Convertible Notes – Issues in Insolvency – MurdockCheng Legal Practice

Convertible Notes – Issues in Insolvency – MurdockCheng Legal Practice

Have you ever wondered what a convertible note is or whether it is suitable for your company to issue them? Or how they operate when a company becomes insolvent?

A convertible subordinate loan note (“convertible note”) is a short term debt security that carries a ‘call option’ allowing the convertible noteholder to convert the value of the debt security into shares, most commonly, shares in the company that issues the convertible notes. This conversion option gives convertible notes a hybrid nature with both debt and equity characteristics. This hybrid nature has ramifications for the company issuing the convertible note and investors alike in terms of flexibility, taxation purposes and priority repayments on corporate insolvency.

A convertible note can be favourable where the company already has loans. This is because of the times of the times a bank will have a restrictive debt covenant that states the company cannot take out any more debt or participate in share offerings, until that specific loan has been repaid. Accordingly, a convertible note gives a company more opportunities to raise capital.

Investors, however, need to understand that in the event that the issuer of the convertible notes becomes insolvent, the note will rank below other loans (i.e. it is ‘subordinated’ debt). Nevertheless, as with all debt securities, the repayment of the note will take priority before shares.

This drawback for investors was demonstrated in the case of Perpetual Trustee Co Ltd v HIH Holdings (NZ) Ltd (in liq) [2013] NSWCA 47. HIH Holdings NZ (“HIH NZ”) issued a number of convertible notes with the terms of issue of the notes being that HIH NZ was permitted to elect to redeem the notes for cash by a certain date after which they would “automatically” be converted into ordinary shares in HIH Holdings NZ’s parent company HIH Insurance Ltd (“HIH”). However, HIH NZ went into liquidation (as did the parent company) without electing to redeem the notes for cash.

The question before the Court was whether the noteholders were owed debts or damages equivalent to the face value of the notes (in this case $213.1 million) for which they were entitled to prove in HIH NZ’s liquidation for debt. The noteholders wanted to be creditors rather than equity holders (whose claims are subordinated to those of creditors) as HIH shares were worthless. The New South Wales Court of Appeal agreed with the Trial Judge that they were not entitled to the face value of the notes as creditors.

Macfarlan JA held that the critical issue to resolve was whether the noteholders’ contracts provided for the face value of the notes to be repaid to them in cash or provided for another, exclusive, means of discharge of the debt that HIH acknowledged in Clause 2A.1(a) of the Trust Deed. It was found that HIH NZ was at no time required to redeem the notes by paying their face value in cash to the noteholders. Whilst the obligation to redeem existed, it was always an obligation to redeem by one, exclusive, means, that is, by applying the redemption money in subscription for HIH shares. In other words, although the redemption money was to be repaid, it was to HIH not the noteholders by way of a share subscription on their behalf and at no time did the noteholders have the right to re-direct the payments to themselves and therefore had no right to receive them.

If you are contemplating raising funds by issuing convertible notes, or if you require assistance in reviewing or drafting a convertible note, feel free to contact us for a free consultation on (02) 9262 5495 or (03) 8899 7870, or visit our website at www.mclp.com.au or Like our Facebook Page at http://goo.gl/Jx2hdO.

This article is not legal advice and should not be relied upon as legal advice. All articles found on this website are intended to provide informative information, nevertheless, in many instances legislation and case law has been simplified and/or paraphrased. If you would like personal legal advice based on your current circumstances, you should contact MurdockCheng Legal Practice for a free consultation.