Issuance of New Rules
Turkish Companies are facing difficulties in tapping into sources of credit as global financial crisis gets deeper. Banks have felt threatened by the increase of non-performing loans and have adopted a more cautious approach in funding companies. On a parallel scale, opportunities for raising capital through stock offerings have reduced. A recent IPO initiative was cancelled during the book building process due to lack of investor interest and the upcoming IPOs are postponed for an indefinite period. In addition, shareholders have shown strong reluctance to participate in rights issues of listed corporations, especially, of those traded below par value. Private placements to controlling shareholders have been considered as a way out for companies seeking cash contribution. However, those shareholders are also suffering from the impacts of global financial crisis and their resources are limited for supporting their affiliates. In this environment of limitations and constraints Capital Markets Board of Turkey (CMB) has issued a new set of rules governing convertible bonds and exchangeable bonds in an attempt to provide alternative funding options for Turkish companies. The rules, enacted under the Communiqué Regarding Principles on Sale of Debt Instruments and Registration of the same with the CMB, have changed the legal infrastructure to a certain extent and have reflected a relatively flexible and liberal approach.
Basic Characteristics of Convertible Bonds
Convertible bond is a type of debt instrument which can be converted into shares of the issuing company, usually at a pre-determined and pre-announced ratio. Convertible bonds reflect the characteristics of hybrid instruments having both debt-like and equity-like features. Investors of convertible bonds are entitled to (i) receive the redemption amount, or (ii) acquire issuer's shares on an optional basis.
Convertible bonds typically offer lower interest rates than prevailing rates. Nevertheless, the margin arising therefrom is compensated with the ability to convert bonds into company shares, usually at a discount to the share's market value. On the other hand, for issuers, the key benefit of raising money by selling convertible bonds is a reduced interest payment. However, in exchange for the benefits arising from relatively low interest rates, shareholders bear the risk of stock dilution which may occur if bondholders prefer to convert bonds into issuer's shares.
Convertible bonds were initially introduced to Turkish Capital Markets in 1992 through the Communiqué Regarding Principles on Convertible Bonds. However, due to limitations imposed by the provisions of this piece of legislation and the crowding-out effect emanating from the heavy presence of government bonds issued for financing budget deficits, Turkish Capital Markets have not witnessed a convertible bond offering.
A Relatively Flexible Framework
According to the principles of former legislation convertible bonds could only be issued with a maturity of two to seven years. However, due to uncertainties in the economic atmosphere and short-term investment habits of local investors, companies have not managed to issue any kind of debt instrument, including convertible bonds, with a maturity exceeding two years. The new Communiqué has decreased the minimum maturity to one year in accordance with the prevailing investment habits. It has also removed the seven year maximum maturity limit in order to provide flexibility for long term offerings that may well be conducted in the future upon stabilisation of the global economic environment.
As per the former legislation convertible bonds may be converted into shares (i) in accordance with the redemption plan, (ii) upon the call of bond holders, or (iii) upon the call of the issuer as prescribed in the prospectus of the relevant convertible bond offering. Those alternatives are also applicable under the new Communiqué, however with changes altering certain limitations.
Former legislation envisaged that bonds may be converted into shares, in whole, at the expiration of a two year period at the earliest. This limitation, together with the minimum maturity requirement, has been considered as a prominent factor impeding the applicability of convertible bond issues. It is generally argued that the opportunity cost of holding convertible bonds increases when the price of underlying shares tends to decrease and shareholders shall be granted the right of conversion at an earlier date in order to prevent or at least minimize losses under such circumstances. This argument was taken into account in the new Communiqué and the two-year waiting period has reduced to one year in accordance with the change in the minimum maturity requirement.
