Full text for verification
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
Canonical record: https://ssrn.com/abstract=2139798
This is an alternate SSRN posting of the same work published at 2097160. Its 40 claims are recorded under that identifier.
Source extraction SHA-256: c6947eb02c2f5fb77cd32099f888451ec489153748c2664aa361843c7bd4a0a6
# 金 UNIVERSITY of ST.THOMAS MINNESOTA
**SCHOOL OF LAW**
**Legal Studies Research Paper Series**
## **CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION**
**64 Washington & Lee Law Review (forthcoming 2013)**
### **Wulf A. Kaal Associate Professor of Law**
#### **University of St. Thomas School of Law Legal Studies Research Paper No. 12-22**
This paper can be downloaded without charge from The Social Science Research Network electronic library at: http://papers.ssrn.com/abstract=2139798
A complete list of University of St. Thomas School of Law Research Papers can be found at: http://www.ssrn.com/link/st-thomas-legal-studies.html
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
# ABSTRACT
_Contingent capital has great potential to improve corporate governance in Systemically Important Financial Institutions (SIFIs). Early initiatives by European SIFIs to include contingent convertible bonds in executive compensation packages lack governance improving designs. This article suggests the use of contingent convertible bonds with an early conversion trigger in executive compensation. The proposal adds an important element to the literature on inside debt and the creditor-centered approach to executive compensation. Contingent convertible bonds with early triggers could be preferable to other debt instruments because, in addition to lowering income inequality and increasing sustainability, the early trigger design can improve incentives for executives to lower risk taking, improve signaling of default risk, and increase incentives for monitoring by creditors and shareholders. The recognition of ownership characteristics in design features adds an important element to the literature on contingent capital trigger designs. The methodological assumptions of incomplete contract theory can improve the analysis of executive compensation arrangements._
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
# TABLE OF CONTENTS
|I. <br>_I_<br>|_NTRODUCTION_.................................................................................................................................................
4 <br>|
|---|---|
|II. <br>|_REFORMPROPOSALS FOREXECUTIVECOMPENSATION_......................................................................
7 <br> <br>|
|_1._ <br>|<br>_Pre Dodd-Frank Act
....................................................................................................................................
9_ <br> <br>|
|_2._ <br>|<br>_Post Dodd-Frank Act
...............................................................................................................................
11_ <br> <br>|
|_3._ <br>|<br>_The Creditor-Centered Approach
.......................................................................................................
12_ <br>|
|III. <br>|_CONTINGENTCAPITAL_.............................................................................................................................
15 <br>|
|IV. <br>|_INCOMPLETECONTRACTTHEORY_........................................................................................................
17 <br>|
|V. <br>|_CONTINGENTCAPITAL INEXECUTIVECOMPENSATION_...................................................................
20 <br> <br>|
|_1._ <br>|<br>_Precedent Barclays
...................................................................................................................................
21_ <br> <br>|
|_2._|<br>_Design of Contingent Convertible Bonds in Executive Compensation
.................................
23_ <br> <br>|
||a) <br>Automatic Institution-Specific “Early” Trigger..........................................................................................................
23 <br> <br>|
||b) <br>The Benefits of “Early” Triggers....................................................................................................................................
26 <br> <br>|
|_3._ <br>|<br>_Design Features to Avoid Abuse
.........................................................................................................
32_ <br>|
|VI. <br>|_IMPLICATIONS FORACADEMICDEBATES_............................................................................................
34 <br> <br>|
|_1._ <br>|<br>_Contingent Capital as Inside Debt
......................................................................................................
34_ <br> <br>|
|_2._ <br>|<br>_Improving the Creditor-Centered Approach
..................................................................................
38_ <br> <br>|
|_3._ <br>|<br>_The Impact of Ownership Characteristics on Trigger Design
.................................................
42_ <br> <br>|
|VII.|<br>_CONCLUSION_.............................................................................................................................................
43|
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
# **I.** **_Introduction_**
Since the financial crisis, existing executive compensation policies and the level of executive compensation have been increasingly scrutinized.<sup>1</sup> Lucian Bebchuk and his co-authors show in several pieces that existing executive compensation practices have resulted in suboptimal incentives for executives.<sup>2</sup> The level of executive compensation in the United States<sup>3</sup> and the focus on equity-based compensation in executive pay packages may have resulted in inappropriate executive risk-taking,<sup>4</sup> short-termism,<sup>5</sup> a lack of sustainability, income inequality, and a classic moral hazard problem.<sup>6</sup>
> 1 _See_ FIN. CRISIS INQUIRY COMM’N, FINAL REPORT OF THE NATIONAL COMMISSION ON THE CAUSES OF THE FINANCIAL AND ECONOMIC CRISIS IN THE UNITED STATES 61-66 (2011) [hereinafter Final Report], _available at_ http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_full.pdf; Simone M. Sepe, _Making Sense of Executive Compensation_ , 36 DEL. J. CORP. L. 189, 196-97 (2011); Carola Frydman & Dirk Jenter _, CEO Compensation_ 9 _(_ Nat. Bureau of Econ. Research, Working Paper No. 16585, Dec. 2010) _available at_ http://www.nber.org/papers/w16585; Lucian A. Bebchuk & Holger Spamann, _Regulating Bankers’ Pay_ , 98 GEO. L.J. 247, 249 (2010); Richard A. Posner, _Are American CEOs Overpaid, and, if So, What if Anything Should Be Done About It?_ , 58 DUKE L. J. 1013, 1026 (2009).; Judith F. Samuelson & Lynn A. Stout, _Are Executives Paid Too Much_ , WALL STREET J., Feb. 26, 2009, at A13.; Claire Hill & Brett McDonnell, _Executive Compensation and the Optimal Penumbra of Delaware Corporation Law_ , 4 VA. L. & BUS. REV. 333, 369 (2009); Sanjai Bhagat & Roberta Romano, _Reforming Executive Compensation: Focusing and Committing to the Long-Term_ , 26 YALE J. ON REG. 359, 363 (2009); Lucian A. Bebchuk & Jesse M. Fried _, Pay Without Performance: Overview of the Issues,_ 30 J. Corp. L. 647, 649 (2005).
> 2 Lucian A. Bebchuk, Alma Cohen, & Holger Spamann, _The Wages of Failure: Executive Compensation at Bear Stearns and Lehman, 2000-2008_ , 27 YALE J. ON REG 257 (2010). _See_ Bebchuk & Spamann, _supra_ note 1, at 274-75 (arguing that because shareholders are incentivized to encourage management to take risks beyond the socially optimal level, corporate governance reforms should include reforms of executive compensation policies. Because of implicit government guarantees for bank debt, existing executive compensation policies do not incentivize bondholders and other creditors to monitor risk-taking by executives).
3 According to a 2012 report by the Economic Policy Institute, CEO compensation grew more than 725% from 1978 to 2011, compared to 5.7% for worker compensation. LAWRENCE MISHEL & NATALIE SABADISH, ECON. POLICY INST. ISSUE BRIEF NO. 331, CEO PAY AND THE TOP 1%: HOW EXECUTIVE COMPENSATION AND FINANCIAL-SECTOR PAY HAVE FUELED INCOME INEQUALITY 4 (2012), _available at_ http://www.epi.org/files/2012/ib331-ceo-pay-top-1-percent.pdf; The CEO-worker compensation ratio in 2011 was 231.0 to 1 if stock options realized were counted, 209.4 to 1 if stock options granted were counted. _Id._ at 6. The Wall Street Journal/Hay Group CEO Compensation Study 2011 reveals that although pay levels flattened due to “say-on-pay” provisions, long-term equity grants were up 34 percent from 2010 levels. HAY GROUP, THE WALL STREET JOURNAL/HAY GROUP 2011 CEO COMPENSATION STUDY SUMMARY 2 (2012), _available at_
http://www.haygroup.com/downloads/ww/WSJ_Hay_Group_2011_Study_Summary_Results_FINAL_5.20 .12.pdf. According to Bebchuk & Grinstein, between 1993 and 2003 the aggregate compensation of the top five executives in the United States amounted to over $351 billion. Lucian Bebchuk & Yaniv Grinstein, _The Growth of Executive Pay_ 21 (Harv., John M. Olin Ctr. for Law, Econ. & Bus., Discussion Paper No. 510, 2005), _available at_ http://dx.doi.org/10.2139/ssrn.648682 . Over the same time period [1993-2003], executive compensation at S&P 500 firms on average rose from $3.7 million to $9.1 million. _Id.,_ at 3. 4 _See_ Final Report, _supra_ note1, at 61-66. 5 _Id._
6 Showing that executive remuneration via stock options resulted in executives’ sharing in shareholders’ gain but insulated them from shareholders’ losses. This may have lead executives to use excessively risky strategies because there was no penalty for management. _See_ Bebchuk
& Spamann, _supra_ note 1, at 249-250. _See_ Bebchuk, Cohen & Spamann, _supra_ note 2, at 2; Rüdiger Fahlenbrach & Rene M. Stulz, _Bank CEO Incentives and the Credit Crisis_ , 99 J. FIN. ECON. 11 (2011) (arguing that the most plausible explanation for these findings is that CEOs “took actions that they believed
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
For more than three decades, theoretical research on executive compensation has focused almost exclusively on adjusting executive compensation with equity-based products alone, such as stocks and stock options.<sup>7</sup> While equity-based compensation policies may increase risk-taking, some empirical studies have shown that risk-taking can decline if executives hold more debt relative to their equity holdings.<sup>8</sup> An increasing part of the literature is now considering the role of debt for manager incentives (the “creditorcentered approach”).<sup>9</sup> Debt in executive compensation packages can help lower risk incentives, lower income inequality, address short-termism, and create sustainability.<sup>10</sup> The benefits of debt in executive compensation packages can be enhanced by using contingent convertible bonds (CCB),<sup>11</sup> which can either be written down or converted into equity upon a triggering event.<sup>12</sup> Unlike traditional contingent convertible
the market would welcome,” but “ex post, these actions were costly to their banks”); Andrea Beltratti & Rene M. Stulz, _Why Did Some Banks Perform Better During the Credit Crisis? A Cross-Country Study of the Impact of Governance and Regulation_ (Dice Center Working Paper No. 2009-12, 2009), _available at_ http://www.ssrn.com/abstract=1433502.
> 7 Michael C. Jensen & Kevin J. Murphy, _CEO Incentives—It’s Not How Much You Pay, But How_ , HARV. BUS. REV., May-Jun. 1990, at 138. (showing that it is more important to focus on the form of executive compensation than the amount of compensation).
> 8 Cory A. Cassell, Shawn X. Huang, Juan Manuel Sanchez & Michael D. Stuart, _Seeking Safety: The Relation Between CEO Inside Debt Holdings and the Riskiness of Firm Investment and Financial Policies,_ 103 J. FIN. ECON. 588 (2012); Frederick Tung & Xue Wang, _Bank CEOs, Inside Debt Compensation, and the Financial Crisis_ (Boston Univ. Sch. of Law Working Paper No. 11-49, 2011), _available at_ http://ssrn.com/abstract=1570161 [hereinafter Tung & Wang]; Chenyang Wei & David Yermack, _Investor Reactions to CEOs’ Inside Debt Incentives_ (Fed. Reserve Bank of N.Y. Staff Report No. 445 2011), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1604046 _;_ Rangarajan K. Sundaram & David L. Yermack, _Pay Me Later: Inside Debt and Its Role in Managerial Compensation,_ 62 J. FIN. 1551, 1553 (2007); Joseph Gerakos, _CEO Pensions: Disclosure, Managerial Power, and Optimal Contracting_ 23 (Pension Research Council, Working Paper 2007-5, 2007), _available at_ http://ssrn.com/abstract=982180 (finding that pension benefits may reduce risk taking). Other studies reject the idea that executive compensation and risk-taking are correlated. _See_ Andrew C. W. Lund, _Compensation as Signaling_ , 64 FLA. L. REV. 591, 593 (2012); Karl S. Okamoto & Douglas O. Edwards, _Risk Taking_ , 32 CARDOZO L. REV. 159, 183 (2010); Fahlenbach & Stulz, _supra_ note 6, at 12 (arguing that the link between incentive and risktaking is not proven).
9 Bebchuk and Spamann propose tying executive pay to a specified percentage of the aggregate value of the common shares, the preferred shares and the bonds issued by a bank or its holding company. Bebchuk & Spamann, _supra_ note 1, at 253. Jack Coffee proposed using “contingent capital,” a debt security that would convert to a fixed return preferred stock with cumulative arrearages and significant voting rights. John C. Coffee, _Systemic Risk After Dodd-Frank: Contingent Capital and the Need for Regulatory Strategies Beyond Oversight_ , 111 COLUM. L. REV. 795, 806 (2011). Hill and Painter argue that bankers should have some personal liability and suggest two approaches: mandatory partnership/joint venture agreements and assessable stock. Claire Hill & Richard Painter, _Berle’s Vision Beyond Shareholder Interests: Why Investment Bankers Should Have (Some) Personal Liability_ , 33 SEATTLE U. L. REV. 1173, 1174 (2010). Fred Tung suggests paying bankers partly with their banks’ public subordinated debt securities. Tung, _supra_ note 8, at 1207.
> 10 Bebchuk & Spamann, _supra_ note 1.
11 Other terms for contingent capital securities (“CCS”) include contingent convertible bonds (“CCB”), or “CoCos”. This article will predominantly refer to these hybrid instruments as Contingent convertible bonds or CCB.
> 12 GOLDMAN SACHS GLOBAL MKTS. INST., CONTINGENT CAPITAL: POSSIBILITIES, PROMISES, AND OPPORTUNITIES 4 (2011), _available at_ http://www.goldmansachs.com/our-thinking/publicpolicy/regulatory-reform/contingent-capital.pdf [hereinafter Goldman Sachs]; GOLDMAN SACHS GLOBAL MARKET INST., EFFECTIVE REGULATION: PART 5: ENDING “TOO BIG TO FAIL” (2009) [hereinafter Goldman
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
bonds issued to investors, the emphasis for contingent convertible bonds in executive compensation is not on a capital infusion when the SIFI is in a crisis,<sup>13</sup> but rather on governance-improving designs to help optimize management’s incentives.<sup>14</sup> Adding contingent convertible bonds with an early trigger to the calibration of executive compensation packages could improve the corporate governance of SIFIs. More specifically, contingent convertible bonds with early triggers in executive compensation packages can help to improve incentives for risk-taking by executives, facilitate monitoring by creditors and shareholders, align executives’ interests with those of different constituents, promote sustainability, and reduce income inequality.<sup>15</sup>
Using contingent convertible bonds with early triggers in executive compensation is not a mere theoretical proposal. Barclays, Inc. (Barclays) has already issued contingent capital securities to its executives under its Contingent Capital Plan (CCP).<sup>16</sup> Barclays’s CCP, however, does not allow for conversion from debt into equity, much less with an early trigger before any other contingent convertible bonds can be triggered. Barclays’s issuance seems to serve a mere signaling function, only marginally improves corporate governance, and leaves the incentives for executives untouched. The design adjustment proposed in this article helps optimize the effectiveness and corporate governance improvements of contingent convertible bonds in executive compensation.
The article is structured in five parts. Part I evaluates reform proposals for executive compensation policies before and after the enactment of the Dodd-Frank Act and demonstrates that the creditor-centered approach to executive compensation adds important elements to the debate on reform proposals. Part II introduces the concept of contingent capital securities, contingent capital’s quasi-public-good characteristics, and
Sachs TBTF], http://www2.goldmansachs.com/our-thinking/public-policy/regulatory-reform/effect-reformpart-5.pdf
> 13 George Pennacchi, Theo Vermaelen & Christian C. P. Wolff, _Contingent Capital: The Case for COERCs_ 9 (INSEAD, Working Paper No. 2010/89/FIN, 2010), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1656994; Robert L. McDonald, Contingent Capital with a Dual Price Trigger 1, 20 (Apr. 11, 2011) (unpublished manuscript) _available at_ http://ssrn.com/abstract=1553430; Mark J. Flannery, No Pain, No Gain? Effecting Market Discipline via “Reverse Convertible Debentures” 30 (Nov. 2002) (unpublished manuscript), _available at_ http://bear.warrington.ufl.edu/flannery/No%20Pain,%20No%20Gain.pdf [hereinafter Flannery No Pain].
> 14 For a summary of the possible applications of contingent convertible bonds in corporate governance _see_ Wulf A. Kaal, _Initial Reflections on the Possible Application of Contingent Capital in Corporate Governance_ , 26 NOTRE DAME J.L. ETHICS & PUB. POL’Y 101 (2012); _see also_ Wulf A. Kaal & Christoph K. Henkel, _Contingent Capital with Sequential Triggers_ , 49 SAN DIEGO L. REV. 221 (2012). The conversion feature of contingent convertible bonds and the threat of dilution for equity holders could change the power structure, control dynamic, and dependencies within SIFIs. The market in contingent convertible bonds is slowly evolving. ( _See infra_ Part VI. 2.) With increasing issuances, contingent capital design features will continue to develop. The efficient functioning of contingent capital designs could benefit from experimentation and a learning experience that takes corporate governance considerations into account. Combined with other corporate governance mechanisms, CCBs, as an internal institution-specific mechanism, could help fill a void left by regulators’ seeming inability to supervise financial institutions effectively.
> 15 _See infra_ Part V. 2. b).
> 16 BARCLAYS, BARCLAYS PLC ANNUAL REPORT 2010 (2010), _available at_ http://www.barclaysannualreports.com/ar2010/files/Annual_Report_2010.pdf [hereinafter Barclays Annual Report]. _See also_ Megan Murphy & Jennifer Hughes, _Barclays Causes a Stir with Cocos Plan_ , FIN. TIMES, Jan. 24, 2011, http://www.ft.com/intl/cms/s/0/f5ea5b78-2805-11e0-8abc00144feab49a.html#axzz1x9CMAEXh.
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
the possible application of contingent capital bonds for corporate governance improvements in SIFIs. Part III shows that the relational elements in executive compensation contracts are inadequately acknowledged by classical contract theory and spot contract theory. The shortcomings in the analysis of executive compensation contracts under the classical contract model and spot contract model can be overcome with the methodological assumptions of the relational or incomplete contract model in New Institutional Economics. Part IV introduces the idea of contingent capital bonds in executive compensation and highlights the design and governance shortcomings in Barclays’s Contingent Capital Plan. Part V shows that contingent convertible bonds with early triggers can add important elements to the literature on inside debt and the creditorcentered approach to executive compensation. The recognition of ownership characteristics in design features also adds an important element to the literature on contingent capital trigger designs.
