Webb-site.com lifts the lid on the toxic convertibles scam in HK, in which small, mostly naive companies surrender control over future equity issuance to an investment bank, whose principal interest is to lock in a profit by converting bonds on a rolling basis at a deep discount to market and selling the resulting shares. CSFB has led the way down this value-destroying path, with Merrill Lynch recently joining the fray. We estimate that the banks make a gross profit on money raised of about 31%, and the average stock price has fallen 30% since a toxic convertible was launched. If you are a listed company, just say no. If you are an institutional investor, take your business elsewhere.

CSFB's Toxic Convertibles
8 June 2005

updated 14-Jun-05

Companies in this story
Art Textile (0565)
Asia Aluminium (0930)
Champion Tech (0092)
China Rare Earth (0769)
EganaGoldpfeil (0048)
Egana Jewellery (0926)
Far East Pharma (0399)
Global Green (0274)
Hua Han Bio (0587)
Rexcapital Intl (0155)
Sinotronics (1195)
South Sea Petro (0076)
Sunway (0058)
Tack Fat (0928)
Tidetime Sun (0307)

Over the last few years, a large and until now fairly well respected investment bank, Credit Suisse First Boston (Hong Kong) Ltd (CSFB) has been peddling a value-destroying financial instrument to small Hong Kong listed companies. In 2004, Merrill Lynch International (Merrill Lynch) also did one of these sordid deals. Like CSFB, they have apparently decided that the huge profit margins from this kind of product are worth the reputational risk it carries. Come back Frank Quattrone and Henry Blodget, all is forgiven.

Webb-site.com has been aware of the toxic convertibles scam for many years and have repeatedly warned the regulators about them in private, urging a regulatory ban. In our view, there can be no logical reason why a listed company would want to cede control to a third party over what amounts to a stream of future equity issues at deep discounts to market. The Listing Rules should be amended to prohibit listed companies from issuing convertible instruments which carry floating conversion prices. We have waited until now to compile this article because we wanted to conduct a comprehensive study of the actual results of these deals, which can each last several years, to prove how damaging they are. Recently, two of the companies we invested in have been ignorant enough to agree to these deals, and so we resolved that it was time to act.

Warning to all listed companies, particularly small, new and ignorant ones

If you run a listed company and get no further than this paragraph, just learn one thing: toxic convertibles with floating conversion prices will seriously damage your wealth. Don't even think about issuing one or your share price will almost certainly fall.

Hopefully after this story is out, CSFB and Merrill Lynch will reassess that reputational risk. if they want to salvage their reputation, they should do the decent thing and cancel the outstanding deals without redemption premiums, and cease and desist from further issues. In the meantime, if you are an institutional investor, you should consider diverting brokerage business to firms which do not promote this kind of instrument, which could damage your portfolio value. Money talks.

What is a convertible bond?

In normal circumstances, a convertible bond represents borrowings by an issuer from an investor, on which the investor receives interest and has a right to convert the bond into shares at a fixed conversion price, normally until the bond matures. The convertible bond represents a combination of a straight loan and an option to subscribe shares, and the value of the option compensates the investor for the lower interest rate than the issuer would normally pay on its borrowings. The conversion price is normally fixed at a premium to the market price at the time the bond is issued. If the shares rise above that price, then the option will be converted and result in a profit for the bondholder, and otherwise, the issuer benefits from lower-cost borrowings until the bond is redeemed. There is nothing wrong in principle with convertible bonds, other than the fact that they can ultimately result in an issue of shares without offering them to existing shareholders, in other words, dilution.

What is a toxic convertible?

CSFB has added a nasty twist to its bonds, namely a floating conversion price. The typical formula is that at any point during the lifetime of the bonds (typically 3 years), the bondholder (CSFB) can look back at the last 30 days (six weeks) of trading, and pick the lowest closing prices within that period, typically over a 4-day or 5-day average. It can then take a portion of the bonds and convert them at a set discount to that low average price, which is typically between 7% and 10%. As a result, CSFB gets a discount on a discount. CSFB can then sell those shares in the market, locking in a profit. The bond allows CSFB to choose either the floating conversion price or the fixed conversion price, whichever is lower. It result in a near-certain profit at the expense of the issuer.

The consequence of a floating conversion price is that there is no certainty over the number of shares that could be issued if the bonds are converted. This creates a massive over-hang on the market, so investors sell the shares, and as the price falls, the floating conversion price falls with it, and the potential dilution gets even worse. This is why they are known as toxic convertibles. In the case of highly geared companies, the effect can be even worse, and the bonds are sometimes known as death spiral convertibles because the price spirals down as the dilution increases. Read what the United States regulator, the SEC, has to say about toxic convertibles.

Theoretically, the lower limit to the conversion price is the par value of the shares, since under the laws of HK, Bermuda and the Cayman Islands, where most HK-listed companies are domiciled, it is illegal to issue shares for less than par value. However par value can often be only a small fraction of the current share price, allowing a long fall.

