Posted by & filed under Derivatives, Equity-Linked Transactions.

The issue of whether you have a freestanding instrument or an embedded feature is one of scope.  Specifically, freestanding instruments are potentially subject to accounting standards that are not applicable to embedded features. For example, ASC 480, Liabilities – Distinguishing Liabilities from Equity, applies only to freestanding instruments. Therefore a threshold requirement to further analysis is making this determination.

Perhaps the easiest way to make this determination is to look at the nature of an embedded feature.  An embedded feature is not something that can be sold or traded separately from the host contract…that is, the contract in which the rights and/or obligations of the feature are embedded. For example, a conversion option in a debt instrument does not have a separate existence without the debt instrument. If the debt instrument ceases to exist through repayment or expiration, the conversion option also ceases to exist. Also, contractually, a convertible debt agreement does not typically contemplate separation of the conversion option from the contract. This would require, instead, a new agreement between one party to the convertible debt agreement and a third party.

The ASC Master Glossery does not provide a definition of an ’embedded feature’, yet the term is used liberally in certain sections of the ASC. As a practical matter, an ’embedded feature’ is a contractual element of a freestanding instrument. An ’embedded feature’, unlike a freestanding instrument, has no substantive existence without the freestanding instrument’s existence. So, even though an embedded feature can be entered into as a separate contractual agreement, it is not entered into separately and and apart from any other instrument; rather, it will specifically reference the instrument to which it is contractually attached. So ask yourself this question, “Does this agreement or contractual provision have the ability to stand on its own as if the host contract or any other agreement does not exist?” If the answer is ‘no’, you have an embedded feature for accounting purposes.

A freestanding instrument is just that, an instrument that stands on its own, that exists based on its own terms independent of the existence of some other instrument or agreement. So, look at the terms of you instrument and evaluate its terms. Does its terms provide for its existence regardless of any other instrument or agreement? If no, then your instrument is probably not freestanding and should be evaluated as a unit with the other instrument(s) or agreement(s) on which its existence is dependent. Going back to the conversion option above, it is not uncommon for a conversion option to be written as a separate agreement from the debt agreement. This can happen at inception of the debt agreement or at some point thereafter. Regardless, the conversion option, even though in a separate agreement, is in substance an embedded feature since its existence is dependent upon the existence of the debt agreement. Therefore, the debt agreement and the conversion option agreement should be combined and evaluated together as a freestanding agreement.

Depending upon the accounting result determined for the combined instruments as a unit, you may still need to subsequently evaluate an embedded feature separately. But, this would only come after first evaluating the freestanding instrument. For example, if the freestanding instrument is determined to be a derivative reported at fair value, then there is no need to separately report the embedded feature. This analysis tool will tell you whether or not you need to evaluate embedded features based upon the analysis of the freestanding instrument. Evaluation of an equity-linked transaction is first performed to the freestanding instrument and then, and only under certain circumstances, must you then subsequently evaluate the freestanding instrument’s embedded features.

Posted by & filed under Debt, Equity-Linked Transactions.

Conventional convertible debt is a technical definition. To be considered conventional convertible debt, the holder may only realize the value of the conversion option by exercising the option and receiving the entire proceeds in a fixed number of shares or the equivalent amount of cash determined at the discretion of the issuer. Additionally, the ability of the holder to exercise the conversion option must be based on the passage of time (immediately convertible would qualify) or the occurrence of a contingent event. This definition permits standard anti-dilution that serve merely to maintain the value of the conversion option are permitted. Provisions that are sometimes referred to as ‘anti-dilution’ but that are actually price protection provisions are NOT permitted.

Mandatorily redeemable preferred stock that meets the above requirements would also qualify as conventional convertible debt if it is considered more akin to debt than equity (refer back to the nature of the host contract analysis performed previously).

Any provisions in the instrument that either 1) changes the number of shares issuable upon conversion from the number issuable at inception other than standard anti-dilution provisions or 2) alters the amount of cash, would violate the conventional convertible debt definition. In other words, the number of shares issuable must be set at inception and must not change for any reason other than the standard anti-dilution adjustments. So, for example, if accrued interest is convertible to shares under the conversion feature and the interest rate is fixed, then the number of shares issuable is determined at inception and the definition is met. However, if the interest rate floats with the market, or if the interest rate is contingent on some event (e.g., an event of default), then the number of shares is variable and the definition is not met.

Additionally, any provisions that would alter the settlement alternatives or give the holder the ability to choose settlement alternatives would violate the definition. The definition allows for either settlement entirely in shares or settlement entirely in cash at the discretion of the entity, but not a combination of the two and not at the discretion of the holder.

Posted by & filed under Debt.

