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What Are Variable Rate Convertible Notes?
What Are Variable Rate Convertible Notes?
Shawn Stevenson avatar
Written by Shawn Stevenson
Updated over 9 months ago

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TLDR:

  • Variable Rate Convertible Notes Defined:

    • Hybrid debt/equity securities allowing note holders to convert debt into shares at a price based on recent stock performance.

    • Typically very dilutive, especially in OTC markets and occasionally in NASDAQ and NYSE stocks, due to conversion terms favoring the note holder with lower stock prices leading to more shares upon conversion.

  • Dilution Mechanics and Impact:

    • The conversion price adjusts based on stock performance, potentially leading to a "death spiral" financing where the stock price is driven lower by conversions and sales, increasing the shares issued.

    • Such notes often have a floor price to limit how low the conversion price can go, but the mechanism encourages continuous downward pressure on the stock price.

  • Example: Castor Maritime (CTRM):

    • Issued a variable rate note with a conversion rate lower of a fixed price or a percentage of the lowest VWAP, subject to a minimum floor price.

    • This setup led to significant dilution when the stock price increased, allowing the note holder to convert at advantageous rates and sell for a profit, exemplified by a substantial issuance of new shares at low conversion prices.

  • Trading Volume and Stock Price Effects:

    • Volume restrictions on conversions can inform traders about potential selling pressure on high-volume days.

    • The impact of note conversion on stock price is significant, especially when the volume of converted shares is large relative to daily trading and total float.

  • Strategic Considerations for Traders:

    • The presence of variable rate convertible notes is a critical red flag indicating potential dilution and stock price pressure.

    • Traders can use tools like Dilution Tracker to identify such notes and potentially avoid losses or strategize short positions by anticipating note holder actions.

  • Conclusion:

    • Variable rate convertible notes are a highly dilutive financing option, often a sign of desperation by the issuing company.

    • Understanding these instruments is crucial for investors and traders to avoid pitfalls and strategize around the dilutionary effects.

The most toxic form of financing, variable rate convertible notes are a form of hybrid debt/equity security that allows the holder of the notes to convert the principal amount of the debt into shares at a conversion price that varies based on the recent stock price. The holders of the note make profit from selling the shares on the market at a price that is higher than the conversion price. These notes are prevalent on the OTC markets but occasionally makes its way onto NASDAQ and NYSE stocks.

Example

Castor Maritime (CTRM) on Jan 31, 2020 issued a $5 million variable rate convertible note to investor YAII PN. The note allowed YAII to convert the $5 million at the lower of a fixed price of $2.25 per share OR the variable rate of 90% of the lowest volume weighted average price (VWAP) in the previous 10 days, subject to a floor price of $0.60 per share.

This note is extremely dilutive because the lower the price of CTRM, the more shares YAII gets to convert and sell, which causes the price to go lower until it hits the floor conversion price of $0.60. For example, at a $2.25 conversion price, YAII receives 2,222,222 shares from converting the full $5 million. At the minimum $0.60 conversion price, YAII gets 8,333,333 shares, nearly four times more than before. This is called a death spiral financing because the noteholder has every incentive to keep converting and driving the price down since he is guaranteed a 10% profit due to the 90% of lowest VWAP clause.

The notes also contain a volume restriction where YAII can only convert up to 20% of the volume traded on a given day if the dollar volume for that day exceeded $400,000. A trader could have used this information and predicted that YAII would take advantage of any day where there is high volume to convert the notes and dump onto the market. This is what led to a large fade after the initial morning spike on March 5th, 2020.

Based on the conversion terms of the notes, YAII would have been able to convert shares at a conversion price equal to 90% of the lowest 10 day VWAP before March 5th, which was roughly 90% x $0.83 = $0.747. Therefore, YAII could make large profits by converting its loan at $0.747 and sell at higher prices immediately on the market for the entire day on March 5th.

We can confirm such conversion and selling occured because in a subsequent annual report filed on March 30, 2020, it was disclosed that “a total number of 3,500,785 new shares were issued in the name of the Investor, thereby converting a total amount of $2,332,991 of principal and interest due under the $5.0 Million Convertible Debentures into common shares.". This disclosure shows that the shares were converted at an average price of $0.66, lower than our $0.747 estimate because YAII likely converted even more shares at lower prices between March 5th and March 30th. If they sold the 3.5m shares at March 5th VWAP of 1.75, that equates to proceeds to YAII of more than $6.1m dollars, which already exceeds their original investment in the loan by 20%. They still have more than half the notes left to convert with guaranteed profit if they convert at ANY price.

The magnitude of the impact on the stock price will depend on the amount of shares being converted relative to the trading volume for the day and its existing float. In CTRM’s case, the 3.5m new shares issued was roughly equal to its entire shares outstanding at the time, which created significant downward pressure on the stock both technically and fundamentally. The technical pressure comes from the fact that YAII’s selling represented nearly 20% of the daily trading volume (the widely accepted heuristic is that a seller wanting to sell more than 10% of the daily volume will have material negative impact on the stock price for the day). There was also negative pressure fundamentally because a doubling in the outstanding shares cuts the existing shareholder’s value in half. Lastly, there was no meaningful news to support any increase in the fundamental value of CTRM.

Given the extremely dilutive nature of variable rate convertible notes, only the most desperate companies tend to resort to these types of borrowing arrangements. Therefore, the fact that a company even enters into such deals can be a major red flag.

A trader that uses Dilution Tracker can see the existence of the variable rate convertible notes held by YAII and avoid losses from longing dips expecting a trend continuation or profit from going short by front running YAII’s selling.

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