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High Frequency Traders In A Hurry To Get In And Out Of Knight Shares

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The Knight Capital convertible preferred documents are a mess. The basic structure is quite nice: Knight's new investors are getting a preferred stock that, eliding the details below, pays a 2% dividend, converts into common at $1.50 a share, automatically converts once the common has traded above $3 for 60 days, and can be converted earlier at the holder's option. Sensible enough: the holders get a liquidation preference if the company goes belly-up in the next few weeks; otherwise they get common that they can get out of quickly via an already-filed registration statement.

But that's not quite right, since the investors are actually getting two sorts of preferred stock, A-1 and A-2, the first of which are convertible now and the second of which won't be until, um, Saturday. The NYSE has rules saying that you can't sell more than 20% of your common stock at below market prices without shareholder approval - to prevent you from screwing shareholders by selling control of the company to someone at sweetheart prices. This was a problem because Knight needed to raise more than their market cap, selling 73% of the company for $400mm. To do this, they took advantage of a NYSE rule that once looked quaint but has since oh say 2007 become all the rage in certain capital markets circles, Rule 312.05, which provides an exception to the shareholder approval requirement "upon application to the Exchange when (1) the delay in securing stockholder approval would seriously jeopardize the financial viability of the enterprise and (2) reliance by the company on this exception is expressly approved by the Audit Committee of the Board."

But even that doesn't get them out of the woods, because it requires the company to mail a letter about the stock issuance to shareholders and wait 10 days before issuing the common stock. This part still looks quaint - a letter! 10 days! - and its purpose is a little unclear to me, since stockholders can't really do anything with this notice but silently fume at the series of mistakes that led them to receive it. I guess they can sue. Shareholders like to sue. And since this rule would otherwise be a good way for companies to screw shareholders by selling control at sweetheart prices, there's no harm in giving shareholders ten days to get together and sue to block a bad deal.

You wouldn't think this ten-day delay would be a big deal, and indeed it didn't bother anyone much during the financial crisis. It doesn't block Knight from selling the preferred stock to its rescuers, or more importantly getting their money. Nor is there any uncertainty as to whether the preferred can convert into common*: it will be convertible, definitely, after 10 days. The only concern is that, for ten days, you have to hold the preferred. But:

However, the investors in Knight’s capital raise were not willing to undertake the transaction absent a reduction in that time period and, as a result, Knight requested specifically that the Exchange assist Knight in providing an accommodation to that time period in light of the exceptional circumstances relating to Knight and its need to complete the capital infusion before the markets opened for trading this morning. After considering Knight’s request and the nature of the time constraints under which Knight was operating, including the fact that Knight believed that without the capital infusion there would be no assurance that Knight’s counterparties would continue support Knight’s activities, the Exchange will file on Monday a proposed rule change to the U.S. Securities and Exchange Commission in a form that the Exchange anticipates will become immediately effective as proposed. In accordance with that rule change, on the date that is the later of August 11, 2012 and two days following the mailing of the letter to stockholders, the convertible preferred stock that would be convertible into more than 19.99% of Knight’s common stock outstanding prior to August 6, 2012 will** ... become convertible into the underlying shares of Knight common stock and will become entitled to vote with the common stock on an as-converted basis.

This is weird. Some things to notice about it:

  • Knight is saving, by my count, three days: if they mailed the letters yesterday, then the ten-day delay should expire August 16; instead, the preferred will be convertible August 11, a Saturday, meaning in practice August 13.
  • To save Knight three days, the NYSE is permanently changing its rules.
  • Not only that, but normally a NYSE rule change itself takes time, usually thirty days, to allow for public notice and comment - but the NYSE and SEC are speeding up that process to, basically, zero days to accommodate Knight.***

Going through all of this just to be able to convert your preferred stock into common three business days earlier than you otherwise would is ... strange, no? Remember that the preferred is better than the common: it's the same as common for voting****, etc., but pays a 2% dividend and has some seniority in bankruptcy. And it's not like you lose the ability to convert if you wait. So why do all of this?

I don't know. None of the investors - Jefferies (who want you to know, btw, that they "conceived and structured the investment"), Blackstone, Getco, TD Ameritrade, Stephens Investments and Stifel - strike me as the sorts of people who would be restricted from holding preferred, and in fact Jefferies, Blackstone, and Getco each gets a board seat as long as they hold 25% of their preferred stock.***** So you wouldn't think they'd be in a hurry to get out. But I guess when you're in the habit of getting in and out of stocks in nanoseconds - and when you're investing $400mm in a company with a track record of losing more than that in 45 minutes - you could get nervous at the thought of waiting an extra three days to get liquidity.

Knight Capital 8-K goodness [EDGAR]
Quick Lunge for a Lifeline Helped Knight Capital Skirt Collapse [DealBook]
Knight's New Investors Ensured Privileged Position [WSJ]

* Unless of course someone successfully sues to block the deal on sweetheart-sale-of-control grounds, which seems far-fetched in this particular case. Though, I mean, in hindsight, they got a pretty good deal.

** The 19.99% point is why there is Series A-1 and A-2: $79.6mm of the investment is convertible immediately into just under 20% of the pre-investment common shares; the other $320.4mm has to wait on this procedure.

*** From the rule change filing:

A proposed rule change filed under Rule 19b-4(f)(6) normally does not become operative for 30 days after the date of filing. However, Rule 19b-4(f)(6)(iii) permits the Commission to designate a shorter time if such action is consistent with the protection of investors and the public interest. The Exchange requested that the Commission waive the 30-day operative delay so that the proposed rule change may take effect upon filing with the Commission pursuant to Section 19(b)(3)(A) and Rule 19b-4(f)(6) thereunder, and also become operative on that same date. The Commission believes that waiver of the 30-day operative delay is consistent with the protection of investors and the public interest.

**** Update: This is not quite right. The A-1 votes immediately on an as-converted basis, but the A-2 doesn't vote: you have to convert it into A-1 after the conditions for convertibility have been satisfied. So this process does get them their voting rights three days earlier. I am not aware of any Knight shareholder votes scheduled for next week - next record date seems to be September - but, y'know, things move fast around there.

***** So, not long then, if it auto-converts in 2 months as long as the stock stays above $3? Also it's not technically Getco that gets the board seat but General Atlantic, its controlling investor.