Transaction Structuring and Canadian Convertible Debt

Many Canadian firms issuing convertible debt over the period 1996-2003 included provisions in the bond indenture giving them the option to repay interest and/or principal in shares rather than in cash. These payment- in-kind (PIK) provisions also allowed firms to classify a significant portion of the proceeds of the convertible debt issuance (beyond the conversion option) as equity in the financial statements. Thus, PIK provisions could have been used to minimize reported leverage or to provide financial flexibility. We find that highly-levered corporations with material convertible debt transactions were more likely to use PIK provisions and record the feature as equity, consistent with these firms minimizing reported financial leverage. In contrast, income trusts, entities with a high commitment to make payouts to owners, used this feature primarily for the financial flexibility afforded by the option to make payments in equity rather than in cash. Further, we document a negative price reaction by corporations with outstanding convertible debt with PIK provisions at the time when standard setters introduced accounting rules prohibiting the classification of anything other than the conversion option as equity, but no share price reaction by income trusts. Finally, we find that the use of PIK provisions declined for corporations but not for trusts following the introduction of the more restrictive accounting. Our findings support standard setters' current efforts to create standards on assets and liabilities capturing the substance of transactions and to limit opportunities for structuring transactions to create the appearance of lower financial leverage.