# **II.** **_Reform Proposals for Executive Compensation_**
Corporate governance reform proposals after the financial crisis of 2008-09 have recognized the importance of executive compensation.<sup>17</sup> Although the effects of equitybased compensation are unclear and subject of a long academic debate,<sup>18</sup> equity-based
17 The Financial Crisis Inquiry Commission in the United States lists executive compensation as one of the primary factors contributing to the crisis (among other factors such as lack of transparency, excessive borrowing, and high risk investments). _See_ Final Report, _supra_ note 1, at xix, xxvi. Executive compensation takes a prominent role among other important factors, such as accounting and liquidity and capital regulation, in the Financial Services Authority’s Turner Review in the United Kingdom. _See_ FINANCIAL SERVICES AUTHORITY, THE TURNER REVIEW: A REGULATORY RESPONSE TO THE GLOBAL BANKING CRISIS, 80 (2009), _available at_ http://www.fsa.gov.uk/pubs/other/turner_review.pdf. 18 Among many others: Christopher S. Armstrong & Rahul Vashishtha, _Executive Stock Options, Differential Risk-Taking Incentives, and Firm Value_ , 104 J. FIN. ECON 70(2012); Mao-Wei Hung, Yu-Jane Lio & Chia-Fen Tsai, _Managerial Personal Diversification and Portfolio Equity Incentives_ , 18 J. CORP. FIN. 38 (2012); James Cash Acrey, William R. McCumber & Thu Hien T. Nguyen, _CEO Incentives and Bank Risk,_ 63 J. ECON. & BUS. 456 (2011); Sepe, _supra_ note 1; Christine Hurt, _Regulating Compensation_ , 6 ENTREPRENEURIAL. BUS. L.J. 21 (2011); Ingolf Dittman, Ernst Maug & Dan Zhang, _Restricting CEO Pay,_ 17 J. CORP. FIN. 1200 (2011); Wei & Yermack, _supra_ note 8; Huasheng Gao _, Optimal Compensation Contracts When Managers Can Hedge_ , 97 J. FIN. ECON. 218 (2010); Frydman & Jenter, _supra_ note 1; Gordon, _supra_ note 8; Bhagat & Romano, _supra_ note 1; Patrick Bolton, Hamid Mehran, & Joel Shapiro, _Executive Compensation and Risk Taking_ (Fed. Reserve Bank of N.Y., Staff Report No. 456, 2011) _, available at_ http://www.ny.frb.org/research/staff_reports/sr456.pdf; John M. Barron & Glen R. Waddell, _Work Hard, Not Smart: Stock Options in Executive Compensation_ , 6 J. ECON. BEHAV. & ORG. 767 (2008); Sudhakar Balachandran, Bruce Kogut & Hitesh Harnal, _The Probability of Default, Excessive Risk, and Executive Compensation: A Study of Financial Service Firms from 1995-2008_ (Columbia Business School Research Paper, 2010), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1914542; Stephen Bryan, Robert Nash, & Ajay Patel, _Can the Agency Costs of Debt and Equity Explain the Changes in Executive Compensation During the 1990s_ ?, 12 J. CORP. FIN. 516 (2006); John E. Core, Wayne R. Guay & Randall S. Thomas, _Is U.S. CEO Compensation Broken_ ?, 17 J. APPLIED CORP. FIN. 97 (2005); Li Jin, _CEO Compensation, Diversification, and Incentives_ , 66 J. FIN. ECON. 29 (2002); John E. Core, Wayne R. Guay & David F. Larcker, _Executive Equity Compensation and Incentives: A Survey,_ 9 ECON. POL’Y REV. 27 (2003); Brian J. Hall & Kevin J. Murphy, _Stock Options for Undiversified Executives_ , 33 J. ACCT. & ECON. 3 (2002); Lisa K. Meulbroek, _The Efficiency of Equity-Linked Compensation: Understanding the Full Cost of Awarding Executive Stock Options_ , 30 FIN. MGMT. 5 (2001); Eli Ofek & David Yermack, _Taking Stock: Equity-Based Compensation and the Evolution of Managerial Ownership_ , 55 J. FIN. 1367 (2000).
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
compensation predominates executive compensation in the United States.<sup>19</sup> The focus on equity-based compensation in executive compensation packages may have resulted in short-termism, suboptimal incentives for managers, a lack of sustainability, income inequality, and a classic moral hazard problem.<sup>20</sup> The appropriate response to the shortcomings in equity-based executive compensation is debated among academics<sup>21</sup> and policy makers.<sup>22</sup> The debate pre and post Dodd-Frank Act has been shaped by the
> 19 Daniel A. Cohen, Aiyesha Dey & Thomas Z. Lys, _The Sarbanes-Oxley Act of 2002: Implications for Compensation Structure and Risk-Taking Incentives of CEOs_ (July 2004), _available at_ http://leedsfaculty.colorado.edu/Bhagat/SOX-CEO-Compensation-Investment.pdf (dividing comp into fixed salary, bonus and options and covering the period from 1992 to 2003). Sundaram & Yermack, _supra_ note 8, at 1553; (defining the ratio of equity to inside debt as defined benefit pensions and deferred compensation); Tung & Wang, _supra_ note 8 (measuring debt as defined benefit pension and deferred compensation); _see_ Cassell et. al., _supra_ note 8, at 597.
> 20 _See_ Bebchuk & Spamann, _supra_ note 1, at 249-250; Bebchuk, Cohen & Spamann, _supra_ note 2, at 2. _See also_ Fahlenbrach & Stulz, _supra_ note 6, at 2 (arguing that the most plausible explanation for these findings is that CEOs “took actions that they believed the market would welcome,” but “ex post, these actions were costly to their banks.”); Beltratti &. Stulz, _supra_ note 6, at 1-2.
> 21 Among others Bebchuk & Spamann, _supra_ note 1 (analyzing how banks’ compensation structures produced incentives for excessive risk-taking); Posner, _supra_ note 1, at 1040-41 (arguing that, while the financial crisis cannot be attributed directly to executive overcompensation, CEOs have an incentive to increase leverage because of compensation tied by stock options to share value, generous severance packages, etc.); Final Report, _supra_ note 1, at xix (stating that “compensation systems—designed in an environment of cheap money, intense competition, and light regulation—too often rewarded the quick deal, the short-term gain—without proper consideration of long-term consequences. Often, those systems encouraged the big bet—where the payoff on the upside could be huge and the downside limited. This was the case up and down the line—from the corporate boardroom to the mortgage broker on the street.”); Jennifer G. Hill, _Regulating Executive Remuneration after the Global Financial Crisis: Common Law Perspectives_ , in RESEARCH HANDBOOK ON EXECUTIVE PAY (Jennifer Hill & R. Thomas, eds. forthcoming 2012) (discussing the nexus between executive compensation and the financial crisis). _But see_ Fahlenbrach & Stulz, _supra_ note 6 (investigating whether bank performance during the recent credit crisis is related to chief executive officer (CEO) incentives before the crisis and finding some evidence that banks with CEOs whose incentives were better aligned with the interests of shareholders performed worse and no evidence that they performed better. Banks with higher option compensation and a larger fraction of compensation in cash bonuses for their CEOs did not perform worse during the crisis); Beltratti & Stulz, _supra_ note 6 (investigating whether bank performance is related to bank-level governance, country-level governance, country-level regulation, and bank balance sheet and profitability characteristics before the crisis).
> 22 Among others: FIN. STABILITY BD., SOUND COMPENSATION PRACTICES: IMPLEMENTATION STANDARDS (2009), _available at_ http://www.financialstabilityboard.org/publications/r_090925c.pdf; ORG. FOR ECON. CO-OPERATION & DEV. , CORPORATE GOVERNANCE AND THE FINANCIAL CRISIS: KEY FINDINGS AND MAIN MESSAGES 14-30 (2009), _available at_ http://www.oecd.org/dataoecd/3/10/43056196.pdf; DAVID WALKER, A REVIEW OF CORPORATE GOVERNANCE IN UK BANKS AND OTHER FINANCIAL INDUSTRY ENTITIES: FINAL RECOMMENDATIONS 106-127 (2009), _available at_ http://webarchive.nationalarchives.gov.uk/+/http:/www.hm-treasury.gov.uk/d/walker_review_261109.pdf. FSA materials concerning remuneration code available here: FIN. SERVS. AUTH, _Remuneration Code_ , http://www.fsa.gov.uk/Pages/About/What/International/remuneration/index.shtml; European Union materials on directors’ remuneration available here: EUROPEAN COMM’N, _Remuneration Policies_ , http://ec.europa.eu/internal_market/company/directors-remun/index_en.htm (last updated May 4, 2011); Paul Davies et al., _European Company Law Experts' Response to the European Commission’s Green Paper ‘The EU Corporate Governance Framework’_ 9-12 (2011), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1912548&download=yes; _See_ Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111–203, 124 Stat. 1376, §§ 951 (codified at 15 U.S.C. § 78n–1), 952 (codified at 15 U.S.C. § 78j–3), 954 (codified at 15 U.S.C. § 78j–4), 956 (codified at 12 U.S.C. § 5641); COMM. OF EUROPEAN BANKING SUPERVISORS (CEBS), GUIDELINES ON REMUNERATION,
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
apparent shortcomings in equity-based executive compensation, the experiences in Enron and other financial scandals, and the Sarbanes-Oxley Act, as well as the financial crisis of 2008-09. Recent efforts to include debt-based instruments in executive compensation could help address many of the shortcomings in equity-based compensation.
# _1. Pre Dodd-Frank Act_
There is some evidence that executive compensation played a role in governance shortcomings before the Enron scandal.<sup>23</sup> Despite this evidence, the regulatory response after the collapse of Enron focused predominantly on audit failure.<sup>24</sup> Executive compensation was only marginally addressed in the Sarbanes-Oxley Act.<sup>25</sup> Increased shareholder involvement in executive compensation, director elections, and other corporate governance matters were notably absent in the Sarbanes-Oxley Act. Reform proposals after the Enron scandal but before the financial crisis and the eventual enactment of the Dodd-Frank Act focused in part on increasing shareholder involvement, linking compensation to executive performance, and optimizing transparency.
Before the 2008-09 crisis and the enactment of the Dodd-Frank Act that would eventually include provisions to enhance shareholder involvement, proposals for reform included attempts to establish say-on-pay plans requiring a stockholder vote on manager compensation.<sup>26</sup> The United Kingdom implemented a say-on-pay scheme in 2002<sup>27</sup> and
POLICIES AND PRACTICES, (2010), _available at_ http://www.eba.europa.eu/cebs/media/Publications/Standards%20and%20Guidelines/2010/Remuneration/ Guidelines.pdf; BASEL COMM. ON BANKING SUPERVISION, COMPENSATION PRINCIPLES AND STANDARDS ASSESSMENT METHODOLOGY (2010), _available at_ http://www.bis.org/publ/bcbs166.pdf; FIN. STABILITY FORUM, FSB PRINCIPLES FOR SOUND COMPENSATION PRACTICES (2009), _available at_ http://www.financialstabilityboard.org/publications/r_0904b.pdf. 23 John C. Coffee Jr., _What Caused Enron? A Capsule Social and Economic History of the 1990s_ , 89 CORNELL L. REV. 269, 273 & 297 (2004) [hereinafter Coffee Enron].
> 24 John Coffee, _Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms_ , 84 B.U. L. REV. 301 (2004) [hereinafter Coffee Gatekeeper]; Jeffrey Gordon, _What Enron Means for the Management and Control of the Modern Business Corporation: Some Initial Reflections_ , 69 U. CHI. L. REV. 1233 (2002).
> 25 Lyman P.Q. Johnson & Mark A. Sides, _The Sarbanes-Oxley Act and Fiduciary Duties_ , 30 WM. MITCHELL L. REV. 1149, 1177, 1190-92 (describing shareholder approval of equity compensation plans under SOX and various NYSE and Nasdaq responses to SOX); Coffee Enron, _supra_ note 23, at 269 (considering executive compensation as a possible cause for the Enron scandal and the eventual collapse of Enron); Roberta Romano, _The Sarbanes-Oxley Act and the Making of Quack Corporate Governance_ , 114 YALE L.J. 1521 (2005) (criticizing section 402 SOX, which prohibits personal loans to directors and officers, critical); Nathan Knutt, _Executive Compensation Negotiation: Corporate America, Heal Thyself_ , 47 ARIZ. L. REV. 493, 510 (2005) (“The majority of Sarbanes-Oxley is not dedicated to executive compensation issues. . .”). _See_ Jeffrey Gordon, _Say on Pay: Cautionary Notes on the U.K. Experience and the Case for Shareholder Opt-In_ , 46 HARV. J. ON LEGIS. 323, 334 (2009) (discussing the lacking effectiveness of Section 304 SOX); _SEC v. Jenkins,_ 718 F. Supp. 2d 1070 (D. Ariz. 2010) (providing some clarification by requiring personal misconduct of the issuer not the executive to grant recovery under Section 304 SOX).
> 26 Hill & McDonnell, _supra_ note 1, at 369. _See also_ Randall S. Thomas, Alan R. Palmiter & James F. Cotter, _Dodd-Frank's Say on Pay: Will it Lead to a Greater Role for Shareholders in Corporate Governance?,_ 97 CORNELL L. REV. (forthcoming 2012), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1975866
> 27 Gordon, _supra_ note 25 (assessing the case for a mandatory federal rule in the US in light of the UK experience with a similar regime adopted in 2002. Arguing for a federally provided shareholder opt-in right to a “say on pay” regime, which would change the present reliance on precatory proposals); Walid Alissa,
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
Germany began allowing non-binding votes on management compensation by shareholders during the annual meeting in 2010.<sup>28</sup>
Other reform proposals before the enactment of the Dodd-Frank Act focused on linking pay with executive performance. Proposals in this context ranged from tying executive compensation to the entity’s performance by granting stock options,<sup>29</sup> backloading executive compensation and tying it to the future performance of the company,<sup>30</sup> prohibiting severance pay,<sup>31</sup> and granting restricted stock with a mandatory holding period.<sup>32</sup> Other proposals to increase executive performance suggest a reduction in equity compensation and bonuses caused by industry-based movements and changes in the economy,<sup>33</sup> awarding bonuses only for accounting improvements that are sustained over time,<sup>34</sup> and curtailing “soft-landing” arrangements.<sup>35</sup>
Another major focus of reform proposals before the enactment of the Dodd-Frank Act has been transparency in the disclosure of executives’ compensation packages. Proposals to improve transparency included placing a dollar value on all elements of executive compensation<sup>36</sup> and disclosing the value in SEC filings,<sup>37</sup> disclosing sales of equity instruments,<sup>38</sup> disclosing non-deductible compensation,<sup>39</sup> appointing a compensation representative to represent shareholder interests in setting executive pay,<sup>40</sup>
_Boards' Response to Shareholders' Dissatisfaction: The Case of Shareholders’ Say on Pay in the UK_ (2009), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1412880 (examining how the UK regulation affected the behavior of shareholders and boards and finding evidence that shareholders use the vote to convey their dissatisfaction with excessive executive compensation practices); Martin J. Conyon & Graham Sadler, _Shareholder Voting and Directors’ Remuneration Report Legislation: Say on Pay in the UK_ (2009), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1457921 (investigating shareholder voting in the UK and finding that less than 10% of shareholders abstain or vote against the mandated Directors’ Remuneration Report); Fabrizio Ferri & David A. Maber, _Say on Pay Votes and CEO Compensation: Evidence from the UK,_ REV. OF FIN. (forthcoming), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1420394 (examining the effect of say on pay regulation in the United Kingdom (UK) and finding that the regulation’s announcement triggered a positive stock price reaction at firms with weak penalties for poor performance).
> 28 Marc Steffen Rapp, Marco O. Sperling & Michael Wolff, _Who is Asking the Shareholders? Voting on Management Compensation in German Listed Firms – Evidence from the Annual Meeting Season 2010 (Wer fragt die Aktionäre? - Abstimmung über das Vorstandsvergütungssystem: Erfahrungen aus der HVSaison 2010_ ) (HHL Research Paper Series in Corporate Governance No. 2, 2010), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1723155 (examining determinants affecting (i) the likelihood of a voting and (ii) the result of a vote and finding that the probability of a voting increases with a higher free float and strong media exposure. Moreover the introduction of a new remuneration system also leads to a higher approval rate).
> 29 Michael C. Jensen & William H. Meckling, _Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure_ 3 J. FIN. ECON. 305 (1976); Frydman, _supra_ note 1, at 5.
> 30 Posner, _supra_ note 1, at 1045.
> 31 _Id._
> 32 Bhagat & Romano, _supra_ note 1, at 363; Samuelson & Stout, _supra_ note 1 , at A13.
> 33 Bebchuk & Fried, _supra_ note 1, at 669.
> 34 _Id._ at 670.
> 35 _Id._ at 671-72. These arrangements provide generous compensation for executives being pushed out due to failure and narrow the payoff gap between good and poor performance.
> 36 Posner, _supra_ note 1, at 1045.
> 37 Bebchuk & Fried, _supra_ note 1, at 668.
> 38 _Id._ at 669.
> 39 _Id._ at 668.
> 40 Lawton W. Hawkins, _Compensation Representatives: A Prudent Solution to Excessive CEO Pay_ , 77
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
and appointing a “high-quality” compensation committee consisting of experienced, independent members.<sup>41</sup>
# _2. Post Dodd-Frank Act_
Congress passed the Dodd-Frank Act<sup>42</sup> as a response to the 2008 financial crisis. The Act adopted many of the suggestions from the pre-crisis literature on executive compensation and added other safeguards. Dodd-Frank Act’s provisions pertaining to executive compensation provide for a non-binding shareholder vote to approve executive compensation,<sup>43</sup> disclosure of relationship between executive compensation and the financial performance of the entity,<sup>44</sup> disclosure of the annual total compensation of the CEO and the relationship to the median annual compensation of employees,<sup>45</sup> disclosure of hedging behavior,<sup>46</sup> claw-back provisions,<sup>47</sup> an independent compensation committee,<sup>48</sup> and prohibition of compensation arrangements that encourage inappropriate risks<sup>49</sup> or could lead to material financial loss to the financial institution.<sup>50</sup>
The post Dodd-Frank Act reform debate is complex and wide ranging but will not be reproduced in this article. A major issues in the debate are the say-on-pay provisions in the Dodd-Frank Act.<sup>51</sup> Critics argue that shareholder voting on executive compensation could actually hurt shareholders because it diffuses responsibility regarding compensation and insulates directors' reputations.<sup>52</sup> With say-on-pay provisions in place, directors may be incentivized to authorize larger compensation packages that are
BROOK. L. REV. 449, 474 (2007). 41 Jerry Sun & Steven Cahan _, The Effect of Compensation Committee Quality on the Association Between CEO Cash Compensation and Accounting Performance,_ 17 CORP. GOVERNANCE: AN INT’L REV. 193, 194 (2009). Empirical evidence has shown that these committees can prevent executives from behaving opportunistically. Patricia M. Dechow, Mark R. Huson & Richard G. Sloan _, The Effect of Restructuring Charges on Executives’ Cash Compensation,_ 69 ACCT. REV. 138, 139 (1994). _See also_ Memorandum from Wachtell Lipton, Jeannemarie O’Brien, David E. Kahan & Samuel E. Eckman, SEC Issues Final DoddFrank Rules on Independence of Compensation Committee and Its Advisers (June 21, 2012) (on file with author); SEC Listing Standards For Compensation Committees **,** 17 C.F.R. §§229 & 240 (2012) (directing the national securities exchanges to prohibit listing the equity securities of any company not in compliance with the compensation committee and compensation adviser requirements of Section 10C of the Exchange Act).
42 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No.111-203, 124 Stat. 1376 (codified as amended in scattered sections of U.S.C. 7,12,15, 22, 31 & 42).
43 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No.111-203, § 951, 124 Stat. 1376 (2010). 44 § 953(a)(i). 45 § 953(b). 46 § 955. 47 § 954(b). 48 § 952. 49 § 956(a)(1)(A).
50 § 956(a)(1)(B).
> 51 For a description of U.S. and European Union steps to reform the ways executives are compensated, _see_ Marisa Anne Pagnattaro & Stephanie M. Greene, _“Say on Pay:” The Movement to Reform Executive Compensation in the United States and European Union,_ 31 NW. J. INT’L L. & BUS. (forthcoming 2011), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1933243. _See also_ Memorandum from Wachtell Lipton, Michael J. Segal, UK Government Announces Binding Vote on Executive Compensation (June 21, 2012) (on file with author).
> 52 Minor Myers, _The Perils of Shareholder Voting on Executive Compensation_ , 36 DEL. J. CORP. L. 417 (2011).
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
less sensitive to performance.<sup>53</sup> Moreover, shareholders may lack the incentives and resources to evaluate the information and may not be able to determine whether executive pay is reasonable.<sup>54</sup> Say-on-pay provisions could give proxy advisory firms more power.<sup>55</sup>
To remedy the shortcomings, some suggest that Congress give shareholders a right to opt in to a binding vote on the board’s pay scheme,<sup>56</sup> while others suggest that shareholders should have a right to decide whether a public firm should schedule a vote on executive compensation,<sup>57</sup> information disclosed should include details on the pay of executives at competitor companies,<sup>58</sup> and shareholders should have a right to decide whether a public firm should schedule a vote on executive compensation.<sup>59</sup>
Despite its many critics,<sup>60</sup> say-on-pay may have led to improvements. As a result of say-on-pay requirements, some firms may have reduced compensation and increased performance measures for executive compensation.<sup>61</sup> Because poorly performing companies with high pay levels can expect shareholder dissent, say-on-pay may attract strong shareholder support.<sup>62</sup> Shareholders may perceive compensation procedures as fairer under say-on-pay, which could increase shareholder confidence in its boards of directors and increased investor interest in the entity.<sup>63</sup>
# _3. The Creditor-Centered Approach_
Executive compensation in the United States mostly takes the form of equitybased instruments. Changes to the tax code and other regulation encourage equity-based compensation for executives.<sup>64</sup> The justification of executive compensation with equitybased products has been a major focus of theoretical research on executive compensation
> 53 _Id._ (proposing an opt-out of the say on pay regime by shareholder vote) _._
> 54 Tiffany Roddenberry, _Say-on-Pay: Cautionary Notes on the Use of Third Party Compensation Guidelines in the United States_ , 38 FLA. ST. U. L. REV. 933 (2011). _See also_ Gordon _, supra_ note 25, at 325.
