Improving Debt Bonus Programs for Executives

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

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

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

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

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

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

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

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

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


Improving UBS’s Executive CoCos

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

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

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

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

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

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

Summary of Recent Study on Hedge Fund Manager Registration under Title IV of the Dodd-Frank Act

Read the article at Cayman Financial Review

Read the full study

This article summarises the results of a recent survey of private fund managers.*

The study identifies the possible effects of hedge fund adviser registration under the Dodd-Frank Act and is intended to support policy makers in implementing new rules pertaining to the hedge fund industry. 

The study suggests that the registration and disclosure requirements under the Dodd-Frank Act and the SEC’s implementation of these requirements created several areas of concern for the hedge fund industry. Overall, however, the hedge fund industry appears to be adapting well to the regulatory environment after the enactment of the Dodd-Frank Act.

The Dodd-Frank Act marks the ending of the era of light-touch regulation and unsupervised hedge fund activities. Before the enactment of the Dodd-Frank Act, hedge fund managers were able to operate in financial markets with minimal regulatory supervision. 

The growth and importance of the hedge fund industry in worldwide financial markets may be attributable, at least in part, to the lack of regulatory oversight for more than half a century. The hedge fund industry thrived without regulatory supervision, generating higher returns and attracting an increasingly larger investor base. 

Given the success of the hedge fund industry in a light-touch regulatory environment, it is not surprising that the industry resisted the SEC’s past attempts to register hedge fund managers. When the SEC in December 2004 issued a final rule requiring hedge fund advisers to register under the Advisers Act1, the hedge fund industry strongly opposed the rule2. 

Two years later, in 2006, the United States District Court of Appeals for the District of Columbia in Goldstein v. SEC vacated the rule requiring registration of hedge fund managers as arbitrary3. 

Most registered hedge fund managers deregistered after the court issued its ruling in the Goldstein decision.

Title IV of the Dodd-Frank Act, entitled the Private Fund Investment Advisers Registration Act of 2010 (PFIARA), and SEC rules implementing the Act changed the regulatory landscape for the private fund industry. First and foremost, PFIARA authorised the SEC to promulgate rules requiring registration of private funds. The Act mandates hedge fund adviser registration so as to increase recordkeeping and disclosure4. 

Hedge fund manager registration under PFIARA, applies to any fund with more than $150 million assets under Management (AUM)5. 

Once registered, private fund managers are subject to enhanced disclosure requirements. Hedge fund managers are required to maintain records to avoid systemic risk6 and provide confidential reports related to systemic risk7. 

Information about the fund and the managers’ portfolio includes: the amount of AUM, the use of leverage, including off-balance sheet leverage, counterparty credit risk exposures, trading practices, trading and investment positions, valuation policies, side letters and other information deemed necessary8.


In order to identify the possible impact of hedge fund adviser registration requirements under the Dodd-Frank Act, the study draws inferences based on a sample of investment advisers from a population of investment advisers registered in the United States. The author and four research assistants collected data by approaching 1264 private fund managers with a survey questionnaire. 

The survey asked private fund managers to describe the possible effects of hedge fund manager registration requirements under the Dodd-Frank Act. Respondents (n=94) answered questions in several categories, including: strategic responses to the Dodd-Frank Act requirements, cost of compliance, long-term effect of reporting and disclosure rules on the private fund industry, compliance measures, long-term effect of reporting and disclosure rules on private funds, effect of the regulatory regime on assets under management, and effect of the regulatory regime on profitability.

Executive summary

The results summarised below are the major findings of the first observational study conducted after the SEC’s registration effective date for hedge fund advisers, 30 March, 2012. The study will help support hedge fund advisers in the administrative management of their funds because it quantifies compliance costs, it evaluates compliance measures and it assesses fund managers’ strategic responses to the implementation of the Dodd-Frank Act. 

Other important findings of the study pertain to the implications of the private fund disclosure requirements under the Dodd-Frank Act and the possible long-term effects of hedge fund manager registration, including the effect on assets under management and profitability.

