Beware The Turn Of The Screw

It was a dishwater-dull pronouncement from that most prosaic of companies, Pep Boys (Manny, Moe & Jack). Early in April, the Philadelphia-based auto-parts chain announced that on May 7 it would redeem all of its $75 million in 6% convertible subordinated debentures. But buried amid the financial minutiae was a bombshell: Holders of the debentures were about to lose six months' worth of interest, totaling a cool $2.3 million.

Investors in Pep Boys convertibles had fallen victim to one of the most expensive phrases in the English language--the "early conversion expiration" provision. Or, as it is not so affectionately known among the few investors who have heard of it, the "screw clause." It's an innocuously worded technicality that is obscure enough to escape the attention of even the most sophisticated investors in convertible securities.

Screw clauses can be invoked legally to deny investors in convertibles an entire interest payment, which can mean as much as half a year's interest. True, Pep Boys is the only issuer known to have recently invoked a screw clause in a way that resulted in investors missing an interest payment. But the Pep Boys imbroglio is likely to be repeated in the future, because the screw clause is becoming standard language in bond covenants. According to McMahan Securities Co., a Greenwich (Conn.) firm that specializes in convertibles, screw clauses can be found in at least 15 recent convertible debenture and preferred stock issues (table). "The screw clauses haven't been around in a while, but you see them reappearing in prospectuses," notes Thomas Revy, managing director of Froley, Revy Investment Co., which manages $600 million in convertible securities. "I think it's a case of attorneys and MBAs trying to earn their keep."

MAYDAY. Screw clauses only become a problem for investors when their convertibles are about to be, well, converted. As their name implies, convertibles are hybrids--part bond, part stock. They pay a set rate of interest but can be converted into common stock at a specified price--which usually is significantly higher than the share price at the time the convertible is issued. That gives the investor an income stream and also a stake in the company's share price. If the share price rises so that it becomes profitable to convert, the issuers frequently call the convertibles for redemption--in effect, forcing the investors to convert their shares. (If they don't change their convertibles into shares, they receive a payment that is usually less than the value of the shares.)

The companies benefit from such conversions because they replace debt with equity. The investors gain from the increased price of the security. But in the case of Pep Boys, the clause resulted in the loss of an entire interest payment.

The Pep Boys screw clause was simple enough: "In the case of debentures called for redemption, the conversion rights will expire at the close of business on the fifth business day prior to the redemption date." This provision made it easier for Pep Boys to handle all the paperwork prior to redemption--and it had another effect. In this case, the redemption date was May 7. The fifth business day before May 7 was Apr. 30. And, as it happened, one of the two interest payment days in 1992 was May 1.

A coincidence? Pep Boys officials would not return repeated phone calls from BUSINESS WEEK to discuss the timing of the redemption. Whatever their motivation, even the most vociferous critics of the screw clauses concede there is nothing illegal about them. It's an instance of ignorance not being bliss. "Most investors don't even know screw clauses are in there, and most companies don't know about them either," observes Michael F. McNulty, co-director of research at McMahan.

CAVEAT EMPTOR. If investors haven't stumbled upon the screw clauses, it's because they haven't been looking. One manager of a large mutual fund that invests in convertibles, who asked that his name not be used, admits that he has not exactly been keeping an eye peeled for such things. "I really haven't focused that much, to tell you the truth, on the screw clauses," says the manager. "It may be a case of 'buyer beware,' but I would put the onus on the underwriter as well."

But what about the issuers? Corporate officials can wipe out screw clauses with the stroke of a pen--and one company, Cincinnati Financial Corp., did just that, after its convertible's preliminary "red herring" prospectus drew complaints from investors. Even if a company has a screw clause, it may not necessarily be used to penalize investors. Home Depot Inc.'s chief financial officer, Ronald M. Brill, insists that the company would never use its screw clause to escape an interest payment if it redeems its recent $805 million convertible issue. If investors had insisted, he says, the screw clause would probably have been eliminated. Observes Brill: "It's certainly not something worth fighting over, if you don't plan to stick it to investors." But investors never even asked. So if they ever find themselves at the receiving end of a "screw clause," they have no one to blame but themselves.

      Issuer                         Issue size
                                Millions of dollars
      COMPTRONIX                      $30.0
      CONTINENTAL HOMES                35.0
      FIRST COMMERCE                   52.5
      FOURTH FINANCIAL                100.0
      GENERAL HOST                     60.0
      GREYHOUND                        90.0
      HOME DEPOT                      805.0
      MARK IV                         100.0
      PIER 1                           70.0
      QUANTUM                         230.0
      STONE CONTAINER                 200.0*
      UNIFI                           200.0
      UNION PLANTERS                   50.0
      *Two separate issues of $100 million each
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