Archive for the ‘ Executive Compensation ’ Category

Improving Debt Bonus Programs for Executives

UBS is the latest bank to issue a debt bonus in the form of contingent capital notes (CoCos) to its top executives. The UBS issuance follows similar programs set up by Barclays and Credit Suisse. This emerging trend has many beneficial implications but debt bonus programs for executives can be further optimized.

Banks’ debt based bonus programs are commendable initiatives because they help counterbalance the downsides of equity-based executive compensation. CoCo issuances to executives can also increase regulatory capital, align executive compensation more closely with creditor interests, and lower executives’ risk taking. The recognition of debt in executive compensation also has the potential to address short-termism and improve corporate governance because executives who hold a substantial portion of debt rather than equity may focus less on quarterly stock price performance.

The existing executive CoCo designs are flawed in one crucial aspect. They do not allow for conversion from debt into equity. Rather, the existing executive CoCo designs provide for a write down to zero should a certain threshold in regulatory capital be reached or should the bank reach non-viability without an equity injection. While the existing designs may signal the banks’ willingness to address public concern over executive compensation, these designs only halfheartedly address the need for internalized bank failure cost and corporate governance reform.  Without a conversion feature to equity, banks’ provide only limited incentives for their executives to lower risk-taking. Under the current designs, the CoCos are 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 executives financially accountable for mismanagement. 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. Management may also curtail risk taking to avoid the reputational loss associated with conversion.

An executive debt bonus program with an “early” conversion trigger to equity can provide additional improvements. Early triggers can improve the internalization of bank failure costs, provide enhanced shareholder protection, and improve corporate governance. Early triggers are especially promising if the respective entity issues CoCos to executives and investors. UBS and Credit Suisse are recent examples of entities that successfully issued CoCos to both investors and executives.

Early triggers in executive Cocos have several advantages. Under an early trigger design, the CoCos held by executives would convert into equity before the CoCos held by investors, creating an early warning system for investors. The early trigger optimizes the signaling of default risk because initially only the portion of CoCos held by executives converts to equity. Improved signaling of default risk prepares the entity for future crises and addresses systemic concerns. Early conversion triggers also provide creditors and shareholders with improved incentives for monitoring management. Shareholders in particular will pay attention to the early conversion of debt to equity because of the impending dilution of their stockholdings and the voting rights allocated to executives upon conversion. CoCos with early conversion triggers are designed to encourage executives to manage the entity, at least in part, to avoid the conversion trigger. An early CoCo trigger also gives managers more time to adjust corporate strategy and management to market conditions, adjust risk-taking, and deleverage in a comparatively liquid market environment. An early trigger design can add another important CoCos feature to avoid future bank bailouts.

Unlike traditional debt instruments and CoCos with a write-down design, an early trigger design aligns the interests of executives with a broader array of company stakeholders. Executives who hold CoCos with long-term maturities and coupon payments have incentives to manage the company with the interests of debt-holders in mind. As a result of managers’ changed incentives and interest alignment with debt-holders, managers’ risk-taking and the strategic management of the entity become more focused on long-term and sustainable development. In the unlikely event that the executives do not succeed in managing to avoid the early trigger and a CoCo conversion into equity occurs, management’s interests would be aligned with shareholder interests when the entity approaches non-viability. Managers’ interests would predominantly be aligned with creditors and only switch to alignment with shareholder interests when most needed, near non-viability.

The success of an early trigger design would ultimately depend on the proportion and calibration of debt bonus programs in the compensation packages of executives. Bank initiatives in this context are important first steps to transition from a focus on equity-based executive compensation towards debt-based compensation.

For further details see: Wulf A. Kaal “Contingent Capital in Executive Compensation” and other pieces on Contingent Capital Designs.

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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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