Another limit to dilution (but not conversion price) comes in the 20% general mandate to issue new shares, but the agreement with CSFB often includes an obligation to seek a fresh mandate from shareholders if the current mandate is exhausted, and in any case, these are multi-year deals so the annual general meeting will likely pass a new 20% mandate each year. It is unclear whether the agreements, which are not themselves published, include any obligation on the controlling shareholders to vote in favour of such mandates. In some cases, the issuers have sought and obtained a blanket issue mandate to cover as many shares as they need for conversions during the life of the bond.

Structural details

The CSFB deals typically split the bonds into 2 or more tranches, with the first tranche or Tranche 1 issued immediately. CSFB usually has an option to require the next tranche to be issued on the same terms, called the Additional Tranche 1. That option in itself has value, because if the share price rises after Tranche 1 is issued, then CSFB benefits from the fact that the maximum conversion price has already been fixed. Often a third tranche, which they call Tranche 2, can be issued at the option of the listed company, and this usually involves resetting the fixed conversion price based on a premium to the market price at the time of the new bond issue.

In recent deals, CSFB has included something called the "downside price", at a deep discount (typically 35-40%) to market. If the market price is at or below the downside price when bonds are presented for conversion, then the issuer has the right to redeem them instead, subject to payment of a premium (they always get their pound of flesh). However, if the issuer does not or cannot exercise that right then the conversion will proceed and the price may decline further. Note that the downside price is not actually a limit on the conversion price, because the 30-day look-back period allows CSFB to convert at less than the downside price after the price has risen back above it.

They have also sometimes included a "put price", at an even deeper discount (typically 50-60%). If the market price is below this level, then CSFB cannot convert the bonds but has the right to require redemption. If the market price reaches this level, then you can bet that the upside is limited so long as CSFB has not called for redemption, because as soon as the price begins to recover, the conversion rights become exercisable again.

It is still possible that a share price will move upwards after the bond is issued, for example, if the earnings grow fast enough to offset the dilution of the share base, or if the issue size is relatively small compared with market capitalisation, then the damage may not be as great and the overhang is smaller. Even in these circumstances, the dilution will still be a drag on the performance of the shares.

The CSFB deals usually include an option to subscribe new shares for cash worth about 15-20% of the face value of the bonds, with an exercise price at a premium to the market price at the time the bonds and options are issued. In most cases, however, the share price falls due the the overhang of the bonds, and the options are not exercised. Companies may be thinking that these options provide some kind of incentive for CSFB not to drive the price down with rapid conversions, but history shows that the options are seldom exercised, and it is clear that the bulk of the profit comes from the bond conversions.

An equity tap - outsourcing the general mandate

In several of the cases we have studied, the agreement with CSFB includes an escrow arrangement, so that part or all of the money received for the bond is placed in a trustee bank account and cannot be used by the company until the corresponding amount of the bond (or part of it) is converted. Meanwhile the money earns interest which can be used to pay the interest on the bond. This makes it even more obvious that the convertible is in effect an "equity tap" (or if you are American, a faucet) in which CSFB taps out freshly issued equity into the market whenever they see fit. Rationally they would choose moments when the floating conversion price is at the largest possible discount to the current market price, to earn the maximum profit. Remember, they can look back 30 days to pick a low point.

As readers will know, we have long opposed the general mandate sought by corporate boards from their shareholders to issue new shares for cash without offering them to existing shareholders. But the equity tap takes this a step further by effectively delegating and outsourcing the general mandate, placing it in the hands of an investment bank whose principal financial interest is to lock in the profit from the conversions.

We have no idea why companies would agree to this, particularly those which already have strong balance sheets (sometimes holding substantial net cash), good core businesses, and low P/Es. We suspect the companies are mostly ignorant rather than dishonest, and the involvement of such a prestigious investment bank might seem like a way to draw attention to an overlooked company. Well, for all the little companies who were seeking attention, now you've got ours.


One of the many defects of Hong Kong's Listing Rules is that, while companies are required to disclose share buy-backs by the morning after the transaction, they are not required to disclose share issues. So when a placing of new shares gets completed, or when share options get exercised, or when bonds are converted, or when scrip dividends are issued, nobody knows about the new shares except the company and the person receiving them, who may then turn around and sell them. A typical HK-listed company has a daily turnover of just 0.1-0.2% of its issued shares, so even a small issue of shares hitting the market can impact the share price.

Another implication is that shareholders who are seeking to monitor whether their shareholdings have passed through the 5% legal disclosure threshold, or any of the 1% boundaries above it (6%, 7%...) don't know for sure how many shares are in issue. All they can do is check this HKEx web page, which is updated only if a company sends in a monthly return. It is unreasonable to expect investors to check that every day for each of their holdings, just in case there has been an update.

We call again on the Listing Committee to amend the rules to require immediate disclosure of all new share allotments by filing with the Stock Exchange, on the same timetable as the disclosure of share buy-backs. The same disclosure should apply to the grant of share options or the creation of any other rights to subscribe shares.

Recently, the Stock Exchange has shown signs of listening to our pleas, because in a stop-gap half-measure, they have begun requiring issuers, as a condition of listing approval for the shares underlying convertibles, to disclose within 5 trading days of each month-end whether any of the convertibles have been converted, and if so how much, and a further requirement that if, during a month, the number of shares issued since the last disclosure is more than 5% of the company, then that must be disclosed too. However, this does not go far enough. 5% of the issued shares is about 5 to 10 weeks' turnover for an average stock, and it is not much consolation to be told about it a month later.

