Gold Reserve's Noteholder Dilemma

| About: Gold Reserve, (GDRZF)

Gold Reserve Inc. (GRZ) has not had a great deal to report on recently. With its flagship Brisas gold-copper property confiscated by the Venezuelan government in 2009, the company's future is now tied to two quietly proceeding legal actions.

By far the more important is the $2.1 billion claim for compensation from Venezuela before ICSID, the International Centre for Settlement of Investment Disputes, a body of the World Bank. In July 2011, the company made its final pre-hearing written submission and arguments are due to be heard by the three-member ICSID panel in February 2012. The other case, the $500 million claim against Rusoro Mining and Endeavour Financial, appears to be moving so slowly through the Canadian court system that it's probably irrelevant to the stock's valuation.

That, however, is not the end of the drama at Gold Reserve as the company faces an interesting and potentially disruptive complication in its relationship with its noteholders.

Issued in May 2007, Gold Reserve's $103.5 million of 5.5% Senior Subordinated Convertible Notes are convertible into common shares at $7.54 and mature in 2022. But they also give holders the option to require the company to repurchase the notes at 100% of principle plus interest on a single day, June 15, 2012. The problem is that, as things stand now, the company at that time will have only 70%-80% of the cash on hand necessary to repurchase the notes assuming every noteholder opts to be bought out. The company does have the option to repay noteholders with a combination, in whatever proportion it chooses, of cash and common shares. Shares, however, would be valued at the market price at the time, and if they are then priced as they are now, about $2.40, the dilution would be severe relative to the conversion price of $7.54, let alone the $2.1 billion ICSID claim, which equates to about $30 per common share.

Worse still, if shareholders, as June 15, 2012 approaches, begin to anticipate that many millions of new shares will be issued to pay off noteholders, that could engender a limited form of death spiral in which fears of impending dilution lead to a lower share price, which translates into even more shares (and greater dilution) needed to pay off noteholders, which in turn drives the share price still lower, etc.

Is it possible that an ICSID judgment would come sooner than four months following the hearing, i.e., before June 15, 2012, potentially rescuing the company from the cash shortfall situation? Yes, but it would be folly to count on that as an ICSID judgment might just as easily be rendered a year or more following the February 2012 hearing.

So Gold Reserve must do something about this. There are three possibilities that suggest themselves.

1) After completing impending mining equipment sales, which would top up the cash balance, and well in advance of June 2012, negotiate the best deal possible to buy out noteholders with a combination of cash and common shares.

As could be the case with waiting until June 15, 2012, this would be quite dilutive. Indeed, settling with noteholders for cash and stock now could be even more dilutive than if the company waited because, with the expenses and uncertainty relating to the February ICSID hearing yet to come, there would be that much more incentive to "play it safe" by keeping a relatively larger cash cushion, i.e., emphasizing shares over cash in paying off noteholders. Note also that if the company simply waits until June 15, it may turn out that only, say, half of the notes are tendered, which would allow for them to be paid for entirely with cash, hence no share dilution, but any repurchase negotiated now would have to involve the creation of new low-priced shares. With even a partial repurchase it would be dangerous to use all cash because it would make the June 15 potential cash shortfall situation with regard to the remaining noteholders even worse.

2) Do a rights offering during the next few months to raise the extra funds needed and thereby be prepared, if required, to buy out all of the notes entirely for cash next June 15.

In many ways this would be preferable to negotiating a cash/stock buyout of noteholders. Plausible terms might be one right to buy a share at $2 for every three shares held, which would raise about $38 million, more than enough. It would keep the company financially strong through June 15, no matter what the noteholders do and, rather than diluting existing shareholders, let them participate equally, and thereby maintain their fraction of ownership, in a more valuable company. That said, there would be expenses and management distraction involved in conducting a rights offering. Also, some shareholders might not entirely appreciate being "invited" to come up with more cash at a time when the markets have been turbulent to say the least.

3) Attempt to negotiate with noteholders a delay in the June 15 repayment privilege day until soon after a settlement with Venezuela or ICSID judgment is announced.

This is where it gets interesting. At first glance, one might wonder why noteholders would agree to delay their repayment privilege. But noteholders--not just the company--have a problem in this June 15 arrangement. To put it quite plainly, if you are a noteholder, what do you actually do when the morning of June 15, 2012 arrives?

