TowerJazz's (TSEM.O) Nasdaq-listed shares were down 8.6 percent at 76 cents in early trade, while its Tel Aviv shares closed 9 percent lower.

They started to fall after Israeli media reported that Leumi (LUMI.TA) and Hapoalim (POLI.TA), the country's two largest banks, were interested in converting the notes into shares so they could finally cash in on their debt.

"TowerJazz has not been provided with notice by any of its capital note holders that they intend to convert capital notes into shares," the Israeli company said in a statement to the reports.

Rather, the banks have asked the company to file a registration statement with the U.S. Securities and Exchange Commission in to register ordinary shares underlying 85 million capital notes -- 45 million for Leumi and 40 million for Hapoalim -- which would be issued if either or both banks wish to convert the capital notes into shares, it said.

The overhang of a possible conversion of notes by the banks into shares is weighing on the stock since such a move would dilute the holdings of existing shareholders.

TowerJazz's parent, conglomerate Israel Corp (ILCO.TA), also holds capital notes from the company.

"Israel Corp has informed the company of its intent to convert all of its holding of capital notes into shares, but as a long term strategic shareholder did not ask to register its shares," TowerJazz said.

"Israel Corp has informed TowerJazz that it does not intend to sell or trade its shares at the present time and has expressed its belief in the company's strategy and growth plans."

In 2006 and 2008, the banks converted debt into capital notes as part of a restructuring of bank debt while Israel Corp injected new money into TowerJazz.

Israel Corp, Hapoalim and Leumi invested $550 million in cash and debt conversion and received 399 million notes. Israel Corp holds 206 million while the banks hold 96.4 million each.

The banks may have difficulty in converting the notes to shares since they would likely represent more than the 5 percent banks are allowed under Israeli law to hold in a company of which it is a debt holder.

Hapoalim said it does not comment on its customers while Leumi was not available for comment.

(Reporting by Steven Scheer and Tova Cohen; Editing by David Cowell)

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