> 55 Gordon _, supra_ note 25, at 325.
> 56 Andrew L. Bethune, _An Efficient “Say” on Executive Pay: Shareholder Opt-In as a Solution to the Managerial Power Problem_ , 48 HOUS. L. REV. 585, 610 (2011).
> 57 Gordon _, supra_ note 25, at 326 (arguing that this regime would focus attention on firms with the most questionable practices).
> 58 Roddenbury, _supra_ note 54, at 952.
> 59 Gordon _, supra_ note 25, at 326 (arguing that this regime would focus attention on firms with the most questionable practices, enabling successful implementation to be observed by similar firms and possibly cause them to change their behavior).
> 60 For a summary of criticism on say-on-pay provisions in the Dodd-Frank Act _see_ Roddenberry, _supra_ note 54, at Part III; Bethune, _supra_ note 56, at 610-14.
> 61 Steven Balsam & Jennifer Yin, _The Impact of Say-on-Pay on Executive Compensation_ (2012), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2026121.
> 62 _Id_ .
> 63 Kendall Bowlin, Margaret H. Christ & Jeremy B. Griffin, _Say-on-Pay and the Differential Effects of Voluntary Versus Mandatory Regimes on Investor Perceptions and Behavior_ (AAA 2011 Management Accounting Section (MAS) Mtg. Paper, 2012), _available at_
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1659862 (finding that say-on-pay’s positive effect on investor behavior is greater when boards give their investors a voice voluntarily than when they are mandated to do so. Also finding that investors react negatively when directors’ compensation decisions do not conform to investors’ expressed say-on-pay preference).
> 64 _See, e.g.,_ 26 I.R.C. § 162(m) (2006). _See also_ Lucian Bebchuk & Jesse Fried, _Paying for Long-Term Performance_ , 158 U. PA. L. REV. 1915 (2010); Council of Institutional Investors, Top 10 Red Flags To Watch for When Casting an Advisory Vote on Executive Pay (March 2010).
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
in the past three decades.<sup>65</sup> However, an increasing part of the literature is now considering the role of debt for manager incentives<sup>66</sup> and empirical studies show that risk-taking can decline if executives hold more debt relative to their equity holdings.<sup>67</sup>
Bebchuk & Spaman show that a compensation package that includes a basket of securities representing a predefined percentage of the aggregate value of all outstanding bonds, preferred shares, and common shares could help address the shortcomings of existing executive compensation practices.<sup>68</sup> Tying executive compensation to this basket of securities issued by either the bank holding company or the bank<sup>69</sup> can improve incentives for executives to consider the losses that risk-taking could impose on shareholders, bondholders, depositors and taxpayers.<sup>70</sup> Regulators could place constraints on the pay schemes to shape how executives choose the actions that are allowed by direct regulation.<sup>71</sup> Moreover, bonuses could be based not only on earnings per share, but rather on broader metrics that also reflect the interests of preferred shareholders, bondholders, and the government as guarantor of deposits.<sup>72</sup> Hill and Painter suggest mandatory partnership or joint venture agreements and assessable stock to ensure that bankers have some personal liability.<sup>73</sup> This personal liability could improve creditor protection because executives would be exposed to some downside risk and would be disincentivized to take excessive risks.<sup>74</sup>
The literature on inside debt similarly emphasizes creditor protection. Inside debt in the form of deferred compensation and pension plans, among other instruments, can help optimize managers’ incentives and serves an important function in the calibration of executive compensation packages.<sup>75</sup> Fred Tung suggests using public subordinated debt securities for part of the compensation of bank executives.<sup>76</sup> Debt and equity hold different risk preferences and creditors’ preferences for more conservative management
> 65 Jensen & Murphy, _supra_ note 7 (showing that it is more important to focus on the form of executive compensation than the amount of compensation).
> 66 Bebchuk & Spamann, _supra_ note 1; Tung, _supra_ note 8; Hill & Painter, _supra_ note 8.
> 67 Tung & Wang, _supra_ note 8; Wei & Yermack, _supra_ note 8; Sundaram & Yermack, _supra_ note 8, at 1553; Gerakos, _supra_ note 8, at 23 (finding that pension benefits may reduce risk taking).
> 68 _See_ Bebchuk & Spamann, _supra_ note 1, at 253, 283-84. How the securities in the basket should be weighted is unclear. Weighting debt securities, including contingent convertible bonds , heavily in the calibration of executive compensation may increase the positive effects of debt in executive compensation packages. At the same time, debt may not be the preferred form of compensation for executives. Calibrating executive compensation packages to account for desired incentives and governance improvements while giving sufficient incentives for executives to perform within expected parameters could require an institution specific relational approach and a learning process for institutions. _See supra_ Part IV. (on the benefits of the incomplete contract theory of NIE).
> 69 _Id._
> 70 _Id._
> 71 _Id._ at 253.
> 72 _Id._
> 73 Hill & Painter, _supra_ note 8, at 1174.
> 74 _Id._
> 75 Sundaram & Yermack, _supra_ note 8 (arguing that inside debt alters managerial incentives and in turn the size of the firm's payouts, the composition of these payouts (dividends vs. share repurchases), the firm's cost of debt and its capital structure, the choice of new securities to be issued (debt vs. equity), project choice, capital expenditure choice, and the incentive to pursue diversifying mergers, among many other things; and discussing whether and under what conditions such debt holdings could be part of an optimal compensation package).
> 76 Tung, _supra_ note 8, at 1207.
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
strategies can help curb managers’ risk-taking.<sup>77</sup> Inside debt in the form of defined benefit plans can make executives sensitive to firm value in bankruptcy, which is desired by creditors.<sup>78</sup> Measured by an entity’s distance to default, aligning managers’ interests with creditors’ can reduce a firm’s risk of defaulting<sup>79</sup> and improve its credit rating.<sup>80</sup> Debt should be part of executive compensation because it is an efficient deterrent to riskshifting.<sup>81</sup>
The creditor-centered approach to executive compensation has encountered some critics who argue that inside debt can be inefficient and may not influence executives’ conduct sufficiently while creating complicated incentive structures.<sup>82</sup> Other criticisms include allegations of too strong a focus on the banking sector and managers’ ability to
> 77 _Id._ at 1212-13. _See also_ Rosalind L. Bennett, Levent Güntay & Haluk Unal, _Inside Debt, Bank Default Risk and Performance during the Crisis_ , _available at_ http://www.tcmb.gov.tr/yeni/konferans/fms/Home_files/Unal_H.pdf (stating that in bank holding companies, lower holdings of inside debt relative to equity by a CEO had an association with higher default risk and worse performance during the crisis period).
> 78 Alex Edmans & Xavier Gabaix, _Is CEO Pay Really Inefficient? A Survey of New Optimal Contracting Theories_ , 15 EUR. FIN. MGMT. 486 (2009). _See also_ Reilly S. White, _Inside Debt and Firm Dividend Policy_ (2012), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2054787 (arguing that managers with high pension holdings will be more reluctant to commit to high dividend policy that can risk their future pension payouts and suggesting that these findings provide support to the manager-owner agency theory, where executive pensions can act as ‘counter options’, and therefore align executive interests away from shareholders towards bondholders).
> 79 Sundaram & Yermack, _supra_ note 8.
> 80 Gerakos, _supra_ note 8.
> 81 Alex Edmans & Qi Liu, _Inside Debt_ , 15 REV. OF FIN. 75 (2011) (justifying the use of debt as efficient compensation and arguing that a debt bias can improve effort as well as deter risk shifting). _See also_ Tung & Wang, _supra_ note 8 (stating that their empirical evidence provides a rationale for the use of inside debt compensation in structuring executive compensation in the banking context); Riccardo Calcagno & Luc Renneboog, _The Incentive to Give Incentives: On the Relative Seniority of Debt Claims and Managerial Compensation_ , 31 J. BANKING & FIN. 1795 (2007) (arguing that the increase in the leverage of AngloAmerican corporations has stimulated the interest in the role of debt as a direct incentive device for management to generate stronger corporate performance and showing that including risky debt in the capital structure changes the “incentive to give incentives” by a principal in charge of managerial contracts); Alex Edmans, _Leadership in Corporate Finance (A Special Report) --- How to Fix Executive Compensation: For Starters, Don't Link Pay Packages Just to Stock; Tie Them to Debt as Well_ , WALL ST. J., Feb. 27, 2012, at R.1; Bolton, Mehran, & Shapiro, _supra_ note 18 (suggesting that debt-like compensation for executives is believed by the market to reduce risk for financial institutions); Sallie Krawcheck, _Four Ways to Fix Banks_ , 90 HARV. BUS. REV. 106 (2012) (suggesting to pay top executive with debt instead of equity-based compensation to give them more incentive to worry about risk); Cassell et al., _supra_ note 8 (stating that CEO inside debt holdings are generally unsecured and unfunded liabilities of the firm and therefore expose the CEO to default risk similar to that faced by outside creditors and arguing that CEOs with large inside debt holdings will display lower levels of risk-seeking behavior); Hernan Ortiz-Molina, _Executive Compensation and Capital Structure: The Effects of Convertible Debt and Straight Debt on CEO Pay_ , 43.1 J. ACCT. & ECON. 69 (2007) (arguing that the hypothesis that debt reduces manager-shareholder conflicts can explain some but not all of the results); Yair Listokin, _Paying for Performance in Bankruptcy: Why CEOs Should Be Compensated With Debt_ , 155 U. PA. L. REV. 777 (2007)(proposing a novel bankruptcy compensation plan, otherwise known as debt compensation, that is expected to provide better incentives for CEOs to perform efficiently).
> 82 Kelli A. Alces & Brian D. Galle, _Is Inside Debt Efficient? Theory and New Evidence from Executive Pensions and Deferred Compensation_ (Boston College Law Sch., Legal Studies Research Paper No. 266, 2012), [___] J. CORP. L. [___] (forthcoming), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2038528.
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
manipulate book value as the only available measure of asset value.<sup>83</sup> Critics have also attacked the creditor-centered approach on methodological grounds because they assume that the principal-agent relationship in that approach is a one-shot transaction rather than a relational contract.<sup>84</sup> Given the shortcomings pointed out by the debate, some call for a paradigm shift to overcome the unnecessary creation of new remuneration narratives.<sup>85</sup>
# **III.** **_Contingent Capital_**
Contingent convertible bonds (CCB) are debt securities that can either be written down or converted into equity upon a triggering event.<sup>86</sup> The many applications and benefits of contingent convertible bonds<sup>87</sup> include their ability to stabilize and prepare SIFIs for future financial crises,<sup>88</sup> signal default risk,<sup>89</sup> prevent bailouts,<sup>90</sup> decrease risktaking,<sup>91</sup> minimize moral hazard,<sup>92</sup> incentivize the increase in capital,<sup>93</sup> internalize bank failure cost,<sup>94</sup> avoid financial contagion,<sup>95</sup> and limit systemic risk.<sup>96</sup> As a hybrid
> 83 Sepe, _supra_ note 1, at 230.
> 84 _Id._
> 85 Jaap W. Winter, _Corporate Governance Going Astray: Executive Remuneration Built to Fail, in_ FESTSCHRIFT FOR PROFESSOR KLAUS HOPT 1521-1535 (2010) _, available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1792483.
> 86 Goldman Sachs, supra note 12; Goldman Sachs TBTF, _supra_ note 12. http://www2.goldmansachs.com/our-thinking/public-policy/regulatory-reform/effect-reform-part-5.pdf
> 87 For a summary _see_ Kaal, _supra_ note 14.
> 88 _See_ MARK J. FLANNERY, STABILIZING LARGE FINANCIAL INSTITUTIONS WITH CONTINGENT CAPITAL CERTIFICATES 2 (2009) [hereinafter Flannery]; Flannery, No Pain, _supra_ note 13, at 30.
> 89 _See_ Raghuram Rajan, _More Capital Will Not Stop the Next Crisis_ , FIN. TIMES (London), Oct. 1, 2009, http://www.ft.com/intl/cms/s/0/a830fcf6-aed1-11de-96d7-00144feabdc0.html#axzz1aQNhCNnY (suggesting that contingent convertible bonds should be used to raise capital “when regulators see a crisis coming”); William C. Dudley, President & CEO, Fed. Reserve N.Y., Some Lessons from the Crisis, Remarks at the Institute of International Bankers Membership Luncheon (Oct. 13, 2009), _available at_ http://www.newyorkfed.org /newsevents/speeches/2009/dud091013.html (proposing that CCS can be used to adequately capture risk).
> 90 Squam Lake Working Grp. on Fin. Regulation, _An Expedited Resolution Mechanism for Distressed Financial Firms: Regulatory Hybrid Securities_ 2 & 4 (Council on Foreign Relations: Center for Geoeconomic Studies, Working Paper, 2009), _available at_
www.cfr.org/content/.../Squam_Lake_Working_Paper3.pdf (suggesting that hybrid securities would help prevent bailouts); Coffee, _supra_ note 9, at 801-03 (promoting contingent capital as an alternative to bailouts); Charles W. Calomiris & Richard J. Herring, _Why and How to Design a Contingent Convertible Debt Requirement_ 39 (Apr. 2011) (unpublished manuscript), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1815406 (averring that contingent capital could help prevent the “too big to fail” problem).
> 91 Pennacchi et al., _supra_ note 13; Dudley, _supra_ note 89 (averring that because bank difficulties would trigger conversion, this dilution of shareholders creates an incentive for bank managers to “manage not only for good outcomes on the upside of the boom, but also against bad outcomes on the downside.”).
> 92 _See_ Flannery, _supra_ note 88, at 15.
> 93 _See_ Squam Lake Working Group, _supra_ note 90; Calomiris & Herring, _supra_ note 90.
> 94 McDonald, _supra_ note 13, at 20; Flannery, _supra_ note 88, at 12. _See also_ Darrell Duffie, _Contractual Methods for Out-Of-Court Restructuring of Systemically Important Financial Institutions_ (2009), _available at_
http://media.hoover.org/sites/default/files/documents/06EndingGovernmentBailoutsAsWeKnowThemDuffi e.pdf.
> 95 _See_ Goldman Sachs TBTF, _supra_ note 12, at 6 (noting that if the appropriate triggers are in place, it could prevent bank runs—though if the trigger is based on market prices, it could worsen bank runs).
> 96 _See_ Kaal, _supra_ note 14; Coffee, _supra_ note 9, at 806.
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
instrument, contingent convertible bonds combine the limited upside of debt in the form of the coupon rate with the unlimited downside risk of equity, i.e. the total loss of the investment. Several successful contingent convertible bond issuances with coupon rates between 7% and 9.2% in Europe show that these securities can display a combination of features that investors and issuers find attractive.<sup>97</sup> The market in contingent convertible bonds is slowly evolving.<sup>98</sup> Because contingent convertible debt has many applications and could help reform policy in many areas, the concept finds increasing support among academics<sup>99</sup> and policy makers.<sup>100</sup>
Contingent convertible triggering events for conversion from debt into equity are typically intended to avert a financial weakening of the entity.<sup>101</sup> The automatic conversion from debt to equity helps increase capital when needed and lowers the debt/equity ratio.<sup>102</sup> The automatic conversion of debt into equity may prove especially attractive to SIFIs who could otherwise be forced into restructuring.<sup>103</sup> Because of the importance of the conversion feature of contingent convertible bonds for purposes of corporate governance improvements, the analysis in this article will focus on contingent convertible bonds with a conversion feature rather than a write-down.
> 97 Kaal, _supra_ note 14, at 312-15.
> 98 Kaal, _supra_ note 14.
> 99 _Id._ ; Kaal & Henkel, _supra_ note 14; DAVID SKEEL, THE NEW FINANCIAL DEAL: UNDERSTANDING THE DODD-FRANK ACT AND ITS ( _UNINTENDED_ ) CONSEQUENCES 84–85 (2011) (noting that the Dodd-Frank Act instructs the General Accountability Office to conduct a study on contingent capital and to begin using it when the study is completed); Pennacchi et al. _supra_ note 13; Coffee, _supra_ note 9; Flannery No Pain, _supra_ note 88; Raghuram G. Rajan, _Too Systemic to Fail: Consequences, Causes, and Potential Remedies_ 25, 28 (Bank for Int’l Settlements, Working Papers No. 305, 2010), _available at_ http://www.bis.org/publ/work305.pdf (“[C]ontingent capital is like installing sprinklers . . . . [W]hen fire threatens, the sprinklers will turn on.”). _But see_ Christian Koziol & Jochen Lawrenz, _Contingent Convertibles: Solving or Seeding the Next Banking Crisis?_ , 36 J. BANKING & FIN. 90, 91 (2012); McDonald, _supra_ note 13, at 20; Duffie, _supra_ note 94.
> 100 _See_ COMM’N OF EXPERTS, FINAL REPORT OF THE COMMISSION OF EXPERTS FOR LIMITING THE ECONOMIC RISKS POSED BY LARGE COMPANIES 59–60 (Sept. 2010), _available at_ http://www.sif.admin.ch/dokumentation/00514/00519/00592/index.html?lang=en (proposing the conversion of contingent capital upon certain triggering events) [hereinafter Swiss Report]; Edmund L. Andrews, _Bernanke, in a Bow to Critics of Fed’s Role, Supports Forming a Regulatory Group_ , N.Y. TIMES, Oct. 2, 2009, at B3 (stating that Chairman of the Federal Reserve, Ben Bernanke, opined that giant financial players might be forced to adopt “contingent” capital, and noting that contingent capital is “gaining popularity within the Fed.”); Daniel K. Tarullo, Federal Reserve Governor, Speech at the Exchequer Club in Washington, D.C. to the Federal Reserve: Confronting Too Big to Fail (Oct. 21, 2009), http:// www.federalreserve.gov/newsevents/speech/tarullo20091021a.htm (commenting that contingent capital is an effort “worth pursuing”). For a description of the policy in the European Union, _see_ Press Release, European Comm’n, Commission Wants Stronger and More Responsible Banks in Europe (July 20, 2011), _available at_
http://europa.eu/rapid/pressReleasesAction.do?reference=IP/11/915&format=HTML&aged=0&language=e n&guiLanguage=en (“The proposal will require banks to hold more and better capital to resist future shocks by themselves . . . . With its proposal, the Commission translates in Europe international standards on bank capital agreed at the G20 level (most commonly known as the Basel III agreement).”). 101 Coffee, _supra_ note 9, at 805; Duffie, _supra_ note 94; Flannery, _supra_ note 88, at 3.
> 102 In the context of automation of financial regulation, _see_ AMAR BHIDÉ, A CALL FOR JUDGMENT: SENSIBLE FINANCE FOR A DYNAMIC ECONOMY (2010); Coffee, _supra_ note 9, at 805 (averring that contingent capital can counter leverage debt).
> 103 _See_ Kaal & Henkel, _supra_ note 14; Coffee, _supra_ note 9, at 805.
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
Contingent convertible bonds have quasi-public-good characteristics<sup>104</sup> and are particularly suitable for purposes of corporate governance improvements in SIFIs.<sup>105</sup> The conversion feature of these securities may have the ability to influence corporate governance in SIFIs.<sup>106</sup> If sufficient volumes of contingent convertible bond issuances are combined with adequate design features, the conversion feature of contingent convertible bonds and the threat of dilution of equity positions in the SIFIs could affect corporate governance in SIFIs.<sup>107</sup> Measures to increase the effectiveness of the conversion feature of contingent capital, such as increased voting rights or sequential triggers, could further increase the impact these securities may have on corporate governance.<sup>108</sup>
In part because of mounting pressure from politicians, policy makers, and legislatures who demanded remedies for corporate governance shortcomings, European SIFIs have issued contingent convertible bonds.<sup>109</sup> CCB’s potential to address corporate governance shortcomings, albeit not fully utilized in the existing designs, may help with public relations because a contingent convertible bond issuance may signal to investors, politicians, and the general public that SIFI management is instituting safety-increasing measures that can help avoid future bailouts. Although the designs of recent contingent convertible bond issuances provide mostly for a write down feature rather than a conversion to equity, the SIFIs who did issue contingent convertible bonds seem to have recognized the market acceptance and investor demand for these hybrid securities. However, the market in contingent convertible bonds is still in its infancy and privately negotiated contingent convertible bond sales have so far not resulted in efficiently functioning contingent convertible bond designs that take corporate governance considerations into account. It is doubtful if market solutions and private ordering alone will produce contingent capital designs that help improve corporate governance in SIFIs.