A study of toxic convertibles in HK

We have conducted an extensive study of 15 current and prior toxic convertible issues for which online records exist - all that we could find, excluding deals with controlling shareholders, although we cover some of those at the end of the article. Of the 15 deals, CSFB has led 13 of them, 1 was by Merrill Lynch, and one by an obscure firm called FB Gemini.

Limitations of the study

As mentioned above, we cannot know exactly which dates all the conversions are made, because there is no disclosure requirement. However, by carefully analysing statements in annual reports, interim reports, shareholder circulars and announcements, we can narrow conversions of blocks of bonds to a range of dates. We can then look at the volume weighted average price (VWAP) during the same period, that is, the average price at which all shares traded in the market during that period, and we can calculate the average discount of the floating conversion price compared with the VWAP. Hence we can estimate the profit that the bondholders made, or the effective discount to market at which the shares were issued during the conversion period.

We emphasise that these are only estimates, and there may be considerable variance between the estimate and the actual profit, depending on exactly when the bonds were converted and the resulting shares sold. However, if you analyse as many cases as we have, then the average of all cases will be a pretty accurate estimate. In some cases, where we do not have access to daily data before 2003, we have measured VWAP to the nearest week. Again, while this makes individual discount calculations less accurate, it will even out on the average and will not affect the validity of the results.

We have adjusted for bonus issues, stock splits, consolidations and rights issues. We use the phrase "scrip-adjusted" to describe this. We ignore the effect of dividends.


In the course of our case studies, apart from the damage caused by toxic convertibles, we found that they also seem to involve unusually high issue expenses, averaging around 5% of the bond issue, whereas a typical equity placing would cost 1-2%. We can't help wondering whether someone, either the subscriber or a middle-man, is charging an arrangement fee. Whatever, the cause, it is a further drag on the company.

Summary and findings

Of the 15 toxic convertible issues we studied, involving 13 listed companies, 9 have run their course, 4 still have bonds outstanding, and the latest 2 have not yet had any bond conversions. The average market cap of the companies involved at the time they agree to the deals was US$142m, and the average maximum size of the deals (excluding the 15-20% options) is about US$18m.

Here is a summary of the findings, in order of issue date.

The above table excludes the US$1.36m redemption premium paid by Sunway to terminate its deal early, and the US$2.51m settlement paid by EganaGoldpfeil to stop another tranche of bonds. Several of these deals are still in progress, so the total profit shown is less than the final figure.

Now we cover the cases in detail. To navigate among them, use the "companies in this story" links at the top of this page.


On 15-Dec-99, EganaGoldpfeil (Holdings) Ltd (EGP, 0048) announced a single-tranche issue of US$15m toxic convertibles to CSFB with a fixed conversion price (scrip-adjusted) of $2.80, compared with a market price of $2.44. EGP had a market value of HK$2,383m (US$305.5m).

In fact, this was not the first toxic convertible by EGP - it announced one back on 21-Apr-97 which was issued on 1-May-97, but we don't have the announcement as it predates the online system, and we don't know who the subscribers were.

Here's the estimated conversion history of the 1999 bond:

The table shows that the average conversion price was $1.726, or a 29.3% discount to the price when the bonds were first announced, and we estimate that CSFB made a profit of $31.8m. At the end of the conversion period, on 30-Nov-02, the shares closed at $1.52, a fall of 37.7% since the bond was announced.

Round 2

Not satisfied, EGP came back for more, and on 27-Feb-03 it announced a new issue of up to US$25m toxic convertibles, with an initial Tranche 1 of US$10m and a fixed conversion price of $1.6184. CSFB also received an option to subscribe up to 9,035,336 shares at the fixed conversion price. The stock closed the previous day at $1.36, valuing EGP at HK$1,539m (US$197.4m). Issue expenses were US$212,500, or 2.125%.

On 6-Jun-03, EGP and CSFB amended the redemption provisions, apparently to deal with the fact that the par value of EGP's shares is HK$1 which sets a floor on the legal price of any shares issued to satisfy a redemption.

On 15-Jan-04, EGP and CSFB amended the agreement again, to reduce the interest rate, reflecting the lower bank deposit rates of the time, and to change the floating conversion price from a 7% discount to a 10% discount to the average of the 5 lowest closing prices in a period of 30 trading days. They then issued US$5m of Additional Tranche 1 bonds. The market price the previous day was $1.85, so the fixed conversion price of $1.6184 was already in the money. CSFB also received options to subscribe 4,517,668 shares at $1.6184 each. At the same time, EGP issued the US$10m Tranche 2, which had a fixed conversion price of $2.0604, and came with options to subscribe 7,066,098 shares at the same price. Issue expenses were US$290k.

On top of all that, on the same day, EGP granted CSFB a further option to require EGP to issue a further US$10m Tranche 3 bonds, exercisable once at any time until 27-Feb-06. The bonds would have a 3-year maturity. On 10-May-05, perhaps finally realising the damage these instruments cause, EGP announced that it had agreed with CSFB to cancel the right to subscribe Tranche 3, as well as the existing share options and the ones which would have come with Tranche 3. The announcement contains numerous errors which have yet to be corrected, and although you won't find it mentioned in the summary, EGP had to pay CSFB US$2.51m (HK$19.6m) to cancel the deal.

