When, in years to come, the academics and economists look back on the current recession, there will undoubtedly be common factors that will draw the interest – the rise of sub-prime markets, the fall of Lehman Brothers, the bankruptcies of entire cities in the United States. For those operating in the financial services arena, however, we think that it is the rise of the regulator, on the back of public and governmental outrage at the behaviour of the financial institutions blamed for the crisis, which will resonate most strongly. Given a remit of “never again”, regulators across the world have sat up, gripped their freshly-bestowed powers firmly, and waded into battle.
These newly aggressive regulators have already left many casualties in their wake, and, later this year, when the UK’s Financial Conduct Authority (“FCA”) will for the first time utilise its product intervention powers, contingent convertible instruments (“CoCos”) will be added to the roster of the fallen.
What are CoCos?
CoCos are hybrid capital securities which feature both debt and equity elements. Issued as a bond paying a coupon, they convert into an equity security when a certain trigger event occurs. This trigger point is normally linked to the issuer’s regulatory capital ratio. CoCos were originally designed for purchase by institutional investors, principally asset managers and banks and their popularity has increased dramatically in recent years given the high yields offered.
The FCA has reported that the value of CoCos issued between 2009 and 2013 is estimated to have reached GBP 40 billion (USD 70 billion), 20.7% of which was issued by UK banks. Indeed, Bank of America Merrill Lynch predicts that the market value for European Additional Tier 1 capital CoCos could exceed EUR 150 billion by 2020.
With expected rapid short-term growth in issuance, the FCA has decided to implement measures to mitigate the potential harm caused to investors by CoCos’ complex and unusual characteristics, and in October 2014, it will restrict the distribution of CoCos to retail investors.
While financial institutions continue to increase their issuance of CoCos to fulfill prudential capital requirements, the FCA fears that their proliferation, and the returns offered, could see the investor market expand to incorporate ordinary retail investors. This is particularly likely at a time such as this of low interest rates when inexperienced and unsophisticated investors are tempted by high headline returns.
The FCA set out its principal concerns over CoCos in August 2014. Essentially, the fear is that the risks and unpredictability of CoCos renders them unsuitable for the mass retail market. For example:
- One particular class of CoCos, called “Additional Tier 1”, features an equity conversion or writing-down trigger, which corresponds to the capital position of the issuer. Should an issuer’s capital position fall to a certain trigger point, the issuer has the ability to write-off (partially or entirely), or convert into equity, the instrument, meaning that some investors could be left with little or no return
- Additional Tier 1 CoCos also feature entirely discretionary coupon payments, meaning that they could be cancelled indefinitely at any point and for any reason
- CoCos are also particularly difficult to price, and the factoring of risks into their valuation can be complex – for higher-rated instruments, although some characteristics, such as trigger levels and the credit spread of an issuer, are reasonably transparent, others, including an issuer’s future capital position and the likelihood of coupon payments, are more difficult to predict, and at the sub-investment grade, CoCos are even more difficult to value
The FCA’s announcement coincided with a statement from the European Securities and Markets Authority on the risks associated with CoCos.
FCA’s product intervention powers
The Financial Services Act 2012 introduced amendments to the Financial Services and Markets Act 2000 (“FSMA”) which, from 1 April 2013, have provided a framework of product intervention powers available to the FCA, including the ability to make temporary product intervention rules relating to certain types of investment and concerning specific persons. The FCA can intervene if it identifies products that could cause detriment to consumers either because of their characteristics or issuer distribution strategies. Intervention effectively prohibits firms from carrying out certain activities, for example entering into specified agreements with any person.
Temporary restriction of CoCos
As mentioned above, from 1 October 2014, the FCA will impose one of these temporary restrictions in relation to CoCos’. The restriction, set out in the “Temporary Marketing Restriction (Contingent Convertible Securities) Instrument 2014”, imposes a 12 month prohibition on firms selling or otherwise doing anything that would result in retail investors buying or holding a beneficial interest in CoCos. The restriction does not apply to professional or institutional clients or to exempt persons, and there are exceptions for some activities – for example, MiFID business relating to the sale (but not the promotion) of CoCos will be permitted.
Whilst the temporary restriction is in place, the FCA will carry out a consultation on CoCos, and a policy paper is expected in the second quarter of 2015, which, it is anticipated, will set out the permanent rules which will come into force on lapse of the temporary restriction on 1 October 2015. Given the increasingly aggressive stance of all regulators, not just the FCA, we consider it likely that the permanent rules will, at least, mirror the temporary restrictions. In any event, we shall report again following publication of the policy paper.