Convertible loans – A flexible hybrid instrument

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Interest rates increased sharply throughout 2022 and some believe they will continue to increase going forward. Equity capital markets have been turbulent for a prolonged period and many companies have struggled to raise funds. With debt and equity being expensive and difficult to obtain, convertible loans could be a useful instrument to obtain funding. Because convertible loans give lenders an option to subscribe for shares in the borrower, interest rates are typically lower than for regular loans.

Introduction
A convertible loan is considered a hybrid instrument as it is neither debt nor equity. Whether it is accounted for as debt or equity depends on the terms of the loan. Convertible loans typically carry interest and have a fixed maturity date, but other varieties also exist. Conversion is triggered by the lender, the borrower or automatically upon the occurrence of a trigger event. The conversion price is pre-agreed and can be fixed or subject to a pre-agreed pricing mechanism.

There are two primary types of Norwegian convertible loans; registered and unregistered loans.

Registered convertible loans
A registered convertible loan is a convertible loan that has been approved by the borrower’s general meeting (or board of directors pursuant to an authorisation granted by the general meeting), and then registered in the Norwegian Register of Business Enterprises (NRBE). From a creditor perspective, the benefit of a registered convertible loan is that the creditor can convert its loan to shares without any further corporate approvals from the borrower.

To be eligible for registration, the loan must comply with the requirements of Chapter 11 of the Norwegian companies act (NCA). The loan must be approved by the general meeting of the borrower with the same majority as an amendment to the articles of association. The general meeting can alternatively grant the board of directors an authorisation to approve a convertible loan. The resolution to approve the loan must include the key terms of the loan as set out in section 11-2 (3) of the NCA. If the resolution does not include the required terms, the NRBE will refuse to register the resolution.

Unregistered convertible loans
An unregistered convertible loan is a loan that has not been approved by the borrower’s general meeting and registered with the NRBE.

The main benefit of an unregistered convertible loan is that the parties have increased flexibility with respect to the terms of the loan and the conversion mechanism. The loan agreement and the board approval do not have to include the specified terms in the NCA. As an example, the conversion period for a registered loan is limited to five years and the notice to the NRBE must include information on the maximum share capital increase that can be made upon conversion. If the instrument and conversion mechanism is complex or dependent on certain factors outside the control of the parties, it can be difficult to determine the maximum share capital increase to be made upon conversion.

The downside of having an unregistered convertible loan is that conversion requires a corporate approval from the borrower. The share capital increase is therefore subject to, amongst other things, the general meeting’s approval. Approval by the general meeting can take time and the lender is not guaranteed that the borrower and the shareholders cooperate at the time of conversion. This can however be mitigated by obtaining undertakings from the majority shareholders to vote in favour of the share capital increases that are required.

Certain considerations for lenders and borrowers
Although convertible loans can be an attractive financing opportunity for companies, the shareholders may pay the price upon conversion. Conversion can lead to substantial dilution for shareholders, primarily if the shareholders are not lenders under the convertible loan. Convertible loans are frequently provided by one or more shareholders of the company, but external investors also provide convertible debt funding. If the borrower does not perform as well as expected during the tenor of the loan, external investors may end up taking control over the borrower.

Whether a lender should provide a registered or unregistered loan depends on several factors such as the need for flexibility, the urgency of the financing need and the relationship between the parties. If the lender is not already a shareholder of the borrower, a registered loan should at least be considered.