While there is no direct precedent for this form of instrument, the closest instruments that have been issued to date that would satisfy this provision are contingent convertible bonds (CoCos). CoCos convert automatically
to common equity when certain capital adequacy metrics are met, or trigger other equity-type features in such an event. Several financial institutions have issued their own versions of CoCos, as described below.
The Lloyds Banking Group, in November 2009, issued subordinated securities with fixed maturities ranging from 10 to 15 years, which automatically convert into equity whenever Lloyd’s core Tier 1 ratio decreases to less than 5% (at issuance, its core Tier 1 ratio was approximately 8.6%). The conversion price was set at approximately 65% of the current market trading price of Lloyd’s common shares at the notes’ date of issuance.
In May of 2010, Rabobank issued instruments that constituted senior debt but will be redeemed for cash at 25% of their principal amount in the event Rabobank’s consolidated equity capital ratio decreases to less than 7% (at issuance, this ratio was 12.5%). The instruments have a term of 10 years. At the time of the issuance of these notes, Rabobank had one of the highest credit ratings in the world, making the redemption unlikely.
In February 2011, Credit Suisse also issued CoCos in the form of subordinated notes with a term of 30 years. The Credit Suisse CoCos were designed specifically to meet the Basel Committee standards. In the event, the common equity Tier 1 ratio of the Credit Suisse group falls below 7% (at issuance, it was approximately 10%) or Credit Suisse essentially becomes “non-viable” (within the meaning of the Basel notice on contingent capital), the notes automatically convert into the common equity of the parent Swiss company. The conversion price is the higher of USD 20 or the then-current market price of the shares. Based on the conversion ratio, if the market price at conversion is USD 20 or higher, the holders will receive shares equal to the full principal amount of their investment, but if it is below USD 20, they will suffer a loss equal to the difference between USD 20 and the lower market value.
In all of the examples above, if the issuer becomes financially distressed and the conversion or redemption is triggered, the issuer automatically recapitalizes. Thus, it has been argued that CoCos may help avoid government bailouts in the event of another financial crisis.
2. The Issuer
2.1. Debt-equity classification 2.1.1. Generally
The US Internal Revenue Service (the IRS) has issued a public ruling that describes certain conditions under which a contingent convertible debt instrument may be treated as debt for US federal income tax purposes, although such instruments are factually different from the CoCos considered in this survey.
In Rev. Rul. 2002-31, the instrument was a 20-year debt instrument with a stated principal amount of USD 1,000x. Except for certain contingent interest, the instrument did not provide for any stated interest. The instrument was convertible at any time into a number of shares of the issuer’s stock having a value, on the date of the issuance of the instrument, that was significantly less than USD 635x. The debt instrument was part of an issue that was not marketed or sold in substantial part to persons for whom the inclusion of interest from the instruments in the issue is not expected to have a substantial effect on their US tax liability.