188.8.131.52. Source of payments
If the only expected source of payment is from the profits of the issuer, the instrument may be viewed as equity rather than debt. Thus, if there is not a legal obligation for payment of interest, such as where an instrument provides that interest payments are made at the option or discretion of the issuer, the instrument could be classified as equity. Similarly, if an instrument provides for a legal obligation of payment of interest, but there is not a realistic expectation of such payment (e.g. if the shareholders of the issuer are also the creditors), the instrument could be viewed as equity.
The CoCos considered here provide for payment of interest at a fixed rate or a floating rate plus a margin. With respect to the CoCos, one would expect the business operations of the financial institution issuers would be able to generate sufficient cash flow to support repayment on the instruments, at least at the time of issuance of the CoCos. However, a feature of the CoCos here is that payment of interest is at the full discretion of the issuer. Further, interest will not be paid and will be canceled if on the interest payment date, the distributable reserves of the issuer are insufficient to make the interest payment. These facts may well support the classification of the instrument as equity, rather than debt.
184.108.40.206. Creditor rights
The fact that the holder of the instrument has the typical rights of a creditor in the event the issuer defaults on the instrument supports the classification of the instrument as debt. Such rights include:
-the right of the holder to assume control of the issuer on a default;
– the right to sue to enforce payment of principal and accrued interest;
– the right to file a claim as a creditor if the issuer goes into receivership;
– the right to institute bankruptcy proceedings;
– the right to share in the assets of the issuer prior to shareholders if the issuer liquidates or dissolves; and
– the right to recover interest and principal payments against a security interest
There is no indication that a holder of a CoCo does not have the typical rights of a creditor in the event of the issuer’s default, so long as the CoCo has not been converted into equity of the issuer. However, if a CoCo is converted into equity, the holder of the CoCo no longer has typical rights of a creditor, so this factor likely turns on the probability of the conversion feature being triggered.
A holder of a debt instrument generally has the right to share with the issuer’s general creditors in the event of the issuer’s liquidation or dissolution. Thus, the subordinated status of an instrument is a factor that supports treatment of the instrument as equity. However, subordination to
general creditors is not necessarily indicative of a stock interest. For example in Rev. Rul. 85-119, the instruments at issue were subordinated to the rights of all general creditors, but the IRS still found the instrument to be debt
Courts have also accepted subordination. In Green Bay Structural Steel, Inc. v. Commissioner, the notes issued to the holders were subordinate and junior in right of payment to all debt of the issuer, secured and unsecured, present and future. The Court said: “Subordination is not condemned but is an approved business practice … We can find nothing objectionable to subordination when it is dictated by the circumstances as here”.
Here, the CoCos are subordinated debt obligations of the
issuer. It is unclear whether the CoCos are completely subordinated to all other debt of the issuer, but even if that were the case, courts and the IRS have found complete subordination does not necessarily cause an instrument to be equity. Thus, this factor is likely neutral as to the determination of whether the CoCo is debt or equity.
220.127.116.11. Identity with shareholders of issuer
The fact that an instrument’s holders are also the shareholders of the issuer of the instrument, supports equity treatment for the instrument. This is because where there is an identity in the holders of the instrument and the shareholders of the issuer, all parties stand to gain or lose equally, depending upon the success of the issuer.
Identity between shareholders and lenders is not determinative of whether an instrument is equity rather than debt, however. Debt has been respected among parent and wholly-owned corporations, and has been respected when held by individual shareholders in proportion to their interests in the corporation. Nevertheless, where there is an identity of interest among the holders of equity and debt, particularly where the equity and debt are held proportionately, courts are more likely to treat a purported debt instrument as an investment in equity.
In the case of the CoCos at issue in this survey, there is no indication that the holders of the instruments are also shareholders of the issuers of the CoCos. Thus, this factor does not weigh in favour of equity treatment for the CoCos.