Floorless Convertible Debenture
So, what is this floorless convertible financing that CLBE is signed up for.
No it is not a rusted out 1958 Chevrolet that covers you with water from under the dashboard if you drive through a puddle. Once again, these stock market people have their own little language. I think they obfuscate things on purpose, but hey, what do I know?
Grab a snack and relax, and let’s start at the beginning. Don’t skip over any of this, OK? Your girlfriend gets naked somewhere in the middle, and you don’t want to miss that, right?
A “floorless convertible” is a kind of bond. A bond is a “note” or “debt instrument” issued by a company in exchange for money. The company borrows money from the person they issue the bond to, in exchange for a promise to pay that money back, usually with interest.
Yes, it’s just like an “IOU”. The company owes the bondholder money.
Unlike a secured bond, a debenture is not secured by company assets, and the holder is not entitled to claim any assets of the company if the company defaults on the note. This particular debenture has a very creative feature attached to it. It’s a convertible debenture, which means the bond can be changed, or “converted” into common stock.
There are advantages and disadvantages to the company when it issues a convertible debenture. Advantages include the ability to raise money without immediately issuing additional stock (thus avoiding immediate dilution of the stockholder’s earnings per share), and the ability to issue the debenture at a lower interest rate than another form of bond, because the purchaser will accept a lower interest rate for the privilege of converting the debenture into common stock at some point in the future.
Disadvantages to the company include dilution of stockholder future earnings, and a potential shift in specific shareholder’s control of stock (and their control of the company) when the conversion takes place.
Conversion takes place according to the “conversion ratio”; debenture value X is converted into Y shares of common stock. The number of shares to be received in the conversion is governed by a formula. Usually, the convertible security is exchanged for common stock of the issuer at the holder’s request by dividing the face value of the debenture by a market price of the common stock that is discounted at the time of the conversion. Parts of these formulas are divulged in the CLBE financials and for one of several Purchase Agreements.
10% convertible debenture with interest due quarterly subject to certain conditions, due three years from the date of the note. The holder has the option to convert unpaid principal to the Company's common stock at the lower of
(i) $0.14 or
(ii) 50% of the average of the three lowest intraday trading prices for the common stock on a principal market for the twenty days before, but not including, conversion date.
In addition, a substantial market discount was attached to the debentures
This is a floorless convertible debenture.
A floorless convertible debenture has a “floating” exchange rate built into the conversion agreement. The conversion rate (number of shares the debenture can be converted into) is “adjusted” to convert to more shares acquired (per dollar of investment) in the event the price of the stock goes down between the time the debenture is issued and the time when it is converted into stock. The lower the stock price goes, the more shares the holder of the debenture gets for his or her note. It’s called “floorless” because there is no “bottom” to the lower price of the stock. Stocks can turn out to be worthless, as we all know. Well, some of us, anyway.
Here’s a very simplified example of how a “floorless” conversion might work:
CLBE issues a floorless convertible debenture with an interest rate of 10% simple interest per year to “investors”. On July 1, 2007, CLBE was trading at $0.016 per share. On July 1, 2007, the “investors” give the company $1,000,000 in exchange for a piece of paper that says the company will pay 10% interest (for example) every year for three years. At any time in those three years, the “investors” have the right to convert their little piece of paper into 7.2 million shares of CLBE.
Additionally, written into this particular note (the floorless convertible debenture) is a clause that says something like,
“If any time in the next five years the stock price is less than $0.14 per share, and if the “investors” decides to exercise their option to convert the note into stock at that same time, then the “investors” gets more than 7.2 million shares of CLBE (as calculated by the conversion ratio written into the note) when the “investors” converts the debenture into shares of stock. In fact, whatever the price is, if it is less than $0.14, the “investors” not only gets more than the 7.2 million shares, the “investors” gets to figure in a additional discount per share of the then existing stock price when converting.
Fast forward and the stock gets crushed. Shocking, yes?
On November 20, 2007, the “investors” decides to convert the note to stock. On that day, the stock is trading at $0.0055. With the conversion rate in the note as their guide, and the discount they get, they are allowed to convert their note into more than 180 million shares of stock.
Sounds like a good deal for the “investors”, eh? Well, it is.
But what if (and I say this with all due respect) the “investors” wanted to take advantage of the situation? In that case, CLBE may have a little problem. Let’s say that CLBE for some reason can’t obtain conventional financing. Let’s further say that the “investors” could short that same company’s stock without actually borrowing it.
Nobody who owns CLBE stock and wants it to go higher would want to loan it out in order for it to be shorted, but the “investors” doesn’t worry about borrowing the stock. The “investors” just sells it short and borrows it from themselves. (Remember, one of the “rules” of selling short is that you have to borrow the stock before you sell it). Naked shorting will not be necessary. This is called convertible arbitrage and is the MO of hedge funds.
The proper definition of convertible arbitrage is the simultaneous purchase of a convertible debt and shorting of the common stock in order to exploit pricing inefficiencies between a convertible and the underlying stock.
This is all legal and nice
In other words, the “investors” has plenty of stock to borrow
However, there is one more nefarious scenario. If the “investors” could short the stock naked, then she could buy the floorless convertible debenture, and then when the time came, the “investors” could convert the debenture into stock (at a discount to the prevailing price) and use the stock received to cover the naked short position!
It sounds like that should be illegal, right?
Yes, it probably should be, but there are some instances when it’s not. And that’s the reason why “floorless convertible debentures” are so dangerous to the company that issues them.
It might be possible for the “investors” (holding the note) to short the stock “naked”, drive the stock price down, and then convert the debenture into stock (at a discount) and cover the short position. Here’s why.
Let’s say the “investors” starts to sell short on Tuesday November 27, 2007 and keeps on selling short. At the end of Tuesday the following week, the clearing agencies reports a fifth consecutive day (T+5) of fails to deliver CLBE securities and CLBE is placed on the SHO list as a threshold security. From then on those B/D and MMs that are short may not effect further short sales without pre-borrowing or entering into an agreement to borrow the security.
If the sum of the money she collected on the short trade and the money she saved on the discounted conversion were more than the money she put into the bond in the first place, then she would make money…maybe a lot of money if the stock were driven down to the point where it was almost worthless before she had to buy it and cover her short position.
This is called dynamic adjustment arbitrage and is the less known and legally questionable. you are selling the equity short and altering the hedge dynamically thereafter. It was my impression that the SEC was to outlaw this practice in July 2007, but I’m not so sure that ever happened.
What else could go wrong?
Plenty. If the company were planning on issuing additional stock to raise the funds to pay back the money it borrowed when it issued the bond, then the company is kinda screwed. The stock is almost worthless, so the offering would have to be much, much larger than would have been anticipated when the bond was issued. A large offering of additional shares would dilute the float considerably, and that is something the shareholders would not like at all. (Remember, the “investors” just diluted the float when they converted.) The ordinary shareholders would resemble charcoal briquettes at that point.
Here’s the point that a lot of investors miss:
Why would CLBE issue a floorless convertible debenture in the first place?
To my way of thinking, there are only a few reasons, and none of them are good.
Either the people that are running CLBE are idiots, which we know they are not or the company is in so much financial trouble that it has no alternative.
No matter what the reason, no matter how “wonderful” the company claims it is or how much the investor likes the stock, the issuance of a floorless convertible debenture is about the biggest red flags out there.
I trust this assists your understanding
