Opinion ID: 387913
Heading Depth: 2
Heading Rank: 2

Heading: Conversion Rights at Common Law and the Need for Contractual Antidilution Provisions

Text: 49 In the case at bar, there are specific portions of the Indenture that set out the rights of the holders of the Debentures, and the obligations of the Trustee and issuer, in the event that the issuer is merged into another company. Nonetheless, the common law's treatment of conversion rights upon merger is important in this case in two different respects. First, it must be determined whether the common law provides the holders of the Debentures with rights in addition to the rights that are set out in the Indenture. Second, an understanding of the common law's treatment of conversion rights upon merger explains the historical development of boilerplate contractual antidilution provisions of the sort found in the Indenture. 50 The Commentaries explain in brief the possible dangers to the conversion rights of the holders of debentures that might attend certain actions by the issuer of the debentures: 51 The anti-dilution provisions are designed to preserve the value of the conversion privilege against diminution by certain voluntary corporate acts. For example, if the conversion price is $25 a share at a time when the common stock has a market value of $30 a share, the conversion right is clearly valuable. If the Company should then split its stock 3 for 1, the market price of its shares would be reduced to approximately $10 per share. Thus the value of the right to convert at $25 per share would have been virtually destroyed, by that voluntary corporate action, in the absence of appropriate protective provisions. 52 Inasmuch as ownership of a convertible debenture does not give the holder the rights of a shareholder, the holder of a convertible debenture would have almost no protection against acts by the Company which would adversely affect the value of the common stock issuable on conversion, such as a split-up of shares, stock dividends, distribution of assets, issuance or sale of other convertible securities, issuance of options, issuance or sale of common stock at prices below the current conversion or market price, merger, sale of assets or dissolution and liquidation of the Company. Events of this type are customarily described as diluting the value of the conversion privilege, and if protection is desired against such dilution, appropriate provisions must be included in the indenture. 53 Commentaries at 527 (1971) (emphasis added; footnote omitted). As justification for the phrase we have italicized above, the Commentaries cite Parkinson v. West End Street Railway Co., 173 Mass. 446, 53 N.E. 891 (1899) (per Holmes, J.). 54 Justice Holmes' decision in Parkinson was aptly cited by the authors of the Commentaries for the proposition that antidilution protection must be provided by contract if it is to be provided at all, for Parkinson holds that there is no such protection at common law. The plaintiff in Parkinson held Highland Street Railway bonds that were convertible into Highland's preferred stock. When West End Street Railway acquired Highland subject to all (of Highland's) duties, restrictions, and liabilities, id. at 447, 53 N.E. at 891, the existing holders of Highland's preferred stock received West End preferred stock or preemptive rights thereto in exchange for their Highland stock. West End refused, however, to convert the Highland bonds into West End preferred stock. The Massachusetts Supreme Court denied relief: 55 (T)he contract does not prevent the corporation from consolidating with another in such a way as to make performance impossible, any more than it prevents the issue of new stock in such a way as to make performance valueless.... A consolidation which makes no arrangement for furnishing stock in the new company, and which ends the existence of the old ones, as a general rule may be presumed to put an end to the right of bondholders to call for stock, not because the law has not machinery for keeping such a right alive, but because, not being bound to do so, it has made dispositions which manifestly take no account of it. 56 Id. at 448-49, 53 N.E. at 892. Thus, according to Parkinson, mergers may extinguish all conversion rights, absent explicit contractual provisions to the contrary. 14 The same idea is expressed in Lisman v. Milwaukee, Lake Shore & Western Railway Co., 161 F. 472 (C.C.E.D.Wis.1908), aff'd mem., 170 F. 1020 (7th Cir.), cert. denied, 214 U.S. 520, 29 S.Ct. 700, 53 L.Ed. 1065 (1909): 57 (I)t would appear that the (issuer) might, in the interest of its stockholders, go out of existence without giving the holder of a convertible bond any just cause of complaint. 58 ... In the sale and purchase both railway companies were acting within their strict legal rights to promote the interests of their respective stockholders. This change of ownership was only one of several vicissitudes liable to happen during 20 years in the life of the corporation, which might render the outstanding option valueless, and still afford no cause of action to the debenture holder. Nothing has taken place which the debenture holders were not bound to anticipate.... If (as a result of the consolidation) the hope of speculative venture on the stock market was extinguished, it is damnum absque injuria. Id. at 477-78. 