A Fresh Regulatory Approach To Convertible Bonds

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...