Improving debt bonus programmes for executives

Read the article in the Cayman Financial Review Magazine 

Debt can play a useful role in executive compensation. Several European banks have recently started to include debt securities in their executive compensation. This emerging trend could support much-needed improvements for executive compensation. Debt securities in executive compensation may offer attractive coupon rates, can support Basel III compliance, and can help improve corporate governance in financial institutions.  

More specifically, debt in executive compensation packages can help lower managements’ risk incentives, address short-termism, and incentivise sustainable management of financial institutions. Empirical studies have shown that risk-taking by executives can decline if executives hold more debt relative to their equity holdings and an increasing part of the literature on executive compensation is now considering the role of debt for manager incentives.

Barclays, Credit Suisse and UBS have already implemented debt instruments in the form of contingent convertible notes (CoCos) as part of their executive compensation. Barclays’s executive compensation package includes a Contingent Capital Plan (CCP), allowing Barclays to issue contingent capital securities to its executives as deferred incentive awards. The CoCos under Barclays’s CCP are not written down nor do they convert into equity like other CoCos.

Rather, Barclays’s “synthetic CoCos” merely lapse when Barclays’s Group Core Tier 1 capital ratio falls below 7 per cent. In that case, the CoCos remain unvested, and the executives receive no coupon payments. Should the Group Core Tier 1 capital ratio recover after six months, Barclays can still release the unvested portion of the CoCos and reinstate the CoCos payments. Should the Group Core Tier 1 capital ratio not recover to above 7 per cent five years after the initial suspension, the CoCos lapse. Credit Suisse and UBS have followed the Barclays precedent and set up similar programmes, issuing CoCos to their executives as part of a debt bonus.

These existing CoCo issuances to executives demonstrate that debt can play a useful role in executive compensation. This compensation practice signals banks’ willingness to address public concern over executive compensation through the use of CoCos. Given the political pressure to make banks safer and avoid bailouts, including European proposals on the uses of bail-ins, early initiatives on CoCos in executive compensation may help financial institutions implement future governance improvements. CoCo issuances as a form of self-regulation could also be an attempt to evade more comprehensive public rulemaking. Banks’ debt-based bonus programmes help counterbalance the downsides of equity-based executive compensation and can help increase much needed regulatory capital for Basel III compliance. CoCos in executive compensation can also help align executive compensation more closely with creditor interests and, thus, help address excessive risk-taking and short-termism.

CoCo issuances to executives have some downsides. The current designs do not allow for a conversion to equity. Without this feature, the CoCos issued by banks provide only limited incentives for their executives to lower risk-taking, and CoCo issuances become mere compensation supplements for executives. The existing CoCo issuances appear to serve primarily a signalling function – suggesting governance improvements to investors and regulators – and only marginally improve governance.

Debt bonus programmes for executives can be optimised. A CoCo design with a conversion feature to equity would give executives nearly worthless equity upon conversion. The conversion feature can hold executives financially accountable for mismanagement and can help curtail risk-taking by management. Moreover, the threat of dilution of investors’ stock holdings upon conversion of executives’ CoCos would help reduce shareholder pressure on management to take higher risks.

Early triggers in combination with a conversion to equity can further improve the design of executive CoCos. The early trigger would only convert the portion of executives’ debt to equity when the entity is still sound on a micro-prudential basis and before investors’ contingent convertible bonds are converted. An early trigger design could be accomplished by adjusting the CDS spread, index value, capital ratio, stock price or other triggering event. The adjustment would make it possible for executives’ CoCos to convert at an earlier point, before other warning signs occur, during the financial weakening of the financial institution. For instance, adjusting a capital ratio trigger from 8 per cent to 10 per cent would make the trigger an “early” trigger for the portion of CoCos that were issued to executives.

Effective early triggers would allow for a triggering event well before the threshold for capital requirements under Basel III is reached. Early capital ratio triggers should be independent of regulatory demands pertaining to capitalisation levels. Early triggers are especially promising if the respective entity issues CoCos to executives and investors. UBS and Credit Suisse have successfully issued CoCos to both investors and executives.

