CFM82190 - Old rules: convertibles pre 2005: nature of the security: likelihood of conversion

Holder likely to convert

This guidance applies to periods of account beginning before 1 January 2005

The legislation in FA96/S92(1)(e) asked whether, when the security was issued, there was a ‘more than negligible likelihood’ that the holder would want to exercise its rights to convert or exchange the securities in whole or in part.

In a normal commercial arrangement, the conversion right is valuable and so the interest payable on the security is likely to be lower than it would be in a non-convertible security. But where the terms of the security provide for a high interest rate, it is likely that the shares will be worth less than the redemption amount, or even have no value at all (such as deferred shares) and the holder will not opt to convert.

Holder unlikely to convert: Example

LB Ltd issued a security for £10,000 with a face value of £10,000, to KD Ltd. The terms showed that

• interest of 15% was payable for 2 years
• at the end of Year 2, the holder could choose to convert the security into LB Ltd shares
• the shares would be issued on a 1 for 1 basis, that is, £1 nominal loan stock would be converted into £1 nominal of shares issued by LB Ltd.

If the market rate of interest was 8%, and LB Ltd £1 shares were worth 20p, it would have been unlikely that KD Ltd would opt for conversion. Instead, KD would be satisfied with a return that was the interest payable, plus the repayment of the amount lent.

From the information available at the time of issue, the likelihood of the holder opting for conversion was negligible, and s92 would not have applied. The legislation only asked for a ‘more than negligible’ chance of conversion on issue.

The test was carried out on issue and not at a later date with the benefit of hindsight. For example, a company may issue a convertible and at a later date the company shares plummet in value. The convertibles may have looked perfectly reasonable at the time of issue, but because the shares are now worth so little, holders are unlikely to exercise their option to convert.