Contingent convertible instruments and the brave new world of regulatory capital

This article examines the emergence of contingent convertible instruments as a potential means of boosting financial institutions' Tier 1 ratios in light of the ongoing global overhaul of the rules governing regulatory capital.

Orlando Fernández, PLC Cross-border


What is contingent convertible capital?

Contingent convertible bonds ( (also known as enhanced capital notes ( (ECNs), mandatory capital notes ( and CoCo bonds ( ) are hybrid securities, usually subordinated, that behave like debt securities ( in normal circumstances but automatically convert into equity securities ( in the issuer if a pre-defined regulatory event, such as a drop in the issuer's core Tier 1 capital  ( below a certain threshold, takes place. For more information on the international framework for capital requirements, see PLC Financial Services, Practice note, Basel II: an overview ( .

Dina Albagli, a partner specialising in capital markets at Herbert Smith LLP defines contingent convertible capital as:

"Securities which, on the date of their issue, are legally in the form of debt but are convertible into common equity and which are designed to provide loss absorbing capital. The precise nature of the conversion trigger will depend on the type of regulatory capital benefits that the issuer seeks, including which bucket within the various limits for Tier 1 capital it wishes the instrument to fall into."

A bank can issue convertible securities that qualify as Tier 1 capital from the moment they are issued provided that they meet the Capital Requirements Directive's (2006/48/EC and 2006/49/EC) criteria as amended by CRD II (2009/111/EC) (see below). The CRD aims to implement an EU-wide definition of hybrid capital and improve "the quality of capital from an industry and supervisory perspective", which in turn reflects the rules under Basel II (see Legal update, Capital Requirements Directive: publication in the Official Journal ( ). For more information on how the FSA has implemented the CRD in the UK, see PLC Financial Services, Practice note, UK implementation of the Capital Requirements Directive ( .

Alternatively, issuers can structure the contingent convertible securities as Tier 2 or lower Tier 2 capital and give them a feature that allows them to convert into Tier 1 capital at a later date, as Lloyds recently did (see below). From a bank's perspective, this structure is useful for the purposes of "stress-testing" under pillar 2 of Basel II (see PLC Financial Services, Practice note, Basel II: an overview ( ).

In addition to CoCo bonds, issuers, such as Rabobank, are experimenting with other forms of contingent but not necessarily convertible capital, such as instruments that automatically write-down to a certain percentage of their nominal value ( and are then repaid to bondholders in cash if the issuer's capital ratio falls below a certain percentage (see below).

Contingent convertible instruments originated in the insurance industry, which has traditionally relied on them, alongside other insurance-linked securities to protect against large one-off losses. For an overview of the main insurance-linked securities see Committee of European Insurance and Occupational Pension Supervisors (CEIOPS), Insurance-Linked Securities Report, June 2009. One of the earliest examples of a bank using contingent convertible capital was a transaction involving the Royal Bank of Canada (RBC) and Swiss Re in late 2000.

Why are issuers and regulators interested in contingent convertible capital?

Until late 2008, market participants believed that traditional hybrid securities ( (debt securities with some equity-like features), such as convertible bonds ( and preference shares ( , could shore up core Tier 1 ratios in times of stress. However, the regulatory and commercial appeal of hybrids nose-dived during the recent crisis, prompting issuers and regulators to seek more effective forms of shock-absorbing capital (see below).

In this context, contingent convertible instruments are gaining recognition as an asset class that could boost lenders' core Tier 1 capital ratios during a crisis without forcing them to stockpile large amounts of capital during prosperous times.

As part of the ongoing overhaul of the rules governing capital adequacy ( , several institutions are examining the potential role of contingent convertible capital in the post-crisis world including:

  • The EU.

  • The G20.

How many issues of contingent convertible securities have taken place so far?

Three transactions involving contingent convertible instruments have been completed since the fourth quarter of 2009:

  • The exchange offer by Lloyds Banking Group (Lloyds).

  • The exchange offer by Chelsea and Yorkshire Building Societies.

  • At the time of publication, Rabobank was also in the process of issuing a new type of contingent securities which, although not convertible into equity, will be automatically written-down to 25 per cent of their face value if the issuer's capital ratio falls below seven per cent (see below).

What are the key concerns about contingent convertible capital?

Despite the interest that contingent convertible capital has generated, there are unanswered questions regarding its potential advantages and disadvantages, these include:

  • Whether a sizeable market for CoCos can develop.

  • Whether they will be able to give Tier 1 ratios a big enough boost during a crisis.

  • Whether the issuer's regulatory capital ratio is an appropriate trigger for conversion.

  • Whether the investment mandates of fixed income investors will allow them to invest in instruments that might mandatorily convert into equity.

Against this background, this article examines the following:

  • The regulatory landscape before the crisis.

  • The rise and fall of hybrid securities.

  • Regulatory reform proposals affecting hybrid and contingent convertible capital.

  • The Lloyds and Chelsea-Yorkshire transactions.

  • Key concerns about contingent convertibles.


