Improving UBS’s Executive CoCos

The FT reports (front page 2/5/2013) that UBS is issuing contingent capital notes (CoCos) to its top 6500 executives. The debt bonus in the form of CoCos will be written down to zero should the bank’s regulatory capital fall below 7 per cent or in the case of a “non-viability” loss.Three keys logo by Warja Honegger-Lavater.

As I have demonstrated in several articles, hedge funds were instrumental in creating the market for CoCos and will play an increasing role in that market. Given the European Commission‘s initiatives on CoCos and the increasing market recognition, I show in another piece “Contingent Capital in Executive Compensation” that CoCo issuances to executives may become increasingly important and create a real opportunity for corporate governance improvements.

The design of UBS’s CoCo issuance could be substantially improved. UBS’s CoCo issuance to its executives does not allow for conversion from debt into equity. Without a conversion trigger, i.e. actual conversion into equity rather than a write down to zero, the CoCo issuance seems to serve a mere signaling function and only marginally improves corporate governance.  By issuing CoCos without a conversion feature to equity, UBS provides only limited incentives for its executives to lower risk-taking. The CoCos seem to be a mere compensation supplement for executives.

By contrast, a CoCo design with a conversion feature to equity would give executives near worthless equity upon conversion and would, thus, hold them financially accountable for mismanagement. Moreover, the threat of dilution of stock holdings in combination with a threat of loss due to conversion could help reduce shareholder pressure on management to take higher risks. Management may also be incentivized to curtail risk to avoid the reputational loss associated with conversion.

Should the respective entity have issued CoCos to executives and investors, early triggers for CoCos in executive compensation packages (“early” means the CoCos held by executives get triggered before the CoCos held by investors get triggered) would increase and optimize the signaling of default risk.  The early default signal facilitated by early CoCo triggers would give managers more time to (1) adjust corporate strategy and management to the then current market conditions, (2) lower risk-taking, and (3) deleverage in a comparatively liquid market environment. The improved signaling of default risk through the early conversion of executives’ CoCos could also help address systemic risk.

Moreover, the hybrid nature of CoCos and the early conversion from debt to equity aligns the interests of executives equally with creditors and shareholders. Before conversion into equity, CoCos align the interests of executives with holders of traditional debt and debt in the form of CoCos. Because executives hold CoCos with long-term maturities and coupon payments, executives have incentives to manage the company with the interests of debt-holders in mind. How well these incentives work may depend on the proportion of CoCos in the compensation packages of executives. Managers’ level of risk-taking and their strategic management of the entity could become more focused on long-term and sustainable development as a result of the interest alignment between managers and debt-holders and managers’ changed incentives. Because the early trigger for executives’ CoCos also protects shareholders and their interest in the continuing existence of the entity, executives’ interests may be equally aligned with shareholders at a time when it is most needed.

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  1. February 25th, 2013

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