Capital Markets

Too Much of a Good Thing

The death knell sound for contingent convertible bonds.
Don DurfeeSeptember 9, 2004

“This came totally out of the blue for us,” is how John Devine, CFO of General Motors Corp., speaking during the company’s second-quarter earnings call, summed up what many CFOs must be thinking about a recent rule change proposed by the Financial Accounting Standards Board.

The rule concerns contingent convertible bonds (“Co-Cos,” for short). They work like regular convertible bonds, with a small — but crucial — difference. Unlike a standard convertible, which an investor can trade in for stock at a fixed price whenever it makes sense, Co-Cos can be converted only when the share price reaches a certain target. This distinction allows the bonds to slip through an accounting loophole: the securities don’t get factored in diluted earnings per share until the stock price hits the target. “These are used purely to avoid upfront EPS dilution,” says Chris Senyek, an accounting analyst with Bear Stearns. “There’s no other economic significance to the contingent feature.”

Now FASB intends to shut the loophole. If the proposed rule goes into effect, companies will have to record an increase in shares outstanding on the day they issue a Co-Co, thus reducing EPS. And the change would be retroactive, a step the board generally reserves for particularly egregious accounting practices, says Dennis Beresford, professor of accounting at the University of Georgia and FASB’s former chief.

This last point explains Devine’s consternation — GM predicts that because of already issued Co-Cos, its EPS will drop by $1, down 14 percent from its 2004 target of $7 per share.

GM isn’t alone. Delighted by the prospect of cheap financing and delayed EPS dilution, companies now issue more Co-Cos than regular convertible bonds. According to Bear Stearns, in fact, 84 percent of convertible bonds issued this year contained a Co-Co provision, up from 65 percent last year.

As FASB mulls its final decision, companies are looking for ways to avoid the hit. One alternative, which GM plans to pursue, is to settle its Co-Cos using cash rather than shares (possible only when the bond includes such a provision). As for Co-Cos themselves, this looks like their end, says Senyek: “I expect the use of the contingent feature to drop off almost completely.”