The regulatory landscape before the crisis

There is no evidence of banks using contingent convertible capital between the RBC-Swiss Re CLOCS deal in 2000 and the Lloyds exchange in November 2009. This is largely due to the dominant regulatory environment before the downturn, which allowed financial institutions to build up excessive leverage while gradually eroding the level and quality of their capital base.

As Carson Welsh, Head of the Equity & Debt Markets Group at Linklaters LLP explains:

"One of the now widely accepted problems in the pre-crisis world was the concept of procyclicality, which caused banks to end up with dangerously low levels of capital at the top of the market. When conditions took a turn for the worse, many banks found themselves with insufficient capital to shield them against the downturn. Regulators now want to impose countercyclical obligations on banks, to cushion the impact of potential future crises on the financial sector. In this context, contingent capital can become an important countercyclical tool because of its ability to display loss-absorbing and equity-like qualities if an issuer reaches a specific regulatory trigger point."

CoCos are not the first or only financial instrument with embedded countercyclical features. Issuers, investors, rating agencies ( and regulators used to believe that the equity-like characteristics of other hybrid securities, such as convertible bonds, would be capable of absorbing financial institutions' losses during a crisis while reducing their cost of capital in prosperous times. However, the value of hybrids plummeted during 2009, fuelling existing doubts over their future regulatory treatment (see below).


The rise and fall of hybrid securities

The rise of hybrid securities

The use of hybrid securities was confined to financial institutions until 2005 when issuings by non-financial companies became prevalent. By December 2008, the global value of hybrid securities had risen to US$800 (EUR568) billion. For background on the hybrid securities markets and how they work in practice see, Article, Corporate hybrid securities: combining debt and equity ( and Article, Corporate hybrid securities: debt equity chameleons ( .

This boom in issuing activity took place predominantly in the US and continental Europe. The first significant issuing of hybrid securities by a non-financial UK company did not happen until the second half of 2007 (see Article, Corporate hybrid securities: Rexam makes the first move ( ).

Several factors contributed to the popularity of hybrid instruments, notably:

  • Their ability to count as "innovative" or "non-innovative" Tier 1 capital subject to certain conditions (such as the FSA's 15 per cent cap on "innovative" Tier 1 instruments).

  • Their treatment for tax purposes which, until recently, allowed them to benefit from tax deductibility on coupon ( payments. For an example of an issue of Tier 1 securities in tax deductible form, see Article, Halifax Group plc Innovative Tier 1 securities ( .

  • The publication by Moody's of a set of guidelines for treating debt-equity hybrid instruments. The guidelines rank hybrids along a "debt-equity continuum" based on their loss absorption, ongoing payments and permanence features (see Moody's Investors Service, "Refinements to Moody's Tool Kit: Evolutionary not Revolutionary!" February 2005, available to registered users on Moody's website).

The fall of hybrid securities

As Welsh points out, "Although regulators and investors tend to look at the market from opposite ends of the spectrum, they both agree that, while many hybrid instruments did indeed absorb losses, not all hybrid capital operated in the way it was expected to during the crisis."

Simon Sinclair, a partner specialising in debt and equity capital markets at Clifford Chance LLP, notes that:

"Hybrid capital has suffered twin body blows recently. On the one hand, the market for hybrid instruments has been battered by coupon deferrals and restrictions on nationalised banks. On the other hand, there is a huge deal of uncertainty surrounding the future regulatory treatment of hybrids. This uncertainty began with the adoption of the CRD and has been made worse by current regulatory proposals under consideration by institutions such as the BCBS".

The market backlash against hybrids during 2009 was fuelled by banks:

  • Deferring coupon payments on certain subordinated instruments, such as convertible bonds.

  • Refusing to redeem them.

  • Buying them back at a significant discount to their nominal value.

Deferrals on coupon payments

Hybrid instruments often carry "optional" coupon payments, in other words, interest that is deferrable and non-cumulative or can be satisfied by, or from the proceeds of, an equity issuance (see Article, Corporate hybrid securities: debt equity chameleons ( ).

Throughout 2009, several European banks that had either been nationalised or received rescue funding from their respective governments deferred payments to subordinated bondholders whose instruments contractually allowed them to do so. Most deferrals were authorised or imposed by the relevant national authorities or the European Commission (Commission). For instance, the UK government, acting under the Banking (Special Provisions) Act 2008 (BSPA 08) and the Banking Act 2009 allowed Bradford & Bingley (B&B), to suspend interest payments to investors in existing subordinated bonds (see The Bradford & Bingley plc Transfer of Securities and Property etc. (Amendment) Order 2009 (SI 2009/320)). B&B later relied on this Order to defer payments to perpetual subordinated bondholders due in July 2009.

The Commission has also asked banks seeking approval for the receipt of government funding under the State aid ( rules to postpone payments to subordinated bondholders whose instruments carry optional coupons. The Commission's restriction implements the idea of "burden sharing", which establishes that capital holders in a bank subject to a government restructuring must contribute to the restructuring as much as possible and bear adequate responsibility for the bank's past behaviour.

