Toxic convertibles have gained notoriety mainly due to their ability to harm existing shareholders and their contribution to firm demise.
Accordingly, this paper seeks to contribute to the literature on toxic convertibles by attempting: (1) to provide a description of their particular features; (2) to examine the rationale for their use in the context of theories of agency and information asymmetry in the corporate finance literature; and (3) to evaluate possible corrections to design flaws that would mitigate their most pernicious effects on issuing firms and make them viable sources of financing for some firms.
Section II describes the salient characteristics of toxic convertibles, section III examines the rationale for the place of toxics in firm capital structure, section IV examines the pros and cons of toxics in the light of theories of agency and capital structure in corporate finance, section V identifies the winners and losers in these deals and, suggests remedies for inherent design flaws.
Toxic convertibles are a particular class of instruments called private investment in public equities (PIPEs).
Based on agency theory, one can argue that if the managers of an issuing company genuinely believe that the issuance of toxic convertibles was the company's only hope, then there may be ways to "bond" themselves to their firm.
Finally, recent investigations, by the Securities and Exchange Commission (SEC) into toxic convertibles helps to alleviate malfeasance associated with trading toxic convertibles.
Newkirk, Associate Director for the Division of Enforcement, is quoted as saying, toxic convertibles "present the temptations for persons holding the convertible securities to engage in manipulative short-selling of the issuer's stock in order to receive more shares at the time of conversion," and said the $1 million penalty "shows the Commission's determination to address these abuses.
To the extent these comments relate to toxic convertibles, in particular, Hillion and Vermaelen (2004) attest to the same development.
In summary, toxic convertibles represent a financial innovation that, through an iterative and--unfortunately, for many investors--costly process, has improved its design but is still used by the same types of firms as in the past.