How Lehman Socked Your Solar Stock

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This story begins with the brainchild of some investment banker. It’s known as a capped call transaction. When entered into concurrently with a convertible debt offering, the intent of a capped call is to help the issuer minimize share dilution resulting from the eventual conversion of debt into equity.

Like any other exotic derivative, the idea sounds good, but things don't always play out as planned.

Over the past year or two, firms ranging from Advanced Micro Devices (NYSE: AMD) to Goodrich Petroleum (NYSE: GDP) to Central European Media Enterprises (Nasdaq: CETV) have entered into pretty straightforward capped calls. Two recent transactions in the solar space, however, introduced a new flavor that's leaving a sour taste in investors' mouths.

In all such transactions, the bankers selling the convertibles may help the note buyers to protect their investment via a short sale or some other derivative transaction involving the common stock. The bank may hedge its own exposure to the capped call agreement, too. This is confusing stuff, but bear with me.

This spring, when JA Solar (Nasdaq: JASO) and Evergreen Solar (Nasdaq: ESLR) entered into capped calls with Lehman Brothers in connection with their respective debt offerings, both companies also executed share-lending agreements with the bank. Lehman would borrow shares to facilitate the aforementioned hedging transactions, and return them to the company several years down the road. By a quirk of accounting standards, such shares would not be included in the quarterly calculation of per-share earnings.

Now that Lehman has declared bankruptcy, though, it's unclear whether JA or Evergreen can get their formerly phantom-like lent shares back. Ditto for SunPower (Nasdaq: SPWR), which had also entered into a share lending agreement with the firm, sans capped call. As Evergreen discussed in a conference call last evening, the worst-case scenario would be that the company is out the money it paid for the capped call ($39.5 million) and there would be 30.9 million extra shares floating around, never to return.

These firms are being punished more or less in proportion to the dilution that would result in the worst-case scenario. While these agreements never should have been entered into in the first place, it's important to recognize that the firms' business operations aren't directly affected. If you're tempted to buy on this sell-off, I would assume the full share-count hit and work from there.

Related Foolishness:

• Yes, I'm still keen on Evergreen.
• I told you JA's creative financing was making things complicated.
• We've got more Lehman coverage than you can shake a stick at.