# **IV.** **_Incomplete Contract Theory_**
This article expands the existing literature on the creditor-centered approach to executive compensation by suggesting the inclusion of contingent convertible bonds in the calibration of executives’ compensation packages. Scholarly contributions in the context of the creditor-centered approach to executive compensation are often (implicitly) based on the classical contract model or spot contract model.<sup>110</sup> This can result in suboptimal and unrealistic outcomes. The classical contract model assumes a system of rules that deals with and legally guarantees all future eventualities. The parties to a contract negotiate and agree ex ante on all possible scenarios and eventually execute the
> 104 _Id_ .
> 105 _Id_ .
> 106 Kaal, _supra_ note 14.
> 107 _Id_ .
> 108 _See_ Kaal, _supra_ note 14; Kaal & Henkel, _supra_ note 14.
> 109 Kaal, _supra_ note 14, at 320-21 (summarizing Swiss efforts to implement contingent capital rules that precipitated voluntary issuances of contingent convertible bonds by Credit Swiss). _See also_ Goldman Sachs, _supra_ note 86.
> 110 Many scholars who endorse the creditor-centered approach to executive compensation may implicitly use the classical or spot-contract model of executive compensation _see e.g._ Gordon, _supra_ note 8 _;_ Hill & Painter, _supra_ note 8, at 1175;Bebchuk & Spamann, _supra_ note 1, at 256. Bebchuk & Spamann claim that using multiple periods for the analysis would unnecessarily complicate the analysis without changes in the conclusions or other substantial benefits _see id._ For a summary _see_ Sepe _, supra_ note 1, at 211-12.
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
contract as agreed. The contract in this model hopes to anticipate all eventualities and is not intended to be ambiguous.<sup>111</sup> The model assumes that the comprehensive nature of the regulation leaves no discretion to the agents, making opportunistic behavior impossible. Transaction costs in the form of initiating, concluding and enforcing the contract are not considered in the classical contract model.
Contrary to the assumptions of classical contract model and spot contract model, executive contracts have an informal relational dimension that goes beyond the written contract between the parties. The relationship between the executive as agent and the corporation and its shareholders as the principal involves more than the contractual terms of the agreement. An executive compensation contract combines elements of a knowledge exchange and relational collaboration. Informal relational behavior between the principal and agent generates confidence in the relationship, creates institutionspecific knowledge, and innovative capabilities. The informal relational elements of executive compensation contracts can often overshadow the legal terms of the agreement. Using a model for the analysis of executive contracts that is based on the single contract between the executive/agent and corporation/principal would ignore the informal relational element of this principal-agent relationship. Given the importance of the informal relational element of executive compensation contracts, the literature on the debt-centered approach to executive compensation should include informal relational-, behavioral-, and incomplete-contract theories.
These shortcomings in the analysis of executive compensation contracts under the classical contract model and spot contract model can be overcome with the relational or incomplete contract model in New Institutional Economics (NIE).<sup>112</sup> NIE is a relatively young offspring of economic theory<sup>113</sup> and shares core assumptions with the neoclassical model, such as methodological individualism, scarcity of resources, and self-interested rational behavior.<sup>114</sup> However, NIE substitutes the assumption of full rationality with bounded rationality<sup>115</sup> and opportunistic behavior<sup>116</sup> and underscores that information is systematically incomplete.<sup>117</sup> NIE emphasizes the functioning, development, and improvements of institutions.<sup>118</sup> Institutions are defined as general rules or sets of general
> 111 O.D. Hart, _Incomplete Contracts_ , _in_ THE NEW PALGRAVE: A DICTIONARY OF ECONOMICS 755 (John Eatwell, Murray Milgate & Peter Newman eds., 1989).
> 112 Rudolf Richter, _Banking Regulation as Seen by the New Institutional Economics_ , _in_ 2 THE ECONOMICS AND LAW OF BANKING REGULATION 136 (1989).
> 113 NIE’s assumptions are increasingly used in modern economic analysis of financial markets and financial rules _see_ HERSH SHEFRIN, BEYOND GREED AND FEAR: UNDERSTANDING BEHAVIORAL FINANCE AND THE PSYCHOLOGY OF INVESTING 9–10 (2002); ANDREI SHLEIFER, INEFFICIENT MARKETS: AN INTRODUCTION TO BEHAVIORAL FINANCE 10 (2000).
> 114 EIRIK G. FURUBOTN & RUDOLF RICHTER, INSTITUTIONS AND ECONOMIC THEORY: THE CONTRIBUTION OF THE NEW INSTITUTIONAL ECONOMICS 5, 7 (3d ed. 2005).
> 115 _See_ STEFAN VOIGT, INSTITUTIONENÖKONOMIK [INSTITUTIONAL ECONOMICS] 22–23 (2d ed. 2009).
> 116 _Id_ . at 88–89; FURUBOTN & RICHTER, _supra_ note 114.
> 117 _See_ VOIGT, _supra_ note 115, at 237–38.
> 118 _See_ FURUBOTN & RICHTER, _supra_ note 114, at 35–37; DOUGLASS C. NORTH, INSTITUTIONS,
INSTITUTIONAL CHANGE AND ECONOMIC PERFORMANCE 3 (1990); RUDOLF RICHTER & EIRIK G. FURUBOTN, NEUE INSTITUTIONENÖKONOMIK [NEW INSTITUTIONAL ECONOMICS] (3d ed. 2003); OLIVER E. WILLIAMSON, THE ECONOMIC INSTITUTIONS OF CAPITALISM 15–16 (1985); VOIGT, _supra_ note 115;
Christian Kirchner, _Public Choice and New Institutional Economics: A Comparative Analysis in Search of Co-Operation Potentials_ , _in_ PUBLIC ECONOMICS AND PUBLIC CHOICE 19, 32 (Pio Baake & Rainald Borck eds., 2007); Ronald Coase, _The New Institutional Economics_ , 88 AM. ECON. REV. 72, 72–74 (1998); Oliver
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
rules, together with their enforcement mechanisms.<sup>119</sup> NIE emphasizes the importance of informal institutions, such as social norms.<sup>120</sup> Because corporate governance issues often involve formal and informal institutions, NIE is ideally suited to examine the efficiency of governance structures. Experimentation, observation, and rule revision in NIE’s model are part of a continuous process that avoids “optimal” or “stable” rules.<sup>121</sup> Experimentation can result in a learning process that can improve the quality of governance structures. Because it is likely that underlying economic conditions will change, contingent convertible bond offerings to the public and to executives may benefit from a process of experimentation and learning.
In contrast to classical contract analysis, NIE’s incomplete contract model recognizes that contracts are inevitably incomplete and rely on control rights to minimize opportunistic behavior.<sup>122</sup> This model takes opportunistic behavior and transaction costs into account.<sup>123</sup> The degree of contractual incompleteness is influenced by the cost of contracting and contracting parties’ ability to anticipate opportunistic behavior.<sup>124</sup> The theory of incomplete contracts under NIE can be considered part of the principal-agent approach because information before and after contracting is asymmetric and the agent has a certain amount of discretion making opportunistic behavior possible.<sup>125</sup>
At the core of the principal-agent relationship in executive compensation is the short-term interest of the manager/agent to generate a high income that conflicts with the long-term ownership interest of the shareholders/principals. The relational elements in executive compensation contracts may further increase the principal-agent problem. The combination of knowledge exchange and relational collaboration in executive compensation contracts makes opportunistic behavior of executives likely.<sup>126</sup> Contracting parties are, however, limited in their ability to anticipate opportunistic behavior of agents. Therefore, control rights to limit opportunistic behavior become increasingly important. Because of incomplete information, information asymmetries in the principle-agent relationship, bounded rationality of contracting parties, the parties’ limited cognition and foresight, and transaction costs, control rights in executive compensation contracts cannot account sufficiently for ex post opportunism of agents. Adding contingent convertible
> E. Williamson, _Transaction-Cost Economics: The Governance of Contractual Relations_ , 22 J.L. & ECON. 233 (1979).
> 119 _See_ FURUBOTN & RICHTER, _supra_ note 114, at 7; VOIGT, _supra_ note 115.
> 120 Recognizing that limiting the analysis to a subset of formal institutions would ignore important problems. _Id._
> 121 _See_ Kaal, _supra_ note 14, at 136-44 (explaining the benefits of experimentation for the evolution of contingent capital rules).
> 122 OLIVER E. WILLIAMSON, THE ECONOMIC INSTITUTIONS OF CAPITALISM: FIRMS, MARKETS, AND
RELATIONAL CONTRACTING (1985). Ronald Coase first examined coordination costs within coordination mechanisms. Coases’ approach became the core concept of contractual theories. Williamson later expanded the analysis to governance mechanisms in relation to transaction costs. OLIVER E. WILLIAMSON,
> COMPARATIVE ECONOMIC ORGANIZATION: THE ANALYSIS OF DISCRETE STRUCTURAL ALTERNATIVES (1991).
> 123 _Id_ . (defining opportunism as “self-interest seeking with guile.”); Furubotn & Richter, _supra_ note 114.
> 124 O. HART, FIRMS, CONTRACTS, AND FINANCIAL STRUCTURE (1995).
> 125 _See_ Furubotn & Richter, _supra_ note 114.
> 126 Short-termism to maximize personal income through stock options, the Fuld Problem ( _see infra_ Part VI.
> 2.), income inequality between senior executives and the rest of the workforce are only a few examples of opportunistic behavior of agents in the context of executive compensation.
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
bonds with an early trigger to executive compensation packages can create a corporate governance mechanism that helps address these shortcomings.<sup>127</sup>
Non-contractual behavior in the form of non-contractual norms, reciprocity, trust, friendship, reputation, altruism, interdependence, and moral obligations may be unenforceable through contractual agreements but also shape economic action.<sup>128</sup> Noncontractual behaviors can harmonize conflicts and help sustain relationships.<sup>129</sup> Therefore, non-contractual behavior should be considered in the attempt to optimize manager incentives for corporate governance improvements.
# **V.** **_Contingent Capital in Executive Compensation_**
The academic literature on executive compensation is largely silent on the use of contingent convertible bonds in executive compensation. Similarly, the literature on contingent capital has mostly ignored the possible application of contingent convertible bonds in executive compensation.<sup>130</sup> The governance-improving features of contingent convertible bonds<sup>131</sup> can be applied to executive compensation. Contingent convertible bonds in executive compensation can help address the core executive compensation issues that emerged after the global financial crisis.<sup>132</sup> More specifically, contingent convertible bonds in executive compensation packages can improve suboptimal incentives for risk-taking by executives, the alignment of executives’ interests with those of different constituents, sustainability, and income inequality. This article suggests the use of contingent convertible bonds with early triggers in executive compensation packages.
> 127 _See infra_ Part V. 2. a) (discussing the design of early triggers in executive compensation).
> 128 Richard H. McAdams, _Cultural Contingency and Economic Function: Bridge Building from the Law & Economics Side,_ 38 L. & SOC’Y REV 221 (2004); Richard H. McAdams, _Signaling Discount Rates: Law, Norms and Economic Methodology_ , 110 YALE L.J. 625 (2001); Richard H. McAdams, _The Origin, Development, and Regulation of Norms_ , 96 MICH. L. REV. 338 (1997); Siegwart Lindenberg, _The Cognitive Side of Governance_ , 20 RES. IN THE SOC. ORGS 47 (2003); JEFFREY PFEFFER, COMPETITIVE ADVANTAGE THROUGH PEOPLE (1994); Bruce Kogut & Udo Zander, _Knowledge of the Firm, Combinative Capabilities, and the Replication of Technology_ , 3 ORG. SCI. 383, 389 (1992); Stewart Macaulay, _Non-Contractual Relations in Business: A Preliminary Study_ , 28 AM. SOC. REV. 55 (1963); Ian R. MacNeil, _The Many Futures of Contracts_ , 47 S. CAL. L. REV. 691 (1974). For a number of studies related to non-contractual behaviors _see_ Eleanor Westney, _Organizational Evolution of the Multinational Enterprise: An Organizational Sociological Perspective_ , 29 MGMT. INT’L REV.56 (1999); David Stark & Laszlo Bruszt, _Who Counts?: Supranational Norms and Societal Needs,_ 17 EAST EUR. POL. & SOCIETIES 74 (2003); Walter Powell, _Neither Market nor Hierarchy: Network Forms of Organizations_ , 12 RES. IN ORG. BEHAV. 295 (1990) (noting that non-contractual behaviors such as altruism, reputation, and friendship can replace ineffectual legal contracts).
> 129 Powell, _supra_ note 129, at 303.
130 Barclays’ issuance of contingent convertible bonds to its executives precipitated some recognition of the possible benefits. Hilscher & Raviv, for instance, recognize that the effects of contingent convertible bonds in executive compensation depend on the terms of the CCB. _See_ Jens Hilscher & Alon Raviv, _Bank Stability and Market Discipline: The Effect of Contingent Capital on Risk Taking and Default Probability_ , 24 (2011), available at http://www.brandeis.edu/global/pdfs/news/HilscherRavivPaper (showing that compensation with contingent convertible bonds can minimize risk-taking by managers).
> 131 _See_ Kaal, _supra_ note 14, at 295-96.
> 132 For a summary of the core themes in executive compensation proposals _see_ Hill, _supra_ note 21
(suggesting that the core themes in recent proposals are income inequality, incentive optimization, interest alignment, and sustainability).
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
# _1. Precedent Barclays_
The proposal in this article to use contingent capital bonds with early triggers in executive compensation is not a mere theoretical construct. European SIFIs have started to add contingent convertible bonds to executive compensation packages. The English bank, Barclays, has issued contingent capital securities to its executives as deferred incentive awards.<sup>133</sup> The contingent convertible bonds issued under Barclay’s Contingent Capital Plan (CCP), however, would not be written down or convert into equity like other CCBs. Under Barclays’s CCP, its “synthetic CoCos” simply lapse when the capital ratio falls below 7%.<sup>134</sup> More specifically, if Barclays’s Group Core Tier 1 capital ratio falls below the threshold, the executives will receive no coupon payment and the Contingent Capital Award (CCA) will remain unvested.<sup>135</sup> However, the unvested portion of the CCA can be released and paid out to the executives if after six months the Group Core Tier 1 capital ratio has recovered.<sup>136</sup> In order to take into account the possible effect of any actions taken to address the shortfall in the capital ratio on shareholders, the release may be adjusted. No coupon will be awarded if there was a downward adjustment.<sup>137</sup> Should the Group Core Tier 1 capital ratio not recover to above 7% five years after the suspension of the CCA, the CCA will lapse.<sup>138</sup>
Barclays’s contingent capital award to executives without a triggering event into equity and a mere lapse is beneficial because it underscores the possible use of contingent convertible bonds in executive compensation. Given European proposals on the use of contingent convertible bonds to make SIFIs safer and avoid bailouts,<sup>139</sup> Barclays
> 133 _See_ Rob Cox, _A Pay System That May Please_ , N.Y. TIMES, Dec. 6, 2010, at B2 (“CoCos would not merely constitute a compensation fig leaf. Throwing the securities into bankers’ stockings better aligns their interests with those of regulators hoping to avoid a repeat of the taxpayer bailouts of the last financial crisis.”); BARCLAYS ANNUAL REPORT, _supra_ note16, at 167 (stating that “deferred incentive awards for 2010 are made under the Share Value Plan (SVP) in the form of Barclays shares and under the Contingent Capital Plan (CCP) in the form of contingent capital awards.”) [hereinafter Barclays Annual Report]. 134 Email from Mark Lane of Barclays Capital to Wulf Kaal, Dec. 14, 2011, 3:52pm (on file with author). _See also_ Jill Treanor, _City Uneasy Over Proposed 'Coco' Bonuses for Barclays Executives_ , THE GUARDIAN, Mar. 18 2011, _available at_ http://www.guardian.co.uk/business/2011/mar/18/barclays-proposed-cocobonuses-executives ("The cocos Barclays intends to use to pay its staff do not convert into equity, however, but merely fall away once the bank's capital ratio falls below 7%."); _Barclays Heads for Investor Clash over Pay_ , REUTERS Apr. 26, 2011, _available at_
http://in.mobile.reuters.com/article/rbssFinancialServicesAndRealEstateNews/idINLDE73K0DP20110426? irpc=984; Jill Treanor, _Barclays Faces Investor Protests Over Bob Diamond's Pay Deal_ , THE GUARDIAN, Apr. 19, 2011, _available at_ http://www.guardian.co.uk/business/2011/apr/19/barclays-shareholders-protest (“Cocos are a new type of financial instrument that can convert into equity during times of severe stress and have been issued by a handful of banks to raise fresh capital from investors. Barclays, though, intends to issue the cocos only to its staff. The Barclays cocos will not convert into equity but merely fall away once the bank's capital ratio falls below 7% – which is why they are being called synthetic cocos.”); _Bankers and Their Bonuses_ , N.Y. TIMES, Feb. 5, 2011, _available at_ http://www.nytimes.com/2011/02/06/opinion/06sun2.html (“Cocos are long-term bonds that convert into equity if the bank hits a crisis. The idea is that paying bankers in bonds encourages them to keep the business solvent. This is even more so if a crisis triggers their conversion into shares that would become worthless in bankruptcy.”); Barclays Annual Report, _supra_ note 16.
> 135 Barclays Annual Report, _supra_ note 16.
> 136 _Id_ .
> 137 _Id_ .
> 138 _Id_ .
> 139 _Commission Proposal for a Directive of the European Parliament and of the Council Establishing a_
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
contingent convertible bond issuance to executives may also signal its willingness to consider the possible uses of contingent convertible bonds to prepare the entity for future crises and systemic shocks. As the first mover in this context, it is also understandable that Barclays has decided to avoid the possible governance shakeup that could be associated with a contingent convertible bond issuance that provides a conversion feature.
Barclays issuance is commendable. Barclays’s CCA, as a deferred compensation award, is inside debt _._ Unlike inside debt in the form of traditional bonds, however, it does not create a fixed claim for managers with a stake in the firm’s liquidation value because it falls away when converted.<sup>140</sup> Barclays’s CCA, therefore, also does not lower agency cost. Without a stake in the liquidation value of the SIFI, executives may also not limit their risk-taking. Barclays’ executives’ interests are aligned with their debt holders because executives are now also debt holders, albeit in a separate class with substantially higher coupon payments. However, because the CCA fall away upon conversion, the executives’ interests are still predominantly aligned with shareholders through equitybased compensation, not through contingent convertible bonds holdings.<sup>141</sup>
Barclays’s issuance of contingent convertible bonds without a conversion feature to its executives shows limited governance improvements. Without a conversion to equity, Barclays provides only limited incentives for its executives to lower risk-taking. In its current form, the CCA seems to be a mere compensation supplement for executives.
