Editor’s note: This is general educational information about how a class of Canadian security is constructed and documented. It is not investment advice and it does not concern any particular issue. It is based on the statute, national instruments and accounting standard listed at the end.

A convertible debenture is a loan with an option stapled to it. The lender receives interest and a promise of principal at maturity, and also holds the right to give up both in exchange for a fixed number of the borrower’s shares. The interest rate is a negotiated number. The exchange rate is a fixed one, set at issue and printed in the indenture, and everything about how the security behaves afterwards follows from where the share price sits relative to it.

The indenture is the security

The terms of a Canadian convertible debenture live in a trust indenture, which the Canada Business Corporations Act defines in section 82 as any deed, indenture or other instrument, including any supplement or amendment, made by a corporation under which the corporation issues debt obligations and in which a person is appointed as trustee for the holders. Part VIII of the Act applies where the debt obligations issued under the indenture are part of a distribution to the public, which is the case for a listed debenture.

The statute then imposes a set of protections that no term of the indenture can bargain away. Section 84 requires the trustee, or at least one of them, to be a body corporate incorporated in Canada or a province and authorised to carry on the business of a trust company. Section 83 bars the appointment of a trustee with a material conflict between that role and any other, and requires a trustee who becomes aware of one to eliminate it or resign within ninety days, though the indenture and the debt obligations remain valid in the meantime.

Section 91 sets the standard of conduct: the trustee must act honestly and in good faith with a view to the best interests of the holders and exercise the care, diligence and skill of a reasonably prudent trustee. Section 93 provides that no term of the indenture or of any agreement between the trustee and the holders or the issuer can relieve the trustee of those duties. Section 92 supplies the limit, protecting a trustee who relies in good faith on a statutory declaration, certificate, opinion or report that complies with the Act or the indenture.

The monitoring machinery is calendar driven. Section 89 requires the issuer or guarantor, at least once in each twelve month period beginning on the date of the indenture and at any other time on demand, to furnish the trustee with a certificate that it has complied with all requirements that would otherwise constitute an event of default, or particulars of any failure. Section 90 requires the trustee to notify holders within thirty days of becoming aware of an event of default that is continuing, unless the trustee reasonably believes withholding notice is in the holders’ best interests and tells the issuer so in writing. Section 85 lets a holder require a list of registered holders and the principal amounts they own within fifteen days, on payment of a reasonable fee and delivery of a statutory declaration.

The number set at issue

What makes the instrument convertible is a defined right of exchange. National Instrument 44-102 defines a conventional convertible security as one that is, according to its terms, convertible into or exchangeable for other securities of the issuer or of an affiliate. The terms fix the conversion price, which divides into the principal amount to give the number of shares each debenture converts into.

That single number splits the life of the security into two regimes. While the share price sits well below the conversion price, the option is worth little and the debenture trades on its coupon and its credit. Its price moves with interest rates and with the market’s view of whether the issuer will repay, and it will trade at a discount or premium to par on those grounds alone. While the share price sits well above the conversion price, the debenture is worth at least the shares it converts into, and it tracks the equity almost one for one. The interesting region is the one in between, where both influences are live and neither dominates, and where the security responds to a change in the share price by less than the equity does and to a change in credit conditions by less than a straight bond does.

Nothing about the conversion price adjusts for a change in the business. It adjusts, if the indenture says so, for share splits, consolidations and similar events, and those adjustment provisions are among the most consequential clauses in the document precisely because they are mechanical.

How the prospectus rules treat them

Convertibles sit in a distinct place in the Canadian offering rules, and the distinctions are worth noticing because they show what regulators think the risk is.

National Instrument 44-101 sets out the criteria for filing a short form prospectus. Section 2.2 is the general test based on the issuer’s own filing record, listing and current financial statements and annual information form. Section 2.5 provides separate qualification for a distribution of convertible debt securities or convertible preferred shares where those securities are convertible into securities of a credit supporter that has provided full and unconditional credit support, and where the credit supporter itself satisfies the section 2.2 criteria. The rules follow the entity whose shares the holder would end up owning.

National Instrument 44-102 carries the same logic into shelf offerings. Section 2.5 of that instrument qualifies an issuer to file a base shelf prospectus for convertible debt securities and convertible preferred shares where it is qualified under section 2.5 of NI 44-101. Non convertible securities are handled separately, in some cases on the strength of a designated rating rather than the issuer’s disclosure record. A convertible cannot use that route, because a rating speaks to repayment and a convertible is partly an equity claim.

What conversion does to reported earnings

The option is visible in the issuer’s financial statements before anyone exercises it. IAS 33 requires diluted earnings per share to be calculated as though all dilutive potential ordinary shares had been converted, adding the shares to the denominator and adjusting the numerator for the interest that would no longer be paid.

The standard also states when that assumption is dropped. Convertible debt is antidilutive whenever its interest, net of tax and other changes in income or expense, per ordinary share obtainable on conversion exceeds basic earnings per share. In that case the instrument is excluded from the diluted figure and disclosed instead in the note listing instruments that could dilute in future but were antidilutive for the periods presented. A weak year can therefore produce a diluted figure that looks untroubled by an outstanding convertible, with the whole of the potential claim sitting in a note.

Analysis: reading it as two instruments that do not share a timetable

The useful discipline is to price the two halves separately and then ask what connects them, because they respond to different things and they mature on different logic.

The debt half is governed by the indenture and by Part VIII of the Act, and its calendar is fixed: annual compliance certificates under section 89, default notices within thirty days under section 90, and a stated maturity. The equity half is governed by the conversion price and has no calendar at all. It becomes valuable when the share price rises above a threshold set years earlier by people negotiating a financing, and it can expire worth nothing without any event occurring.

That asymmetry is where a careful reader would look first. The wider the gap between the conversion price and the share price at issue, the further the shares must rise before the option has intrinsic value, and the larger the share of the security’s return that has to come from the coupon. A conversion price close to the market inverts that split. Neither figure is disclosed as a headline number, and both are recoverable from the offering document.

The second question is what the indenture adds beyond the statutory floor. The Act supplies the trustee’s duty of care, the prohibition on contracting out of it, the conflict rules and the notice periods. Everything else, including the change of control provisions, the adjustment clauses and any right of the issuer to settle in shares rather than cash, is negotiated. Two debentures from the same issuer with the same coupon can differ entirely on those terms, and the indenture is the only place they are written down.