The conversion history, as near as we can estimate, is as follows:

As shown, the average conversion price of the bonds was $1.308, and CSFB has made an estimated profit of HK$14.0m so far, plus the $19.6m they were paid to cancel Tranche 3 and the options, plus whatever they will make on the US$15.7m of toxic convertibles outstanding at the latest interim report date of 30-Nov-04.

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China Rare Earth

On 13-Jun-00, less than 8 months after it listed, rare earth and refractory products maker China Rare Earth Holdings Ltd (CRE, 0769) agreed an issue of up to US$10m toxic convertibles to CSFB, with an initial Tranche 1 of US$5m and a fixed conversion price of HK$1.34, a 24% premium over the closing price that day of about $1.08, when CRE was valued at HK$648m (US$83.1m). CSFB also received an option to subscribe 4m shares at $1.6035. CRE had an option to issue a Tranche 2 of US$5m within 75 days after Tranche 1 was fully converted, but they let it lapse. At least they got that right.

The estimated conversion history is as follows:

So the average conversion price (including the options) was $1.157, which was a 40.0% discount to the estimated selling price CSFB could have obtained during the conversion period. On 7-Jun-05, the shares closed at $0.95.

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On 25-May-00, less than 9 months after it listed, calculator maker Sunway International Holdings Ltd (Sunway, 0058) agreed an issue of up to US$20m toxic convertibles to CSFB and The SCM Growth Fund II L.P. (SCM), with an initial Tranche 1 of US$10m and a fixed conversion price of HK$2.1087, a 20% premium to the closing price that day of about $1.76, which valued Sunway at $1,760m (US$225.6m). The bond subscribers also received options to subscribe 11.5m shares at the fixed conversion price.

Update, 14-Jun-05

In the original version of this article, we incidentally suggested that SCM may have been managed by Strong Capital Management Inc. Sources now indicate that this was not the case, and SCM was more probably managed by a firm called "Strategic Capital Management". We regret any confusion caused.

The estimated conversion history is as follows:

As you can see, only US$1.3m was converted, at an average price of $0.491, or 72.1% below the market price when the bond was first announced. The bonds included an option for Sunway to redeem the bonds if they were presented for conversion while the market price was $1.00 or less, at a redemption price "determined under the Subscription Agreement", the formula for which was not disclosed. The market price did indeed descend well beyond this point, and Sunway ended up paying a total premium of about HK$10.6m to redeem the rest of the bonds, which is more than the $10.1m value converted. Overall then, Sunway issued 20.6m shares for a negative price. What a painful lesson. Since then, they haven't issued any shares. The stock closed at $0.29 on 7-Jun-05.

Incidentally, Sunway is one of only a few companies in HK with 3 generations simultaneously on the board - a Grandfather, his daughter, two granddaughters and their mother (who was married to the late Chairman).

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Asia Aluminium

On 30-Aug-00, Asia Aluminium Holdings Ltd (AA, 0930), which in a tech-bubble moment, renamed itself "Global Applied Technologies Holdings Ltd" before reverting to its old name, agreed an issue of up to US$16m toxic convertibles, including an initial Tranche 1 of US$13m, of which US$8m went to CSFB and US$5m to SCM, and a US$3m Tranche 2 to be issued 3 weeks later to SCM. So overall, the US$16m deal went 50:50 between CSFB and SCM.

Both Tranches had a fixed conversion price of HK$1.375 (scrip-adjusted). The Tranche 1 bond issue was completed on 1-Sep-00, and then next day it was disclosed that AA had also granted options to CSFB and SCM to each subscribe for 12.5m shares at $1.42 (adjusted) per share.

The estimated conversion history is as follows:

On 31-Aug-00, the day before the first bond was issued, the shares closed at $1.2125 (adjusted), valuing AA at about HK$2.51bn (US$322m). As you can see, the average conversion price was $0.517, a 57.4% discount to that price, and an average 25.9% discount to market prices prevailing during the estimated conversion periods over the next 2 years. We estimate that CSFB and SCM made a profit of HK$44m while AA raised $124.8m before expenses. The amount of expenses was not disclosed. None of the share options was exercised.

AA is a company which has spewed out new shares like Vesuvius. The toxic convertible was just a part of this. In the 4 years from Jun-00 to Jun-04, its Earnings Per Share fell 23.8% even though its net profit rose 37.2%. It's hard to grow your EPS when your "S" grows faster than your "E". The shares closed on 7-Jun-05 at $0.90.

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Tidetime Sun

On 28-Feb-01, Tidetime Sun (Group) Ltd (Tidetime, 0307), which has had 3 names in the last year alone, agreed an issue of up to US$16m toxic convertibles to CSFB, with an initial Tranche 1 of US$8m and a fixed conversion price of HK$0.2399. The shares closed the previous day at $0.225, valuing Tidetime at HK$1,381m (US$177.1m). CSFB also received options to subscribe up to 70m shares at $0.2369 each. Issue expenses were US$400k (5%). These options were not exercised, and Tidetime did not exercise its option to issue a US$8m Tranche 2.