_Framework for the Recovery and Resolution of Credit Institutions and Investment Firms and Amending Council Directives 77/91/EEC and 82/891/EC, Directives 2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC and 2001/35/EC and Regulation (EU) No 1093/2010,_ COM (2012) 280/3, _available at_ http://ec.europa.eu/internal_market/bank/docs/crisis-
management/2012_eu_framework/COM_2012_280_en.pdf; Alex Barker & Brooke Masters, _Brussels Looks to Bank Investors Not Taxpayers_ , FIN. TIMES, June 6, 2012, _available at_ http://www.ft.com/cms/s/0/f94b6432-afeb-11e1-ad0b-00144feabdc0.html#axzz1xDA7jik4 ("The Reform blueprint gives national Regulators summary power to write down unsecured creditors in failing banks and establish a network of national funds to cover resolution costs…"); Gareth Murphy, Mark Walsh & Matthew Willison, _Precautionary Contingent Capital_ (Bank of England Financial Stability Paper No. 16, 2012), _available at_ http://www.bankofengland.co.uk/publications/Documents/fsr/fs_paper16.pdf (“replacing debt with contingent capital could encourage risk-shifting behaviour.”); George M. von Furstenberg, _Contingent Capital to Strengthen the Private Safety Net for Financial Institutions: Cocos to the Rescue_ ? 10 (Deutsche Bundesbank Discussion Paper No. 01/2011, 2011), _available at_ http://www.bundesbank.de/Redaktion/EN/Downloads/Publications/Discussion_Paper_2/2011/2011_02_07 _dkp_01.pdf?__blob=publicationFile (“This is the same year in which LBG later managed to launch a greatly oversubscribed cocos issue of “Enhanced Capital Notes” (ECNs), for almost £9 billion (worth $15 billion).”).
140 Contrast this outcome with the proposal in this article to use contingent convertible bonds with early triggers in executive compensation _see infra_ Part V. 2. b) (showing that contingent convertible bonds with early triggers can lower agency costs more than traditional inside debt; that they provide greater incentives to lower risk-taking, that they align executives’ interest with both debt holders and shareholders, and that they lower income inequality).
> 141 _See infra_ Part V. 2. b) (explaining how contingent convertible bonds in executive compensation align the interests of executives with debt holders’ interests before conversion while increasing incentives for sustainability and lowering risk-taking and income inequality. Conversely, upon conversion into equity, contingent convertible bonds in executive compensation align executives’ interests with the interests of equity holders when it is most needed and beneficial for the SIFI, i.e. early before the entity becomes insolvent.).
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
_2. Design of Contingent Convertible Bonds in Executive Compensation_
Contingent convertible bonds issued to investors can have corporate governance implications as a result of the conversion feature and the threat of equity dilution following a conversion.<sup>142</sup> Issuing contingent convertible bonds to executives as part of their compensation can have different governance implications. Perhaps most important for this article is contingent capital’s ability to generate powerful incentives for SIFI managers and thereby lower their risk-taking.<sup>143</sup> This applies to contingent convertible bond issuances to investors,<sup>144</sup> but also, and more importantly, to the issuance of contingent capital to executives as part of their compensation.
Designing contingent convertible bonds in executive compensation like contingent convertible bonds issued to investors could result in suboptimal outcomes. Unlike contingent convertible bonds issued to investors, contingent convertible bonds may be issued to executives in volumes that may not suffice to dilute investors’ equity holdings. The lower volume of contingent convertible bonds issued to executives may not provide a sufficiently strong equity infusion during a crisis. Without a design adjustment, contingent convertible bonds held by executives may not play a significant role in preparing SIFIs for future financial crises. Contingent convertible bonds in executive compensation should not be treated like other contingent capital securities. The design adjustment proposed in this article helps to optimize the effectiveness of contingent convertible bonds in executive compensation and can improve corporate governance.
# a) Automatic Institution-Specific “Early” Trigger
The literature on contingent capital trigger designs focuses on the efficient calibration of triggering events.<sup>145</sup> The efficient calibration of triggering events is central to the design of contingent capital because the trigger affects if and when the conversion
> 142 _See_ Kaal, _supra_ note 14.
> 143 Kaal, _supra_ note 14; Coffee, _supra_ note 9, at 806; Dudley, _supra_ note 89 (“If the bank encounters difficulties, triggering conversion, shareholders would be automatically and immediately diluted. This would create strong incentives for bank executives to manage not only for good outcomes on the upside of the boom, but also against bad outcomes on the downside.”).
> 144 _See_ Kaal, _supra_ note 14.
145 _See_ McDonald, _supra_ note 13; Pennacchi, _supra_ note 13; Pennacchi et al., _supra_ note 91; Squam Lake Working Group, _supra_ note 90, at 4 (2009); Suresh Sundaresan & Zhenyu Wang _, Design of Contingent Capital with a Stock Price Trigger for Mandatory Conversion_ 4 (Fed. Reserve Bank of N.Y., Working Paper, Apr. 30, 2010), _available at_
http://www.newyorkfed.org/research/economists/wang/BankDebtTrigger.pdf _;_ Coffee, _supra_ note 9. _See also_ Duffie, _supra_ note 94; Flannery, _supra_ note 88; Flannery No Pain, _supra_ note 88, at 30; Paul Glasserman & Behzad Nouri, _Contingent Capital with a Capital-Ratio Trigger_ (Working Paper, Aug. 31, 2010), _available at_ http://ssrn.com/abstract=1669686; Ceyla Pazarbasioglu et al., _Contingent Capital: Economic Rationale and Design Features_ , IMF STAFF DISCUSSION NOTE 18 (Jan. 25, 2011), _available at_ http://www.imf.org/external/pubs/ft/sdn/2011/sdn 1101.pdf; FINANCIAL STABILITY BOARD, KEY ATTRIBUTES OF EFFECTIVE RESOLUTION REGIMES FOR FINANCIAL INSTITUTIONS 1, 9-10 (Oct. 2011), _available at_ http://www.financial stabilityboard.org/publications/r_111104cc.pdf; Goldman Sachs, _supra_ note 12, at 4; SWEDISH MINISTRY OF FINANCE ET AL., SWEDISH ANSWERS TO THE DG INTERNAL MARKET AND SERVICES WORKING DOCUMENT “TECHNICAL DETAILS OF A POSSIBLE EU FRAMEWORK FOR BANK RECOVERY AND RESOLUTION” 1, 43 (2011), _available_
_at_ http://www.riksbank.se/Upload/Dokument_riksbank/Kat_publicerat/Remisser/2011/Consultation_03031 1.pdf. [hereinafter Swedish Ministry of Finance]
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
takes place. The timing of conversion is crucial for possible corporate governance improvements.
The early trigger for contingent convertible bonds held by executives serves a different purpose than the trigger for contingent convertible bonds held by investors. The early trigger converts only the portion of executives’ debt to equity, before investors’ contingent convertible bonds are converted, when the entity is still sound on a micro prudential basis. The purpose of an “early” or “strong” trigger design for CCB held by executives is to establish an early warning system<sup>146</sup> that is independent of the capitalization needs of the entity<sup>147</sup> and to provide corporate governance improvements. To ensure that the early warning objective of the early trigger is accomplished, it is important to distinguish between the two general categories of triggers discussed in the literature: (i) regulatory triggers and (ii) transactional and automatic triggers.<sup>148</sup>
Regulatory triggers give regulators the authority to decide when to convert the contingent convertible bonds. The regulatory trigger may depend on a regulator’s determination that the respective bank is not viable without a public sector injection of capital or a write-off.<sup>149</sup> It can also be based on the evaluation of a bank during a stress test conducted by regulators.<sup>150</sup> Regulatory triggers may lead to market uncertainty and ad hoc decisions by regulators and result in adverse market responses. Because regulatory triggers generate the highest level of uncertainty,<sup>151</sup> they may not be the best option for the design of contingent convertible bonds in executive compensation. Regulatory discretion in triggering the conversion could create unfavorable market movements against the entity. While a regulator may decide to trigger executives’ CCBs as an early warning sign in a pending crisis, the cost of supervision could be prohibitive and regulatory discretion could alienate managers. Similarly, even though a regulatory trigger could help avoid abuse by executives,<sup>152</sup> regulatory triggers may insufficiently incentivize executives to lower risk because the executives would not have to selfmonitor and adjust their risk-taking preferences to avoid the trigger.
Transactional triggers, which are also called institution-specific triggers, are privately negotiated terms for triggering events in bond contracts. They have the advantage of being flexible and tailored to the parties’ subjective needs.<sup>153</sup> Automatic
> 146 The early warning nature of the early trigger design and the fact that only the executives’ portion of CCBs gets converted to equity could make it easier for the SIFI to negotiate bridge loans because the entity is still sound on a micro-prudential basis. If investors’ CCBs get triggered, some lenders may be unwilling to provide bridge loans. In effect, the early trigger could help avoid a scenario in which lenders who could help ensure the financial future of the entity turn away from the company when a large portion of its debt is converted into equity.
> 147 The benefit of providing additional capital when needed derives predominantly from the conversion of contingent convertible bonds issued to investors, not the portion of contingent convertible bonds issued to executives.
> 148 _See_ Christoph K. Henkel & Wulf A. Kaal, _Contingent Capital in European Union Bank Restructuring,_
> 32 NW. J. INT'L L. & BUS _._ 191, 256 (2012).
> 149 _See_ Goldman Sachs, _supra_ note 12.
> 150 _Id._
> 151 _Id. See_ Graph 1 (suggesting that a regulatory systemic trigger “can be a trigger that converts CCS into equity upon, for instance, a regulator’s decision that additional capital is needed.”).
> 152 _See infra_ Part V. 3.
> 153 _Id_ . _See also_ Swedish Ministry of Finance, _supra_ note 145 (favoring contractual trigger and arguing contractual trigger should come before statutory trigger).
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
triggers are mostly privately negotiated terms in bond contracts that convert debt into equity when a certain capital ratio, stock price, CDS spread, index value, or other trigger is reached.<sup>154</sup> Because institution-specific automatic triggers are flexible and independent from regulatory discretion, they constitute a good option for early trigger designs. However, market-based measures may be susceptible to market manipulation and banking runs.<sup>155</sup> Accounting-based measures in institution-specific automatic triggers are arguably too infrequently updated to respond adequately in a financial crisis.
Early triggers for contingent convertible bonds in executive compensation could yield particular benefits if they convert to equity before the contingent convertible bonds that were issued to investors.<sup>156</sup> Early triggers could be based on various combinations of design features<sup>157</sup> including perhaps already existing designs of previously issued contingent convertible bonds to investors. An entity that has issued contingent convertible bonds to investors could simply lower the executives’ trigger threshold in contrast with that of the CCBs that were issued to investors.<sup>158</sup> In the case of automatic institution-specific triggers, lowering the trigger could be accomplished by adjusting the capital ratio, stock price, CDS spread, index value, or other triggering event for the executives’ CCBs to cause the conversion at an earlier point during the financial weakening of the respective entity.<sup>159</sup>
In the case of contingent convertible bonds with a capital-ratio trigger,<sup>160</sup> an “early” trigger for executives’ contingent convertible bonds could mean a 10% capital ratio whereas the “late” trigger for the contingent convertible bonds of investors could be
> 154 Coffee, _supra_ note 9, at 831; Flannery, _supra_ note 88, at 11–12; Flannery No Pain, _supra_ note 88, at 30 (“Frequent trigger evaluations eliminate moral hazard incentives and expose the RCD to surprisingly low default risk.”); McDonald, _supra_ note 13, at 2 (proposing “a form of contingent capital for financial institutions that converts from debt to equity if two conditions are met: the firm’s stock price is at or below a trigger value and the value of a financial institution’s index is also at or below a trigger value.”); Glasserman & Nouri, _supra_ note 145.
> 155 _See supra_ note 154.
> 156 _See infra_ Part V. 2. b).
> 157 _See_ Kaal & Henkel, _supra_ note 14, at 251-252 (evaluating various designs and suggesting a sequential trigger design with a first trigger that converts CCBs into equity when the SIFI is still sound on a microprudential basis but encounters early signs of financial weakening and a second trigger that increases the voting rights of CCB holders after conversion into equity if the SIFI does not recover after the contingent convertible bonds induced equity infusion) If contingent convertible bonds are issued to executives as part of a contingent convertible bond issuance with a sequential trigger design, the design should be adjusted to avoid potential abuse by executives. Executives may use the early trigger to obtain cheap stock in a crisis. Executives’ portion of the contingent convertible bond issuance should include a mandatory holding period of at least five years after conversion. Because executives’ interests could be adverse to those of CCB investors, executives’ portion of the CCB issuance should not include a voting rights increase.
> 158 Problems with trigger mechanisms have been discussed at length in the literature. _See_ Coffee, _supra_ note 9, at 827-829. Accounting-based measures may not be adequately responsive and may be too infrequently updated to respond effectively in a financial crisis. Market-based measures may be susceptible to market manipulation and banking runs. Regulatory triggers may lead to ad hoc decisions by regulators that result in market uncertainty and adverse market responses.
159 Although it may be difficult to calibrate the trigger to provide for a specific time period before the conversion of investors’ CCB, the early trigger should give sufficient warning of the weakening financial condition of the entity.
160 The capital ratio of an entity is the percentage of the entity’s capital to its risk-weighted assets. For a discussion of contingent capital with a capital-ratio trigger and partial and on-going conversion _see_ Glasserman & Nouri, _supra_ note 145.
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
around 8%.<sup>161</sup> Regulatory capital requirements and industry standards for SIFIs or other banks that are categorized as “well-capitalized” may change over time.<sup>162</sup> To be effective, early triggers should be well above the threshold for capital requirements under Basel III.<sup>163</sup> But early triggers in the form of capital ratios should be independent of regulatory demands pertaining to capitalization levels.
# b) The Benefits of “Early” Triggers
Automatic institution-specific early triggers for contingent convertible bonds issued to executives may increase the overall effectiveness of these bonds and improve executive compensation policies.<sup>164</sup> The benefits of early triggers may partially depend on whether the entity issues contingent convertible debt only to executives or to executives and investors.<sup>165</sup> The early trigger for the portion of contingent convertible bonds held by executives can be an early warning system and buffer for contingent convertible bond investors and shareholders.<sup>166</sup> Early triggers in contingent convertible bonds issued to executives provide several advantages; they lower risk-taking by executives and increase shareholder monitoring. They also offer a better signal for default risk and align executives’ interests with a more diverse group of constituents.<sup>167</sup>
Studies have shown that executives who hold more debt relative to their equity holdings take fewer risks when managing an entity.<sup>168</sup> Increasing the debt portion of
161 This is just a numerical example that does not take other factors into account. The purpose of this article is not to suggest specific design features for “early” triggers. Rather, the purpose here is to show that the nature of ownership can have an impact on trigger designs and their potential to improve corporate governance.
> 162 The recognition of contingent capital as Tier I Capital ( _see_ Kaal & Henkel, _supra_ note 14, at 240) and the capital adequacy standards under Basel III may also influence the adequacy of an early trigger for contingent convertible bonds held by executives.
163 Under Basel III banks will have to hold better quality capital. Banks will have to hold minimum capital representing 8% of risk-weighted assets (RWA) as well as an additional capital buffer of 2.5% of RWA, whereby 7% must be comprised of Tier 1 common equity. BASEL COMMITTEE ON BANKING SUPERVISION, BANK FOR INT’L SETTLEMENTS, BASEL III: A GLOBAL REGULATORY FRAMEWORK FOR MORE RESILIENT BANKS AND BANKING SYSTEMS 1, 55 (Dec. 2010), _available at_ http://www.bis.org/publ/bcbs189.pdf 164 _See infra_ Part V.
165 Issuing contingent convertible bonds to investors and executives with the same design features creates a risk of management opportunism if managers are heavily involved in the drafting process. Management opportunism can lead to socially suboptimal designs. _See infra_ Part V. 3. (elaborating on design features to prevent abuse).
166 Investors would be able to anticipate a possible conversion of their CCBs if the early trigger resulted in a conversion of executives’ CCBs. The warning and signaling function of early triggers would benefit CCB investors and shareholders of the entity that may be faced with a level of dilution if the investors’ CCBs are converted to equity.
167 These benefits could help make contingent convertible bonds generally more marketable. In the United States, for example, many investors still perceive contingent convertible bonds as a hybrid instrument that does not display enough attractive features despite a substantial coupon rate. The early trigger design of CCBs issued to executives could help signal the entity’s intent to address default risk and systemic risk, to lower risk incentives, to align executives’ interests with creditor interests, and to increase monitoring and other corporate governance improvements. This could generate increased investor interest and help create a market for contingent convertible bonds in the United States.
> 168 Edmans & Liu, _supra_ note 81; Tung & Wang, _supra_ note 8, at 1; Wei & Yermack, _supra_ note 8; Sundaram & Yermack, _supra_ note 8; Joseph Gerakos, _supra_ note 8(finding that pension benefits may reduce risk taking). Other studies reject the idea that corporate governance and executive compensation could be correlated _see_ Core et al., _supra_ note 8; Dorff, _supra_ note 8; Johnson et al., _supra_ note 8; Carter &
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
executive compensation packages with contingent convertible bonds can help lower managers’ risk incentives.<sup>169</sup> This effect could be even more pronounced depending on the proportion of CCBs included in the total compensation of executives. However, path dependencies in the executive compensation culture in the United States will likely make it difficult for executive compensation policies to move entirely to contingent convertible bonds or other debt instruments. It is more likely that compensation committees will continue to combine debt instruments with equity-based compensation.
The conversion of contingent convertible bonds from debt to equity, if triggered, would mean that executives hold a highly discounted equity interest in the entity.<sup>170</sup> This may in turn depress the stock price of the respective entity.<sup>171</sup> A negative effect on the stock price of the entity may lower the value of the equity-portion of executives’ compensation package.<sup>172</sup> The conversion, thus, not only affects the debt portion of executives’ compensation but also the equity portion after the contingent convertible bonds portion is converted and when equity is increasingly important to maintain the overall value of executive compensation.<sup>173</sup> The combined effect could be a strong
Lynch, _supra_ note 8 (finding no relationship between institutional ownership and the repricing decision). _See also_ Anderson & Bizjak, _supra_ note 8; Kam-Ming Wan, _supra_ note 8 (finding “no systematic evidence that board composition affects change in CEO compensation”).
> 169 Edmans & Liu, _supra_ note 81 (justifying the use of debt as efficient compensation and arguing that a debt bias can improve effort as well as deter risk shifting); Tung & Wang, _supra_ note 8 (stating that their empirical evidence provides a rationale for the use of inside debt compensation in structuring executive compensation in the banking context); Riccardo Calcagno & Luc Renneboog, _The Incentive to Give Incentives: On the Relative Seniority of Debt Claims and Managerial Compensation_ , 31 J. OF BANKING & FIN. 1795 (2007) (arguing that the increase in the leverage of Anglo-American corporations has stimulated the interest in the role of debt as a direct incentive device for the management to generate stronger corporate performance and showing that including risky debt in the capital structure changes the “incentive to give incentives” by a principal in charge of managerial contracts); Alex Edmans, _How to Fix Executive Compensation: For Starters, Don't Link Pay Packages Just to Stock; Tie Them to Debt as Well_ , WALL ST. J., Feb. 27, 2012, at R.1; Bolton, Mehran, & Shapiro, _supra_ note 18 (suggesting that debt-like compensation for executives is believed by the market to reduce risk for financial institutions); Sallie Krawcheck, _Four Ways to Fix Banks_ , 90 HARV. BUS. REV. 106 (2012) (suggesting that top executives be paid with bank debt instead of just stock and stock options, to give them more incentive to worry about risk); Cassell et al., _supra_ note 8 (arguing that CEOs with large inside debt holdings will display lower levels of risk-seeking behavior); Hernan Ortiz-Molina, _Executive Compensation and Capital Structure: The Effects of Convertible Debt and Straight Debt on CEO Pay_ , 43 J. OF ACCT. & ECON. 69 (2007) (arguing that the hypothesis that debt reduces manager-shareholder conflicts can explain some but not all of the results); Listokin, _supra_ note 81 (proposing a novel bankruptcy compensation plan, otherwise known as debt compensation, that is expected to provide better incentives for CEOs to perform efficiently).
> 170 On the potential for abuse _see infra_ note 191 and accompanying text.
171 Depending on financial institutions’ implementation of contingent convertible bonds and the evolution of the market in CCBs, the potential effect of CCB conversion on stock prices may be evaluated in future research. _See_ Sundaresen & Wang, _supra_ note 145 (suggesting that under their design of contingent capital, where the state-contingent conversion ratio prevents value transfer, the prices would be kept “‘smooth’ at conversion.”).
172 This effect would be multiplied if the design of early CCB triggers also prohibited the exercise of stock options in anticipation of the early trigger and after the triggering event. It could be technically difficult to delineate what “in anticipation of the early trigger” means. Defining a suitable time period for the prohibition before the early trigger could be equally difficult.
