Definition of Mandatory Exchange of Stocks

The mandatory exchange of stocks is a corporate action in which holders of one class of a company's stock are required to exchange it for another class of stock. An example would be the forced exchange of Convertible Preferred Stock, or CPS, for common stock. Shareholders have no discretion about accepting a mandatory exchange, except to sell their preferred shares. Preferred stock differs from common stock in that: (1) it usually pays a high dividend; (2) it has seniority over common stock during bankruptcy; and (3) preferred shares usually lack voting rights. CPS allows shareholders to exchange their preferred shares for common stock after a specified date.

The conversion ratio is a calculation that determines how many shares of common stock will be received for CPS. Management sets this ratio at the time it issues the CPS. For example, a share of XYZ Corporation CPS is issued with a purchase price, or par, of $100. At issuance, XYZ specifies a conversion ratio of 6.5 common shares for each share of preferred. The conversion price is the quotient of convertible's par value and the conversion ratio: $100 / 6.5 = $15.38.

The conversion premium is the percentage difference between the CPS par value and the price the shares would fetch upon conversion and sale, which is equal to the market price of the common share times the conversion ratio. For example, if XYZ common is currently trading at $12 per share, a preferred share's value would be $12 x 6.5, or $78 – this is how much you could expect from selling the CPS in the secondary market rather than converting it. The premium is ($100 - $78) / 100, or 22 percent. There is an inverse relationship between the price linkage between share classes and the conversion premium: a lower premium implies that preferred stock can be sold closer to par. A premium of zero percent occurs when the amount of money you receive from converting a share of the preferred and selling the resulting common stock is equal to the par value of a preferred share. Conversions when premiums are negative result in capital gains.

A convertible share is "busted" if it has a relatively high conversion premium, usually 50 percent or higher. Conversion at positive premium results in a capital loss, and a high premium implies that it is unlikely conversion will result in a capital gain for the foreseeable future. A busted CPS has little price linkage to the underlying common stock, and trades more like a bond. That is, traders would find the preferred shares attractive if the shares paid a dividend competitive with current interest rates on a risk-adjusted basis – stock is riskier than bonds and thus must have a higher return to attract risk-adverse investors.

Management can issue CPS with a mandatory exchange feature. This feature allows management to call for conversion of the preferred shares after some specified reset date. The feature reduces the value of the shares to traders because of the uncertain common stock value at the time of the forced conversion. If management calls CPS when conversion premiums are positive, investors who immediately sell the resulting common stock would realize a capital loss.