Accounting Standards Codification (ASC) generally applicable to debt is either missing (because the applicable accounting is ‘generally accepted’), or found in locations other than the primary Codification topic for debt, ASC 470, Debt. Here’s my take on the debt accounting hierarchy from both a practical point of view and as defined in the Codification.

This is a general overview and is not intended to be a comprehensive review of the entirety of GAAP applicable to debt. I’ll get to a more comprehensive analysis in time, but this will cover the majority of the situations encountered in practice. Look for articles and posts coming up that will address specific areas within the debt accounting hierarchy together with examples and calculations.

Posted by & filed under Derivatives, Equity-Linked Transactions.

A registration rights agreement (RRA) typically accompanies an equity-linked transaction and spells out the registration obligations of the issuer. Typically, these obligations are designed to ensure that the shares underlying the equity-linked instrument(s) are freely tradable. In many cases, the only means for the investor to receive return of invested capital and a return on that capital is to convert the instrument into the underlying shares and sell.

In the absence of registration, the shares are not freely tradable until the Rule 144 holding period has elapsed. Since registration is critical to the investor’s investment, the RRA will often set forth very stringent registration obligations and may have monetary penalties in the event that the company fails to meet the requirements. An RRA may provide for the initial registration of the shares as well as maintaining the effectiveness of the registration through timely filings of reports with the SEC. The RRA may also provide for the listing of the shares on a recognized exchange, maintaining that listing or both.

An RRA can have two primary accounting impacts.  First, there is the penalty for failure to meet the registration and/or listing obligation(s). The FASB refers to this as a ‘registration payment arrangement’ and has provided specific accounting guidance in the form of ASC 825-20 which addresses payment arrangements involving registration of the shares with the SEC as well as payment arrangements involving listing of the shares on an exchange. ASC 825-20-15-3 provides unusually clear (for the FASB) description of the arrangements that fall within the scope of ASC 825-20. ASC 825-20-15-4 lists the instruments/transactions that are specifically excluded from its scope. The most significant of these exclusions, in my opinion, is the last which covers a payment arrangement that actually settles the related instrument. This is not a penalty. It is a settlement alternative that is contingent on a future event and must be addressed in the context of the related instrument which is usually a warrant or a convertible instrument, but could be any other equity-linked instrument covered by the RRA. Settlement alternatives for equity-linked transactions have potentially far-reaching effects. If the payment arrangement settles the instrument, include this in the analysis of the instrument using our equity-linked transaction analysis tool.

But, assuming is within the scope of ASC 825-20, you simply account for the payment arrangement as a contingency in accordance with ASC 450-20. In other words, disclose the contingency if material, but give no other accounting recognition until the obligation becomes probable and reasonably estimable and/or the contingency is resolved (i.e., you have incurred a liability as a result of failing to meet the terms of the RRA). I’ll leave the full treatment of contingency accounting to another post.

The second primary accounting impact of an RRA is its role in evaluating the related equity-linked instrument (warrant, convertible note, whatever…) under the various applicable accounting guidance. For example, the RRA may impact the determination of whether or not the company can settle the instrument in registered shares. This could impact the determination of whether the instrument (or embedded feature within the instrument) is subject to derivative accounting or other fair value accounting.

The real point to this second impact, is that the accounting issue is not actually the RRA itself, but its effect on the analysis of the related equity-linked instruments. The settlement alternative issue mentioned previously is but one of these. We designed our equity-linked transaction analysis tool to address these areas.

Posted by & filed under Derivatives, Equity-Linked Transactions.

Settlement alternatives, and the party that controls the settlement alternatives, figure significantly in determining the accounting treatment of an equity-linked freestanding or an embedded derivative. The pre-Codification guidance was contained primarily within EITF-0019, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock. The Codification guidance is buried within ASC 815 (primarily ASC 815-40). While the accounting guidance assumes cash settlement if the counterparty has the choice of settlement, and share settlement if the issuer controls the choice, these assumptions can be overcome based on the substance of the transaction.

You’ll recall that once you have a derivative, whether freestanding or embedded, the only way out of fair value accounting is to meet the conditions for one of the remaining scope exceptions. One of those exceptions is if the instrument (or embedded) is both indexed to the company’s own stock and classified in equity.  To be indexed to the company’s own stock is a two-part test. Once passed, you move on to determining classification based on its settlement terms.

If net cash settlement is required under the contract terms, then equity classification is prohibited. If physical or net share settlement is required, then equity classification is required as long as all other conditions for equity classification are met. The list of conditions is lengthy. These are two most straight-forward settlement provisions to evaluate. Things get stickier when one of the parties has a choice of settlement alternatives.