173 There is a risk that opportunism may lead managers to increase the risk profile of the entity after conversion to regain the lost equity value in their portfolio. However, such action is not likely to occur because an increase in the risk profile would affect the ability of the entity to obtain other forms of financing such as bridge loans. The increase in the risk profile after conversion is also improbable because
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
incentive for executives to take lower risks in order to avoid the triggering event.<sup>174</sup> The implicit reduction in agency costs<sup>175</sup> may be difficult to measure without actual implementation. The early conversion feature does not only create incentives for managers to lower their risk-taking; indeed, the implicit threat of financial loss for all contingent convertible bond investors in combination with the threat of dilution to existing shareholders could create overall increased pressure on managers to avoid the conversion of any portion of CCB, including the conversion of investors’ CCBs.
The issuance of contingent convertible bonds with early triggers to executives may motivate shareholders, CCB investors, and other creditors to increase their monitoring. Because of an implicit expectation that the government will provide bailout funding due to the nature of the entity, ordinary SIFI creditors may have suboptimal incentives to monitor the performance of management.<sup>176</sup> These incentives may change if a SIFI issues contingent capital securities with a conversion feature for investors and with an early conversion feature for its executives.<sup>177</sup> Should the conversion of executives’ contingent convertible bonds occur, investors’ CCBs would likely be next in line for
the early conversion will likely increase monitoring by contingent convertible bond investors and shareholders. Many boards may decide to let managers go upon the occurrence of an early trigger. 174 Managing to avoid the triggering event alone may be possible by ignoring the other interests of various constituents. However, this article does not attempt to provide a holistic approach to corporate governance reform in SIFIs.
175 For purposes of this article, agency cost is defined as the cost for the corporation as principal to supervise its executives as agents and protect against their opportunism. Executive compensation agreements can be seen as attempts to reduce agency costs. _See_ Jensen & Murphy, _supra_ note 7, at 138, 139–40 (executive compensation agreements and compensation awards are mostly attempts by the principal to minimize agency costs, i.e. minimize their agents’ opportunism and tendency to be risk averse, to invest in suboptimal or idiosyncratic projects, to shirk etc.); Bebchuk & Fried, _supra_ note 64, at 61-62. Agency cost may have played a minor role in the case of Barclays’ Contingent Capital Award (CCA) program because the CCA falls away if it gets triggered.
> 176 Bebchuk & Spaman, _supra_ note 2, at 266-67. Unlike many other corporations, SIFIs are subject to a high probability of default and high leverage. Because insured depositors, a large part of SIFI creditors, are insured by the government, insured depositors have fewer incentives to monitor SIFI performance. Indeed, the government is in effect the primary creditor of the SIFI, which creates moral hazard problems for SIFI management. Julian T.S. Chow and Jay Surti, _Making Banks Safer: Can Volcker and Vickers Do It?_ 3 (IMF Working Paper No. 11/236, 2011), _available at_
http://www.bankofengland.co.uk/publications/Documents/events/ccbs_workshop2012/paper_SurtiChow.P DF; Margaret M. Blair, _Financial Innovation, Leverage, Bubbles and the Distribution of Income_ , 30 REV. BANKING & FIN. L. 225, 229 (2011); David Jones, _Emerging Problems with the Basel Capital Accord: Regulatory Capital Arbitrage and Related Issues_ , 24 J. BANKING & FIN. 35 (2000); Arthur E. Wilmarth Jr., _Reforming Financial Regulation to Address the Too-Big-To-Fail Problem_ , 35 BROOK. J. INT’L L., 707 (2010); Arthur E. Wilmarth Jr. _Narrow Banking: An Overdue Reform that Could Solve the Too-Big-To-Fail Problem and Align U.S. And U.K. Regulation of Financial Conglomerates_ (GWU Legal Studies Research Paper No. 2012-40, 2012), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2050544; Jeffrey Gordon & Colin Mayer, _The Micro, Macro and International Design of Financial Regulation_ 7 (2011), _available at_ http://www.ecgi.org/ceo/2012/documents/unrestricted/Mayer%20Gordon.pdf (stating that “government securities are far less secure than was previously thought and in the process of seeking to rescue financial institutions, governments may undermine the security of the assets that they have required their banks to hold.”).
177 Once a SIFI has issued contingent convertible bonds with conversion features, creditors are likely to be aware of the triggering events in the executives’ portion of CCBs because it becomes public information. If a SIFI issues CCBs, its intent is likely to avoid future bailouts. Creditors would be aware of the SIFI’s intent and the measures taken to avoid a bailout and may be less likely to rely on future bailouts.
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
conversion.<sup>178</sup> In effect, the conversion of the contingent convertible bonds issued to executives provides early notice to investors that their CCBs may also convert into equity unless they address the underlying issues. Accordingly, managers would likely be subjected to increased scrutiny by investors who fear the conversion of their contingent convertible bonds into near worthless equity. Shareholders who fear the loss of their entire investment should the entity go into bankruptcy may also put managers under increased pressure to lower their risk-taking.<sup>179</sup> The impending threat of dilution for existing shareholders due to the possible conversion of the contingent convertible bonds held by investors may motivate existing shareholders to get actively involved in the governance of the entity.<sup>180</sup> Shareholder voting on management proposals to address perceived concerns could increase. The implicit threat of financial loss for all contingent convertible bonds investors in combination with the threat of dilution to existing shareholders could create overall increased pressure on managers to avoid the conversion of any portion of the CCBs.
Early triggers for contingent convertible bonds in executive compensation packages may increase and optimize the signaling of default risk at a time when the risk of default is present but still somewhat remote. Various existing measures signal default risk.<sup>181</sup> Early triggers in executive compensation, however, signal an entity’s default risk
178 The proximity of conversion of executives’ CCBs and investors’ CCBs will depend on the trigger design. If the entity uses an institution-specific early automatic trigger based on a capital ratio for executives’ CCBs and a similar trigger with a less aggressive triggering threshold for investors’ CCBs, the proximity of conversion would depend on the difference in capital ratio in the respective trigger designs of executives’ CCB and investors’ CCBs.
179 A possible downside of early conversion as a warning signal could be added pressure on the stock price, which could have negative effects in a pending crisis.
> 180 On the need for increased shareholder governance _see_ Lucian Bebchuk, _The Case for Increasing Shareholder Power,_ 118 HARV. L. REV. 833 (2005) (arguing that increased shareholder democracy will improve corporate governance and enhance managerial accountability, thereby curbing abuses of authority and misconduct); Lucian A. Bebchuk & Assaf Hamdani, _Federal Corporate Law: Lessons from History_ , 106 COLUM. L. REV. 1793, 1804 (2006) (“With stock ownership divided among many owners, shareholders have little incentive to exert effort to monitor management and actively intervene in corporate decisionmaking.”); Bernard S. Black, _Shareholder Passivity Reexamined_ , 89 MICH. L. REV. 520, 530-66 (1990) (providing an overview of various legal obstacles to shareholder action).
> 181 Existing signaling mechanisms for default risk, such as credit default swap pricing and CAMEL ratings, do not seem to have provided sufficient protection for SIFIs during the past crisis. CAMEL ratings and credit default swap pricing did not suffice to signal default risk in the cases of Lehman Brothers, Bear Stearns, and Merrill Lynch. _See generally_ Tao Sun, _Identifying Vulnerabilities in Systemically-Important Financial Institutions in a Macro-Financial Linkages Framework_ (IMF Working Paper No. 11/111, 2011), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1848543; Aline Darbellay & Frank Partnoy, _Credit Rating Agencies and Regulatory Reform_ , in RESEARCH HANDBOOK ON THE ECONOMICS OF CORPORATE LAW (2012). Although CAMEL ratings may reach the public through bank financial statements and other disclosures made after a downgrade, CAMEL ratings are only released to top management. _See_ A.N. Berger & S.M. Davies, _The Information Content of Bank Examinations_ , 14 J. FIN. SERVICES RES. 117-144 (1994); J.S. Jordan, J. Peek & E.S. Rosengren, _The Impact of Greater Bank Disclosure Amidst a Banking Crisis_ (Fed. Res. Bank of Bos., Working Paper No. 99-1, 1998), _available at_ http://www.bos.frb.org/economic/wp/wp1999/wp99_1.pdf; D.P. Morgan, _Judging the Risk of Banks: What Makes Banks Opaque?_ (Fed. Res. Bank of N.Y., Working Paper No. 98-05, 1998), _available at_ http://www.newyorkfed.org/research/staff_reports/research_papers/9805.pdf; R. Alton Gilbert, _Federal Reserve Lending to Troubled Banks During the Financial Crisis, 2007-10_ 9 (Fed. Res. Bank of St. Louis Working Paper No. 2012-006A, 2012), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2038578&download=yes. There is also some evidence
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
much sooner than previously proposed triggers for contingent convertible bonds issued to investors and other mechanisms. The benefits of this early default signal include more time for managers to (1) adjust to the current market conditions, (2) lower their risktaking, and (3) deleverage in a comparatively liquid market environment. The improved signaling of default risk through the early conversion of executives’ CCBs may help address the systemic risks that SIFIs pose. Early triggers in CCBs, when used in executive compensation, can improve the core function of CCBs, i.e. lowering systemic risk.
The hybrid nature of contingent convertible bonds and the early conversion from debt to equity aligns the interests of executives equally with creditors and shareholders.<sup>182</sup> Before the unlikely but theoretically possible conversion into equity, contingent convertible bonds in executive compensation align the interests of executives with holders of traditional debt and debt in the form of contingent convertible bonds. Because executives would be holding securities with long-term maturities and coupon payments, executives would have incentives to manage the company with the interests of debt holders in mind.<sup>183</sup> How well these incentives work may depend on the proportion of debt 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
that on-site bank exams can provide additional information beyond what is publicly available _see_ R. DeYoung, M.J. Flannery, W.W. Lang, & S.M. Sorescu, _The Informational Advantage of Specialized Monitors: The Case of Bank Examiners_ (Fed. Res. Bank of Chi., Working Paper No. 98-4, 1998), _available at_ http://www.chicagofed.org/digital_assets/publications/working_papers/1998/wp98_4.pdf. CAMEL ratings also may require on-site examinations to verify the accuracy of reports and to gather further supervisory information _see_ Jose A. Lopez, FRBSF Economic Letter 99-19; June 11, 1999 _available at_ http://www.frbsf.org/econrsrch/wklyltr/wklyltr99/el99-19.html _. See also_ Bolton, Mehran & Shapiro _, supra_ note 18 (suggesting a reduction in excessive risk-taking by tying CEO compensation to the financial firm’s credit default swap spread; a high CDS results in lower compensation and vice versa).
> 182 Traditionally, because shareholders elect directors and senior executives play a major role in this process, executives’ interests were aligned with shareholder interests. _See_ Bebchuk & Fried, _Pay Without Performance: Overview of the Issues,_ 30 J. CORP. L. 647, 655-56 (2005) (showing the enormous influence CEOs can have in the election of directors and other governance issues). The emphasis on equity-based instruments in executive compensation made a large proportion of executives’ compensation dependent on stock performance, which also aligned executives’ interests with those of shareholders. _See e.g._ Lisa K. Meulbroek, _The Efficiency of Equity-Linked Compensation: Understanding the Full Cost of Awarding Executive Stock Options_ , 30 FIN. MGMT.5 (2001) (“Finance theory has long made the case for the use of equity-linked compensation plans as an effective means to align managers' incentives with those of shareholders. In the last decade, finance practice, particularly in the United States, has embraced this prescription, with stock-options and restricted-stock plans forming a vastly increased proportion of senior management's total compensation.”); Michael C. Jensen and Kevin J. Murphy, _Performance Pay and TopManagement Incentives_ , 98 J. POL. ECON. 225 (1990) (estimating the magnitude of the various mechanisms through which compensation policy can provide value-increasing incentives, including performance-based bonuses and salary revisions, stock options, and performance-based dismissal decisions); Core, Guay & Larker, _supra_ note 18 (synthesizing the broad literature on equity compensation and executive incentives, and highlighting topics that seem especially appropriate for future research). _Cf._ Guido Ferrarini & Maria Cristina Ungureanu, _Economics, Politics, and the International Principles for Sound Compensation Practices: An Analysis of Executive Pay at European Banks,_ 64 VAND. L. REV. 431, 460 (2011). Without a substantial portion of compensation in the form of debt instruments, managers may give into shareholder pressure to take higher risks for higher returns.
183 Managing the entity in the interest of debt holders has implications for risk-taking, income inequality, and the sustainable development of the entity _see infra_ Part VI. (discussing the impact of the proposed design on income inequality and sustainability).
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
sustainable development as a result of the interest alignment between managers and debt holders and managers’ changed incentives.<sup>184</sup> Because the early trigger for executives’ contingent convertible bonds also protects shareholders and their interest in the continuing existence of the entity,<sup>185</sup> executives’ interests may be equally aligned with shareholders<sup>186</sup> at a time when it is most needed.<sup>187</sup>
If contingent convertible bonds replace a portion of equity-based compensation, contingent convertible bonds could lower income inequality<sup>188</sup> and increase sustainability. If financial institutions begin using CCBs in executive compensation packages, depending on the calibration of the packages, the replacement of equity-based compensation with contingent convertible bonds could lower the overall compensation of executives. Although contingent convertible bonds would likely pay a substantial coupon rate,<sup>189</sup> the return for executives would likely be incomparable with the return attainable with stock options and other equity-based compensation. If stock options are replaced with CCBs, not only would the total compensation for executives be lowered; shorttermism and executives’ focus on quarterly stock price performance would also be disincentivized. Executives are more likely to consider the sustainable development of the entity when stock price appreciation no longer directly benefits them personally. However, it is important to note that path dependencies in the executive compensation culture<sup>190</sup> in the United States could make the lowering of overall compensation for
184 Given that the average tenure of executives in the United States is less than seven years, interest alignment between managers and debt holders could be limited. However, debt in executive compensation could help shift executives’ management increasingly to a long-term perspective. Managing for the longterm, in turn, could translate into longer tenures for executives. Discussing the increasing turnover rate of CEOs in the United States _see e.g._ Steven Kaplan & Bernadette Minton, _How Has CEO Turnover Changed?,_ 12 INT’L REV. FIN. 57 (2012), _available at_
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=924751 (stating that a study of CEO tenure reveals that turnover from 1992 to 2007 was 15.8%, implying an average tenure as CEO of less than 7 years. Since 2000, total CEO turnover increased to 16.8%, implying an average tenure of less than 6 years); _The Doofus Factor: How Can You Tell a Good Board of Directors from a Bad One?_ ECONOMIST, Sept. 17, 2011, _available at_ http://www.economist.com/node/21529101(“During the past decade the average tenure of chief executives has fallen to 6.6 years from 8.1 years, according to a recent study by Booz & Co, a consultancy.”).
> 185 _See supra_ Part VI. (elaborating on improved incentives for lowering risk, improved signaling of default risk, and improved monitoring).
186 Regardless of compensation policies, the strong relationship between managers and shareholders will likely endure. It is unlikely that firms will compensate managers entirely with debt. 187 The early trigger design could help align the interests of the two most powerful constituents in a financial institution at a time when it is most needed. Because executives become equity holders at a time when their actions should be most aligned with equity holders’ interests, i.e. early before a possible insolvency of the entity, the early trigger design enables a shift in executive compensation and a corresponding interest alignment when it is most needed. Although the interests of managers are likely to be more aligned with those of shareholders, executives who hold hybrid securities may be incentivized to manage for the long-term and sustainable development of the entity and avoid volatility.
> 188 _See_ Brett H. McDonnell, _Two Goals for Executive Compensation Reform_ , 52 N.Y.L. SCH. L. REV. 586 (2007).
> 189 _See supra_ note 97 and accompanying text (discussing the coupon rate of between 7% and 9.2% paid by previously issued CCBs).
> 190 _See generally_ Lucian A. Bebchuk & Mark J. Roe, _A Theory of Path Dependence in Corporate Governance and Ownership_ , 52 STAN. L. REV. 127 (1999) (proposing the "path dependence theory" where corporate law structure depends on the structures with which the economy was started);
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
executives and the addition of new design elements in executive compensation difficult.
# _3. Design Features to Avoid Abuse_
If SIFI executives are compensated with contingent convertible bond instruments, opportunism could lead them to manipulate the triggering event to obtain stock upon contingent convertible bonds’ conversion at a depressed price before or during a crisis.<sup>191</sup> For instance, the conversion into equity at a value of $3 with a book value of $10 would create a substantial payoff. Opportunism may lead executives to disregard the impact of triggering the conversion on their reputation and career development prospects if the payoff is substantial.
Without rules and regulatory guidance regarding the design and issuance of contingent convertible bonds, SIFI executives may only be curtailed by their fiduciary duties. Existing fiduciary duties could prove insufficient to limit opportunism and abuse if the payoff for executives is substantial.<sup>192</sup> Contingent convertible bondholders, regular bondholders, and shareholders would benefit from broader fiduciary duties.<sup>193</sup>
Reinhard H. Schmidt & Gerald Spindler, _Path Dependence and Complementarity in Corporate Governance_ , _in_ CONVERGENCE AND PERSISTENCE IN CORPORATE GOVERNANCE 114 (Jeffrey N. Gordon and Mark J. Roe eds., 2004); Amir N. Licht, _The Mother of All Path Dependencies Toward a CrossCultural Theory of Corporate Governance Systems_ , 26 DEL. J. CORP. L. 147 (2001); Edward S. Adams, _Corporate Governance After Enron and Global Crossing: Comparative Lessons for Cross-National Improvement_ , 78 IND. L. J. 723, 764-65 (2003); Hill & McDonnell, _supra_ note 26. _But cf._ S. J. Liebowitz & Stephen E. Margolis, _Path Dependence, Lock-In, and History_ , 11 J.L. ECON. & ORG. 205, 205-06 (1995) (challenging path dependence theory).
> 191 Murphy, Walsh & Willison, _supra_ note 176 (arguing that “the trigger metric could be undermined if it could be manipulated. For instance, with a trigger metric based on a bank’s equity price, there would be a risk that investors may short-sell a bank’s equity to drive the equity price down in the absence of any change in the underlying value of a bank’s assets and trigger a conversion event that results in a transfer of value from existing equity holders to precautionary contingent capital holders [….] the risk of using market capitalisation to define the trigger event is that it could give investors an incentive to manipulate the equity price to trigger a conversion.”).
> 192 Claire A. Hill & Brett H. McDonnell, _Fiduciary Duties and Emerging Jurisprudence, in_ RESEARCH HANDBOOK ON THE ECONOMICS OF CORPORATE LAW 133 (Claire A. Hill & Brett H. McDonnell, eds., 2012); Johnson & Sides, _supra_ note 25, at 1192-1195 (In “corporate law, the duties are broad and usefully ill-defined—decision-makers must act with “loyalty” and “care” and in “good faith,” but are accorded wide latitude in discharging their governance responsibilities in conformance with these standards.”); Randall Thomas & Harwell Wells, _Executive Compensation in the Courts: Board Capture, Optimal Contracting, and Officers’ Fiduciary Duties,_ 95 MINN. L. REV. 846 (2011) (explaining that courts have a stronger doctrine they can employ when called on to monitor abuses in executive compensation: the fiduciary duties of officers); Donald C. Langevoort, _Agency Law Inside the Corporation_ : _Problems of Candor and Knowledge_ , 71 U. CIN. L. REV. 1187, 1196 (2003); A. Gilchrist Sparks, III & Lawrence A. Hamermesh, _Common Law Duties of Non-Director Corporate Officers_ , 48 BUS. LAW. 215, 217 (1992). _See also_ Thomas J. Moloney, Paul R. St. Lawrence, III & Angela F. Hamarich, _Fiduciary Duties, Broker-Dealers and Sophisticated Clients: A Mis-Match That Could Only Be Made in Washington_ , 3 J. SEC. L. REG. & COMPLIANCE 336 (2010), (providing an overview of the fiduciary duty debate); Cheryl L. Wade, _Fiduciary Duty and the Public Interest_ , 91 B.U. L. REV. 1191 (2011) (analyzing fiduciary duties in the recent economic downturn); Lyman P.Q. Johnson & David Millon, _Recalling Why Corporate Officers Are Fiduciaries_ , 46 WM. & MARY L. REV. 1597, 1600 & n.10 (2005) (“[C]ourts and commentators routinely describe the duties of directors and officers together, and in identical terms.”). .
