CoCos in the Courts

Contingent Convertibles

Contingent convertibles (‘CoCos’) are subordinated debt instruments that either convert into shares or are written-down on the occurrence of a ‘trigger’ event.  If they convert, they are conventionally called convertible CoCos, despite the tautology.  The trigger for most convertible CoCos turns on the amount of equity the bank holds.  The trigger is set ex-ante in the prospectus for the CoCo.  Between 2009 and 2014 roughly US$140bn of CoCos were issued by banks within Europe.  As of July 2014, there were approximately US$30bn of CoCos outstanding in the United Kingdom.

BNY Mellon Corporate Trustee Services Ltd v LBG Capital No. 1 plc [2015] EWHC 1560 (Ch), [2015] 2 BCLC 261 concerned the remaining £3.3bn of convertible CoCos issued by Lloyds Banking Group in 2009.  The question was not whether the CoCos had been triggered, but whether Lloyds could redeem them under a call option inserted into the terms of issue.  Since CoCo issuance is predominantly motivated by the banks’ desire to meet regulatory capital requirements without issuing fresh equity, and because the interest rate attached to the bonds usually has to be generous to induce investors to take on the write-down/conversion risk, most issues contain terms permitting the bank to redeem the bonds if they cease to fulfil this goal.  The case highlights the difficulty of fixing CoCo contractual terms at the time of issuance when regulatory standards are in a state of flux.

Factual Background

In this case the Cocos issued by Lloyds would convert into ordinary shares at a 5% trigger level, i.e. when the bank’s equity fell to this level.  Equity was defined as being the bank’s Core Tier 1 (CT1) capital, as laid down in the then operative rules of the Basel Committee on Banking Supervision.  The call provision would become operative in either of two situations: if the CoCos ceased to count towards minimum regulatory capital, or if the Cocos ‘cease to be taken into account’ in any stress test applied to the bank.  The first call provision reflected the bank’s need for the CoCos to count towards regulatory capital not only when conversion was triggered but from the moment of issue.  In the aftermath of the financial crisis, the question of whether debt of any sort would continue to count towards regulatory capital was under intense discussion within the Basel Committee, and in 2009 it was not clear what the outcome would be.  In the event CoCos with triggers at this level did survive as an ingredient of regulatory capital, but only within the lowest level of that capital (‘Tier 2’ capital).  A higher trigger was required for CoCos to count as ‘Additional Tier 1’ (AT1) capital. The Lloyds notes did not make this grade, but did count as Tier 2 capital, and this was enough to defeat the first call option.

The second call option reflected the second situation in which capital is important to banks, i.e. when they are subject to stress tests by their national regulators.  A stress test is a simulation exercise in which the resilience of banks’ regulatory capital is tested in a hypothetical adverse scenario devised by the regulator.  The origins of the CoCos at issue in this case lay in such a stress test.  In 2009, the FSA stress-tested Lloyds against a threshold level of CT1 capital of 4% of risk weighted assets.  The purpose of the test was to assess whether in a crisis scenario the risk weighted assets of Lloyds would fall below 4% of CT1 capital.  The FSA found that Lloyds had a shortfall of £24-29 billion of CT1 capital.[1]

After considering various options, Lloyds embarked on a programme of raising further CT1 capital by raising £13.5 billion of equity through a rights issue, but also raising Tier 2 capital by exchanging existing debt securities for the CoCos at the heart of this case, which were known as Equity Convertible Notes (ECNs).  From a stress test perspective, the ECNs would convert into CT1 capital if, in the stress scenario, the bank’s CT1 fell to below 5%.  Consequently, the ECNs would be taken into account as CT1 capital as part of a stress test if the ‘pass mark’ in the stress test remained below 5% CT1 capital and the bank’s equity capital remained at a low level.

However, in the maelstrom of post-crisis regulatory reform, these things did not remain constant.  In 2014, the Prudential Regulatory Authority (the FSA’s successor) conducted a further stress test.  Under that test, the pass level was 4.5%, but now 4.5% of CET1, not CT1.  This change in terminology apparently reflected the more rigorous post-crisis Basel definition of what counted as assets for the purpose of regulatory capital assessment.  In any event, the crucial point is that the PRA confirmed to the bank that ‘as a result of the differences between the definitions of CT1 and CET1 capital, it is likely the ECNs would only reach the contractual conversion trigger [of a 5% CT1 ratio] at a point materially below 4.5% CET1.’[2]  In other words, the trigger point for conversion was now below the ‘pass mark’ in the stress test.  At the same time, as a result of regulatory pressure, the bank’s actual CET1 capital at this time was 10.1%, and in the stress test of that year its CET1 did not fall below 5%.  Consequently, the bank passed the stress test without relying on the ECNs.