According to the Commission, in a restructuring scenario, "The discretionary offset of losses by beneficiary banks in order to guarantee the payment of dividends and coupons on outstanding subordinated debt, is in principle not compatible with the objective of burden sharing." The Commission does, however, distinguish between instruments with discretionary coupon payments and those with mandatory ones (see Commission (EC) Communication 2009/C 195/04, on the return to viability and the assessment of restructuring measures in the financial sector in the current crisis under the State aid rules). For further information on State aid, see PLC Competition, Practice note, Competition regime: State aids ( , Article, Investigating state aid: the Commission's procedure ( and Commission Decision (EC) No N 615/2008 State aid to BayernLB.

Refusals to redeem

During 2009, several banks also decided not to redeem subordinated debt instruments whose terms and conditions allowed them to do so.

For instance, on 4 September 2009, the Royal Bank of Scotland (RBS) announced that, in the context of ongoing discussions between the UK Government and the Commission regarding its restructuring plans, it would not redeem four subordinated debt instruments with call dates in October 2009.

Bond buybacks

Additionally, a number of banks including UBS, Lloyds, RBS, Credit Agricole and Barclays bought back Upper Tier 2 and, in some instances, Tier 1 bonds at a discount during 2009. These transactions further evidence the lack of issuer and investor appetite in subordinated capital that marked most of 2009 and the related emphasis on "core" Tier 1 capital. For further discussion of these transactions, see Article, Core capital is king ( .

Market reaction

As a result of these developments, rating agencies concluded that governments would be unwilling to support hybrid bondholders in rescued institutions and downgraded the credit rating of these securities accordingly. Some agencies, such as Fitch, even modified their methodology for rating hybrids (see Fitch Ratings, Report, Fitch Downgrades Lloyds, RBS, ING, other EU Banks' Hybrids on Increased Risk of Coupon Deferral, 20 August 2009). The market value of hybrid securities consequently plummeted during 2009.

Welsh expects reduced levels of hybrid issuing activity to continue for the first part of 2010, mainly because of regulatory uncertainty. He also notes: "The role that hybrids will play going forward is currently the subject of an active and lively debate."

Regulatory reform proposals

Improving the quality and quantity of capital that financial institutions should hold is currently a key priority for regulators worldwide. For background on the key international reform proposals see, PLC Financial Services, Practice note, Hot topics: Proposals relating to the quality and quantity of capital ( ).

The EU, in collaboration with the BCBS, has so far been the driving force behind these initiatives in Europe.

Welsh hopes that a new regulatory landscape that clarifies "what capital will need to look like, how much of it banks will have to hold and what grandfathering ( provisions may continue to be available" will emerge during the second half of 2010.

This section examines recent proposals and statements relating to contingent convertible and hybrid capital made by the BCBS, EU, G20, FSA, several US Federal Reserve Banks and the US Congress.


The BCBS has played a pivotal role in the development of international capital adequacy rules since the publication of the Basel Accord ( (Basel I) in 1988.

In 1998, the BCBS published the "Sydney Press Release" (see BIS, Press Release, Instruments eligible for inclusion in Tier 1 capital), which had a major impact on the treatment of hybrid securities for regulatory capital purposes worldwide.

On 7 September 2009, the Group of Central Bank Governors and Heads of Supervision, which acts as the BCBS's governance body, published a set of measures to strengthen the regulation, supervision and risk management of the global banking sector (see Bank for International Settlements, Basel Committee on Banking Supervision, Press Release, Comprehensive response to the global banking crisis).

Central to the measures' objective is the need to raise the quality, consistency and transparency of Tier 1 capital. To achieve this, the BCBS concluded that, "The predominant form of Tier 1 capital must be common shares and retained earnings" (see PLC Financial Services, Practice note, Hot topics: Proposals relating to the quality and quantity of capital ( ).

The BCBS published two consultative documents on 17 December 2009, one of which contains proposals "to strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector" (see Legal update, BCBS consults on proposals to strengthen global capital and liquidity regulation ( and BCBS Consultative Document, Strengthening the resilience of the banking sector).

The BCBS is currently undertaking a comprehensive impact assessment of the capital and liquidity standards proposed in the December 2009 documents. Based on this assessment, it will review the regulatory minimum level of capital and the reforms proposed in the document.

Among other proposals, the impact assessment aims to examine the role that "contingent capital, convertible capital instruments and instruments with write-down features should play in a regulatory capital framework", both in terms of their inclusion into regulatory capital and their use as buffers.

In relation to hybrid securities and other innovative capital instruments, the consultative document advocates "phasing out" instruments that are not capable of absorbing losses on a going-concern basis.

The BCBS is also considering the appropriate treatment of Tier 1 capital instruments which have tax deductible coupons (see above).

Although most practitioners expect the regulatory treatment of hybrid securities to be tightened, they are anxious about the document's lack of detailed information regarding what grandfathering or transitional arrangements, if any, will be available. Although the BCBS is considering the possibility of allowing instruments issued by banks before 17 December 2009 to benefit from grandfathering , banks and investors will have to wait for the outcome of the impact assessment to know whether this will be the case.