The Communiqué has also liberalized alternative conversion methods. Former legislation provided that under a conversion to be conducted in accordance with the redemption plan, the issuer may prefer to covert bonds into shares in equal annual instalments until the end of the maturity period where the first conversion shall be conducted at the expiration of a two year period. Former legislation also envisaged that where such conversion is based on instalments, bond holders, whose bonds would be converted into shares, shall be selected by lot before a public notary. The new Communiqué has removed the equal instalment basis by granting the issuer the right to determine due dates and the amount of each instalment without any limitation. The Communiqué has also removed the requirement of allotment which is considered to interfere with the preferences of investors, and instead has established a book building procedure where the bondholder is the sole decision maker. On a parallel scale, as per the previous legislation conversions could also be conducted through instalments in callable bond issues provided that each conversion is conducted on the date designated for annual interest payment. The Communiqué has broken this link and under the new provisions conversion dates of those issues may be determined irrespective of the dates designated for interest payments.
Additionally, the Communiqué removes the restrictions regarding dates of interest payments. In international practice intervals of interest payments could be freely determined by the issuer provided that it is clearly stated in the prospectus. However, for local convertible bond issues it was stipulated that interest payments shall be made once in a year until the maturity of the relevant convertible bond issue. It is generally accepted that this requirement affected the competitiveness of local convertible bond issues negatively in comparison to both foreign convertible bond issues and other investment instruments, and should be removed in order to enable issuers to determine shorter intervals. The Communiqué have taken into account this criticism and clearly left this matter to the discretion of issuers. In other words issuers are free to set the dates of interest payments pursuant to the structure of each convertible bond offering.
Unlike former rules the Communiqué has paved way for private placements of convertible bonds. As per the principles convertible bonds may be issued to certain investors on a private placement basis without having to produce any disclosure document. However, the number of real persons or legal entities to whom convertible bonds are privately placed shall not exceed 100. Accordingly, any private placement directed to an investor base of more than 100 shall be deemed as a public offering which necessitates abiding by initial and ongoing disclosure rules. It should be noted that this limitation is not applicable for sophisticated investors as defined by the relevant legislation.
The Communiqué has also simplified procedures for the registration of convertible bond issues with the CMB. According to new principles, any registration application to be made before the CMB may be made to encompass all issues to be conducted within a period of one year. This simplification aims to reduce issuance costs by speeding up the registration process.
Ensuring Investor Protection: A Top Priority Issue for Turkish Capital Markets
In addition to the changes introducing flexibility, the Communiqué has come up with new provisions ensuring investor protection. Under the new principles, the conversion ratio announced through the convertible bond prospectus shall be adjusted accordingly if the issuer decides to conduct a bonus issue, a rights issue where pre-emptive rights are exercised below market price, an interim or annual dividend distribution or a merger or a similar corporate restructuring affecting the price of underlying share. Former provisions required adjustment only in cases of a bonus issue or a rights issue where pre-emptive rights are exercised below market price. The Communiqué, with an intention to strengthen investor protection, has adopted a broader perspective on this matter and has demanded adjustment in cases of capital increase, dividend distribution or any other transaction affecting the price of underlying share. Such a perspective covers all situations which are triggered by the decisions of the issuer and which require recalculation of underlying share price and could be considered as a prominent step for an enhanced investor protection in convertible bond issues.
The new legal infrastructure has also granted the CMB the authority to request a third-party guarantee in order to secure payment obligations of the relevant issuer. While examining a registration application, the CMB may come to the point that the issuer may face difficulties in fulfilling its payment obligations in cases where investors do not opt for converting bonds into shares and may require the issuer to provide a third-party guarantee. According to the Communiqué the guarantee, if requested, shall be provided by a bank or a third party resident in Turkey in order to secure the enforceability of the same. In addition, issuers may provide a third-party guarantee without a CMB request with the aim of encouraging investor demand. Such a precaution could be considered as an additional move to strengthen investor protection and may well contribute to the applicability of convertible bond issues of financially distressed companies.
The final move to support investor protection intends to protect issuer's shareholders. As per the new principles bonds shall be converted into shares in a way not to damage the rights and benefits of issuers and issuers' shareholders. Additionally, should a convertible bond private placement fall under the definition of related party transaction, any conversion with respect thereof shall be conducted at an arm's length basis. It is stipulated that in such a case, conversion price shall be determined in accordance with the pricing rules envisaged for capital increases of publicly traded companies. Protective measures for issuers' shareholders have been expressed explicitly for the first time since the introduction of convertible bonds to the Turkish Market in an attempt to balance the protection of bondholders and shareholders.
