An embedded derivative feature, in contrast to a freestanding derivative, is evaluated relative to its host contract. Bifurcation of the embedded derivative is not required if its risks and characteristics are clearly and closely related to those of the host contract. If they are clearly and closely related, then the fair value of the embedded derivative and the host contract will typically move in the same direction and the same time and in response to many of the same factors. An embedded feature whose fair value moves counter to that of the host contract, or in response to a set of factors that do not similarly affect the host, is probably not clearly and closely related.
To determine whether the economic risks and characteristics of the embedded derivative feature are clearly and closely related to the economic risks and characteristics of the host contract, you must first determine the nature of the host contract. This is done by evaluating all of the significant terms of the contract and deciding whether, when all of the terms are taken together, the contract is predominantly debt-like or predominantly equity-like.
A debt-like instrument will have primarily debt-like characteristics. Debt typically calls for periodic interest payments (or is issued at a discount that provides an effective interest rate result), will have a fixed repayment amount, will have a maturity date, will be collateralized with assets, has a higher priority on assets in liquidation than equity, carries no voting rights or other rights/privileges normally associated with equity.
An equity-like instrument will lack the debt-like features described above, will often have voting rights, will rank lower on the order of receiving a payout on liquidation, and will have a return based on the financial performance of the entity.
It is not uncommon for preferred stock to be more debt-like than equity-like. Preferred stock that carries a guaranteed periodic dividend payment, ranks relatively high in liquidation, is mandatorily redeemable or is putable at the option of the holder, or has a priority claim on assets is very likely a debt instrument. This evaluation is made regardless of the host contract’s balance sheet classification. A contract may be classified in permanent or temporary equity for balance sheet purposes yet still be considered a debt-like instrument.
The SEC, at the 2006 AICPA National Conference on Current SEC and PCAOB Developments, highlighted certain attributes that should be part of the analysis in determining the nature of the host contract. The list includes, but is not limited to, the following:
- The existence of any redemption provisions in the agreement (indicating a debt-like host);
- The nature of the returns to the holder…a stated rate would be indicative a debt host while participating return would indicate an equity host;
- Whether the returns to the holder are mandatory (debt-like) or discretionary (equity-like);
- Whether the instrument conveys any voting rights to the holder (equity-like);
- Whether there are any collateral requirements (debt-like);
- Whether the preferred shareholders in a preferred stock instrument participate in the residual of the entity upon liquidation (equity-like);
- Whether the preferred shareholders have a liquidation preference (debt-like);
- Whether the preferred shareholders have creditors rights (debt-like).
Once the nature of the host contract has been determined, evaluate the embedded derivative feature. If the feature is an equity-like feature but the host contract is debt-like, then the economic risks and characteristics are not considered clearly and closely related. Likewise, a debt-like feature is not considered to be clearly and closely related to an equity-host contract. Equity-like features relate to the operations of the company (e.g., revenue, net income, earnings per share), the performance of its stock (e.g., trading volume, share price), completion of a public offering and similar events. Debt-like features relate to interest payments, credit-sensitive payments, redemption rights and collateral, among other things.
In the context of equity-linked transactions, the primary concern will be an equity-like features embedded in a debt-host contract. The majority of hybrid instruments encountered in practice are debt-host contracts. Additionally, it will be highly unusual for an equity-linked feature to not be clearly and closely related to an equity-host contract. Generally, an embedded feature that meets the conditions for being considered indexed to the company’s own stock will also be considered clearly and closely related to an equity-host contract.