The document discusses the characteristics of ideal financial securities, emphasizing the advantages and disadvantages of debt and equity. It introduces coercive bond structures, such as Coco bonds and coerc, which aim to manage financial distress while avoiding wealth transfers during distress events. The analysis reveals how coerc mechanisms can provide discipline and mitigate risks for both bondholders and shareholders while improving corporate financial stability.

1. The case for COERCS
Theo Vermaelen
Professor of Finance
INSEAD

2. How should an Ideal Financial Security
look like?
• Tax efficient
• No negative information signal
• No costs of financial distress
• No agency costs
• No wealth transfers from shareholders to others
2

3. Equity
• Not tax efficient if company is profitable (-)
• Negative information signal as market expects timing (-)
• Low costs of financial distress (+)
• high agency costs (-)
• If shares undervalued, wealth transfer to new shareholders
(-)
3

4. Debt
• Tax efficient when company is profitable (+)
• No negative information signal (+)
• Costs of financial distress (-)
• Low agency costs (+)
• If shares undervalued, no wealth transfers to new
shareholders (+) 4

5. Choice between Debt and Equity
Imperfection Debt Equity
•Corporate taxes 1 2
•Expected COFD 2 1
•Agency costs 1 2
•Undervaluation 1 2
5

6. Government policies can correct tax disadvantage
• Example : Cooreman-De Clercq ( 1982)
• Companies that issued equity could deduct 13 % of the
amount issued from their taxable income for 10 years
• Personal tax advantages for individuals who invest in
common stock
• Result : More equity issued in 1982-1983 than during
previous 13 years
• Belgian stock market became “market of the year”
6

7. Cooreman-De Clercq and the stock market
Monthly cumulative return difference between KB-index and the “world”
index, from January 1981 until January 1984
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8. However : how to elimate COFD ?
Imperfection Debt Equity
•Corporate taxes 1 2
•Expected COFD 2 1
•Agency costs 1 2
•Undervaluation 1 2
8

9. 9
Coco bonds
• Contingent convertibles (CoCos) are bonds that mandatorily
convert to equity after a triggering event such as a decline
in the bank’s capital (Flannery (2005).
• Motivation: providing discipline of debt (tax deductions?) in
good times, avoiding COFD (bailouts!) in bad times.
• Since 2009 : 20 banks for $ 100 bn
• Although designed for banks potentially interesting for other
corporations ?

10. Cocobonds
• In good times: normal debt
• Bad times: mandatory conversion into equity
• Today mostly issued by banks
• Sometimes no conversion but total writedown
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11. Problems with Cocos
• How to define “bad times”?
• If “bad times” are based on stock prices how to avoid
manipulation and undeserved conversions?
• How to make sure they are not very risky so it is very
likely you are going to get your money back ?
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12. 12
Solution: COERC
• Call Option Enhanced Reversed Convertible
• Trigger based on market values
• When the trigger is hit, bondholders are forced to
convert at huge discount from stock price, creating
large potential dilution
• However,shareholders get the pre-emptive right to buy
new shares at the conversion price and repay debt
• As a result Coco bond becomes nearly riskless
• COERC coerces shareholders to pay back debt holders
12

13. Example
Assets: 100 Equity 60
COERCS 40
5 million shares outstanding (stock price $12)
Coerc converts into equity when equity falls to 1/3 of firm value.
When this happens the conversion price is 25 % of the stock price.
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14. Conversion will create Dilution
• Assume equity market value falls to 1/3 of assets because
assets fall to $ 60 million and equity to $ 20 million
• Assume that when this happens stock price is $ 4 which
means the conversion price is $ 1
• If conversion would take place bondholders would end up
with 40m/ 1 = 40 million shares or 40/45 = 89 % of total
assets = 89% x 60 = $ 53.3 million
• This means a windfall gain of (53.3 – 40) = $ 13.3 million
14

15. Preventing Conversion
• In order to avoid this wealth transfer to bondholders,
equityholders have pre-emptive rights to buy the shares by
repaying the debt
• Rights issue is announced for 40 million shares at $1
• After completion of rights issue firm is all equity financed with 60
million assets divided by 45 million shares or $1.33
• Rights issue would be unsuccessful if during rights period assets
would fall below 45 million
• Insurance against this failure can be bought by buying an
underwriting contract ( put option). Otherwise bondholders will
ask credit spread to compensate for this risk.
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16. How much would insurance cost ?
• Put option
• Maturity : 20 days
• Stock price : 1.33
• Exercise price 1
• Volatility : 70 %
• Jump process with 3 jumps per year jump size 50%
• P = 0.006 or 40 m x 0.006 = $ 0.24 m
• So you pay insurance fee of 0.6 %
• Ideally issuer should provide cash collateral for this fee.
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17. • There are 5 million shares outstanding
• Each share has 1 right
• 40 million new shares, so with each share you can
buy 8 new shares if you pay $ 1 x 8 = $ 8
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Payoffs to Investor