The estimated conversion history is as follows:

So the conversion price averaged $0.0969, a 56.9% discount to the market price when the bond was announced.

Round 2

Tidetime's then management did not learn much from this experience, because on 6-Jun-02 it announced another toxic convertible, this time up to US$26m with FB Gemini Asset Management Ltd (FB Gemini). The shares closed the previous trading day at $0.136, valuing Tidetime at HK$1,267m (US$162.5m). An initial US$6m Tranche 1 was issued on 9-Jul-02 and US$3.5m was immediately converted at $0.102. FB Gemini also received an Option to subscribe US$150k at the fixed conversion price.

On 27-Aug-02, the agreement was amended and FB Gemini surrendered its right to require Tidetime to issue another US$20m of bonds, and in return, received a "Further Option" to subscribe up to US$4m at any of the actual conversion prices of the Tranche 1 bonds. On 27-Sep-04, the deal was amended again, to change the conversion formula for the remaining US$200k of bonds, to lower the exercise price of the $150k option and to cut the size of the Further Option.

Here's the estimated conversion history so far:

So the average conversion price so far has been a 53.7% discount to the market price before the deal was announced. The deal expires on 9-Jul-05. We should note that Tidetime is one of the most prolific issuers of shares in the market, and has reported a loss for 9 consecutive years under various management. As of 30-Apr-05 it had 23.22 billion shares in issue. The shares have been suspended since 25-Apr-05 at $0.017.

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Far East Pharmaceutical Technology

On 14-Aug-01, just under a year after listing, Far East Pharmaceutical Technology Co Ltd (FEPT, 0399) agreed an issue of up to US$12m toxic convertibles to CSFB, with an initial Tranche 1 of US$4m and a fixed conversion price of HK$0.41125 (scrip-adjusted). The stock closed at $0.335 that day, valuing FEPT at HK$461m (US$59.1m). CSFB also received options to subscribe up to 18,966,564 shares (adjusted) at the fixed conversion price. Issue expenses were US$320k, or 8% of Tranche 1.

On 14-Dec-01, CSFB exercised its right to require FEPT to issue US$4m Additional Tranche 1 with the same fixed conversion price as Tranche 1. FEPT also exercised its right to issue US$4m Tranche 2 with an amended fixed conversion price of HK$0.4775 (adjusted). The floating conversion price for Tranche 2 was amended from a 7% discount to a 9% discount to the (lowest) average of any 4 consecutive closing prices in a 30-day look-back period. The stock closed at $0.425 that day. Issue expenses were US$320k, or 4%.

On 7-Jan-02, FEPT announced that on 18-Dec-01, CSFB waived the requirement in the agreement for shareholders' approval of the Additional Tranche 1 and Tranche 2 but, with the general mandate almost exhausted, FEPT obtained a fresh general mandate to issue shares at an EGM on 29-Apr-02.

The estimated conversion history is as follows:

As you can see, the volatile nature of this stock allowed CSFB to achieve exercise prices which averaged 33.3% less than the volume weighted average price for the periods in which bonds were converted. We estimate that they made a profit of HK$50m, while FEPT raised $96.4m net of expenses of $5.0m.

FEPT's crash

We divert briefly to tell you what happened to FEPT afterwards. Readers may recall that on 17-Jun-04, FEPT's share price crashed 92% and swas suspended 4 minutes before the market closed, never to trade since. On 24-Jun-04, brokerage Guotai Junan Securities (Hong Kong) Ltd (GJ), the Co-lead Manager of FEPT's IPO, disclosed that on 17-Jun-04, the day of the crash, it had enforced a share pledge on 25.9% of FEPT and had sold about 5.53% at an average of $0.069 in the market that day. On 29-Jun-04, Celestial Securities Ltd (Celestial) also disclosed that it had acquired and sold 8.56% at an average of $0.101 on the day of the crash. These two sales added up to 14.09%. At least one other party was involved, because the controlling shareholder reported a reduction of its holding of 15.81%, and recorded sales at a higher maximum price than the brokers.

As brokers, GJ and Celestial were exempt from disclosing their security interest in the shares until it became enforceable, so the public never knew about the pledges, and could not factor this information into their investment decision to hold the shares. This and several other cases pushed the Securities and Futures Commission to review whether the exemption for banks and brokers should be continued, and we have long called for it to be scrapped. Pledges represent the potential for a forced sale, and this is negative to valuation of stocks, particularly when a company's loans include covenants that the controlling shareholder will remain in control, as they did in this case, so a forced sale means that the company's bank loans go into default.

Predictably, banks, brokers and listed companies were opposed to disclosing such negative information, and recently, the SFC decided to do nothing but form a working group to study it further.