An executive debt bonus programme with an early conversion CoCo trigger to equity can provide significant governance improvements with possible long-term effects for the respective financial institution. Early triggers with a conversion feature can improve the internalisation of bank failure costs, provide enhanced shareholder protection, and improve corporate governance. More specifically, an early trigger design can (1) optimise the signalling of default risk, (2) increase incentives for executives and lower risk-taking, (3) align the interests of executives equally with creditors and shareholders and (4) increase incentives for monitoring by creditors and shareholders.

Early triggers in executive CoCos may help optimise the signalling of default risk when the risk of default is less prevalent. Because of the early triggering mechanism, early CoCo triggers in executive compensation can signal an entity’s default risk much sooner than other measures. This early warning mechanism can help executives adjust to the triggering conditions and the then-current market environment, deleverage and institute any other measures to avoid default.

Because executives hold a highly discounted equity interest upon conversion of their CoCos, the stock price of the respective entity may be equally affected which may also impact the value of the equity-portion of executives’ compensation package. The CoCo conversion would, therefore, not only affect the debt portion of executives’ compensation but also the equity portion after the CoCo portion is converted and when equity is increasingly important to maintain the overall value of executive compensation. These combined effects could incentivise executives to lower their risk-taking to avoid the economic repercussions of the triggering event. The threat of financial loss for all CoCo investors, in combination with the threat of dilution to existing shareholders, could further increase the pressure on executives to avoid the conversion.

CoCos in executive compensation can help align the interests of executives with holders of traditional debt and debt in the form of CoCos, diluting the traditional alignment of interests between management and shareholders. CoCos in executive compensation packages would mean that management would be holding securities with long-term maturities and coupon payments. Depending on the calibration of CoCos in relation to equity-based compensation, executives could be incentivised to represent debt holders and equity holders equally. As a result of the interest alignment between executives and debt-holders, the strategic management and corresponding risk-taking by executives could become more focused on long-term and sustainable development.

CoCos in executive compensation may also increase incentives for monitoring by creditors and shareholders. Because the conversion of executives’ CoCos would mean that investors holding CoCos are increasingly likely to be affected as well, the early conversion of the executives’ CoCos provides an early warning with regard to the impending conversion to investors. Existing shareholders may get more actively involved in the governance of the entity. More specifically, shareholders may subject executives to increased scrutiny and demand lower risk-taking to avoid the conversion of their CoCos into near-worthless equity or the dilution of their holdings. These changes in incentives could help increase shareholder voting.

Early initiatives by European banks are important first steps to transition from an exclusive focus on equity-based executive compensation towards a combination of equity-based and debt-based compensation. There are, however, several caveats. The success of CoCos in executive compensation depends on the proportion and calibration of debt bonus programs in the compensation packages of executives. Although CoCos pay substantial coupon rates, existing CoCo issuances pay coupon rates between 7 per cent and 9.2 per cent, equity-based compensation can outperform the returns attainable through CoCos. Replacing a portion of equity-based compensation with CoCos would lower the total compensation for executives.

The existing executive compensation culture and path dependencies in the United States may also delay the addition of debt-based elements in executive compensation. In the long run, however, CoCos in executive compensation could prove an invaluable asset to help address many of the shortcomings in executive compensation and corporate governance.

 

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Wulf A. Kaal

Wulf Kaal is a tenured associate professor of law at the University of St. Thomas School of Law in downtown Minneapolis. He is a leading expert on hedge fund regulation in the United States and the European Union.  Before entering the academy, Kaal worked for Cravath, Swaine & Moore LLP in New York and Goldman Sachs in London.  Kaal has published more than two dozen articles in the United States and Europe. His articles were published in leading peer reviewed law and finance journals and in American law reviews such as the Minnesota Law Review, the Washington & Lee Law Review, and the Wake Forest Law Review, among others.  Kaal’s study on the effects of hedge fund registration requirements under Title IV of the Dodd-Frank Act has gained national attention and was covered in a Business Week article and other journals. He is the author of a book chapter on Investment Advisers and Investment Companies in the Securities Law Handbook published by Edward Elgar.
He has also been a consultant to major corporations and hedge funds regarding various aspects of financial markets and regulation.

 Wulf A. Kaal
Associate Professor
University of St. Thomas School of Law
1000 LaSalle Avenue
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Minneapolis, MN 55403
United States
 

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