One reason for issuing CoCos is, like conventional convertible debt or preferred stock, the relatively low cost. By paying for the conversion feature, investors willingly accept a lower return on the debt portion. The other reason to release these instruments rests upon a glitch in the accounting rules. Specifically, Statement 128 allows firms to exclude these contingent convertibles unless certain conditions apply (Section 128, Paragraph 30). So again, some managers may be trying to hide what they are doing from the investment community.

Consider the case of Juniper Networks, which recently issued a CoCo. While I would rate the disclosure as average to above average, there is still room for improvement. Juniper's 10-K Footnote 4 reveals the following:

In June 2003, Juniper Networks received $392.8 million of net proceeds from an offering of $400.0 million aggregate principal amount of Zero Coupon Convertible Senior Notes due June 15, 2008 (the "Senior Notes"). The Senior Notes are senior unsecured obligations, rank on parity in right of payment with all of the Company's existing and future senior unsecured debt, and rank senior to all of the Company's existing and future debt that expressly provides that it is subordinated to the notes, including the 4.75% Convertible Subordinated Notes due March 15, 2007 (the "Subordinated Notes"). The Senior Notes are convertible into shares of Juniper Networks common stock, subject to certain conditions, at any time prior to maturity or their prior repurchase by Juniper Networks. The conversion rate is 49.6512 shares per each $1,000 principal amount of convertible notes, subject to adjustment in certain circumstances.

The remainder of the note discusses partial redemptions and partial conversions of the convertible debt. It also lists future redemption prices and divulges the carrying values, as well as the fair values.

What I like about the disclosure is the clear description of most of the features of the CoCo, including its proceeds, the face value, its seniority vis-à-vis other liabilities, the maturity date, the conversion rate, and the redemption prices.

The first thing I don't like about the footnote is that it says so little about the contingencies. In fact, an investor who reads the note too quickly might overlook those key words about the convertibility feature -- "subject to certain conditions." Admittedly, an investor could discover that information if he or she digs into Juniper's S-3 filed on July 8, 2003 (but, aside from university professors, who has time to read these things?). On pages 19-22 of Form S-3 the investor can discern the conversion rights, the most important of which is that the investor does not have the right to convert the debt into equity until "the closing sale price of our common stock … was more than 110% of the then current conversion price." While I do not advocate that companies be required to copy one filing into another, surely Juniper Networks could have said a bit more about the natures of these contingencies in its 10-K.

A second problem is that the 10-K does not discuss any safety features via restrictive covenants. Again, one may read the S-3 and discover that there is no such protection for this security. Couldn't management add just one sentence to its 10-K footnote to that effect?

The third and biggest problem is that the 10-K and the S-3 do not address the future impact of the conversion feature. Analysts can take the details of the offering and work out these effects, but many investors do not have that ability or that time. It would be helpful if management would tackle this issue head on instead of ducking it.

Regulators such as the Financial Accounting Standards Board and the Securities and Exchange Commission are looking into this matter and may impose additional rules. But why do managers have to be pulled into treating investors and creditors as their capital customers? Shouldn't customers be treated better than this?

J. EDWARD KETZ is the MBA Faculty Director at the Smeal College of Business at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals, and columnist of The Accounting Cycle.