It appears that a syndicate of banks led by Raiffeisen Zentralbank Osterreich AG (Singapore branch) and Standard Chartered Bank (SCB) were taken for a ride, agreeing a US$80m loan on 10-May-04. On 15-Sep-04, SCB filed a winding-up petition, and on 22-Sep-04 provisional liquidators were appointed. All the directors who were on board at the time of the crash have since quit citing "health reasons" or "personal reasons". Questions remain over why a company which apparently had so much cash was in need of a bank loan, and what happened to all that money. The last annual accounts for 30-Jun-03, audited by CCIF CPA Ltd, showed cash in the balance sheet of HK$644m.

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Global Green Tech

On 13-Dec-01, just under a year after its IPO, skin cream maker Global Green Tech Group Ltd (GGT, 0274) agreed an issue of up to US$12m toxic convertibles to CSFB, with an initial Tranche 1 of US$4.08m and a fixed conversion price of $1.8019 (scrip-adjusted). CSFB also received an option to subscribe 3m shares at $2.0791 each. The shares closed that day at $1.267 (adjusted), valuing GGT at HK$467.6m (US$59.94m).

On 9-Apr-02, GGT and CSFB agreed to swap the remaining US$1.78m of the original Tranche 1 with a new batch on identical terms, in order to get around the depleted general mandate. On 30-Apr-02, GGT sent a circular to shareholders and obtained their approval to issue as many shares as necessary to satisfy all future conversions of the bonds.

On 9-Jul-02, GGT exercised its right to require CSFB to subscribe US$3.84m Tranche 2, with a fixed conversion price of $2.2453 (adjusted). On 30-Jan-04, CSFB exercised its right to require GGT to issue the US$4.08m Additional Tranche 1.

The estimated conversion history is shown below.

The table shows that the average conversion price was $0.987, a discount of  22.1% to the price when the bond was first announced. The shares closed on 7-Jun-05 at $0.80.

Options excess

As a side note, we should remark that GGT is one of the worst exploiters of Hong Kong's lax listing rules on share options, dishing them out not just to employees but to consultants, customers and suppliers. We calculate that as of 25-Apr-05, 36.5% of the existing issued share capital had resulted from the exercise of options. Of course, the value of these options has not until now been required to be recorded as an expense in the income statements. New accounting standards should change that.

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Champion Technology

On 22-May-02, Champion Technology Holdings Ltd (Champion, 0092) agreed an issue of up to US$24m toxic convertibles to CSFB, with an initial Tranche 1 of US$8m and a fixed conversion price of HK$2.3635. The stock closed at $1.88 the previous day, valuing Champion at HK$1,070m (US$137.2m). CSFB also received options to subscribe 4,949,905 shares at the fixed conversion price. Issue expenses were US$306k.

On 27-Jun-02, Champion announced that it would sent a circular to shareholders seeking authority to issue "the appropriate number of shares" on conversion of the bonds - in other words, opening the door to almost unlimited dilution of the share capital, beyond the 20% general mandate that they already held. The circular failed to spell out the maximum number of shares that could be issued in a worst-case scenario, instead focussing on the fixed conversion price. Approval was obtained.

On 26-Sep-03, US$8m of Tranche 2 bonds were issued, with a fixed conversion price of HK$1.98. The market price that day was $1.68, valuing Champion at HK$1,169m (US$149.8m). CSFB also received an option to subscribe 5,881,515 shares at $1.98 each. Issue expenses were US$262k.

You will notice that we have skipped the Additional Tranche 1, which CSFB had not called to be issued. The 3-year term of the original bonds was set to expire on 22-May-05, but on 28-Apr-05, CSFB and Champion amended the agreement and issued US$8m Additional Tranche 1 bonds, extending the maturity until 22-Nov-05 and amending the put price to $1.00. The shares closed on 28-Apr-05 at $1.18. Issue expenses were another US$273k. As previously agreed, CSFB also received an option to subscribe 4,949,397 shares at the fixed conversion price of $2.3635 each, although that is obviously of little value now.

On 13-May-05, Champion disclosed the formula which would apply if bonds were presented for conversion while the market price was below the downside price of $1.10. Basically Champion would then have the option to redeem by payment of an extra 8% interest. CSFB wins either way.

Obviously this deal is still in progress, but based on the accounts up to 31-Dec-04, here is the estimated conversion history:

As you can see, the average conversion price up to 31-Dec-04 was $1.116, which was a 40.6% discount to the market price when the bonds were first issued. Champion had issued equity for HK$92.8m, paid expenses of US$841k (HK$6.6m), and CSFB has made an estimated profit of HK$27.7m. The stock closed on 7-Jun-05 at $1.21.

Champion is a sorry story in itself - if you adjust for 3 bonus issues, a consolidation and a rights issue, then the IPO price in Aug-92 was $3.673. The company has also pumped out a stream of bonus warrants to its shareholders so that there has been one in issue at almost all times since it was listed. All that a warrant issue does is to reduce the company's ability to optimise the capital structure, since they cannot control when the warrants will be exercised.

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Tack Fat

On 19-Dec-02, less than 8 months after listing, Tack Fat Group International Ltd (Tack Fat, 0928) announced an issue of up to US$12m toxic convertibles to CSFB, with an initial Tranche 1 of US$4m and a fixed conversion price of HK$0.62. The stock closed at $0.55 that day, valuing Tack Fat at HK$730.4m (US$93.6m). CSFB also received options to subscribe US$0.8m for 11.744m shares at $0.531 each.