Strategic responses to Dodd-Frank

Hedge fund managers can implement a broad array of legal and strategic responses to address perceived concerns of new regulations. For instance, managers can change the legal structure of their funds and management companies, they can lower or increase the assets under management, or they can change the strategy pertaining to their funds.

As Figure 1.1 shows, a minority of respondents in the survey has planned a strategic response to the Dodd-Frank Act requirements. This suggests that the requirements in Dodd-Frank and the SEC regulations implementing these requirements are not perceived as materially changing the existing business and compliance model.

Plan a Strategic Response to Dodd-Frank
Figure 1.1

This finding is confirmed by Figure 1.2: a clear majority of respondents did not plan to change their assets under management in response to the new regulatory environment even though lowering the AUM below a certain threshold could exempt hedge fund advisers from the Dodd-Frank Act requirements.

Consider Current Regulations to Determine AUM Size
Figure 1.2

Figure 1.3 illustrates hedge fund managers’ most common strategic responses in reaction to the registration and disclosure requirements under the Dodd-Frank Act. Most respondents indicated that they are addressing the requirements through compliance measures. By contrast, Figure 1.4 shows that a change of the funds’ legal structure, lowering the AUM, and other changes to escape the application of the Dodd-Frank Act do not constitute common strategic responses.

Most Common Actions Taken
Figure 1.3

Least Common Actions Taken
Figure 1.4

Figure 1.5 shows that 25 per cent of respondents plan on decreasing the AUM size of their funds to avoid the regulatory hassle. Others will increase current AUM size to cover expenses.

Take Regulatory Regime into Account for AUM by
Figure 1.5

Figure 1.6 suggests that the ideal AUM size for most respondents is somewhere between $150 million and $1.5 billion. However, existing regulation does not appear to have influenced funds’ choice regarding the size of their AUM. Rather, figure 1.7 suggests that choosing a particular AUM size is based on a fund’s strategy and its existing size.

Desired AUM After Dodd-Frank
Figure 1.6

Factors Influencing AUM Preference
Figure 1.7

Private fund profitability after the enactment of the Dodd-Frank Act

A major concern of the hedge fund industry prior to the enactment of the Dodd-Frank Act pertained to the possible effect of new rules and regulations on privacy, proprietary trading positions, and profitability. Managers were concerned that a leak of sensitive data managers report to the SEC could affect their profitability, result in possible reverse-engineering of a fund’s strategy, and the detection of weaknesses that rival firms could exploit. 

Figure 2.1 illustrates managers’ responses pertaining to the profitability of their hedge funds and the effects of the Dodd-Frank Act on investors. While the new requirements do not appear to have affected the earnings of hedge funds, Figure 2.2 suggests that the profitability of the management company will be affected. Future research examining hedge fund performance after the enactment of the Dodd-Frank Act may help clarify if the tectonic shift in hedge fund regulation through the Dodd-Frank Act had a latent or delayed effect on hedge fund earnings9.

Dodd-Frank Affect Fund’s Earnings?
Figure 2.1

Dodd-Frank Affect Management Compnay Porfits?
 Figure 2.2

Another major concern of the hedge fund industry revolved around the possible cost of compliance. The industry and regulators have not addressed the possible consequences of compliance costs. A high level of compliance costs could make it more difficult for new hedge fund start-ups to enter the market and result in consolidation of larger funds. If the consolidation of hedge funds should increase systemic risk, Title IV of the Dodd-Frank Act could result in the exact opposite of Congress’s intent10.  

Figure 2.3 indicates that the cost of compliance for the hedge fund industry is somewhat moderate. 48 per cent of respondents did not incur more than $100,000.00 in compliance costs per year after the enactment of the Dodd-Frank Act.

Cost Required to Comply with Dodd-Frank
Figure 2.3

Conclusion and future research

Despite initial industry grumbling, the results of this study suggest that hedge fund advisers are taking the new regulatory burdens under the Dodd-Frank Act in stride. Most hedge fund managers are not altering the size of their funds to avoid Dodd-Frank Act requirements. Managers are also not altering their investing styles. Most of the new registration and disclosure requirements have not affected the returns for hedge fund investors. 

