A Modest Proposal: Sustainability-Linked Bonds Reinvestment Trigger

A Modest Proposal: Sustainability-Linked Bonds Reinvestment Trigger

I’m going to try something a little different. I recently suggested that sustainability-linked bonds (SLB) could benefit from some creative thinking in terms of sustainability performance target (SPT) triggers. Well, I put my money where my mouth is and drafted a sample provision whereby an issuer, upon a failure to achieve an SPT, would be required to invest amounts comparable to a coupon step-up on an annual basis for the purpose of furthering its SPTs.

The primary benefit of reinvestment in lieu of a coupon-step up is that the SLB becomes a more holistic sustainable instrument that creates a virtuous cycle. Best case scenario, the issuer achieves its SPTs. Worst case scenario, the issuer misses its SPTs and is required to further invest in sustainability initiatives. This is in lieu of noteholders receiving an economic benefit from an issuer’s inability to meets its SPTs. Presumably, investors that are truly focused on the promotion of ESG and sustainability financing would welcome this trade off.

An additional impact of such a reinvestment requirement is that it gives the ESG/sustainability features of an SLB more “teeth” when it comes to the issuer’s covenant package (a common argument lobbed at ESG financial instruments), in the sense that the issuer’s failure to reinvest would result in a breach of the indenture. For those that have been arguing against the introduction of ESG-related covenants that could result in a default, I have two responses. First, SLBs already indirectly contemplate an ESG-related default in that, if an issuer fails to comply with the coupon step-up, an interest payment default occurs. Second, the reinvestment requirement, is strictly in the control of the issuer and is one that should be able to be achieved.               

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Sustainability Reinvestment

In the event that the Issuer fails to achieve the Sustainability Performance Target(s) by the SPT Deadline, the Issuer, any Restricted Subsidiary or any Affiliate of the Issuer shall apply an amount equal to 100% of the Sustainability Reinvestment Amount to make a Permitted Sustainability Investment, within [150] days from the end of each fiscal year commencing the fiscal year ending after the SPT Deadline [Note: timing should ideally align with annual sustainability report]; provided that a binding agreement or commitment entered into not later than such [150]th day shall be treated as a permitted application of the Sustainability Reinvestment Amount from the date of such agreement or commitment so long as the Issuer, such Restricted Subsidiary or Affiliate, enters into such agreement or commitment with the good faith expectation that such Sustainability Reinvestment Amount will be applied to satisfy such agreement or commitment within the later of such [150]th day and [90] days of such agreement or commitment. The issuer will report annually with respect to the utilization of the Sustainability Reinvestment Amount in its sustainability reports. Such sustainability reports will be separate from, and in addition to, the reporting required under the Indenture.  

The foregoing requirement to apply the Sustainability Reinvestment Amount will not be required in the event the Issuer has achieved the Sustainability Performance Target(s) on or prior to the SPT Deadline, as certified by the Issuer to the Trustee in an Officer's Certificate, which shall also include the SPT Verification Letter. 

[…]

"Permitted Investment" means (in each case, by the Issuer or any of the Restricted Subsidiaries):

 ( ) Permitted Sustainability Investments;

"Permitted Sustainability Investments" means any Investments or expenditures funded by Sustainability Reinvestment Amounts made in furtherance of the Group's achievement of its Sustainability Performance Target(s)   

"SPT Deadline" means [ ]

"SPT Verification Letter" means [ ]

"Sustainability Performance Target(s)" means [ ]

"Sustainability Reinvestment Amount" means an annual amount equal to [Note: comparable to coupon step-up (e.g. 0.25)]% of the aggregate principal amount of the then outstanding Notes

Eric Goodwin

Associate at Sidley Austin LLP | Shareholder Activism Defense and M&A

2y

I like this a lot, but my personal view is that the interest ratchet economics are a red herring in SLBs. The quantums at risk are not now—and I think will never be—a sufficient incentive for the issuer to undertake the investments to hit the SPTs (especially ambitious SPTs). In a world starved of high-quality ESG disclosures, the real value of SLBs to investors is information: the issuer's soft commitment to hit the SPTs and the periodic reporting of the KPIs. SLBs should evolve to maximize their informational content (more KPIs, universal reporting covenants, etc.) over the interest ratchet economics.

Angela Kerek

Contributing to create a happier world by being an Entrepreneur and Founder / Advisory Board Member / Finance Lawyer - Banking / Ex Professional Tennis Player / Author

2y

I like this idea and your approach, and would also favour buying carbon certificates - quality of the issuing project and lack of sale of multiple certificates need to be insured through technological solutions. Does anyone know btw what carbon certificates are legally? Is transfer of ownership of the certificate itself required?

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Clara Melly

U.S. Finance Associate and Sustainable Finance at Ropes & Gray LLP

2y

Good idea. Also avoids the criticism that it’s rewarding the lender upon a failure to meet the SPTs...

Darius Dills

Legal, Strategy & Business Development (Venture Capital, Emerging Companies, Strategic Partnerships, M&A, MedTech, BioTech)

2y

As blockchain-based smart contracting continues to develop, one can envision these triggers being set to result in the agreed investment being made immediately.

Aaron Franklin

Finance and legal professional with expertise in sustainable finance, ESG, leveraged finance and international trade law and with experience working in United States and Europe/UK, Japan and Africa. All views are my own.

2y

Great work here. We talk about this frequently with clients and I agree it will take off. See eg the framework for LaFarge Holcim’s SLB, New World’s SLB and the Etihad sustainability linked sukuk. Variety of approaches but I’m partial to buying carbon offsets in the voluntary market. That market needs to grow exponentially and the SLB market could help create more demand.

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