In order to transpose the Sydney Press Release into European legislation, the EU amended the original Capital Requirements Directive (2006/48/EC and 2006/49/EC) through a new directive (2009/111/EC) (CRD II), which addresses the treatment of hybrid securities among other areas. The FSA is currently trying to implement CRD II via a consultation paper entitled Strengthening Capital Standards 3 (CP09/29) (see below).

The Committee of European Banking Supervisors (CEBS) (an advisory body made up of high level representatives from the banking supervisory authorities and central banks of the EU) played an instrumental role in the adoption of CRD II, mainly by providing the Commission with technical advice and, more recently, publishing implementation guidelines for hybrid capital instruments (see CEBS, Implementation Guidelines for Hybrid Capital Instruments and Legal update, CEBS publishes guidelines on hybrid capital instruments for the purposes of the Capital Requirements Directive ( ).

Following the BCBS's publication of "Strengthening the resilience of the financial sector" (see above), the Commission wants to introduce further amendments to the CRD (CRD4) and launched a consultation process in February 2010 (see EU Commission, Public consultation regarding further possible changes to the Capital Requirement Directive ("CRD") and PLC Financial Services, Legal update, European Commission publishes consultation on CRD 4 proposals ( ).


On 5 September 2009, the G20 published a declaration outlining further initiatives aimed at strengthening the financial system to prevent the build-up of excessive risk and future crises and support sustainable growth (see G20 Meeting of Finance Ministers and Central Bank Governors, Declaration on Further Steps to Strengthen the Financial System, London (G20 Declaration)).

The statement recommends exploring the possible role of contingent capital as a means of developing stronger prudential regulation (see PLC Financial Services, Legal update, G20 finance ministers and central bank governors publish communiqué following preparatory meeting ( and Contingent convertibles gain credence ( ).

Following the G20's meeting in St. Andrews on 7 November 2009, Prime Minister Gordon Brown also identified "contingent capital arrangements" as a possible mechanism to devise "a better economic and social contract to reflect the global responsibilities of financial institutions to society" (see PLC Financial Services, Legal update, G20 Finance Ministers and Central Bank Governors publish communique following meeting in St Andrews ( ).


On 10 December 2009, the FSA published CP09/29, which sets out its proposals for implementing CRD II into UK legislation (see PLC Financial Services, Legal update, FSA publishes consultation paper on strengthening prudential regime ( ). Chapter 3 of CP09/29 examines the FSA's proposed approach for implementing the CRD in respect of hybrid capital. For further information, see PLC Financial Services, Practice notes, UK implementation of the Capital Requirements Directive ( and The future of financial services regulation and supervision: the Turner Review and DP09/2 ( ).

In relation to hybrid and contingent capital, CP09/29 mirrors the view outlined in paragraph 4.3.8 of the FSA's feedback statement (FS09/3) to the Turner Review, which states that hybrid capital instruments must be capable of supporting core Tier 1 by means of a conversion or write-down mechanism at an appropriate trigger. CP09/29 further asserts that "Instruments with these characteristics could be seen as a form of contingent core tier one capital" (see PLC Financial Services, Legal update, FSA publishes feedback to Turner Review and DP09/2 ( ).

According to Welsh, CP09/29 raises interesting questions regarding the future role of hybrid capital instruments in general. According to CP09/29, GBP9 billion (EUR10.4 billion) of preference shares and close to GBP30 billion (EUR34.8 billion) of innovative capital will need to be refinanced in the UK by 2020. Welsh believes that these refinancings are going to require a lot of capital. He maintains that:

"In circumstances where GBP39 billion worth of hybrid instruments will need to be refinanced, where regulators are going to require increased levels of capital and where there will be selling pressure in the equity markets at roughly the same time as European governments try to sell down their equity stakes in rescued banks, one would expect there to be an important ongoing role for hybrid instruments."

Although CP09/29 does not expressly mention contingent capital, FSA Chairman Adair Turner recently urged banks to either "accept that debt capital had little or no role in the required capital of large systemically important banks or create a role for contingent capital" (see PLC Financial Services, Legal update, FSA Chairman addresses the issue of systemically important banks being 'too big to fail' ( ).

According to its business plan for 2010/11, published on 17 March 2010, the FSA plans to continue contributing to the ongoing international reform of the rules on capital adequacy, notably by:

  • Participating in the BCBS's impact assessment in order to "Help inform final decisions on the definition and calibration of capital". The FSA also intends to argue for the inclusion of "appropriate phase-in measures and grandfathering provisions".

  • Continuing to examine "the potential role of contingent capital and convertible capital instruments in line with further work by the BCBS".

  • Implementing CRD II and participating in the consultation regarding CRD4 (see FSA Business Plan 2010/2011 ( ).