Very few managers have changed their funds’ legal structure in response to Dodd-Frank Act requirements. Rather, hedge funds are adapting to the new requirements by outsourcing compliance work, hiring additional counsel, establishing new record-keeping policies, hiring additional staff, and changing marketing materials and investor communication. 

Hedge funds should easily absorb the cost of these measures. There is some evidence, however, that smaller investment advisers could be disproportionally affected by the registration and disclosure requirements in the Dodd-Frank Act. Future research may help policy makers appreciate the effects of the regulatory regime on smaller fund advisers11.

There is also some anecdotal evidence that ambiguities in the SEC forms may enable fund managers to report data in disparate ways. Disparate data reporting could make it more difficult for the newly created Financial Stability Oversight Council (FSOC) to conduct a comparative and comprehensive assessment of systemic risk. The FSOC’s work could be further complicated by funds’ use of estimates and educated guesses in disclosing the required data to the SEC. Future research could help clarify whether FSOC and SEC d12.

January 6, 2013: Paper Presentation at Annual Meeting of the Association of American Law Schools

Link to the paper: Forum Competition and Choice of Law Competition.

Forum Competition and Choice of Law Competition in Securities Law after Morrison v. National Australia Bank

Wulf A. Kaal

University of St. Thomas, Minnesota – School of Law

Richard W. Painter

University of Minnesota Law School


Minnesota Law Review, Vol. 97, 2012
U of St. Thomas Legal Studies Research Paper No. 12-12
Minnesota Legal Studies Research Paper No. 12-16

In Morrison v. National Australia Bank, the U.S. Supreme Court in 2010 held that U.S. securities laws apply only to securities transactions within the United States.

The transactional test in Morrison could be relatively short lived because it is rooted in geography. For cases involving private securities transactions in which geographic determinants of a transaction and thus applicable law are unclear, this article suggests redirecting the inquiry away from the geographic location of securities transactions towards the parties’ choice of law. In the long run, allowing parties to choose the law pertaining to private transactions could be more effective than relying on geography that is both indeterminate and easy to manipulate. Jurisdictions could then compete to induce transacting parties to bring private transactions within their jurisdictional reach by designing substantive law and procedures that parties choose ex-ante (“Choice of Law Competition”).

Recent cases expanding the jurisdictional reach of Dutch courts suggest that the Netherlands or another EU member state could engage in a different type of jurisdictional competition. Jurisdictions performing this role adjust their procedural rules to set up a forum within their borders for litigation that appeals to plaintiffs and their lawyers (“Forum Competition”). The U.S. engaged in some Forum Competition for extraterritorial securities litigation prior to Morrison, and the Dodd-Frank Act of 2010 empowers the SEC to continue to bring suits in the United States over securities transactions outside the United States. For many issuers and investors who do not choose the forum ex-ante, Forum Competition can be suboptimal. Depending on future developments, the acceptable outer bounds of Forum Competition between the United States and Europe may need to be defined by treaty or multilateral agreement.

Number of Pages in PDF File: 74

Keywords: securities, securities law, securities regulation, securities and jurisdiction, securities and choice of law

Accepted Paper Series

Venture Backed IPOs and the Competitiveness of US Capital Markets

The competitiveness of US capital markets can be impacted by IPO trends and listings of US companies and non-US companies on non US stock exchanges. Corporate Governance in the United States can influence listing decisions by management. A recent report from Wilson Sonsini ( on venture-backed IPOs has several interesting findings:

  • 98% of these companies had adopted a code of business conduct.
  • 94%  of the companies are incorporated in Delaware
  • Over 80% of the companies implemented a classified board in connection with the IPO.
  • More companies separated the chairman and CEO roles than combined them.
  • Venture capitalists who had invested in the companies are often represented on board committees (counting the VCs as independent,” despite their share ownership).

Inaccurate data reporting and suboptimal evaluations may prove to be a very serious issue that could really call into question FSOC’s work. To help policy makers evaluate these issues, I present data and discuss results in my forthcoming article.

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