Convertible Securities

A "convertible security" is a security—usually a bond or a preferred stock—that can be converted into a different security—typically shares of the company's common stock. In most cases, the holder of the convertible determines whether and when to convert. In other cases, the company has the right to determine when the conversion occurs.

	The company issues convertible securities that allow the holders to convert their securities to common stock at a discount to the market price at the time of conversion. That means that the lower the stock price, the more shares the company must issue on conversion.
	The more shares the company issues on conversion, the greater the dilution to the company's shareholders will be. The company will have more shares outstanding after the conversion, revenues per share will be lower, and individual investors will own proportionally less of the company. While dilution can occur with either fixed or market price based conversion formulas, the risk of potential adverse effects increases with a market price based conversion formula.
	The greater the dilution, the greater the potential that the stock price per share will fall. The more the stock price falls, the greater the number of shares the company may have to issue in future conversions and the harder it might be for the company to obtain other financing.

Before you decide to invest in a company, you should find out what types of financings the company has engaged in - including convertible security deals - and make sure that you understand the effects those financings might have on the company and the value of its securities. You can do this by researching the company in the SEC's EDGAR database and looking at the company's registration statements and other filings. Even if the company sells convertible securities in a private, unregistered transaction (or "private placement"), the company and the purchaser normally agree that the company will register the underlying common stock for the purchaser's resale prior to conversion. You'll also find disclosures about these and other financings in the company's annual and quarterly reports on Forms 10-K and 10-Q, respectively, and in any interim reports on Form 8-K that announce the financing transaction.

If the company has engaged in convertible security financings, be sure to ascertain the nature of the convertible financing arrangement - fixed versus market price based conversion ratios. Be sure you fully understand the terms of the convertible security financing arrangement, including the circumstances of its issuance and how the conversion formula works. You should also understand the risks and the possible effects on the company and its outstanding securities arising from the below market price conversions and potentially significant additional share issuances and sales, including dilution to shareholders. You should be aware of the risks arising from the effects of the purchasers and other parties trading strategies, such as short selling activities, on the market price for the company's securities, which may affect the amount of shares issued on future conversions.

Companies should also understand the terms and risks of convertible security arrangements so that they can appropriately evaluate the issues that arise. Companies entering into these types of convertible securities transactions should understand fully the effects that the market price based conversion ratio may have on the company and the market for its securities. Companies should also consider the effect that significant share issuances and below market conversions have on a company's ability to obtain other financing.

Companies or investors seeking to learn more about the SEC's registration requirements for common stock issuable upon conversion of unregistered convertible securities, including the timing of the filing of the resale registration statement and the appropriate form that the company may use to register the resale, should consult the Division of Corporation Finance's Compliance and Disclosure Interpretations.