Balancing downside risk and upside potential 6 min read
A noticeable fundraising trend in the first half of calendar year 2023 has been ASX-listed entities issuing convertible notes to strategic investors – which has caught the ASX's attention.1 We expect convertible notes to only grow in popularity given the uncertain equity market conditions and the fact that convertible notes allow investors to balance downside risk and upside potential.
In this Insight, we explain what potential issuers and investors need to know when issuing convertible notes.
- Convertible notes are a common method of investing in start-ups because they don't require a value be put on a company's equity at the time of investment. They are a much less common method of investing in listed entities, whose shares are trading on a market and therefore have a market price.
- In times of economic turbulence, it is unsurprising to see investors in even ASX-listed entities looking to protect themselves from downside risk, without completely sacrificing upside potential – and this is what convertible notes allow.
- At the end of May 2023, ASX published a compliance update specifically in relation to convertible notes and associated Listing Rule compliance issues (Compliance Update no 05/23).
- The update is a timely reminder to market participants there are a number of unique and potentially complicated legal issues applying to convertible note issues by ASX-listed entities that both potential issuers and potential investors should be aware of.
A convertible note is a hybrid debt / equity instrument. It is typically a short- to medium-term instrument that is issued by a company in order to raise funds, but can also convert to equity at a specified point in time or in certain circumstances. It is an alternative to a vanilla debt instrument (eg a loan) or straight equity (eg ordinary shares).
It provides the investor with the benefits of a debt-like instrument (such as regular interest payments on the face value of the loan), while also giving them the ability to participate in any potential upside to the value of the issuer's share price by converting the debt to equity.
A convertible note is a relatively simple investment instrument but ensuring it is issued in a way that complies with the ASX Listing Rules and other relevant regulatory requirements is not.
Note terms must be 'appropriate and equitable'
- ASX Listing Rule 6.1 provides the terms that apply to each class of a listed entity's equity securities must, in ASX’s opinion, be appropriate and equitable.
- In its compliance update, ASX has reminded market participants that listed entities that issue convertible notes must be able to demonstrate how the securities comply with the listing rules, and that ASX may investigate and take action where it has any concerns about how convertible note (or any other equity-based financing arrangements) comply with the listing rules.
- ASX notes that if the proposed terms of the convertible note are not market standard, in-principle advice should be sought from it regarding whether the terms comply with Listing Rule 6.1.
- Given ASX's recent focus on convertible notes, both issuers and investors should take care to ensure that the proposed terms of any convertible note comply with Listing Rule 6.1. This will be more relevant if the conversion terms are complex, potentially highly dilutive to existing shareholders or have other unusual features.
Entity must have sufficient placement capacity available
- Convertible notes are generally classified as 'equity securities' under the ASX Listing Rules, and so any issue of, or agreement to issue, a convertible note will count towards a listed entity's 15% placement capacity under ASX Listing Rule 7.1 at the time the convertible note is issued.
- The issuer will need to ensure that it has sufficient placement capacity at the time of issue. If it does not, shareholder approval will need to be obtained before the issue of the convertible notes; or, alternatively, the issue of the underlying shares will need to be conditional on shareholder approval being obtained.
The takeover threshold must not be exceeded
- The investor should not obtain a relevant interest in the issuer's voting shares that exceeds the 20% takeover threshold under Chapter 6 of the Corporations Act 2001 (Cth).
- A convertible note does not give the holder of the note a relevant interest in voting shares. The relevant interest is acquired when the note is converted into voting shares.
- It has not been a common feature of most recent convertible note issues that the investor has acquired a relevant interest in the issuer that would potentially exceed 20%; however, there have been some recent examples where the investor's ownership stake on conversion could exceed 20%.2
- To comply with the takeover laws under Chapter 6 of the Corporations Act, either the investor would need to be limited to acquiring a relevant interest of up to 19.99% or the terms of the note would need to be structured to ensure compliance (eg by requiring that any interest above 19.99% be subject to shareholder approval or that conversions be staggered in a way that falls within the 'creep' exception).
A cleansing notice may be needed
- Most convertible notes are issued without a prospectus or disclosure document, usually relying on the sophisticated or professional investor disclosure exemption. In these circumstances, due to the on-sale restrictions under the Corporations Act, the underlying shares will not be freely tradeable on conversion.
- The investor may require the issuer to lodge a 'cleansing notice' with ASX, to ensure that the underlying shares, upon conversion, are freely tradeable.
- The cleansing notice can either be lodged either at the time of issue of the underlying shares or when the convertible notes are issued (provided the conditions in ASIC Corporations (Sale Offers: Securities Issued on Conversion of Convertible Notes) Instrument 2016/82 are satisfied).
Don't forget to think about FIRB
- If the investor is foreign, consideration should be given to whether approval from the Foreign Investment Review Board (FIRB) under the Foreign Acquisitions and Takeovers Act 1975 (Cth) is required.
- Whether or not FIRB approval is required will depend on a range of factors, including the nature of the issuer and investor, and the equity interest the investor will acquire in the issuer.
If you have questions about, or require assistance with, the issues raised in this Insight, please contact any of the people below.
There were 20 convertible note issues by ASX-listed entities between 1 January 2023 and 23 May 2023, the date that ASX issued a compliance update focused on convertible notes.
See the issue of convertible notes by Syrah Resources Limited to Australian Super announced on 27 April 2023.