> 193 _See_ TAMAR FRANKEL, FIDUCIARY LAW (2011) (clarifying the theoretical underpinning for an expansive version of fiduciary duties, and applying fiduciary theory to such contemporary problems as those in the securities industry, the professions, as well as corporate issues such as executive compensation); Liability of Asset Managers [_] (Danny Busch & Deborah DeMott, eds., 2012); Thomas
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
In practice, the proportion of contingent convertible bond instruments in the total mix of executive compensation packages will likely be limited which may counteract possible abuse. A mandatory holding period for all equity securities held by executives in the entity they manage<sup>194</sup> after the conversion of their contingent convertible bonds into equity takes place would help limit possible abuse. A broader approach to curtail abuse could entail the cancelation of any stock options or other equity-based pay arrangements in the compensation packages of executives upon the conversion of executives’ CCBs. Ultimately, manager/agent opportunism that results from the design of CCB triggers and managers’ participation in the design may necessitate regulatory guidance in the form of general principles or best practice guidelines for the design of CCBs and their issuance to investors and executives.
Although executives are unlikely to be directly involved in designing their own contingent convertible bond awards, executives often have a strong involvement and influence in the executive compensation process.<sup>195</sup> Assuming that executives act opportunistically<sup>196</sup> within the bounds of their fiduciary duties, executives may not create
Lee Hazen, _Stock Broker Fiduciary Duties and the Impact of the Dodd-Frank Act_ , 15 N.C. BANKING INST. 47 2011 (concluding that although the existing framework for broker-dealer regulation is robust, it could be fine-tuned by possibly adding an express fiduciary duty requirement as well as more specific rule-based prohibitions); Douglas C. Michael, _The Corporate Officer’s Independent Duty as a Tonic for the Anemic Law of Executive Compensation_ , 17 J. CORP. L. 785, 786 & 824 (1992) (arguing that officers should be found to have a “duty not to accept unreasonable compensation” and that courts should use officers’ fiduciary duties to engage in a sweeping review of compensation for its reasonableness); _Wall Street Fraud and Fiduciary Duties: Can Jail Time Serve as an Adequate Deterrent for Willful Violations? Before the S. Subcomm. on Crime and Drugs, Comm. on the Judiciary,_ 111th Cong. 835 (2010) (statement of John C. Coffee, Jr., Adolf A. Berle Professor of Law, Columbia University Law School) (arguing that legislation is needed “to protect investors and to maintain market transparency and economic efficiency’ and return to the traditional norm that brokers should seek ‘to serve their clients (and not seek to profit from their losses).”). _See also_ Lisa M. Fairfax, _Spare the Rod, Spoil the Director – Revitalizing Directors’ Fiduciary Duty through Legal Liability,_ 42 HOUS. L. REV. 393 (2005-2006) (asserting that “legal liability represents an essential mechanism for ensuring directors' fidelity to their fiduciary duties and for questioning reform efforts that do not include such liability.”). For advocates of a fiduciary duty to bondholders _see, e.g._ PROGRESSIVE CORPORATE LAW (Lawrence G. Mitchell ed., 1995); Margaret M. Blair, _Stakeholders as Shareholders, Ownership and Control: Rethinking Corporate Governance for the Twenty-First Century_ , 109 HARV. L. REV. 1150 (1996); William W. Bratton, Jr., _Public Values and Corporate Fiduciary Law_ , 44 RUTGERS L. REV. 675 (1992); Wai Shun Wilson Leung, _The Inadequacy of Shareholder Primacy: A Proposed Corporate Regime that Recognizes Non-Shareholder Interests_ , 30 COLUM. J.L. & SOC. PROBS. 587 (1997); David Millon, _Communitarians, Contractarians, and the Crisis in Corporate Law_ , 50 WASH. & LEE L. REV. 1373 (1993); David Millon, _Redefining Corporate Law_ , 24 IND. L. REV. 223 (1991); Lawrence E. Mitchell, _A Critical Look at Corporate Governance_ , 45 VAND. L. REV. 1263 (1992). _See generally_ Jensen & Meckling, _supra_ note 29, at 305. _Contra Wall Street Fraud and Fiduciary Duties: Can Jail Time Serve as an Adequate Deterrent for Willful Violations? Before the S. Subcomm. on Crime and Drugs, Comm. on the Judiciary,_ 111th Cong. 835 (2010) (statement of Larry E. Ribstein, Associate Dean for Research, & Mildred Van Voorhis Jones Chair, University of Illinois College of Law); Larry E. Ribstein, _Fencing Fiduciary Duties,_ 91 B.U. L. Rev. 857 (2011) (arguing for a more precise definition and more limited application of fiduciary duties because their usefulness depends on differentiation from other duties that apply in other settings) For cases that discuss officers’ fiduciary duties _see generally_ Claire A. Hill & Brett H. McDonnell, _Fiduciary Duties and Emerging Jurisprudence, in_ RESEARCH HANDBOOK ON THE ECONOMICS OF CORPORATE LAW 133 (Claire A. Hill & Brett H. McDonnell, eds., 2012). 194 In the context of equity-based compensation _see_ Baghat & Romano, _supra_ note 18, at 2-3. 195 Bebchuk & Fried, _supra_ note 182. _See also_ Bebchuk & Spamann, _supra_ note 2. 196 _See supra_ Part A.IV. (showing that the incomplete contract theory model acknowledges agent opportunism in the analysis of executive compensation policies).
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
socially optimal designs for contingent convertible bonds. Executives’ opportunism and involvement in drafting the trigger could result in suboptimal early triggers in contingent convertible bonds issued to executives. If the trigger design allows executives to influence the early trigger, the suboptimal early trigger could increase the potential for abuse because executives may use the trigger to obtain cheap stock during a crisis. If executives are involved in drafting the features of contingent convertible bonds issued to investors, their opportunism could result in contingent convertible bond designs that do not result in a significant threat of equity dilution upon conversion and other governance improving design features.<sup>197</sup> Because regulators and others are unlikely to provide rules, guidelines, and best practice guidance for contingent convertible bond designs and issuances anytime soon, executives may continue to have a strong involvement in the design of contingent convertible bonds.<sup>198</sup> Regulatory guidance on contingent capital designs and issuances may be needed to curtail the involvement of executives in the design of contingent convertible bonds and create socially optimal designs.<sup>199</sup> Contingent convertible bonds with early triggers in executive compensation could help create socially optimal designs for contingent convertible bonds issued to investors.<sup>200</sup>
# **VI.** **_Implications for Academic Debates_**
Instituting contingent convertible bonds with early triggers in executive compensation packages adds a new perspective to the academic debate in the context of inside debt, the creditor-centered approach to executive compensation, and the design of triggering events. As a result of their early conversion into equity (or the threat thereof), contingent convertible bonds provide several advantages beyond the benefits of traditional inside debt instruments in executive compensation. Contingent convertible bonds also add benefits to the creditor-centered approach to executive compensation. In the context of the creditor-centered approach, adding contingent convertible bonds or replacing other debt instruments in executive compensation packages with contingent convertible bonds can optimize managers’ risk incentives, especially in comparison with traditional debt instruments in executive compensation packages. In the context of the debate on trigger designs, contingent convertible bonds with early triggers show that the ownership characteristics of the contingent convertible bondholders can have an impact on the efficient design of contingent capital triggers.
# _1. Contingent Capital as Inside Debt_
Empirical studies have demonstrated that risk-taking declines if executives hold more debt relative to their equity holdings.<sup>201</sup> Inside debt may be defined as a
> 197 Kaal, _supra_ note 14.
> 198 Institution and industry-specific knowledge may make executives indispensable in the drafting of contingent convertible bonds. Regulatory guidelines and best practice guidance for contingent convertible bond designs could help ensure that executives are sufficiently involved but do not create socially suboptimal designs.
> 199 _See_ Kaal, _supra_ note 14, at 139-141 (noting that private ordering and market mechanisms may not result in socially optimal designs for contingent convertible bonds).
> 200 _See supra_ Part A.V.2.b) (discussing the benefits of a design with early triggers).
> 201 Edmans & Liu, _supra_ note 81 (arguing that a debt bias can improve executives’ efforts as well as deter risk shifting); Tung & Wang, _supra_ note 8 (showing that their empirical evidence provides a rationale for the use of inside debt compensation in structuring executive compensation in the banking context);
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
corporation’s debt held by firm insiders.<sup>202</sup> Inside debt, which includes pensions and deferred compensation,<sup>203</sup> is already a substantial part of executive compensation in the United States.<sup>204</sup> Unlike equity-based compensation, inside debt creates fixed claims for managers with a stake in the firm’s liquidation value, which reduces risk-taking incentives for executives and the associated agency costs.<sup>205</sup> When managers have a stake in the liquidation value of the firm, they are more likely to increase their efforts in the vicinity of insolvency.<sup>206</sup> Inside debt could provide adequate signaling of managers’ risk-taking.<sup>207</sup>
Riccardo Calcagno & Luc Renneboog, _The Incentive to Give Incentives: On the Relative Seniority of Debt Claims and Managerial Compensation_ , 31.6 J. BANKING & FIN. 1795 (2007) (arguing that the increase in the leverage of Anglo-American corporations has stimulated the interest in the role of debt as a direct incentive device for the management to generate stronger corporate performance and showing that including risky debt in the capital structure changes the “incentive to give incentives” by a principal in charge of managerial contracts); Tao-Hsien Dolly King & Min-Ming Wen, _Shareholder Governance, Bondholder Governance, and Managerial Risk-Taking_ , 35 J. BANKING & FIN. 512, 530 (2011) (showing that strong bondholder governance incentivizes low-risk investments); Hernan Ortiz-Molina, _Executive Compensation and Capital Structure: The Effects of Convertible Debt and Straight Debt on CEO Pay_ , 43.1 J. ACCT. & ECON. 69 (2007) (examining how CEO compensation is related to firms' capital structures and arguing that the hypothesis that debt reduces manager-shareholder conflicts can explain some but not all of the results). _See also_ Wei & Yermack, _supra_ note 8; Sundaram & Yermack, _supra_ note 8; Gerakos, _supra_ note 8, at 23 (finding that pension benefits may reduce risk taking). Other studies reject the idea that corporate governance and executive compensation are correlated _see_ Core et al., supra note 8, at 385-88; Dorff, supra note 8, at 5; Johnson et al., _supra_ note 8, at 17, 38; Carter & Lynch, _supra_ note 8, at 222 (finding no relationship between institutional ownership and the repricing decision). _See also_ Anderson & Bizjak, _supra_ note 8, at 24-25; Wan, supra note 8, at 23 (finding “no systematic evidence that board composition affects change in CEO compensation.”). Some scholars argue that there is no role for inside debt in efficient compensation because bonuses, salaries or managerial reputation constitute adequate remedies to the agency costs of debt _see_ D. Hirshleifer & A. Thakor, _Managerial Conservatism, Project Choice, and Debt_ , 5 REV. FIN. STUD. 437–470 (1992); J. Brander & M. Poitevin, _Managerial Compensation and the Agency Costs of Debt Finance_ , 13 MANAGERIAL & DECISION ECON. 55–64 (1992). T. John & K. John, _Top-Management Compensation and Capital Structure_ , 48 J. FIN. 949–974 (1993). 202 Jensen & Meckling, _supra_ note 29, at 369 (defining inside debt as “debt held by the manager.”); Edmans & Liu, _supra_ note 81, at 75 (defining inside debt as debt (or any security with payoffs very similar to debt) held by the manager and contrasting it with outside debt, which is held by external investors); Sundaram & Yermack, _supra_ note 8, at 1 (“The most common form of these intra company IOUs (“inside debt” in the language of Jensen and Meckling) are defined benefit pensions and deferred compensation.”); Cassell et al., _supra_ note 8 (“CEO inside debt holdings (pension benefits and deferred compensation) are generally unsecured and unfunded liabilities of the firm.”); Tung & Wan, _supra_ note 8, at 13 (defining bank CEOs’ inside debt as the present value of the CEO’s pension and deferred compensation balances).
> 203 Sundaram & Yermack, _supra_ note 8, at 1 (“The most common form of these intra company IOUs are benefit pensions and deferred compensation.”); Tung & Wan, _supra_ note 8, at 13 (defining bank CEOs’ inside debt as the present value of the CEO’s pension and deferred compensation balances); Edmans & Liu, _supra_ note 81, at 76 (“U.S. CEOs hold substantial defined benefit pensions. These are unsecured, unfunded obligations which, in nearly all cases, have equal priority with other creditors in bankruptcy and thus constitute inside debt.”).
> 204 _See_ Sundaram & Yermack, _supra_ note 8.
> 205 Edmans & Liu, _supra_ note 81 (showing that the probability of default and the manager’s ability to affect liquidation values affect the appropriate amount of inside debt).
> 206 Tung & Wang, _supra_ note 201, at 4.
> 207 Tung, _supra_ note 76, at 35 (arguing that subordinated inside debt on the subsidiary level is preferable to debt of the holding company for signaling); _Contra_ Bebchuk & Spamann, _supra_ note 2, at 12-16 (proposing to pay executives through debt of the bank holding company).
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
Inside debt in the form of contingent convertible bonds has characteristics that could prove preferable to traditional inside debt.<sup>208</sup> Managers’ inside debt stake in the firm’s liquidation value and the associated governance benefits,<sup>209</sup> incentive optimization,<sup>210</sup> and reduction of agency costs<sup>211</sup> depend on the solvency of the respective entity. Inside debt without a conversion feature provides no mechanism to ensure the solvency of the entity. Contingent convertible bonds with a conversion feature offer the additional benefit of creating an early warning system and a buffer before insolvency that can help an entity avoid default.<sup>212</sup> As a debt instrument with an early trigger before conversion, contingent convertible bonds in executive compensation have all the benefits of inside debt<sup>213</sup> in addition to the benefits of an early trigger design.<sup>214</sup>
Because the contingent convertible bonds in executive compensation packages would convert into equity early before insolvency, the value of the equity after conversion of the respective executives’ contingent convertible bonds before bankruptcy could still be higher than the liquidation value of traditional inside debt. Unlike the liquidation value of traditional inside debt, the equity in executives’ portfolios after the conversion of the contingent convertible bonds can still be increased because the early trigger creates a substantial buffer before insolvency. Contingent convertible bonds as inside debt would not only have the benefits of inside debt before conversion but would also provide significant incentives for management to maintain the value of equity after conversion.
Contingent capital bonds in executive compensation could also help optimize inside debt instruments to incentivize lower risk-taking by managers. Similar to other inside debt instruments, the market price of contingent convertible bonds would likely be
> 208 _See supra_ Part V. 2. b) (elaborating on the benefits of an early trigger design).
> 209 Edmans & Liu, _supra_ note 81, at 3; Tung, _supra_ note 76, at 26; Sundaram & Yermack, _supra_ note 8, at 1558; Cassell et al., _supra_ note 8, at 589 (stating that “other studies find that inside debt holdings are associated with higher firm liquidation value (Chen, Dou, and Wang, 2010) and lower credit default swap spreads (Bolton, Mehran, and Shapiro, 2010).“).
> 210 Tung, _supra_ note 76, at 3 (arguing that market pricing of inside debt is particularly sensitive to downside risk and including inside debt to banker’s compensation packages could therefore give management “direct personal incentives to avoid excessive risk.”).
> 211 _Id. See also_ Jensen & Meckling _, supra_ note 29; Sundaram & Yermack, _supra_ note 8, at 1572 (“debtbased compensation reduces the agency costs of debt […] we should observe a positive association between the CEO's debt-to-equity ratio and the firm's leverage.”); Edmans & Liu, _supra_ note 81, at 3 (demonstrating that inside debt is a superior remedy to the agency costs of debt than the bonuses advocated by prior research).
> 212 _See_ Kaal & Henkel, _supra_ note 14 (discussing the use of contingent capital to create a buffer in the vicinity of bankruptcy).
> 213 For a discussion of the benefits of inside debt _see_ Tung, _supra_ note 76, at 26 (“Though the possibility of including debt in executives’ compensation arrangements has until quite recently been largely ignored, a nascent body of literature offers strong preliminary support for the notion that holding fixed claims against the firm may dampen CEOs’ risk-taking incentives.”); Sundaram & Yermack, _supra_ note 8, at 1558, 1583 (“Inside equity aligns managers with equity holders in good states, but inside debt aligns managers with debt holders in bad states. […] Debt-based compensation provides managers with interesting incentives to reduce the agency costs of debt.”); Edmans & Liu, _supra_ note 81 (“Inside debt can be a more effective solution to creditor expropriation than salaries, bonuses, reputation and private benefits, owing to its sensitivity to liquidation value.”).
> 214 _See supra_ Part V. 2. b) (explaining the benefits of the early trigger design).
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
affected by managers’ risk-taking.<sup>215</sup> Like subordinated inside debt on the subsidiary level,<sup>216</sup> before conversion into equity, contingent convertible bonds can incentivize executives to lower their risk-taking because contingent convertible bond prices will be sensitive to downside risks of SIFIs including the risk of default.<sup>217</sup> Contingent convertible bonds, however, provide an additional feature. Upon the conversion of the contingent convertible bonds,<sup>218</sup> the downside pressure on equity puts additional places additional weight on the value of the equity portion of executives’ pay packages. Upon conversion, the executives would not only forego the contingent convertible bonds in their compensation packages; they would also hold converted equity and equity held prior to the conversion at a depressed value. The price-sensitivity-induced incentives for lowering risk before conversion and the new emphasis on the equity portion of the pay package after conversion create a combined effect on executives’ incentives. This combined effect could create comparatively stronger incentives for executives to take fewer risks in order to avoid the triggering event.<sup>219</sup> The emphasis in this design is on incentives that lower executives’ risk-taking and help avoid the early trigger.<sup>220</sup>
Critics argue that liquidity shocks and other exogenous factors could influence debt trading prices unrelated to managers’ risk-taking, making debt at the subsidiary level less useful for signaling.<sup>221</sup> Contingent convertible bonds should be less prone to liquidity shocks because of their inordinately high coupon rate of between 7% and 9.5%.<sup>222</sup> Although there is no assurance that oversubscribed issuances<sup>223</sup> guarantee future
> 215 _See_ Tung _, supra_ note 76, at 3 (discussing the pricing sensitivity of inside bank debt on the subsidiary level with regard to executive risk taking) _. Contra_ Bebchuk & Spamann, _supra_ note 2, at 12-16 (suggesting inside debt in the form of debt of the bank holding company).
> 216 Tung, _supra_ note 76, at 35.
> 217 _See_ Murphy, Walsh & Willison, _supra_ note 191, at 6 (arguing that the pricing of contingent convertible bonds could be a guide to the markets' view of the riskiness of financial institutions).
218 The conversion of contingent convertible bonds signals to the market that the entity could be insolvent which may result in downside pressure on the stock price.
219 Managing to avoid the triggering event alone may be possible by ignoring the other interests of various constituents. However, the proposal in this article is not intended to provide a holistic approach to corporate governance reform in SIFIs.
220 Executives are unlikely to increase their risk-taking after conversion of their CCB to salvage the equity value of their portfolio because of the public nature of the trigger, the entity’s vicinity to bankruptcy, and managers’ inability to obtain other forms of financing if they increase the risk profile of the entity. _See infra_ Part V. 3. (suggesting a mandatory holding period upon the conversion of executives’ contingent convertible bonds for all equity in the entity the executives manage).
> 221 Sepe, _supra_ note 18, at 211 (arguing that the creditor-centered approach is flawed for three reasons: “(1) it focuses exclusively on the banking sector, (2) the proposals for compensation do not constitute a feasible solution, because managers can manipulate the only available measure of asset value, i.e., book value, and (3) the proposals present methodological problems – they assume that the firm-manager relationship is a one-shot transaction when executive compensation contracts are better described as being relational in nature.”).