This was one of the smaller deals, so the overhang was less and the stock price actually rose. On 3-Oct-03, CSFB exercised its option to require Tack Fat to issue US$4m Additional Tranche 1 bonds, together with options to subscribe another 11.744m shares at $0.531 each. That day, the share price was $0.87, so the Additional Tranche 1 with options already had an expected profit of HK$16.56m (US$2.12m).

We estimate the conversion history was as follows:

Overall, the table shows that Tack Fat issued 123.1m shares for HK$71.9m (before expenses of $3.4m) at an average price of $0.584, and CSFB earned an estimated profit of $18.0m, or about 20% of the estimated gross amount raised. At 28-Dec-04 (when the interim report was finalised) they also still had options to subscribe 5.528m shares at $0.531. That day, the shares closed at $0.85, implying an intrinsic value of $1.8m.

So far, Tack Fat has not, as far as we know, exercised its right to require CSFB to subscribe the final Tranche 2 of US$4m. Perhaps they have learnt from their experience. Tack Fat closed on 7-Jun-05 at $0.98.

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Hua-Han Bio-Pharmaceutical

On 22-Jul-03, Hua Han Bio-Pharmaceutical Holdings Ltd (HHBP, 0587) announced an issue of up to US$12m toxic convertibles to CSFB. The stock closed at $1.19 before the announcement, valuing HHBP at HK$676m (US$86.7m). The fixed conversion price was $1.4879.

Tranche 1 was US$3.5m (HK$27.3m), less expenses of HK$2.9m. CSFB also received options to subscribe 4,587,078 shares at $1.3094 each. Further details were disclosed in an  announcement on 8-Aug-03, and, and an Additional Tranche 1 of US$4.5m (HK$35.1m), less expenses of HK$2.3m was issued on 5-Sep-03, when the shares closed at $1.35.

On 30-Oct-03 the company issued a further clarification and the next day dispatched a circular to obtain shareholders approval for the possible issue (at the option of HHBP) of US$4m Tranche 2 convertible bonds and the issue of "such number of new shares as may be required" upon their conversion. In other words, an unlimited general mandate had bee outsourced to CSFB.

As of 31-Dec-04, a total of US$7.25m had been converted and US$0.75m remained outstanding, so the company had not yet pulled the trigger on the next US$4m tranche. The conversion history, as near as we can estimate, is as follows:

As you can see, up to 31-Dec-04 the average conversion price was $0.964 per share, or 19% less than the market price when the bond was first issued. The company has so far issued equity for $56.5m before expenses of $5.2m. Net of expenses, HHBP has raised only $51.27m, or $0.876 per share.

On 7-Jun-05, HHBP closed at $1.00 per share. The company has also been a heavy issuer of share options to directors, employees and consultants.

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Egana Jewellery & Pearls

Earlier in this chronology we covered the toxic convertibles issued by EganaGoldPfeil. EGP has a listed subsidiary, Egana Jewellery & Pearls Limited (EJP, 0926). On 10-Feb-04, EJP agreed to issue up to US$45m of 5-year toxic convertibles, not to CSFB, but to Merrilll Lynch, who were jumping on the toxic bandwagon for the first time in Hong Kong, at least.

The shares closed the previous day at HK$2.10, valuing EJP at HK$651.4m (US$83.52m) so the maximum bond issue represented a huge portion of the company.

The initial US$10m (HK$78m) Tranche 1 carried a fixed conversion price at the lesser of $2.50 or 122% of the market price the day before closing. When the issue closed on 26-Feb-04, the market price was already $2.475 (a price not seen since then), so the fixed conversion price was set at $2.50, and Merrill Lynch received options to subscribe about 5,548,929 shares at the same price. Issue expenses were HK$3m.

An additional US$5m Tranche 1a was agreed to be issued between 45 and 150 days later. Each side had an option to issue another US$5m Tranche 2a from day 151 to day 250, which EJP could optionally increase with a US$5m Tranche 2b on the same day. The same fixed conversion price of $2.50 applied to all these tranches. Apparently neither Tranche 1a nor Tranche 2 was issued.

Merrill Lynch was also given an option to subscribe US$5m Tranche 3a from day 251 to day 350, and US$5m Tranche 4a from day 351 to day 500. If either of these options was exercised, then EJP had the right to increase the issue size with US$5m Tranche 3b or US$5m Tranche 4b, on the same respective issued dates. As clarified on 26-Feb-04, the fixed conversion prices for Tranche 3 and Tranche 4 would be 122% of the 30-day volume-weighted average price prior to issue.

On 13-Jan-05, Merrill Lynch exercised its right to require US$5m Tranche 3a to be issued, together with options to subscribe 3,518,342 shares at the fixed conversion price of $1.656. EJP chose not to add a Tranche 3b. The shares closed that day at $1.37. On 18-Feb-05, EJP announced that listing approval for the underlying shares had been obtained, but didn't say when. On 7-Mar-05 EJP announced that the approval was in fact obtained on 4-Feb-05, and from then until 28-Feb-05, US$2.5m had been converted. On 17-Mar-05, EJP announced that the rest of Tranche 3a had been converted on 9-Mar-05, which was the same day that they had put out a standard statement saying they had no idea why the volume had increased. Really!

