A common feature of many convertible debenture indentures is the ability of the issuing company to repay the debentures at maturity by issuing shares. The financial challenges faced by many oil and gas companies in today's markets are likely to result in an increase in repayments of convertible debentures in this fashion. This was the situation with Perpetual Energy Inc. (Perpetual). Perpetual recently announced that it would repay a series of its convertible debentures by issuing shares as part of a series of recapitalization transactions which included a dilutive rights offering that holders of debentures were not permitted to participate in. Several of Perpetual's debentureholders challenged the rights offering at the Alberta Securities Commission (the ASC) by attempting to have the rights offering cease traded.
On January 5, 2016, the ASC released the reasons for its decision in Perpetual Energy Inc. In the decision, the ASC declined the debentureholders' challenge.
Background to the debentureholders' challenge
On November 20, 2015, Perpetual announced recapitalization transactions that included: (i) a $25 million fully backstopped rights offering to existing shareholders and (ii) the repayment of its 7% convertible debentures due December 31, 2015 (the Debentures) using common shares (Perpetual Shares) of Perpetual (which Perpetual had the ability to do under its convertible debenture indenture). Each right entitled the holder to acquire a number of Shares for $0.163 per Perpetual Share based on a formula that will result in current shareholders owning 78% of the Perpetual Shares and debentureholders owning 22% of the Perpetual Shares upon completion of the recapitalization transactions.
The rights offering was challenged by Polar Asset Management, K2 & Associates Investment Management Inc. and Cambridge Global Asset Management (the Applicants). The Applicants viewed the rights offering as unfair and dilutive to the debentureholders' share ownership in Perpetual following the repayment of the Debentures in Perpetual Shares.
Under the terms of the indenture under which the Debentures were issued (the Indenture), the Debentures could be repaid at maturity in Perpetual Shares, based on a 20-day volume weighted average of Perpetual's share price (VWAP). The lower the VWAP, the greater the number of Perpetual Shares the debentureholders would receive on maturity and the greater the percentage ownership in Perpetual the debentureholders would hold post-repayment in Perpetual Shares.
The rights offering was structured such that the percentage ownership of Perpetual following the repayment of the Debentures in Perpetual Shares and the completion of the rights offering would be set at 22% for debentureholders and 78% for current shareholders. These percentages were established using what the ASC called a "notional value" of $0.64 per Perpetual Share based on advice Perpetual's independent committee received from its financial advisor and accepted (Perpetual's Shares closed at $0.45 on the day before the reorganization transactions were announced and have traded downward since the announcement of the recapitalization transactions, closing at $0.04 on January 6, 2016). In essence, the number of Perpetual Shares issued under the rights offering was to be such that, regardless of the 20-day VWAP amount, enough Perpetual Shares would be issued to existing shareholders so that they would hold 78% of the equity upon completion of the recapitalization transactions. The Applicants noted at the hearing that this would give the shareholders holding rights more Perpetual Shares than the debentureholders at a much lower cost per Perpetual Share.
The locked-in percentage ownership mechanism was not explicitly precluded by the Indenture. From Perpetual's perspective, the rights offering was necessary in the context of its financial challenges and the locked-in percentage ownership mechanism was a key element in securing the backstop support for the rights offering. From the Applicants' perspective, the locked-in percentage ownership mechanism thwarted the bargain the debentureholders made with Perpetual that the Debentures could be repaid in Perpetual Shares of equivalent worth to the principal of the Debentures on maturity. The crux of the disagreement between the parties was how to determine what value to provide to the debentureholders. The Applicants believed debentureholders should receive Perpetual Shares with a value based on TSX trading prices that reflected the principal amount of the Debentures. Perpetual believed that it was appropriate to set a measure of value other than TSX trading prices and did so in establishing the notional value which was used for the locked-in percentage ownership mechanics of the rights offering.
The hearing was the first of its kind to be heard by the ASC. Given the time constraints inherent with the recapitalization transactions, the ASC heard the application in two days on December 22 and 23, 2015. The ASC found that the Applicants did not establish that the rights offering amounted to abuse of the debentureholders nor did they establish harm to the capital markets, which were the thresholds that the Applicants had to meet for the ASC to grant the application to cease trade the rights offering. In assessing abuse, the ASC found that Perpetual had a genuine and legitimate business purpose for the recapitalization transactions and while there was some internal logic to the transactions (which the ASC did not find as "entirely compelling" from the perspective of a pre-announcement debentureholder), Perpetual's board had a basis for believing that they were treating debentureholders fairly. The ASC further found that the Applicants failed to prove widespread harm to the capital markets and noted that in the future convertible debenture indentures could be drafted to avoid the dilutive effect of similar rights offerings. While the ASC ultimately declined to cease trade the rights offering for those reasons, it found the rights offering "troubling" and discerned "unfairness" to debentureholders that invested before the announcement of the recapitalization transactions. The ASC specifically noted that arrangements designed and likely to "thwart a negotiated bargain could well face an unwelcome regulatory response – irrespective of the outcome of this [a]pplication" in the future.
The ASC's only remedy would have been to cease trade the rights offering. The ASC was reluctant to issue such an order given the potential consequences in that there could be a "regulatory windfall" to debentureholders that purchased Debentures post-announcement of the recapitalization transactions and that it could harm shareholders who did not have any say in the recapitalization transactions.
Implications of the ASC's decision
The decision is noteworthy in view of the potential financial challenges faced by many oil and gas companies given current commodity prices and the optional repayment in shares at maturity feature found in many convertible debenture indentures for oil and gas companies. There is a significant market for convertible debentures with approximately $12 billion in such publicly traded convertible debentures in Canada.
The key takeaways from the decision and the recapitalization transactions are:
- Companies should carefully consider, with the benefit of advice from financial advisors, the impact that recapitalization transactions would have on their debt and equity holders. While the ASC declined to cease trade the rights offering, it cautioned that the regulatory response may be different for future transactions that "thwart a negotiated bargain." Companies should not view the ASC's decision as a sanction for recapitalization transactions that could have a potential dilutive effect to certain debt holders; in fact, the ASC's decision may deter such arrangements.
- For underwriters/debenture investors negotiating convertible debenture indentures, anti-dilution provisions should be added that would cure what the Applicants felt was an unfair result. One drafting solution would be to include a mechanism to allow debentureholders to take part in any potentially dilutive equity transactions, such as rights offerings, that are announced concurrently with or within a certain period after the announcement that repayment of such convertible debentures at maturity will be satisfied in shares.
- Securities regulators are often constrained by the limited remedies available to them, such as the cease trade order in this case, when addressing appropriateness of equity transactions (such as defensive private placements and any dilutive recapitalization rights offerings). They will be reluctant to use such remedy where there are windfalls to some parties and harm to other parties, particularly where those other parties did not take part in establishing the impugned transactions. Securities regulators will, as the ASC did specifically in this case, likely continue to note that commercial courts are better equipped to provide remedies to aggrieved parties that can balance the interests of various parties.
*Osler represented Polar Star, K2 & Associates and Cambridge Global as co-counsel before the ASC.
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