Understanding Anti-dilution Provisions in Convertible Securities

October 5, 2011

Anti-dilution provisions are designed to protect holders of convertible securities against dilution from a large variety of corporate events, including among others, stock dividends and splits, cheap issuances of additional common stock, and distributions of cash or property. These provisions are complex and can have significant economic consequences; yet they have been subject to little systematic thought. Even the most experienced practitioners often poorly understand how common anti-dilution provisions work.

This article provides a framework to understand various anti-dilution adjustments and to reconcile the apparent inconsistencies among various clauses. We believe the scope and extent of different types of anti-dilution provisions can generally be understood as a rational response to the nature and level of the information barriers and agency costs typically confronted in the particular circumstances, and the existence or absence of other mechanisms to address these issues.

Because dilution arising from information barriers essentially occurs at the time the investment in the convertible security is made and dilution arising from agency costs occurs at the time of the subsequent action, anti-dilution provisions designed to protect primarily against information barriers adjust for dilution differently than those designed to protect primarily against agency costs.

In cases where information barriers are the primary concern, anti-dilution provisions are designed to reduce (or eliminate) the economic dilution from initial investment that arises because the investor had imperfect information at the time the convertible security was issued. Because information barriers are not a significant issue for large public companies, anti-dilution provisions addressing information barriers are rarely included in the convertible securities of these companies.

In cases where agency costs are the primary concern, anti-dilution provisions are designed to reduce (or eliminate) the economic dilution from current value that can arise from the transfer of value to common stockholders. Because the risk of agency costs is present regardless of the type of issuer, these provisions are generally included in all types of convertible securities unless alternative means are available to protect against these actions.

October 2005

No. 1

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