What are CoCo bonds? Capital bonds salvaging the issuer’s liquidity

The Act amending the Act on investment funds and management of alternative investment funds, the Act on bonds, the Act on the Bank Guarantee Fund, the deposit guarantee system and compulsory restructuring and certain other acts of 14 April 2023 introduced a new financial instrument into the Polish legal order – capital bonds. What are these instruments? Who can issue them? Who can purchase them? What rights do they give to bondholders? I answer all these questions in the article below.

Capital bond issuers

The group of capital bond issuers is precisely defined in the Act on bonds of 15 January 2015 (“Bonds Act”) and it includes:

1. domestic banks,
2. brokerage houses that operate in the form of a joint-stock company or a limited liability company,
3. domestic insurance undertakings,
4. domestic reinsurance undertakings.

The catalogue of issuers of capital bonds is therefore very short and limited only to highly professional entities.

Purpose of issuing capital bonds

If the memorandum or articles of association of the issuer so provide, the issuer may issue capital bonds in order to classify:

1. to own funds as instruments:
2. additional in Tier I in accordance with Article 52 of Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012 (“Regulation 575/2013”),
3. in Tier II in accordance with Article 63 of Regulation 575/2013,
4. to own funds as basic own-fund items:
5. category 1 in accordance with Article 71 of Commission Delegated Regulation (EU) No 2015/35 of 10 October 2014 supplementing Directive 2009/138/EC of the European Parliament and of the Council on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II) (“Commission Delegated Regulation (EU) 2015/35”),
6. category 2 in accordance with Article 73 of Commission Delegated Regulation (EU) 2015/35,
7. category 3 in accordance with Article 77 of Commission Delegated Regulation (EU) 2015/35.

The above objectives sound very enigmatic for an entity outside the group of financial institutions issuing capital bonds. Namely, the regulations in force in the European Union establish prudential requirements for institutions strictly related to the functioning of banking and financial services markets, which ensure financial stability of economic entities on these markets, as well as a high level of protection for investors and depositors. These requirements are intended to reflect a reduction in the level of risk depending on the nature, scale and complexity of the risks that result from the business model of a given institution and its activities. For this purpose, the capital structure of these institutions is divided into categories called “Tiers”. It is puzzling why even in the Polish version of Regulation 575/2013, the words “level” or “stage” were not used instead of “Tier”. In any case, this allows certain hybrid financial securities to be classified into these categories called Tiers.

Pursuant to Regulation No 575/2013, the institution’s (banks and brokerage houses) own funds consist of the sum of Tier I and Tier II capital. Tier I capital is divided into CET1 (Common Equity Tier I), i.e. the highest quality capital, and AT1 capital (Additional Tier 1), i.e. additional capital. In accordance with Article 51 of Regulation No 575/2013, additional Tier I items may include capital instruments that meet the conditions and criteria specified in Article 52(1) of this Regulation. The AT1 capital category may include contingent convertibles equipped with a loss absorption mechanism. The classification of a given financial instrument into an appropriate Tier is, as a rule, based on the ability of that capital to absorb losses.

Capital requirements for insurance market entities and the rules for classifying own funds into individual categories, as well as quantitative limits for the amounts of own-fund items classified into individual categories were established in the EU Directive commonly known as “Solvency II Directive” and “Commission Delegated Regulation (EU) 2015/35”.

The insurance and reinsurance undertakings are obliged to have eligible own funds in the amount not lower than the Solvency Capital Requirement (SCR) and eligible basic own funds in the amount not lower than the Minimum Capital Requirement (MCR). The provisions of the Act distinguish between basic own funds and supplementary own funds. Own-fund items are classified into three categories: category 1, category 2 and category 3. The classification of own funds into categories depends on the degree to which they have qualitative features defined as constant availability and subordination, taking into account the factors such as duration, lack of incentives for redemption, no mandatory service costs and lack of encumbrances. Category 1 is the highest category.

Buyers of capital bonds

The minimum nominal value of one capital bond is PLN 400,000 or the equivalent of this amount denominated in another currency. Therefore, the minimum value itself shows that this instrument is not intended for an “average Joe”. However, the Bonds Act specifies that only a professional client defined in Article 3(39b) items a–m of the Act on trading in financial instruments can be the subscriber or purchaser of capital bonds. This group includes, among others: banks, investment companies, AICs, AICMs, IFCs, insurance companies and pension funds.

Rights of bondholders

The principle is that capital bonds, just like irredeemable bonds, may entitle the bondholder to receive interest for an indefinite period. However, in the cases specified in the Bonds Act, the issuer’s management board may waive all or part of the interest on capital bonds or suspend its payment. Such action by the issuer is not failure to perform or improper performance of an obligation or a delay in the performance of an obligation.

A characteristic feature of capital bonds, commonly called “CoCos” (contingent convertible bonds), is that in the event of the occurrence of an initiating event described in the terms of issue, the issuer of capital bonds (depending on the legal form of the issuer and the classification of the capital bond):

• writes them down in the form of a permanent write-down or a temporary write-down, which reduce in whole or in part the nominal value of the capital bond,
• converts capital bonds into shares,
• makes deductions that reduce, in whole or in part, the nominal value of the capital bond,
• applies a loss coverage mechanism other than those specified above, which allows for a result equivalent to the results of the loss coverage mechanisms specified above.

For obvious reasons, the conversion of capital bonds into shares is not possible in the case of a cooperative bank, a brokerage house operating in the form of a limited liability company and a state bank.

The consent of bondholders is not required to carry out the above mechanisms. These mechanisms should be characterised by some kind of automaticity; that after the initiating event occurs, without unnecessary additional formalities, they are implemented, thus striving to save the issuer from bankruptcy.

Summary

As indicated in the justification to the draft act introducing capital bonds into the Polish legal system, enabling financial institutions to increase their capital base and classify capital instruments as additional components of own funds or basic own-fund items of financial institutions will contribute to increasing their competitiveness and the level of financial stability.