Toxic Convertible

Toxic Convertible

Used by companies that are in such bad shape, that there is no other way to get financing. This instrument is similar to a convertible bond, but convertible at a discount to the share price at issuance and for a fixed dollar amount rather than a specific number of shares. The further the stock falls, the more shares you get. Popular in the mid to late 1990s. Also known as death spiral convertibles or floorless convertibles.

Death Spiral

A loan that investors give to a publicly-traded company in exchange for convertible bonds. The convertible bonds give the investor a right to buy shares in the company at a low, agreed-upon price. However, issuing these bonds creates more shares outstanding when they are converted, which results in a drop in the share price. The low share price encourages more bondholders to convert their bonds to equity, which causes a further drop in price and the process continues. Because of this disadvantage, companies only engage in death spirals if they badly need cash.
References in periodicals archive ?
As a conjecture, management may truly believe that the capital raised through a toxic convertible will be enough to save the company ("prettiest baby syndrome").
Toxic convertibles have gained notoriety mainly due to their ability to harm existing shareholders and their contribution to firm demise.
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." (9) The SEC's aggressive action, while delayed and arguably isolated except in this instance, points to regulators' steps to curb excesses designed to manipulate stock prices.
To the extent these comments relate to toxic convertibles, in particular, Hillion and Vermaelen (2004) attest to the same development.