Pursuant to these amendments, holders of securities issued in unregistered offerings that are not affiliates of the issuer may generally resell without restriction after six months from the issue date of the securities if the issuer is subject to the reporting requirements of the 1934 Act. If the issuer has not filed all required reports (other than reports on Form 8-K or 6-K) or if the issuer is not subject to the reporting requirements of the 1934 Act, then holders who are not affiliates may freely sell the securities after one year from the issue date.

Since the period of free tradability under the amended rule commences at the point when a prospectus was historically provided, certain of the historical registration rights provisions are viewed as redundant. Some transactions completed shortly after the adoption of the Rule 144 amendments required the filing of a registration statement only if the unregistered securities were not eligible for resale (for example, where the issuer has failed to file a required document (other than a report on Form 8-K or 6-K) pursuant to the 1934 Act) commencing six months from the issue date. Other transactions executed during this period dispensed with registration rights in their entirety, requiring only the payment of liquidated damages if the unregistered securities were not eligible for resale without limitation by holders who are not affiliates of the

Since the period of free tradability under the amended rule commences at the point when a prospectus was historically provided, certain of the historical registration rights provisions are viewed as redundant. Some transactions completed shortly after the adoption of the Rule 144 amendments required the filing of a registration statement only if the unregistered securities were not eligible for resale (for example, where the issuer has failed to file a required document (other than a report on Form 8-K or 6-K) pursuant to the 1934 Act) commencing six months from the issue date. Other transactions executed during this period dispensed with registration rights in their entirety, requiring only the payment of liquidated damages if the unregistered securities were not eligible for resale without limitation by holders who are not affiliates of the