Attorneys Seek Guidance on Some Public Market Transactions

Honorable Eric Solomon

We write to request that the Treasury and the Internal Revenue Service promptly publish guidance on public market transactions commonly known as "bond hedge and warrant" transactions. We have recently made presentations at the Treasury and the Internal Revenue Service about these transactions. Since 2003, more than 90 such transactions have occurred involving a diverse group of issuers. We believe that published guidance on the Government's position with respect to the transactions would be beneficial to all concerned.

Briefly, as a typical illustrative example, a public market issuer issues convertible bonds to the public with terms calling for periodic cash interest payments and providing a right to convert the bonds into common stock of the issuer over the term of the convertible bonds (typically three to ten years) at a strike price in excess of the current market price of the common stock (typically 110% -140% of the current price). The issuer then enters into two additional contracts with one (and sometimes more than one) counterparty. The first contract (the "bond hedge") is a hedge of the conversion feature under which the counterparty agrees in exchange for an upfront cash premium payment to sell to the issuer any common stock required to satisfy the conversion feature of the publicly- issued convertible bonds. The bond hedge is designed to mirror closely the conversion option terms in the bonds and has such other terms such that the issuer can elect to integrate it with the bonds pursuant to Treas. Reg. § 1.1275-6. By electing to integrate the bond and the hedge, the issuer in effect creates a synthetic, fixed- rate ODD debt instrument from these two components which reflects the economic position of the issuer. In addition, the issuer will typically issue higher-strike-price warrants to the same counterparty or counterparties for the hedge in return for an upfront cash premium payment by the counterparty to acquire the warrants. In a typical transaction, the strike price for the warrants is substantially higher than the issue date market price of the common stock (typically 150% - 200% of the current market price) and significantly higher than the conversion price of the bonds. The warrants, however, typically have temporal terms that are somewhat shorter or longer than the temporal term of the bonds and the bond hedge as well as other variations in their contractual provisions, and the warrants are not integrated by the taxpayer with the bond and hedge under Treas. Reg. § 1.1275-6.

The example above is illustrative only. Variations in contractual provisions other than strike prices also have occurred, but the basic structure described above has been utilized in substantially all of the market transactions to date. We have provided more detail concerning the transactions in our prior meetings and will attempt to provide additional information that you may request in your consideration of these transactions; we note that in many cases, the documents (including bond hedge agreements and terms of warrants) appear in public filings of the issuers.

These transactions fill a market need by permitting issuers to reduce significantly the potential economic dilution of a typical convertible bond financing because ultimate dilution to the issuer will occur only if the warrant with the higher strike price is exercised (i.e., the issuer's dilution does not depend on conversion of the publicly-issued convertible bonds with the lower strike price). Through the transactions, the issuer secures the benefits of obtaining the funding in the broad and deep convertible bond market on terms that are expected in that market. Thus, the transactions produce very attractive financing terms for the issuer. In addition, the transactions provide other benefits to the issuer both in tax (additional OID deductions) and accounting (only the cash coupon on the bonds flows through the income statement as an expense while the cost of the bond hedge and warrant premium proceeds are reflected in equity).

We urge you to issue published guidance concerning these transactions as promptly as possible. Please let us know if we can assist you in your consideration of this request.