US Federal Reserve and US Congress

Federal Reserve

US regulators are also exploring the potential shock-absorbing features of CoCos. On 13 November 2009, William Dudley, president of the Federal Reserve Bank of New York ( , stated that the Federal Reserve was extremely interested in the idea of contingent capital. Similarly, Eric Rosengren, president of the Boston Federal Reserve Bank recently mentioned recently that he "strongly endorses" the idea of requiring banks to hold debt that converts into equity during times of stress.

US Congress

Additionally, Section 1115 of H.R. 4173 of the Wall Street Reform and Consumer Protection Act, which the House of Representatives passed on 11 December 2009, authorises the Federal Reserve Board of Governors to issue regulations that "require a financial holding company to maintain a minimum amount of long-term hybrid debt that is convertible into equity when:

H.R. 4173 will have to be reconciled with the Restoring American Financial Stability Act , which was introduced to the US Senate on 15 March 2010 (see PLC US Corporate & Securities, Legal update, Senator Dodd Introduces Revised Senate Financial Regulatory Reform Bill ( ). The Senate Bill lists contingent capital requirements as one of several prudential standards that a proposed new Agency for Financial Stability would be responsible for establishing by regulation. These requirements would be broadly similar to those in H.R. 4173. For an overview of the main financial regulation reform proposals under discussion in the US see, PLC US Corporate & Securities, Practice note, Financial Regulation Reform Initiatives ( .


The Lloyds and Yorkshire-Chelsea transactions


Lloyds Banking Group (which is currently is 43.4 per cent owned by the UK Government) and HM Treasury spent a considerable part of 2009 negotiating the bank's state-led restructuring plan with the Commission. These negotiations made it clear that the Commission would require Lloyds to suspend optional coupon payments to subordinated bondholders (see above, Deferrals on coupon payments).

On 3 November 2009, Lloyds announced that it would:

Lloyds capital-raising had an initial target of GBP21 (EUR23.8) billion to be raised through a GBP13.5 (EUR15.3) billion rights issue and a GBP7.5 (EUR8.5) billion offer to exchange subordinated bonds for ECNs.

The securities eligible for exchange into ECNs included:

  • GBP2.52 (EUR2.9) billion of Upper Tier 2 securities.

  • GBP7.68 (EUR8.7) billion of Tier 1 securities.

  • Preferred stock with an aggregate liquidation preference of GBP4.09 billion.

The ECNs are subordinated debt (Lower Tier 2 capital), with fixed maturities ranging from ten to 15 years. However, if the bank's core Tier 1 ratio falls below five per cent, they will convert into equity shares in Lloyds. For a summary of the Lloyds transaction’s key terms see box PLC What's Market? Lloyds Banking Group plc enhanced capital notes and PLC Finance, Legal update, Lloyds issues contingent convertibles, a new form of hybrid security ( .

The exchange was highly successful with a take-up rate of 86 per cent, comprising 90 per cent of investors who would have been affected by Lloyd's suspension on coupon payments and 78 per cent of those bondholders who still would have been paid coupon.

Practitioners have noted that the exchange's high success rate was to be expected as, in addition to maintaining coupon payments (unlike the bonds they were replacing), the ECNs offered yields up to 2 per cent higher (see key concerns about contingent convertibles).

Chelsea-Yorkshire Building Societies Merger

On 3 December 2009, Chelsea Building Society announced that it would exchange GBP200 (EUR 223.9 ) million of dated Tier 2 securities with mandatory coupons for GBP100 (111.9) million of new notes issued by Yorkshire Building Society as part of the merger between both mutuals.

The new notes are Tier 2 securities with a 13.5 per cent coupon and 15 year maturity. They convert to Profit Participating Deferred Shares (PPDS) should the Core Tier 1 ratio of the merged entity fall below 5 per cent The exchange was relatively popular despite the fact that the old securities carried mandatory coupons (and were therefore not at risk of deferral) and investors were getting one new note for two of the existing ones. For an overview of the FSA's position on PPDS see, PLC Financial Services, Legal update, FSA issues statement on profit participating deferred shares ( .


A new contingent senior unsecured ten-year eurobond, which Rabobank was reportedly in the process of marketing at the time of publication, may provide a litmus test for the attractiveness of contingent capital to new money investors.

Rabobank's bonds behave like debt securities (carrying a coupon of 6.875 per cent) unless the issuer's capital ratio falls below seven per cent, at which point they are written down by 75 per cent, with the remaining 25 per cent being returned to investors.

These contingent securities are substantially different to Lloyds's ECNs, notably:

  • Rabobank is a mutual with no equity capital. Consequently, these securities will not, unlike Lloyds's ECNs, convert into equity upon the occurrence of a trigger event, they will simply be written down. They are contingent but not convertible.

  • While Lloyds's ECNs are designed to boost the bank’s core Tier 1 capital upon conversion, Rabobank's securities would reduce the issuer's balance sheets liabilities upon the occurrence of a trigger event.

  • Lloyds's ECNs bonds were rated BB/Ba2, Rabobank's bonds will be unrated.