For the sake of argument, let's forget about any rights offering and assume the company's financial strength then to be roughly the same as it is now. When June 15 arrives, each noteholder will have to confront the possibility of getting paid off entirely in cash because only, say, half of the noteholders opted for repayment and then seeing one week later an ICSID judgment that pushes the stock far above the $7.54 conversion price. So, for example, even if Gold Reserve were awarded only $1 billion (of its $2.1 billion claim), that would equate to roughly $15 per share (about twice the notes' $7.54 conversion price) or 200 cents on the dollar for the notes.

For the noteholders, the June 15 repurchase privilege can be understood as a put option that is granted (and expires) in one day and which is, more to the point, one half of a particular kind of option straddle. The call option is embedded in the right to convert at $7.54, which could be worth quite a bit in the event of a positive ICSID judgment. The put option (the repurchase privilege) provides the right to sell notes at par plus interest, but with the kicker that if enough noteholders exercise (and the company lacks the cash to buy out the entire issue) then noteholders could receive a large fraction of their payment in shares priced far below the conversion price. The complication for noteholders is that they cannot exercise the put option without losing the call option but if enough of them exercise then the low-priced shares they receive as partial repayment could fully compensate them for the loss of that call option.

The point here is that if a noteholder believes there is a decent chance of a positive ICSID judgment then the value that will be derived from demanding repayment on June 15 will depend on what other noteholders do. The more noteholders who exercise, the greater proportion of the repayment will be made in low-priced shares, which could more than compensate for the loss of the call option implicit in the notes' conversion feature. Consequently, and this is a key point, if the company lacks the cash to buy out the entire issue on June 15, then the noteholders have an incentive to collude, to act as a kind of noteholders cartel.

Following this logic, noteholders, if presented with the possibility of delaying the June 15 repurchase privilege day, should rationally accept unless they are colluding and confident that they can trust each other in their collusion. What it comes down to is that the call option increases in value the further into the future its expiry is extended and the increase in value is surely greater than any loss in value in an equal delay of the granting (and expiry) of the put option (unless, of course, a holder is desperate for cash or believes that the company will simply lose its ICSID case, in which case one might wonder why they would own the notes in the first place). Indeed, given the 5.5% paid on the notes, not bad in today's market, one could make a case that there is value in delaying the granting and expiry of the put option alone, without even considering the call option. Why not keep collecting the 5.5% for a little longer while maintaining that future opportunity to cash out? Best of all should be delaying the entire arrangement until soon after the event that the call option is anticipating, a settlement or ICSID judgment.

One might ask, if the shares are such a great bargain at current prices, why noteholders shouldn't tender their notes on June 15, or even sell on the market now for somewhat less, and then use the cash proceeds to buy shares. For small noteholders that might make sense. But most of the notes are apparently held in large positions by a small number of institutions and for them the trading in the shares is probably too thin for such a move to have much appeal.

This is by no means intended as an exhaustive analysis of all the scenarios that can play out here. To offer one example, suppose there were an institution that had a large holding of notes and an even larger holding of shares. The proportion between the two might be such that there would be no upside in tendering its notes on June 15, following a limited death spiral decline, because the loss in the value of the shares through dilution would exceed any possible gain from picking up new low-priced shares. But what might be perfectly rational for such a holder would be to let the dilution-fear limited death spiral occur, or even find a way to encourage it, and then use the opportunity to buy more shares on the cheap and then not tender, thereby preventing or limiting any dilution. Needless to say, if Gold Reserve does not get on top of the situation there will be plenty of potential for this sort of mischief as June 15 approaches.

What is going on here is not just some academic exercise. The market for the shares (and the notes) will be influenced by this entire dynamic. As things currently stand, the threat of noteholders colluding and exercising their put option en masse on June 15, is a cloud hanging over the company and it is probably weighing on the stock right now. As we get closer to June 15, it is likely to weigh on the stock even more.

The rational way forward for the company is to approach noteholders with an offer to delay the repayment privilege day until a time soon after an announcement of either an ICSID judgment or a settlement with the Venezuelan government. If the company does not get enough takers to reduce its possible June 15, 2012, payout to something well below its likely cash balance at that time then it could sweeten the offer, perhaps by letting that in-the-future repayment privilege day extend beyond a single day, perhaps even all the way to maturity. Noteholders, faced with a kind of prisoners' dilemma, will have every reason to jump at such an offer. If none does, then it would be reasonable to assume that noteholders are indeed colluding, in which case the company should quickly proceed with a rights offering so as to ensure that it will be capable of repurchasing every single note on June 15 entirely for cash.

Disclosure: I am long GRZ.