PwC between a rock and a hard place with JPMorgan-Tesla dispute

PwC will be fine, though, because the firm is a pro at navigating rough seas between battling clients

Neutrality is at times a graver sin than belligerence.
― Louis D. Brandeis

JPMorgan Chase filed a federal lawsuit for breach of contract against its client Tesla on November 15, seeking to recover over $162 million dollars JPM says is “immediately due and payable by Tesla” for a deal the two companies entered into back in 2014.

The lawsuit recounts the transactions Tesla entered into with several banks including JPM, which required Tesla to deliver either shares of its stock or cash to JPMorgan if, at the time the warrants expired, Tesla’s share price was above the contractual “strike price.” The warrants expired in June and July 2021, when Tesla’s stock price was well above both the original and adjusted strike prices. JPM demanded the shares or cash due, but Tesla has ignored what JPM says is a clear contractual obligation to pay the bank in full.

Bloomberg’s Matt Levine broke down the rationale for the complex transaction and its technical aspects in excruciating but lucid detail the next day. It’s one of those ‘heads I win, tails you lose’ type of deals investment banks talk seemingly sophisticated company treasurers into.

Tesla had sold $1.38 billion of 7-year convertible bonds with a 1.25% coupon and a conversion price of $359.87, a 42.5% premium above its stock price of $252.54 at the time of the sale in 2014.  Tesla’s $1.38 billion 7-year convertible would convert into about 3.8 million shares of stock, so Tesla bought a 7-year option on 3.8 million shares with a strike price of $359.87.

Then Tesla sold several banks, including JPM and Goldman Sachs, a separate option (the “warrant”) at a higher strike price. … “a 7ish-year warrant with a strike price of $560.6388, a 122% premium above the stock price when it issued the convertible bonds.  The overall result is that the company has effectively issued a synthetic high-premium convertible: If the stock goes up 80% or 100%, it will issue some shares on the convertible but get them back from the bond hedge; it only “really” issues shares if the stock goes up more than 122% and the warrant is in the money.

In effect they buy an option from the banks (the bond hedge) that mirrors the conversion option in the convertible…

Convertible bonds almost always dilute the ownership percentage of current shareholders, resulting in those shareholders owning a smaller piece of the company after bondholders exercise conversion rights. Even though a 42.5% conversion premium seems high, Levine says it is likely not high enough to make the dilution of the shares worth it for existing shareholders like senior executives. But, if you set the conversion premium on the bonds at 100% few would buy them.

JPM says in a footnote to its lawsuit:

Concurrently with the sale of the 2021 Warrants, Tesla also issued certain convertible notes and purchased call options (known as a bond hedge) from JPMorgan. The bond hedge and warrant transactions, collectively, benefitted Tesla by mitigating the stock dilution resulting from Tesla’s issuance of the convertible notes and were structured to allow Tesla to make certain federal income tax deductions.

Each of the 2021 Warrants was a call option for Tesla’s common stock, the lawsuit says. In exchange for a premium paid up front by JPMorgan to Tesla, Tesla gave JPMorgan the right to purchase, on the warrant’s designated expiration date, one share of Tesla common stock per underlying 2021 Warrant at a specified ‘strike price’.

Tesla sold the warrants to JPM and purchased over-the-counter call options under an International Swaps and Derivatives Association form agreement, according to Levine. There are many more complex aspects to this deal and I highly recommend Levine’s column on the subject. As is common with many complex equity transactions, it is standard for the deal to have an adjustment provision in case of a corporate event such as a bankruptcy or an acquisition that gives the bank broad discretion to adjust the terms of the deal to maintain its value to the bank. 

Here’s how Tesla said in its last 10-K that it accounted for the transactions:

As these transactions meet certain accounting criteria, the convertible note hedges and warrants are recorded in stockholders’ equity and are not accounted for as derivatives. The net cost incurred in connection with the convertible note hedge and warrant transactions was recorded as a reduction to additional paid-in capital on the consolidated balance sheet.

What I’m interested in is the fact that something happened that gave JPM, and the other banks, the right to adjust the value of the option on the bank’s books but it appears that Tesla did not make the same adjustment for the deal on its books. When the convertible note hedge and warrant transactions expired, JPM told Tesla it owed more money because of JPM’s adjustments. But Tesla disagreed and did not pay JPM the extra money the bank said it owed.