  • Whereas Lloyds ECN's were offered in exchange for existing debt, Rabobank's bonds represent a new capital injection.

  • Unlike Lloyds, Rabobank is currently a AAA-rated issuer and is issuing these bonds from a position of strength.

The transaction has reportedly generated strong interest, with EUR2.6 (USD3.47) billion of orders from 180 institutional investors including insurers, asset managers and hedge funds. For further information see, PLC Finance, Legal update, New form of contingent convertible bond ( and Rabobank Offers New Type of Contingent Bonds ( .

A recent HM Treasury discussion paper on capital requirements for building societies identifies contingent convertible notes, such as those issued as part of the Chelsea-Yorkshire Building Societies merger, and contingent notes with write-down features, such as those issued by Rabobank as some of the new instruments that building societies have recently created in order to enhance their capital base. Although the paper recognises that these new instruments "highlight some of the challenges building societies and other financial institutions face", it does suggest that these new forms of capital could provide an "alternative to pursuing significant business model changes that might enhance societies’ appeal to investors". At the time of publication, the paper is seeking comments from building societies, investors, members and other interested parties on a contingent capital arrangements and other options for securing the long term stability and growth of the building society sector. For further information, see PLC Financial Services, Legal update, HM Treasury publishes discussion paper on building society capital and related issues ( and HM Treasury, Building Society Capital and related issues: a discussion paper.

In March 2009, RBS considered exchanging some of its bonds (which like Lloyds's are currently subject to a suspension on coupon payments) for coupon paying instruments with write-down or convertible features. In the end however, RBS abandoned the idea of issuing contingent capital instruments and opted for a buyback of up to GBP7.7 (USD11.4) billion of debt and preference shares. RBS cited "the changing shape of regulation and the changing dynamic around stress tests" as one of the reasons why it opted for this, admittedly, more conservative structure. This suggests that issuers are erring on the side of caution until the new developing international regulatory landscape becomes more certain.


Key concerns about contingent convertibles

Although contingent convertibles have recently generated a lot of interest, practitioners agree that they are still at the trial stage. There are also concerns about certain characteristics of CoCo bonds. The main criticisms are summarised below.

There may not be a market for contingent capital

The respective up-takes in the Lloyds and Chelsea exchanges were a success, Welsh observes, "For many of Lloyd's investors the option they had was either to hold on to an instrument that would pay no interest for two years or swap it for a coupon-paying instrument."

Albagli says that the Lloyds transaction only shows how the market might react "if you issue convertible instruments further up the capital structure and as part of an exchange for instruments that are not paying coupon. Investors may react rather differently to CoCos issued in different circumstances."

Rabobank's issue was the first "new money" issue of contingent capital by a AAA-rated issuer. Although the take-up figures have so far been encouraging, practitioners agree that it is still too early to talk about contingent capital taking off commercially.

The conversion may not happen quickly enough

The trigger point in both of the Lloyds, Chelsea-Yorkshire and Rabobank issuances is based around regulatory capital, which, it has been argued, may be too late for it to be an effective loss-absorber in practice.

A recent report by Standard & Poor's outlining the agency's criteria regarding contingent capital notes that, "The conversion would need to happen early enough in the issuer's credit deterioration to be able to make a difference to that decline. A trigger level set at the regulatory capital threshold (or very close to it) is generally insufficient to warrant equity-like treatment in advance of actual conversion" (see Standard & Poor's, Ratings Direct, Standard & Poors Ratings Services Criteria Regarding Contingent Capital Securities).

Some commentators have suggested that the trigger point for conversion could be based on triggers other than capital ratios. Welsh notes that, "Looking back at how quickly some of the banks failed during the crisis, it could certainly be argued that a bank's ability to withstand major shocks may, depending on where the trigger point is actually set, not be reflected in its published regulatory capital ratio speedily enough." While Welsh acknowledges that Core Tier 1 ratios are not likely to react to a market deterioration as quickly as some other triggers, such as credit ratings or share prices, he identifies an issue with linking the conversion to a more market-based trigger, namely the fact that those triggers can be affected by many market events extraneous to the health of the particular bank. "If you were to link the conversion of CoCos to a market-based trigger, you would likely need to devise a structure that filters out those extraneous factors."

Additionally, as Albagli notes:

"If a bank wanted to issue a convertible instrument that qualified as Tier 1 under the CRD II definition within the 50 per cent bucket upon issue, it would have to structure it so that conversion was mandatory during emergency situations and could be triggered at the initiative of the competent authorities at any time. This could create a potential trigger based on the discretion of the competent regulatory authority. Although CRD II suggests that the exercise of the regulator's discretion would be based on the financial and solvency situation of the issuer, it remains to be seen whether an instrument containing this feature would find favour with investors given that, based on recent statements, it clearly does not appeal to one of the rating agencies."

On 11 February 2010, Moody's published a report stating that it would only rate contingent capital securities that convert into common equity if it could reasonably assess when their conversion would likely occur, in other words, only if the trigger is "objective and measurable", which will depend almost entirely on how it is defined. Moody's report also said that the agency will not rate any contingent convertible instruments the conversion of which:

  • Is at the issuer's discretion.