In these circumstances it is perhaps not surprising that the bank concluded that the ECNs were not earning their keep.  They were unlikely to help the bank pass any future stress test and bank’s actual CET1 ratio meant that it met the international and national minimum capital requirements without them.  On the other hand, the ECNs were very expensive by today’s interest-rate standards, carrying a coupon of above 10%; the bank was locked into them in some cases for another seventeen years; and it was paying some £940,000 a day in interest payments.  It was clearly in the bank’s interest to redeem the notes and either not replace them or replace them with a higher trigger issuance of CoCos, whose conversion would be triggered at a level above the pass mark.

To this end, the bank seized on the regulator’s confirmation to the bank that the ECNs had not been taken into consideration in determining whether the bank passed the stress test to argue that the bank could redeem the notes under the second call option.

In the Lloyd’s ECNs, the stress test option was formulated as follows:[3]

a ‘Capital Disqualification Event’ is deemed to have occurred … (2) if as a result of any changes to the Regulatory Capital Requirements or any change in the interpretation or application thereof by the FSA, the ECNs shall cease to be taken into account in whole or in part (save where this is only as a result of any applicable limitation on the amount that may be so taken into account) for the purposes of any ‘stress test’ applied by the FSA in respect of the Consolidated Core Tier 1 Ratio.”

Issues and Judgment at Trial

Lloyds' central argument was that the call option would be triggered if the ECNs did not satisfy the purpose of providing capital to enable Lloyds to stay above the pass mark in a stress test.[4]  The judge did not agree with what he considered a “narrow interpretation of the definition of a [call option] which focuses only on the role of the ECNs in helping LBG to pass the stress test.”[5]  Rather, it was necessary to look at the role of the ECNs in the aftermath of a failed stress test.

Specifically, he said:[6]

“What is important is that, as Mr Goldring observed, a stress test does not stop at the point at which it can be seen that the stress test is either passed or failed. The stress test reveals not only whether a bank is able to meet internationally agreed minimum standards but, if it fails to do so, the extent of the shortfall and the most appropriate remedial measures that the regulator ought to require to be taken. Even though the minimum standard currently set ... by reference to CET1 means that the conversion trigger for the ECNs will never be reached before the stress is failed, the ECNs will still be relevant, if LBG were to fail the stress test, in ascertaining the extent of any shortfall in capital and the kind and extent of remedial action required.”

This is a very difficult argument to understand in the light of the fact that, as the judge accepted, the trigger point was below the pass mark.  It is absolutely true that the importance of failing a stress test lies for the bank in the remedial action it is required by the regulator to take.  Indeed, banks which only narrowly pass the stress test may be required to take further capital-building measures. (See Bank of England, Stress testing the UK banking system: 2014 results, December 2014).  However, it is difficult to see why the regulator should moderate the measures it might otherwise require of the bank because of the existence of CoCos with a trigger point below the pass mark.  The judge did not explain how this might occur.  The purpose of the remedial measures is to ensure that the bank would meet (or meet more easily) the pass level on a re-run of the test.  CoCos with a trigger point below the pass mark can never contribute to the achievement of that goal.

This argument is consistent with the Prudential Regulatory Authority’s actual decisions in relation to the two banks which only narrowly passed the stress test, RBS and Lloyds itself.  (See the Bank of England document, above.)  Those banks would normally have been required by the PRA to produce a revised capital plan (as the Cooperative Bank, which failed the test, was required to do).  But the PRA did not impose this on the two passing banks because of the progress they had made in relation to their capital position since the stress test.  Interestingly none of the identified progress consisted in raising Tier 2 capital, let alone Tier 2 capital with a trigger point below the pass-mark.  In the case of RBS, the progress consisted of increasing CET1 equity and issuing high-trigger AT1 CoCos.  In the case of Lloyds, the PRA pointed in particular to the fact that “in April 2014, the bank also exchanged certain Tier 2 capital instruments into £5.3 billion of high-trigger AT1 securities.”  Ironically, these were apparently the very same ECNs the remainder of which Lloyds was attempting to redeem in this case.[7]  It appears that, not only the bank’s shareholders, but also its regulator would have been happy had these notes been redeemed and replaced by a higher trigger CoCo.  In any event, if redeeming and replacing the ECNs would have been regarded as a positive step by the regulator, it is difficult to believe that the regulator would have attached much, if any, mitigating value to the continuance in existence of Tier 2 CoCos with a trigger point below the pass mark, if Lloyds had failed the test.  On that basis, the bank should have been allowed to redeem since it met the second condition for doing so.

[1] BNY Mellon at [5]

[2] At [20].

[3] At [25-6]

[4] At [52].

[5] At [55] (emphasis added).

[6] At [55].

[7] “£5 billion of those ECNs have recently been exchanged for other instruments, and approximately £3.3 billion across 33 series remain in issue in their original form.” (At [8])