What Are Equity Securities under the Prospectus Directive?

Stockholm-based attorney, Jens Pohl examines the EU’s new Prospectus Directive, which has now been implemented in most member states.

A new Prospectus Directive entered into force in the European Union in 2003, and most Member States have now implemented it. On December 31, 2003, a new Prospectus Directive (PD) entered into force in the European Union, replacing the provisions of the previous Directive dating from the 1970s and 80s. The last transposition date for the PD was July 1, 2005, and most member states have now implemented its provisions into their national legislation. The PD introduced a new set of definitions, whereby among other things, a distinction is made between equity securities and non-equity securities. These definitions are of pivotal importance in determining the limits of the applicability of the PD, and the jurisdiction of the competent authorities of the member states as well as the format and content of a prospectus.

Throughout the EU, prospectus rules are an increasingly integrated part of a rapidly growing area of law: European Securities Regulation. Through the so-called Lamfalussy Directives —including the PD—this area of regulatory law has been equipped with detailed rules relating to securities prospectuses, market abuse, disclosure requirements, and market transparency rules, as well as rules relating to exchange offers.

Is a convertible debt instrument an equity security? In many circumstances, the answer would be affirmative, in others, negative. However, anyone trying to find the answer in the new PD would quickly realize that this, apparently simple, question has been given ambiguous and conflicting treatment. According to Article 2(1)(b) of the PD, ‘equity securities’ are:

shares and other transferable securities equivalent to shares in companies, as well as any other type of transferable securities giving the right to acquire any of the aforementioned securities as a consequence of their being converted or the rights conferred by them being exercised, provided that securities of the latter type are issued by the issuer of the underlying shares or by an entity belonging to the group of the said issuer. [Author’s italics]

Convertible debt therefore seems to be included in the definition. However, Recital 12 to the PD, which describes the background and reasons for the PD, reads as follows:

[C]onvertible notes, e.g. securities convertible at the option of the investor, fall within the definition of non-equity securities set out in this Directive.

According to the Recital, which is intended to clarify the meaning of Article 2(1)(b), convertible debt should apparently not be included in the definition of equity securities. What securities then, if not convertibles, do the words ‘securities giving the right to acquire any of the aforementioned securities as a consequence of their being converted’ refer to?

Article 2(1)(b) of the PD must be interpreted as implying that convertible debt instruments are equity securities, whereas Recital 12 categorically states that convertible debt instruments are non-equity securities. These two conclusions are mutually exclusive . It is argued that because Recitals do not form part of the Directive proper , Recital 12 cannot modify the interpretation of Article 2(1)(b) in a way that is not supported by the wording of that Article. If Recital 12 were given priority, it would mean that language of Article 2(1)(b) would be rendered partially meaningless, viz. the reference to transferable securities ‘giving the right to acquire any of the aforementioned securities as a consequence of their being converted’. The word ‘conversion’, in terms of securities, is normally used only to refer to the situation where a security of one type is exchanged for a security of another type, both securities having the same issuer. Both debt and equity instruments can be convertible, although convertible shares fall under Article 2(1)(b). However, it cannot be ruled out that the word ‘convertible securities’ in the PD might also be used to denote debt securities giving the holder (or retaining for the issuer) the right to redeem the securities against consideration in the form of other securities not issued by the debtor. It cannot therefore be ruled out that Recital 12 should only be regarded as an—perhaps clumsy—attempt to bring attention to the fact that convertible debt instruments, like depositary receipts and derivative securities in general, can fall under the definition of non-equity securities under the Directive, provided that the criteria of the definition of equity securities in Article 2(1)(b) are not met. One such criterion is whether the securities underlying the convertible instruments are shares that will be issued or transferred by the issuer of the convertible instrument or an entity belonging to the group of such issuer.

One conclusion that does not seem to follow from Recital 12 is that convertible debt should be classified as equity securities or non-equity securities depending on whether the conversion right belongs to the issuer or the holder of the security. The Recital mentions convertible securities categorically and only mentions securities convertible at the option of the investor as an example. It is not possible to draw the contrary conclusion that securities convertible at the option of the issuer should be treated differently. For these reasons, convertible securities should fall under the definition of equity securities provided that the securities can be converted into shares at least at the option of the investor. If a mandatorily convertible instrument confers conversion rights to both the issuer and the investor, the fact that a conversion right exists for the investor should suffice to classify the instrument as an equity security. Mandatorily convertible instruments conferring the conversion right only on the issuer or a third party or instruments which are convertible on the occurrence of a particular event or at a particular moment in time or otherwise according to its predetermined terms and conditions would, however, fall outside the definition of equity securities in Article 2(1)(b) and should therefore be regarded as non-equity securities, whether or not the underlying securities are shares in the issuer.

Jens Pohl, LL.M. and M.B.A., attorney-at-law (admitted in Sweden) is a senior associate within the Corporate and Capital Markets Group in the Stockholm Office of Advokatfirman Vinge, specializing in prospectus issues and European securities regulation. Vinge is one of the largest law firms in Scandinavia and offers a full range of commercial legal services. With more than 290 lawyers, Vinge has offices located in Stockholm, Gothenburg, Malmö, and Helsingborg, as well as in London, Paris, Brussels, Hong Kong, and Shanghai. Vinge’s corporate and capital markets practice represents corporate clients and investment banks in a wide variety of matters in the capital markets area, such as domestic and international financing transactions, tender and exchange offers, IPOs, cross-border mergers and acquisitions as well as acting as local Swedish counsel in U.S. registered and unregistered offerings, including Rule 144A and Regulation S offerings.

This article is an adaptation of an article in Swedish published by the author in Förvaltningsrättslig Tidskrift, vol. 2, 2006, pp. 187–222.