  • Is linked to triggers that are unrelated to the issuing bank's financial health.

  • Uses a credit rating in a conversion trigger.

At present, Moody's will not rate contingent convertible instruments the conversion of which is subject to the exercise of regulatory discretion or the breach of regulatory capital triggers, although it may do so if clear regulatory rules enhancing the predictability of a triggering event develop in the future.

Any rating that Moody's may assign to contingent convertible instruments would be no higher than the rating on the issuer's non-cumulative preferred securities and would also likely be non-investment-grade, irrespective of the bank's financial strength.

Restrictions on fixed income investors

CoCos could prove difficult to market if certain fixed income investors are barred by their investment mandates from investing in equity securities (which would prevent them from holding on to CoCos in a hypothetical post-conversion scenario).

According to Sinclair this is a realistic concern, "The concept of hybrid capital converting into equity has been foreshadowed by the CRD and there have already been discussions about what this would mean for fixed income investors."

Capital markets practitioners may be able see around these restrictions by, for instance, setting up structures that deliver the cash value of the equity to fixed income investors (provided that the underlying shares can be sold).

As Welsh adds, "The only empirical evidence one can point to in relation to this issue is the take-up rate in the Lloyds offer, which was very strong. Future transactions will shed further light on this issue."


Going forward

CoCos have generated a lot of expectation but they are still at an experimental stage. Some practitioners are slightly perplexed by the amount of press coverage that an instrument that, until recently, had only been used in two tailored situations has generated.

The broad consensus among lawyers is that the future of CoCos is entirely in the hands of regulators. As Sinclair concludes, "We are still in the dark about how regulators will ultimately treat CoCos. For all we know, they could still prove an absolute non-starter." Sinclair also believes that, "Given the amount of attention that they have been receiving from regulators, there must be a role for hybrid capital securities, at least from the banks' perspective. Whether investors will continue to find these instruments attractive will depend on their own pricing versus risk analysis. In any event, it seems fairly certain that the hybrid market is unlikely to go back to the size it was before the crisis in the near future."

According to Welsh, "Assuming the numerous impact studies and reviews currently being conducted conclude that it is going to be impractical to source all the extra capital that is going to be needed over the coming years from the equity markets, you will need products which are both good quality capital instruments and attractive for fixed income investors. In that scenario, there is certainly scope for CoCos and other hybrid securities to fill that gap."

Albagli concludes that, in the light of recent regulatory developments, banks will certainly have to boost their Tier 1 capital. While the future importance of contingent convertibles remains to be ascertained, whether an active market for CRD II-compliant Tier 1 hybrid capital instruments with the requisite write-down features can emerge in the near future is also a moot point: failing that, there could be a real question mark over the future of Tier 1 hybrid capital.


PLC What's Market: LLoyds Banking Group plc enhanced capital notes


LBG Capital No.1 plc or LBG Capital No.2 plc

Date announced

3 November 2009


GBP7.5 billion (aggregate value)

Deal summary

Enhanced Capital Notes (ECNs or contingent capital bonds (Cocos)) issued by LBG Capital No.1 plc or LBG Capital No.2 plc guaranteed by Lloyds Banking Group plc (LBG) or Lloyds TSB Bank plc (Lloyds TSB). Holders of certain classes of tier 1 and upper tier 2 securities were invited to offer to exchange those securities for ECNs or an amount payable in new and/or existing shares, or cash.

The fixed interest rate and maturity date for each ECN was set out in the Pricing Schedules in Part B of Appendix 2 of the Offering Memorandum of the US exchange offer or the Pricing Schedules in Part B of Appendix 6 ( of the Offering Memorandum of the non-US exchange offer.

Issuer country of incorporation

England and Wales

Industry sector


Market on which bonds are listed

Main Market

Market(s) on which shares are listed

Main Market


The Exchange Offer Memorandum stated that it was expected that:

  • The ECNs guaranteed by Lloyds TSB would be assigned a rating of BB by Standard & Poor's, Ba2 by Moody's and BB by Fitch.

  • The ECNs guaranteed by LBG would be assigned a rating of BB- by Standard and Poor's, Ba3 by Moody's and BB by Fitch.


Bearer or registered (as specified in the relevant Pricing Schedules)

Interest payment dates

The interest payment dates for each series of ECNs were specified in the relevant Pricing Schedules.

Initial conversion price (and premium)

59.2093 pence per ordinary share.

Conversion rights

The ECNs were not convertible at the option of the ECN holders at any time.

Mandatory conversion

If at any time LBG's consolidated core tier 1 ratio was less than 5 per cent each ECN would be converted into new and/or existing ordinary shares in LBG.

Adjustments to conversion price

The conversion price would be adjusted in certain circumstances. The circumstances reflected those that are customarily included in a convertible bond issue.

See paragraph (b) of the Deed Poll ( (summarised in condition 7).