> 222 Regarding the Credit Suisse issuance and coupon rate _see_ Goldman Sachs, _supra_ note 12, at 17 (discussing the Credit Suisse issuance – CS issued (1) $3.5 billion of 9.5% CoCos to Qatar (potentially exchanging $3.5 billion of 11% Tier 1s) and (2) CHF 2.5 billion of 9% CoCos to the Olayan Group); Press Release, Credit Suisse, Credit Suisse Group places 7.875% Tier 2 Buffer Capital Notes (Feb. 17, 2011), _available at_ https://publications.credit-
suisse.com/app/article/index.cfm?fuseaction=OpenArticle&aoid=300504&coid=293551&lang=EN; Regarding the Barclays issuance and coupon rate _see supra_ notes 133 & 134 _. See also_ Jill Treanor, _City Uneasy Over Proposed 'Coco' Bonuses for Barclays Executives_ , THE GUARDIAN, Mar. 18, 2011, _available at_ http://www.guardian.co.uk/business/2011/mar/18/barclays-proposed-coco-bonuses-executives (“The
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
liquidity, the coupon rates of contingent convertible bonds could help hedge the liquidity risk.
Critics also allege that the inside debt theory of executive compensation ignores suboptimal short and long-term incentives that may result from the inclusion of long-term debt in the compensation packages of executives.<sup>224</sup> They argue that long-term debt securities in the compensation packages of executives will not dis-incentivize high risk short-term transactions because managers can expect short-term gains that exceed the discounted value of their long-term debt securities.<sup>225</sup> Adding contingent convertible bonds with early triggers as part of the inside debt portion of executives’ compensation packages could change managers’ incentives. Executives would no longer simply focus on the debt versus equity portion of their portfolio; they would also consider the effects of triggering events.<sup>226</sup> In the day-to-day operation of the business, managers would need to consider the triggering event of a substantial portion of their outstanding debt instruments and the implications a triggering event would have on the entity and their personal finances. Managing to avoid the early trigger would allow for enough risktaking by managers to generate sufficient returns but, at the same time, would curtail risktaking enough to avoid the negative effects of the triggering event.<sup>227</sup>
# _2. Improving the Creditor-Centered Approach_
Contingent convertible bonds with early triggers in executive compensation can help to improve the creditor-centered approach to executive compensation. Existing compensation practices have an effect on managers’ risk-taking and risk preferences as
Barclays cocos would pay a 7% coupon – or rate of interest – annually, not compounded.”); Paul Clarke, _Barcap’s 7% Coco Coupon Is Decidedly More Generous Than Most Deferred Bonuse_ s, REUTERS, Apr. 20, 2011 _, available at_ http://news.reuters.efinancialcareers.co.uk/News_ITEM/newsItemId-32101 (“The coupon rate of 7% is not just too generous for shareholders, it also outstrips the rate of interest being paid on most other deferred cash bonuses.”). For a summary of market developments in contingent capital _see Kaal, supra_ note 14, at 134-37.
> 223 Mary Watkins, _Credit Suisse to Use ‘Cocos’ to Raise Sfr250M_ , FIN. TIMES, Mar. 7, 2012, _available at_ http://www.ft.com/intl/cms/s/0/e77c968c-686e-11e1-b803-00144feabdc0.html#axzz1xgvtwSc2 (“The bank last year raised $2bn using cocos in a heavily oversubscribed issue.”); Katharina Bart, _Credit Suisse Sells $2 Billion of Co-Cos to Public_ , WALL ST. J., Feb. 17, 2011 _, available at_ http://online.wsj.com/article/SB10001424052748704546704576150861690164484.html (“A person familiar with the situation said the issue was oversubscribed.”); Murphy, Walsh & Willison, _supra_ note 191, at 9 (stating that the CS issue was around eleven times oversubscribed). _See also_ Kaal, _supra_ note 14, at 134-37.
> 224 Sepe, _supra_ note 18, at 223.
> 225 _Id_ . With equity-based compensation in managers’ compensation packages, managers may still be incentivized to drive up the stock price and exercise stock options at an opportune time. However, risktaking generated by equity-based pay can be overcome if the calibration of debt and equity-based compensation in the executive compensation package favors debt and requires a minimal holding period. _See_ Bhagat & Romano, _supra_ note 18, at 2-3 (discussing the equity-based part of the compensation package).
> 226 _See supra_ Part V. 2. (discussing the effects of triggering events and management incentives). Triggering events in contingent capital securities can take various forms. The debate on what triggers should be used is ongoing _see_ Kaal, _supra_ note 14; Kaal & Henkel, _supra_ note 14 (discussing the different trigger designs and their effects on risk-taking).
227 These are ideal typical model assumptions. However, with the right trigger design, executives’ incentives and interests could be substantially improved.
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
well as the firm’s long-term profitability and sustainability.<sup>228</sup> Including a basket of securities in executive compensation packages that represents a predefined percentage of the aggregate value of all outstanding bonds, preferred shares, and common shares could help address the shortcomings of existing executive compensation practices.<sup>229</sup> Adding contingent convertible bonds to the basket of securities in executive compensation could further improve executive compensation practices. Like other debt securities in executive compensation, contingent convertible bonds may increase
> 228 Bebchuk & Fried, _supra_ note 182; Council of Institutional Investors, Top 10 Red Flags To Watch for When Casting an Advisory Vote on Executive Pay (March 2010), http://www.cii.org/UserFiles/file/resource%20center/publications/March%202010%20%20Say%20on%20Pay%20Checklist.pdf (“Poorly-designed incentives can promote excessive risk-taking and get-rich quick mentalities — key contributors to the financial crisis.”); Carl R. Chen, Thomas L. Steiner & Ann Marie Whyte, _Does Stock Option-Based Executive Compensation Induced Risk-Taking? An Analysis of the Banking Industry_ , 30 J. BANKING & FIN. 915 (2006) (“The compensation level and structure employed by each bank has implications for risk-taking and for the agency relation between managers and stockholders.”); Bolton, Mehran, & Shapiro, _supra_ note 18 (“structuring CEO incentives to maximize shareholder value in a levered firm tends to encourage excess risk taking.”); Jensen & Meckling, _supra_ note 29; Robert Haugen & Lemma Senbet, _Resolving the Agency Problems of External Capital Through Options_ , 36 J. FIN. 629, 640 (1981) (“While the issuance of stock options may be used to resolve the agency problem associated with the consumption of perquisites, there may remain an incentive for the manager to engage in either high or low risk investment programs. This is the well-known wealth transfer problem associated with the existence of risky debt in the capital structure.”); Clifford W. Smith & Rene M. Stulz, _The Determinants of Firms' Hedging Policies_ , 20 J. FIN. & QUANTITATIVE ANALYSIS 391, 399 (1985) (suggesting that shareholders can affect management's risk aversion through the design of compensation contracts); Jeffrey L. Coles, Naveen D. Daniel & Lalitha Naveen, _Managerial Incentives and Risk-Taking_ , 79 J. FIN. ECON. 431 (2006) (providing empirical evidence of a strong causal relation between managerial compensation and investment policy, debt policy, and firm risk). Several empirical studies have explored the connection between managerial stock and/or option holdings and financial strategy/corporate focus (such as leverage, repurchase, or the extent of derivatives usage and hedging) _see generally_ Hamid Mehran, _Executive Incentive Plans, Corporate Control, and Capital Structure,_ 27 J. FIN. & QUANTITATIVE ANALYSIS 539 (1992); Hamid Mehran, _Executive Compensation Structure Structure, Ownership, and Firm Performance,_ 38 J. FIN. ECON. 163 (1995) _;_ Peter Tufano _, Who Manages Risk? An Empirical Examination of Risk Management Practices in the Gold Mining Industry,_ 51 J. FIN. 1097 (1996); Anup Agrawal & Gershon Mandelker, _Managerial Incentives and Corporate Investment and Financing Decisions._ 42(4) J. FIN. 823 (1987); Richard DeFusco, Robert Johnson & Thomas Zorn, _The Effect of Executive Stock Option Plans on Stockholders and Bondholders,_ 45(2) J. FIN _._ 617 (1990); Wayne R. Guay, _The Sensitivity of CEO Wealth to Equity Risk: An Analysis of the Magnitude and Determinants._ 53 J. FIN. ECON. 43 (1999); Philip Berger, Eli Ofek & David Yermack _, Managerial Entrenchment and Capital Structure Decisions,_ 52 J. FIN. 1411 (1997); Christine Jolls, _Stock Repurchases and Incentive Compensation_ (NBER Working Paper No. w6467, 1998), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=226212C; Schrand, H. Unal _, Hedging and Co-Ordinated Risk Management,_ 53 J. FIN. 979 (1998) _;_ Daniel A. Rogers _, Does Executive Portfolio Structure Affect Risk Management? CEO Risk-Taking Incentives and Corporate Derivatives Usage,_ 26 J. BANKING & FIN. 271 (2002); David Denis, Diane Denis & Atulya Sarin, _Agency Problems, Equity Ownership, and Corporate Diversification,_ 52 J. FIN. 135 (1997).
> 229 _See_ Bebchuk & Spamann, _supra_ note 2, at 253, 283-84. How the securities in the basket should be weighted is unclear. Weighting debt securities, including contingent convertible bonds, heavily in the calibration of executive compensation packages may increase the positive effects of debt in executive compensation packages. At the same time, debt may not be the preferred form of compensation for executives. Calibrating executive compensation packages to account for desired incentives and governance improvements while giving sufficient incentives for executives to perform within expected parameters may require an institution-specific relational approach and learning from experience. _See supra_ Part IV. (on the benefits of the incomplete contract theory of NIE).
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
sustainability and can help overcome income inequality.<sup>230</sup> If a SIFI issues contingent convertible bonds to replace a substantial portion of its executives’ equity-based compensation, the coupon rate of contingent convertible bonds (currently between 7% and 9.2%<sup>231</sup> ), albeit higher than traditional debt instruments, could help address concerns over income inequality.<sup>232</sup> For the remaining portion of executives’ equity-based compensation, a mandatory holding period upon the conversion of the contingent convertible bonds could provide incentives for sustainability.<sup>233</sup> The coupon rate of contingent convertible bonds may be incomparable with the upside potential of equitybased compensation, especially for stock options. However, the coupon rate of contingent convertible bonds is higher than the coupon rate of traditional debt instruments. This higher coupon rate could make it a more attractive instrument in executive compensation. The attractive features of CCBs may help establish CCBs in the executive compensation culture in the United States and thereby improve corporate governance.
Because of the conversion feature, contingent convertible bonds may have additional benefits. Unlike traditional debt instruments in executive compensation, contingent convertible bonds provide incentives for increased monitoring by creditors and shareholders. They also align executives’ interests with the interests of shareholders and creditors.<sup>234</sup> Most importantly, adding contingent convertible bonds or replacing other debt instruments in executive compensation packages with contingent convertible bonds with early triggers help improve managers’ risk incentives. The conversion feature of contingent convertible bonds decreases executives’ risk-taking incentives because holding a substantial portion of debt rather than equity dis-incentivize short-termism and executives’ focus on quarterly stock price performance. The early conversion feature also creates a risk that if executives do not lower their risk-taking and manage the entity well enough to avoid the trigger, they would receive equity at a point in time when the equity value would be substantially diminished.<sup>235</sup>
> 230 _See e.g._ McDonnell, _supra_ note 188 (elaborating on general inequality as a concern); Bebchuk & Fried, _supra_ note 64, at 1 (“the increase in CEO pay is a factor in the increase in income inequality at the very top end of the income distribution. It is not, however, the driver of that inequality.”); Michael C. Jensen, Kevin J. Murphy & Eric G. Wruck, _Remuneration: Where We’ve Been, How We Got to Here, What are the Problems, and How to Fix Them,_ 24 (ECGI – Fin. Working Paper No. 44/2004, 2004), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=561305 (showing that the pay for chief executive officers (CEOs) in large US firms increased dramatically over the past three decades, driven by an explosion in grants of share options); Thomas Piketty & Emmanuel Saez, _Income Inequality in the United States, 1913-1998_ , 118 Q. J. ECON. 1 (2003); Steven N. Kaplan & Joshua D. Rauh, _Wall Street and Main Street: What Contributes to the Rise in the Highest Incomes?_ 1 (NBER Working Paper 13270, 2007), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=931280 (considering in detail how much of the inequality today at the top end of the income distribution can be attributed to four different sectors of the economy – top executives of non-financial firms (Main Street); financial service sector employees from investment banks, hedge funds, private equity funds, and mutual funds (Wall Street); lawyers; and professional athletes and celebrities).
> 231 _See supra_ note 222 and accompanying text on Credit Suisse issuance.
> 232 _See supra_ Part V., note 188 and accompanying text.
> 233 _See_ Bahgda & Romano, _supra_ note 18 (suggesting a 2 to 4 year holding period for equity-based compensation).
> 234 _See supra_ Part V.
235 The amount to be received upon conversion would depend on the trigger design. Most triggers currently discussed in the literature favor a conversion shortly before bankruptcy. If this is the case, the equity received by the executive would be near worthless. If the SIFI chooses a contingent capital bond design
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
Replacing a substantial portion of equity-based compensation with contingent convertible bonds can also help create incentives for managers to keep the business solvent. During the financial crisis, Lehman Brothers experienced a severe shortfall in solvency in part because its CEO, Richard S. Fuld, Jr., had a substantial equity stake in the company and, in an effort to preserve his own interests, refused to pursue a dilutive capital infusion or sell the firm in order to avoid the firm’s failure (the “ _Fuld Problem”_ ). Motivated in part by a desire to address the Fuld Problem, Jeffrey Gordon suggests using convertible equity-based pay, i.e. executives in financial firms receive a substantial part of their stock-related compensation in equity securities that convert to subordinated debt upon a triggering event.<sup>236</sup> Gordon contrasts convertible equity-based pay with contingent convertible bonds and argues that contingent convertible bonds would not address the Fuld problem.<sup>237</sup>
If a financial institution issues contingent convertible bonds to the general public and its executives and a large part of equity-based executive compensation is replaced with CCBs,<sup>238</sup> SIFI managers may be more concerned with managing the entity to prevent the early triggering event<sup>239</sup> than averting an equity infusion to avoid dilution of their own equity stake. If executives’ compensation packages do not include a large equity portion, managers have no incentives to avoid an equity infusion to preserve the value of their own equity. Even if a substantial portion of executives’ compensation remains equity-based, the early conversion of contingent convertible bonds not only affects the debt portion of executives’ compensation but also the value of the equity portion after the contingent convertible bonds portion is converted.<sup>240</sup> The lower value of the equity portion after the conversion of the contingent convertible bonds, in combination with the negative impact of the CCB conversion on the existing equity of the respective entity, makes it less likely for executives to fear the effect of raising additional equity, such as a negative impact on price and the dilutive effect.
Because contingent convertible bonds are addressed to the entire equity base and would, according to some proposals, become a (mandatory) feature of SIFIs’ balance sheet, the dilution and the effect on managers could be greater with convertible equity
with a write-down feature for its executive compensation packages, managers would perhaps have even less incentives to take risks because they would not get any financial benefit from the contingent capital bond if it is triggered into a write-down. The beneficial effects could increase in proportion to the volume of contingent convertible bonds issuance to executives.
> 236 _See_ Gordon, _supra_ note 18, at 11 (“Senior executives at financial firms should receive a significant portion of stock-related compensation in the form of equity that will convert into subordinated debt upon certain external triggering events, such as a downgrade by the regulators to a “high risk category,” a specific deterioration in the firm’s book-to-equity ratio (or some other critical ratio), or perhaps a stock price drop of a specified percentage over a limited time period.”).
> 237 _Id._ at n. 18.
> 238 Credit Suisse and other SIFIS have already issued contingent convertible bonds to the public _see_ Kaal _, supra_ note 14, at 126. Barclays has already issued contingent convertible bonds to its executives _see supra_ note 133.
> 239 _See supra_ Part V.
> 240 _See supra_ Part V. 2. Opportunism may lead managers to increase the risk profile of the entity after conversion, enabling them to regain the lost equity value in their portfolio. On the other hand, an increase in the risk profile would affect the ability of the entity to obtain other forms of financing such as bridge loans. The increase in the risk profile after conversion is also unlikely because the early conversion would probably increase CCB investors and shareholders’ monitoring of the entity. Many boards may decide to let managers go upon the occurrence of an early trigger.
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
based-pay.<sup>241</sup> However, the effect of the conversion from equity to debt will largely depend on the trigger design. There is currently no consensus on the ideal trigger design for convertible securities.<sup>242</sup> Depending on the trigger design, a mandatory conversion of senior managers’ equity into subordinated debt on a valuation basis may not lead to a significant loss if the trigger from equity to subordinated debt comes after a likely significant loss in the share price of the entity. Although mandatory contingent convertible bond issuances with predefined triggering events could have better corporate governance outcomes,<sup>243</sup> it is noteworthy that the contingent convertible bond market has evolved without mandatory issuances.<sup>244</sup> Also, the Fuld problem<sup>245</sup> is only one of many corporate governance concerns pertaining to SIFIs. The approach in this article is broader.<sup>246</sup> The issuance of contingent convertible bonds to the public has great potential to improve several aspects of corporate governance in SIFIs.<sup>247</sup> Contingent convertible bonds in executive compensation can solidify and in some cases intensify the positive effects on corporate governance.<sup>248</sup>
_3. The Impact of Ownership Characteristics on Trigger Design_
The literature on trigger designs of contingent capital focuses on the efficient calibration of triggering events.<sup>249</sup> The efficient calibration of triggering events is central to the design of contingent capital because the trigger affects if and when the conversion of contingent convertible bonds takes place. The efficient conversion of contingent convertible bonds into equity has substantial implications for the effectiveness of contingent convertible bonds and their ability to make financial institutions safer.<sup>250</sup>
The literature on contingent capital trigger designs is largely silent regarding the effect of trigger designs on corporate governance.<sup>251</sup> Contingent convertible bonds issued to executives<sup>252</sup> place a new emphasis on the impact of ownership characteristics on trigger designs.<sup>253</sup> Trigger designs that may work well in financial institutions with the traditional mix of debt holders and shareholders, may be suboptimal if executives also hold debt instruments in the form of contingent convertible bonds.<sup>254</sup> The nature of ownership of contingent convertible bonds may create different demands on the design features. Who owns the contingent convertible bonds can impact the efficiency,
> 241 _See_ Gordon, _supra_ note 18.
> 242 _See_ Kaal, _supra_ note 14. _see also_ Henkel & Kaal, _supra_ note 148, at 251-57 (showing the uncertainty and risk involved in the different trigger designs).
> 243 Kaal, _supra_ note 14.
> 244 _Id._ at 134-37 (discussing the evolving market in contingent capital).
> 245 Gordon, _supra_ note 18, at 12.
> 246 The common denominator between Gordon’s proposal and the proposal in this article is the avoidance of SIFI resolution and distress in the financial sector.
> 247 Kaal, _supra_ note 14.
> 248 _See supra_ Part V.
> 249 _See_ Kaal, _supra_ note 14; Henkel & Kaal, _supra_ note 148.
> 250 _See_ Kaal & Henkel, _supra_ note 14.
> 251 _See_ Kaal, _supra_ note 14.
> 252 _See supra_ note 133 & Part V. 1. (discussing Barclays’ issuance of contingent convertible bonds to executives).
> 253 _See supra_ Part VI. 3.
> 254 _See supra_ Part VI.
CONTINGENT CAPITAL IN EXECUTIVE COMPENSATION
effectiveness, and corporate governance results of trigger designs.<sup>255</sup> Recognizing that ownership characteristics can have an impact on the efficient design of contingent capital triggers can help adjust designs and avoid suboptimal outcomes.<sup>256</sup>
# **VII.** _Conclusion_
Contingent convertible bonds in executive compensation are not a mere theoretical concept. European SIFIs have started to add contingent convertible bonds to executive compensation packages. Path dependencies could make it difficult to adopt governance improving elements in executive compensation policies in the United States. Contingent convertible bonds display many commercially attractive features that could help establish these hybrid securities in the compensation packages of executives in the United States. Like other debt securities in executive compensation, contingent convertible bonds can lower income inequality and incentivize the long-term and sustainable development of SIFIs. Additionally, an early trigger design for contingent convertible bonds in executive compensation can help further improve governance shortcomings in SIFIs. Contingent convertible bonds with an early trigger design enable earlier signaling of default risk; they provide increased incentives for monitoring by creditors and shareholders as well as incentives for executives to lower their risk-taking.
> 255 _Id._
> 256 Adjusting the design of CCBs to take ownership characteristics into account could complicate this analysis, which already deals with a substantial amount of parameters. However, the design of CCBs should not be compromised in order to avoid complexity.