15 59 Broad has cited no persuasive authority which would indicate that the common law of New York or of any other jurisdiction would provide any additional protection for his conversion rights upon merger, other than that protection which might be included in the Indenture. 16 But the common law cases cited by the parties do shed light on the origin of and need for boilerplate antidilution provisions of the sort at issue here. 60 As the Lisman case points out, holders of debentures were charged at common law with the knowledge that various voluntary corporate actions might dilute or even render nugatory the value of their debentures' conversion feature; because dilution was (at least constructively) within their contemplation when they purchased the security, there was no unfairness in denying the holders of debentures any compensation in the event of such dilution. But of course, even before the occurrence of a diluting event, this risk of dilution itself significantly diminished the value of the conversion feature. As Justice Holmes noted in Parkinson, however, the law does have machinery through which, if the parties so choose, the value of the conversion right may be protected. The draftsmen of indentures may guard against dilution through the insertion of any of three types of special contractual provisions. 61 The first and most drastic type of provision is the outright prohibition of certain types of voluntary corporate conduct. Such prohibitory covenants are more typically used to protect the value of the debt obligation represented by the debenture. 17 But prohibitory covenants may also be used to protect the value of the conversion feature e. g., by means of an absolute ban on mergers. The efficacy of this means of antidilution protection must be balanced against the loss of business flexibility it means for the issuer. Some sorts of corporate conduct can be limited with little loss of flexibility, but other restrictions may so hamstring the company that they threaten its continued existence. 62 Happily, there are two less restrictive means of antidilution protection that do not bear such high costs in terms of business flexibility, as the following excerpt from the Commentaries indicates: 63 In modern convertible debenture indentures it is virtually universal to provide some anti-dilution protection (that provides for the adjustment of the conversion price upon the taking of specific actions by the issuer that would cause the value of the conversion right to be diluted), usually in combination with provisions (requiring advance notice to the debentureholders of such acts), plus a provision for equitable adjustment in the event of a merger or other reorganization (in which the issuer is the surviving company). However, adjustment of the conversion price by itself cannot provide the debentureholder with protection against all events which might substantially affect the conversion privilege. For example, when the Company is to be merged into another corporation and the Company's common stock is to be replaced by convertible preferred stock or debentures of the surviving corporation, adjustment of the conversion price would not provide adequate protection. Thus it is now customary to provide that the debentureholder will be given the right to convert his debentures into whatever securities are to replace the common stock of the Company. 64 Commentaries at 528 (emphasis added). 18 Professor and former SEC Chairman Cary makes the same point: 65 As a consequence of cases such as Parkinson, it has been found necessary in the conversion contract to provide for protection in the event of consolidations, mergers, conveyance of substantially all assets, capital reorganizations and reclassifications. If any of these occur the instrument frequently provides that the holder of the convertible security shall have the right thereafter to convert it into the kind and amount of shares of stock and other securities and property receivable ... by a holder of the number of shares of capital stock into which such (convertible security) might have been converted immediately prior to such reclassification, change, consolidation, merger, sale, or conveyance. 66 W. Cary & M. Eisenberg, Cases and Materials on Corporations 1155 (5th ed. unabr. 1980) (elipsis and bracketed portion in original). The Commentaries contain a suggested antidilution provision with strikingly similar language to that set out in the above passage. 19 67 While the common law's treatment of conversion rights in the event of merger provides a useful background, and while various antidilution provisions promulgated by the American Bar Foundation and the commentators are useful for purposes of comparison, the resolution of this case ultimately turns upon our construction of the specific language in the Indenture under which the Debentures were issued in 1967.