Introduction
One of the most fundamental features of a convertible note is the rate at which it converts into shares or other securities. Often this is a simple 1 for 1 conversion, but it can sometimes be determined by a formula involving a range of variables. A recent case highlights how disputes about the conversion formula can arise, and be avoided.
Who needs to know?
Businesses, debt and equity investors and corporate finance advisers who deal with convertible notes. It’s also relevant to people who prepare and negotiate contracts generally.
Background
The case of BB Retail Capital Pty Ltd v Alexandria Landfill Pty Ltd [2014] NSWSC 1363 relates to the financing of a recycling and waste facility conducted by Alexandria Landfill Pty Ltd (ALF) at Eastern Creek in New South Wales.
In high level terms, ALF issued a total of $30 million worth of convertible notes to BB Retail Capital (BBRC) in late 2010 and early 2011. The funds raised were used by ALF to repay other debt and to progress development of the facility. The notes were issued pursuant to a deed poll which contained the “Terms of Issue”. This deed poll was entered into by ALF in January 2009 and it had been previously used by ALF to issue several tranches of convertible notes to a range of other investors.
The notes were convertible into preference shares on maturity (1 January 2013). The number of shares to be issued was determined by a formula. Critically, the conversion formula was expressly stated to apply unless ALF and BBRC “otherwise agree”.
The only variable in the conversion formula was the amount of ALF’s “Organic Debt”. This essentially comprised bank debt and any other amounts borrowed to complete the purchase and establishment of the facility at Eastern Creek. If the project went to plan, the Organic Debt would have been paid off by the time the convertible notes matured and this would have resulted in a 1 for 1 conversion. However, if Organic Debt remained at the time of conversion, a proportionately greater number of shares would be issued depending on the amount of Organic Debt. In any event, the formula worked such that BBRC would get at least 1 preference share for every $1 face value of convertible note.
Various ancillary documents were entered into between the parties, including a subscription deed, a priority deed and an accession deed.
The subscription deed provided for the notes to be issued in 2 separate tranches of $10 million and $20 million. It also included a put option in favour of BBRC. This put option gave BBRC the right to sell 20 million preference shares to the sole shareholder of ALF. The recitals to the subscription deed expressly stated that BBRC “will be the legal and beneficial owner of [20 million preference shares] upon conversion of BBRC Convertible Notes with a face value of $20 million”.
As it eventuated, not all of the Organic Debt was repaid by the maturity date. BBRC argued that the conversion formula in the Terms of Issue should apply and that accordingly it should be given more than 1 share per $1 face value of convertible note.
ALF took a different view. It argued that the parties had “otherwise agreed” to a 1 for 1 conversion rate instead of the conversion formula in the Terms of Issue. It primarily based this argument on the way in which the recitals were implicitly predicated on a 1 for 1 conversion (i.e. $20 million face value of notes converting into exactly 20 million preference shares). Notwithstanding that the subscription deed contained an “entire agreement” clause, AFL also sought to bolster its argument by referring to the term sheet between the parties which stipulated a 1 for 1 conversion rate.
What did the Court say?
The Court agreed with BBRC.
Interpretation of the conversion rate
The court noted that the alleged variation to the conversion formula could have had profound consequences for both parties. It therefore held that if the parties had truly intended to vary the conversion formula in the Terms of Issue they would have:
“done more than insert into the [subscription deed] the “Background” recital and would have made plain their intention in the body or “Operative part” of the [subscription deed]”.
As an example of “doing more”, the Court noted that the subscription deed did in fact contain special provisions regarding redemption (but not conversion) which the Court held did vary the redemption clause in the Terms of Issue.
Moreover, the Court also held that the background wording in the recitals was “doing no more than acknowledging that , as a matter of fact, once BBRC’s $20 million convertible notes were converted, it would hold 20 million shares which, if it chose, it could put to [the sole shareholder] pursuant to the Put Option”. Ultimately, the Court was not concerned by the put option being fixed over only 20 million preference shares even though the conversion rate could result in more than 20 million preference shares being held by BBRC.
Reference to the term sheet
In relation to the term sheet, the Court held that it was inadmissible. ALF referred to earlier High Court authority (see Codelfa Construction Pty Ltd v State Rail Authority (NSW) [1982] HCA 24; 149 CLR 337) and argued that the term sheet constituted “objective background facts which were known to both parties” and which should therefore be allowed into evidence in support of its interpretation arguments. The Court simply disagreed. The term sheet was part of the negotiations leading up to the subscription deed which superseded it. The Court viewed the term sheet as being reflective of the parties’ actual (i.e. subjective rather than objective) intentions and expectations and was therefore inadmissible.
Practical Points to Take Away
- Using a phrase like “unless otherwise agreed” is usually fine. However, for fundamental clauses (such as a conversion formula) it is probably better practice not to include this type of phrase because it opens the door to potential disputes on fundamental matters. If this type of phrase is to be included, try to limit it to matters that are expressly agreed. Any variations or “other agreements” should also be in writing and signed by the parties, as was the subscription deed.
- Always ensure consistency throughout the documentation. For example, if the recitals to the subscription deed had been written as “[BBRC] will be the legal and beneficial owner of not less than [20 million preference shares] upon conversion of BBRC Convertible Notes with a face value of $20 million” this whole dispute probably wouldn’t have made it to court.
- The subscription deed contained a “paramountcy clause” to the effect that if there was any inconsistency between the subscription deed and the Terms of Issue, the subscription deed would prevail to the extent of the inconsistency. These clauses are useful, but as this case demonstrates, it is clearly preferable to ensure consistency by way of clearly agreed variations rather than arguing for implied agreements or reliance on a paramountcy clause. In this case it appears that the Court would not have held that an inconsistency existed anyhow.
- Always include an “entire agreement” clause to reduce the chances of an earlier term sheet muddying the waters.
- Always include the key matters in the body of the agreement, rather than just in the background section or recitals.
- Whilst the court in this case did not allow the term sheet into evidence, there have been other cases (see for example the High Court decision in Royal Botanic Gardens and Domain Trust v South Sydney City Council [2002] HCA 5; (2002) 186 ALR 289) where courts have allowed term sheets into evidence for the purpose of interpreting the formal legal agreements, particularly if there is an ambiguity in the wording of the formal legal agreements.