When ESG Failure Triggers Control Rights: Sustainability‐Linked Convertibles and Incomplete Contracting

The majority of existing sustainability‐linked bonds and loans utilize a pricing‐based approach in order to link the terms of the financing to an issuer's environmental, social and governance (ESG) performance. However, from a governance perspective, such an approach suffers from a critical weakness. When an issuer fails to meet its sustainability targets, its decision‐making rights are typically not affected, which creates the risk of ESG moral hazard and greenwashing. This study develops the concept of sustainability‐linked convertibles (SLC) as a conceptual governance mechanism. From a mechanism design perspective, the SLC is conceptualized as a state‐contingent governance mechanism that is based on an incomplete contracting approach. Under an SLC, the failure of an issuer to meet its ESG targets triggers cash‐flow penalties and also allows investors to obtain control rights through conversion. Relational monitoring between issuers and investors can also be incorporated into the terms of an SLC. The SLC therefore has the potential to strengthen the credibility of an issuer's sustainability commitments and also to serve as a conceptual governance mechanism that can distinguish between an issuer that is engaged in a genuine transition to sustainability and one that is merely signaling its commitment to ESG.