So far, the estimated conversion history is as follows:

As you can see, the average conversion price has been $1.136, a discount of 45.9% to the market price of $2.10 when the toxic convertibles were first announced, and we estimate that Merrill Lynch has made about $31m from the issue so far, plus any profits they may make from the share options if the price recovers. The number of shares in issue has been diluted by 33.2% since the bond was announced, entirely because of conversions. The stock closed on 7-Jun-05 at $1.32.

As far as we know, Merrill Lynch has not yet required EJP to issue Tranche 4a, and they have until the 500th day after the first bond, being 10-Jul-05, to do so.

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Art Textile

On 6-Dec-04, Art Textile Technology International Co Ltd (Art Textile, 0565) agreed an issue of up to US$15m toxic convertibles to CSFB, including an initial US$10m Tranche 1 with a fixed conversion price of $0.8579. Issue expenses were US$563k, or 5.63%. The shares closed the previous day at $0.69, valuing Art Textile at HK$604.8m (US$77.54m). Up to 31-May-05, none of the bonds had been converted, but the overhang has been enough to drive the market price down 24.6% in 5 months, closing at $0.52 on 7-Jun-05. The fall came despite the fact that the company reported interim net profit up 32.3% for the six months to 31-Dec-04.

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On 27-Apr-05, CSFB found its latest victim, Sinotronics Holdings Ltd (Sinotronics, 1195), which agreed to an issue of up to US$15m toxic convertibles, including an initial Tranche 1 of US$10m with a fixed conversion price of $1.1722. Issue expenses were US$600k, or 6%. The shares closed the previous day at $0.85, valuing Sinotronics at HK$421.3m (US$54.02m).

Up to 31-May-05, no bonds have yet been converted, but since the announcement, the shares have fallen 12.9%, closing on 7-Jun-05 at $0.74.

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Dishonourable Mentions

The toxic convertible has also been used by lesser-known subscribers, and we mention them here as a warning to our readers.

Rexcapital International

On 12-Jun-01, REXCAPITAL International Holdings Ltd (RexInt, 0155) agreed an issue of HK$100m 5% 3-year toxic convertibles to a BVI company called Kingfair Co Ltd, whose owner was not disclosed. The fixed conversion price (scrip adjusted) was $0.982 and the bonds were issued on 26-Jun-01. They were fully converted by 26-Jan-04. The average conversion price (adjusted) was $0.230.

On 22-Jul-02, in a connected transaction, Rexcapital International Holdings Ltd (RexInt, 0155) agreed to buy Rexcapital (Hong Kong) Ltd from Rexcapital Partners Incorporated, which in turn was 75% owned by Victor Chan How Chung, the Chairman and then 29.5% shareholder of RexInt, in return for HK$80m of 2-year toxic convertibles with a fixed conversion price of $0.36 (scrip-adjusted). The market price the previous trading day was $0.26. The acquisition was completed on 13-Dec-02. By the time the notes matured on 13-Dec-04, a total of $60m had been converted into shares at an average price of $0.070, a 73.1% discount to the market price when the bond was issued.

RexInt closed on 7-Jun-05 at $0.166, valuing the company at $456.9m. Net tangible assets at 30-Sep-04 were $346.2m, but this includes a receivable of $350m for the purported sale on 29-Oct-03 of 87.5% of REXCAPITAL Infrastructure Ltd (RI) to a BVI company called Sky China Holdings Ltd (Sky China), the owners of which have never been disclosed. Sky China has not paid a penny, and in the audit report for the year ended 31-Mar-04, Grant Thornton said "we have been unable to obtain sufficient information to satisfy ourselves as to the recoverability of a receivable". The reason the sale is so questionable is that in the 2 years ended 31-Mar-03, RI, which purportedly owns a fibre optic network in the PRC, recorded zero turnover. This business had been acquired for huge piles of cash in a series of transactions in 1999 and 2000, from a BVI company, the owner of which was not disclosed. The acquisition was made despite the PRC ban on foreign ownership of telecom networks.

BUBBLE WARNING: If you count the receivable at zero, and adjust for a recent placing and bond conversions, then RexInt has net tangible assets of only about HK$38m, so it is trading at about 12x adjusted net assets. If you own RexInt, get out now.

South Sea Petroleum

On 25-Nov-04, South Sea Petroleum Holdings Ltd (SSP, 0076) announced a HK$80m toxic convertible with companies represented by a man who had been negotiating "for a certain period of time" with the government authority of Mongolia to establish a 60:40 oil exploration joint venture in the country. The shares closed that day at $0.53, valuing SSP at HK$254m. On 4-Apr-05, the agreement was terminated, without shares being issued. By then, the shares had fallen to $0.39, down 26.4%.

As a footnote, readers may recall that SSP was a ramped stock which underwent a spectacular 1-day 88.9% crash on 31-Aug-04, falling from $3.325 to $0.37, during which some of the Chairman's shares were dumped by a margin lender. As in the case of Far East Pharmaceutical (see above), there had been no legal requirement for prior disclosure of the pledge.

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