18. Wealth of the Investor with $ 8 in cash who owns
1 share worth $ 4
• If he exercises the right : 9 new shares at $ 1.33 = $ 12
• If he sells the right to buy new shares to someone else and
keeps his $ 8
cash $ 8
1 share $ 1.33
1 right = 8 x (1.33-1) $ 2.64
-------------------------- ---------
Total $ 12
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19. After the dust has settled
Assets: 60 Equity 60
45 million shares outstanding (stock price $1.33)
You cleaned up your balance sheet without transferring
wealth to debt holders
Potential to re-lever
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20. Implication for Bondholders
• The fear of dilution coerces equityholders into
repaying the debt as long as conversion price is
set at a significant discount from trigger price
• Debt is very likely to be repaid, rather than forced
to convert
• The only risk is that because of “jumps” the value
of the assets falls below $ 40 milion so that fully
diluted stock price falls below $ 1.
• In order to largely eliminate this risk issuers can
pay for firm commitment underwriting contract.
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21. Implication for Shareholders
• Because you are able to make a credible
commitment that you will pay back debt holders in
periods of financial distress, credit spreads will be
very small
• ROE will go up, although WACC remains the same
• As debt has become large risk-free, no more costs
of financial distress, hence total firm value will
increase
• Death spirals because of manipulation and panic
can be prevented
• COERC issuance is not a signal of overvaluation ! 21

22. Choice between Debt, Equity and Coerc
Imperfection Debt Equity Coerc
•Corporate taxes 1 3 1
•Expected COFD 3 1 1
•Agency costs 1 2 1
•Undervaluation 1 2 1
22

23. Intuition
• “Normal“ debt is risky because equityholders have
limited liability
• The Coercive feature of the COERC forces
shareholders to bail out bondholders to avoid dilution
• Because financially constrained shareholders can sell
their rights to others these constraints don’t matter
• Of course, this assumes that rights can be sold at fair
value
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24. Difference with other bonds
• Covered bond : collateral is put up front, illiquid?
> COERC: collateral is cash provided by Coercive rights
issue when needed
• Subordinated debt : credit spread charges for default risk
> COERC : no credit spread but firm commitment rights
underwriting fee when trigger is hit
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25. A case study
• Bidder is considering making a $ 120 million bid for Target
• It does not want to pay with stock
• If it borrows to pay for it it will have to issue bonds below
investment grade
• Can COERC be the solution ?
25

26. 26
Balance sheet of Bidder ( $ million)
Assets Liabilities
230 Debt 50
Equity 180
230 230
Stock price : $112 shares outstanding : 1.7 million
Debt/Assets = 22 %

27. 27
Balance sheet of Target
Assets Liabilities
115 Debt 25
Equity (E) 90
115 115

28. 28
Bidder after merger (assume $120 m purchase price for
target equity paid by issuing COERC; assume other debt)
Assets Liabilities
375 Debt 75
COERC 120
Equity 180
375 375
Debt/assets = 195/375 = 52 %
COERC converts when Debt/Asset = 65 % Discount of 50%

29. The trigger
• Based on market values of equity and book values of debt
• Because book values are normally calculated only quarterly,
company should update book values if it changes more than
1 %
• Note that this is not the same as a stock price trigger : you
can’t control the stock price but you can control leverage to
a large extent
29

30. What happens at conversion ?
• Debt/Assets = 65 % and Debt = 195
• Assets = 195/0.65 = 300
• Equity = 300 – 195 = 105
• This represents a fall in equity of (180-105)/180 = 42 %
• Current stock price is $ 112
• A 42 % decline means new stock price will be $ 65
• Then you announce a rights issue at a 50 % discount ($
32.5)
• This means new shares issued : 120 m/32.5 = 3.7 m
• Total number of shares outstanding is 3.7 m + 1.7 m =5.4 m
30

31. After the dust settles
• Total firm value is still 300
• Non-Coerc debt = 75
• Equity = 225
• Stock price (fully diluted) = 225/5.4 = $ 42
• Issue will fail if stock falls below $32.5 in 20 days
. Insurance : Underwriter firm commitment = put option
• Value of put ? Volatility = 70 % 3 Jumps per year of 50%
• Put = 0.226
• Total cost = 0.226 x 3.7 m = $ 0.836 m
• Total cost =0.7 % of 120 m raised
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32. 32
Bidder after merger + conversion
Assets Liabilities
300 Debt 75
Equity 225
300 300
Debt/assets = 25 %

33. Why issue COERCS ?
• You can borrow at (almost) the risk-free rate (A rating)
• You have however to commit to buy insurance by having the
rights issue underwritten.
• The underwriting fee only has to be paid when conversion is
triggered
• You may however put enough collateral aside to pay for the
underwriting fee
• Only if you are a true high credit risk you will pay the
insurance !
• This is better than issuing subordinated debt now with a
large credit spread to be paid every year
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34. Why buy COERCS ?
• You have a corporate alternative to buying government
bonds (low risk, A rated)
• Because the company has committed to insure the proceeds
of a rights issue to repay you when conversion is triggered,
your risk is largely eliminated
• High risk-aversion ( Banks ?)
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35. Why no COERC issued by Banks so far?
• Regulators insist on capital ratio triggers, not
market based triggers
• This in spite of proven failure of such triggers during
the financial crisis
• Regulators/bankers like capital ratio triggers for a
variety of reasons
• Corporate non-banking sector has freedom to
design contracts
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36. Regulatory Capital versus Market Value Capital Triggers
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37. Barclays partially Endorses COERC
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38. The ideal issuer
• Company perceived as risky
• Management feels market undervalues cash flows/
overestimates risk
• Profitable and therefore taxable business
• Current large shareholders don’t want to issue equity now
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