Additional Steps Must be Taken
In international practice, most convertible bonds have call provisions and most provisions have important qualifications or protections. Broadly speaking, convertibles may have absolute protection (not callable), hard call protection (noncallable for a specified period), provisional or soft call protection (callable if certain conditions on stock price are met), or no protection (callable any time). As mentioned earlier, under the principles of the Communiqué, it is possible to issue convertible bonds having call provisions. However, such principles could be considered inadequate on the matter of call protection. The one-year time limitation for converting bonds into shares could in itself be considered as a protection mechanism. However, an additional precaution shall be taken in order to boost investor confidence and support the establishment of a convertible bond market. In this respect, for callable convertible bond issues where conversion may be initiated upon the call of the issuer, it may be stipulated that issuers may only call if market price of underlying shares has been above the conversion price at a rate of %20 or %30 for a period of 20 or 30 days. Although such approach has not been adopted by the CMB, issuers may opt for designing callable bond issues with soft call protections. The Communiqué allows sufficient flexibility to structure convertible bond issues pursuant to the needs of issuers and investors. Nevertheless, a compulsory soft call protection mechanism may have a positive effect on the development of a convertible bond market.
Convertible bonds shall be issued within certain limits prescribed by the Communiqué. As per the rules governing issuance limits, equity of the relevant issuer is taken into account in calculating such limits and coefficients to be used in the calculation are specified by the criteria of whether the issuer's latest financial statements are audited and whether such statements show profits. The new legal infrastructure has not revised issuance limits in a way to support convertible bond offerings. In an environment where companies have faced difficulties in reaching financial sources relaxing issuance limits may well worth considering.
On a separate note, in order to increase the competitiveness of convertible bonds, a compulsory rating requirement may be envisaged for issuers and tax incentives may be provided to investors preferring to participate in offerings.
A New Instrument for Turkish Capital Markets: Exchangeable Bond
An issuer may conduct a public offering of convertible bonds provided that its shares are traded on a stock exchange or on an organized market. Under this approach it is clear that convertible bonds may only be issued by publicly traded companies. This limitation paves way only for a small portion of Turkish companies, approximately 300, to tap into the convertible bond market. However, the Communiqué has presented an additional instrument called exchangeable bond in order for privately held companies to benefit from the convertible market by using the shares of a publicly traded company for conversion purposes.
An exchangeable bond is a debt instrument with an embedded option to exchange the bond for the shares of a company other than the issuer under prescribed conditions. Save for the type of shares that may be submitted to bond holders, exchangeable bonds share the same characteristics with convertible bonds. It is expected that privately held companies which belong to corporate groups comprising publicly traded companies or which keep shares of publicly traded companies for long term purposes will be the ones which may issue exchangeable bonds.
Will New Rules Pave Way for the Establishment of a Local Convertible Bond Market?
Although introduced in the early nineties as an alternative investment vehicle, convertible bonds have not been practiced in Turkish Capital Markets due to the rigid legal structure and the crowding out effect of government bonds. The recently enacted Communiqué adopts a relatively liberal approach and provides freedom for structuring bond issues pursuant to the needs of the market participants. In this connection, the new framework may create alternative funding options in the real sense by both renewing the legal infrastructure of convertible bond and introducing exchangeable bond. It is considered that share prices of Turkish companies has hit rock bottom and a permanent rising trend may be observed in the upcoming period which shows that convertible bonds and exchangeable bonds may be profitable investment options for investors. It is also believed that the declining trend in the interest rates of government bonds is another factor supporting the competitiveness of convertible and exchangeable bonds. In an environment where financial sources are limited, companies should consider those alternative financial instruments seriously. Nevertheless, it seems that additional steps are required in order to establish a healthy and efficient market. In this respect, whether new rules will pave way for the establishment of a local convertible bond market remains to be seen.
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