Capital distribution

The conversion price would be adjusted if LBG paid or made any dividend or distribution (including a cash or non-cash dividend) to shareholders.

See paragraph (b)(iii) of the Deed Poll ( (summarised in condition 7).

Spin off events

A spin-off of LBG would be treated as a dividend to shareholders under paragraph (b)(iii) of the Deed Poll ( and would trigger a conversion price adjustment.

Position on change of control of issuer

If the conversion of ECNs to ordinary shares of LBG was triggered after an approved person or persons acting in concert acquired control of LBG the ECNs would be converted into shares of the acquiror at a conversion price determined by the calculation in paragraph (g) of the Deed Poll  ( (summarised in condition 7).

The conversion price initially would be an amount determined in accordance with a formula based on the volume weighted average price of the shares in the acquiring entity and would be adjusted in the circumstances provided in the Deed Poll.

If LBG did not within a specified timeframe following the change of control enter into arrangements to its satisfaction with the acquiror for delivery of shares upon a conversion of the ECNs then no conversion would take place at any time. If the acquiror was not an approved person then no conversion would take place at any time.

Issuer early redemption option

The issuer could not redeem the ECNs prior to the final maturity date other than in these circumstances:

  • A tax event had occurred and was continuing. A tax event was deemed to have occurred if (a) the issuer (or guarantor, if the guarantee had been called) was obliged to pay additional tax as a result of a change in UK tax law or regulation or general application or interpretation of such law or regulation which could not be avoided by taking reasonable measures or (b) as a result of such change in tax law the issuer (or guarantor) would not be entitled to (x) a tax deduction in respect of its financing expenses in relation to the ECNs or the guarantee or (y) have any loss resulting from such deduction taken into account when computing the group's tax liabilities, and in each case the issuer (or guarantor) could not avoid the event by taking reasonable measures.

  • A capital disqualification event had taken place and was continuing. A capital disqualification event was deemed to have occurred if (a) at any time LBG or Lloyds TSB (if it was the guarantor) was required by the FSA to have regulatory capital, in which case the ECNs would no longer qualify for inclusion in the lower tier 2 capital of LBG or Lloyds TSB or (b) as a result of any changes to the regulatory capital requirements or any change in interpretation or application of the requirements by the FSA, the ECNs had ceased to be taken into account for purposes of any "stress test" applied by the FSA in respect of the consolidated core tier 1 ratio.

Bondholder put option


Events of default

The ECNs would become immediately due and repayable upon the trustee giving notice to such effect following the occurrence of an event of default. The events of default described included only:

  • If there was a default in payment of any principal, premium or interest due in respect of the ECNs or (b) if an order had been made or a resolution passed for the winding-up of the issuer or either guarantor.

  • The trustee could, if the issuer was in default on payment or in breach of binding terms, institute proceedings for the winding-up of the issuer and/or the relevant guarantor or bring enforcement proceedings against the issuer and/or the relevant guarantor.

The trustee could take the actions described above at its discretion, but was required to do so if it was requested by the holders of at least one-quarter in principal amount of the ECNs outstanding or if it was directed to do so by an extraordinary resolution.

For details see Condition 12 (

Details of any lock up arrangements

No lock up.

Reason for issue

LBG intended to use the proceeds to increase its core tier 1 capital in order that it would not need to participate further in the Government Asset Protection Scheme. The exchange offers were part of a larger capital raising that included a £13 billion rights issue, see What's Market: Lloyds Banking Group rights issue.

Governing law

English (save that Condition 4  ( was governed by Scots law where the guarantor was LBG).

Selling restrictions

Restricted jurisdictions: US (only for non-US exchange offer) and Italy.

Lead managers

Merrill Lynch International (joint global co-ordinator, joint sponsor, lead dealer manager and joint structuring adviser)

UBS Limited (joint global co-ordinator, joint sponsor, lead dealer manager and joint structuring adviser)

Lloyds Banking Group plc (joint structuring adviser)

Citigroup Global Markets UK Equity Limited (dealer manager)

Goldman Sachs International (dealer manager)

HSBC Bank plc (dealer manager)

JP Morgan Securities Ltd (dealer manager)


BNY Corporate Trustee Services Limited

Legal advisers

Linklaters LLP (issuers)

Allen & Overy LLP (managers)

Public documents

Announcement dated 3 November 2009 (

Shareholders circular dated 3 November 2009 (

Non-US exchange offer

Non-US exchange offer memorandum 3 dated November 2009  (

Unadjusted conversion price announcement non-US exchange offer dated 18 November 2009  (

Results announcement non-US exchange offer dated 23 November 2009 (

Conversion price announcement non-US exchange offer dated 27 November 2009  (

US exchange offer

US exchange offer memorandum 3 dated November 2009 (

Unadjusted conversion price announcement US exchange offer dated 18 November 2009  (

Conversion price announcement US exchange offer dated 27 November 2009 (

Results announcement US exchange offer dated 8 December 2009 (

PLC materials

For a summary of this transaction and other recent convertible bond issuings, see PLC What's Market

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