"CoCos and bail-inable bonds" how does this fit with transparency

The Financial Services Sector is getting prepared for the Capital Requirements Directive IV (CRD IV) which introduces new pay rules from 1st January 2014 and will impact bonuses paid in 2015 (in respect of the 2014 performance year). The area of this new Directive which is getting much focus is the Cap on Variable pay.

The banks are going to have to set appropriate ratios between fixed and variable pay, such that the variable portion granted each year must not exceed 100% of the fixed component. It is only with shareholder approval (of at least 66% of the shareholders,provided 50% of the shares are represented) that companies can increase the fixed:variable pay ratio up to a maximum of 1:2 (200% variable pay).

Fixed pay = payments or benefits without consideration of any performance criteria.

Variable pay = additional payments (or benefits) depending on performance and in excess of that required to fulfill the employee's job description. So this would include any bonus payable and the  long-term incentive plan (importantly valued at the date of grant). A discount rate of up to 25% can be applied to the variable pay, provided that it is paid in instruments which are deferred for 5 years or more.

Some creativity in this area is therefore expected, in the same way that EBTs/FURBS were used for Executives as a substitute for pensions provision when the Pensions Earnings Cap was introduced back in 1989 (was it really that long ago!), even though CRD IV does contain anti avoidance provisions.

So what are the likely solutions?

Increasing the fixed element of pay: there are lots of reasons why not to do this including increasing the fixed cost base of the financial institution, employment law implications as it is difficult to reduce fixed pay once implemented and of course public perception.

Introduce different types of variable pay: which have a low initial upfront value (at the time they are granted) but with greater potential upside. This would include co-ownership share structures (which already exist) whereby the employee only receives the gain on the value of the share which is subject to capital gains tax and an employee benefit trust holds the shares.

It will be interesting to see whether the financial services sector starts to (and is allowed to) use more complex alternative financial instruments as a substitute for the more traditional forms of variable pay - cash or stock incentive plans.

Some examples I heard of today and were new to my vocabulary were "CoCos" and "bail-inable bonds"! For those of you reading this blog who are not investment experts I have included a short definition below:

CoCos (or Contingent convertible bonds) are a form of debt securities that are coverted into equity upon a trigger event.

Bail-inable bonds are also a form of debt securities that are converted into shares upon a trigger event but they are also written down, potentially to zero, in order to "bail in" the bank.

My concern and reason for writing this, is how the potential creation of these new pay instruments sits against the UK Government reform on the reporting of directors pay and greater transparency on pay practices overall, but especially in the financial services sector where public and shareholder opinion is so high.

I will watch this space with continued interest over the next 12 months!