Let’s look at the the counterparty first. In most cases, the assumption of net cash settlement prevails and equity classification is prohibited.The only way to overcome this assumption is to have settlement alternatives that have different economic values. In other words, if the value of share settlement is greater than net cash settlement, then it is possible to argue that the counterparty will choose share settlement because of this value difference. However, the value difference needs to be significant enough to cover transaction costs of converting the shares to cash and the potential impact selling the shares may have  on the value of the stock. Additionally, if there is a history of cash settlement, then there is no point making this value difference argument. The past net cash settlements will trump the value difference. Personally, I think this position is nearly impossible to sustain since the first time the counterparty chooses net cash settlement taints every settlement that follows. Net cash settlement must be assumed. I have only rarely seen a counterparty choose share settlement in lieu of net, and I have not not seen this position successfully supported.

If the company has the choice of net cash settlement or share settlement, share settlement is assumed and equity classification is permitted as long as all other conditions are met. Again, this is a lengthy list and the Equity-Linked Transactions decision analysis tool goes through each condition. But, there conditions are not the only potential problem. There may be other contracts with the counterparty that cause problems. For example, if the counterparty holds a put on all shares issued to him/her by the company and the put price is in the money (i.e., greater than the fair value of the stock), then the transaction is effectively a debt issuance. Equity classification is prohibited.

Posted by & filed under Derivatives, Equity-Linked Transactions.

An entity’s stock price is often used to determine the number of shares issuable upon conversion of a convertible note. For example, if you have a very simple convertible note and the number of shares issuable is based on the entity’s stock price on the conversion date, you have what is known as stock-settled debt. The conversion feature will probably be considered clearly and closely related to the debt-host contract. Why? Well, the fair value of the conversion feature will always be the amount of convertible debt since the number of shares issuable is variable. So the fair value of the note without the conversion feature and the fair value of the embedded conversion feature move together.

And, yes, I’m ignoring a whole host of potential issues like, for example, the impact stock-settled debt with no limit on the number of shares issuable may have on other equity-linked contracts. Not the point of this post. Onward.

As long as the settlement date of the conversion is the same as the conversion notice date, then you have avoided a potential accounting issue. This is rarely the case.  Most conversions have a settlement date that lags at least a few days behind the conversion notice date. For example, let’s say you receive a conversion notice from the note holder and the number of shares issuable is based upon yesterday’s closing price. Let’s also say you contractually settle the conversion (i.e., you issue the shares in exchange for the amount of note being converted) 15 days following the conversion notice. The entity’s stock price on the conversion date will very likely have changed in the 15-day period so that on the date of settlement, the economic value of the transaction will probably have changed, perhaps significantly (since by now the conversion has been publicly announced), from the value of the transaction on the conversion notice date 15 days prior. That change provides an equity-like return to the investor since the company is required to issue a fixed number of shares once the conversion notice has been made. And that equity-forward feature, with it’s equity-like return, is almost certainly not clearly and closely related to the debt-host contract. And if the contract provides for stock-settled interest payments as well, then you have yet another embedded derivative.

For accounting purposes, this embedded feature exists at inception of the contract, not only upon receipt of a conversion notice. So this needs to be evaluated at inception as a potentially bifurcated embedded derivative. Having determined that it is not clearly and closely related to the debt-host contract, the only way out of derivative accounting is to determine that the feature is both indexed to the company’s stock and can be classified in equity.

Posted by & filed under Derivatives, Equity-Linked Transactions.

This one has bugged me for some time. There are, as we are well aware of at this point, three elements to the accounting definition of a derivative: 1) and underlying and either i) a notional, ii) a payment, or iii) both; 2) little or no initial investment and 3) net settlement. I want to focus on net settlement.

Net settlement can happen in one of three ways (yes, another list): 1) by the terms of the contract, 2) by way of a market mechanism and 3) by delivering, in physical settlement, an item that is readily convertible to cash or is itself a derivative. If the subject of the analysis is an embedded equity-linked provision, such as a stock conversion right in convertible debt, and if the company is publicly traded with enough volume to absorb the converted shares, we immediately conclude that the net settlement condition is met. The problem I see is that we do this regardless of whether the shares actually deliverable are eligible for resale. Just because the company is listed and its shares trade doe NOT mean that the shares in a particular contract can be traded.

Take, for example, a convertible instrument that is subject to a registration rights agreement in which the issuer has agreed to use commercially reasonable best efforts to registered the underlying shares. Until the registration statement becomes effective, if it ever becomes effective, the shares can not be sold UNLESS the one-year Rule 144 holding period has expired. Seems to me that until the registration statement is declared effective or the one-year holding period expires, the shares are not readily convertible to cash.

I have searched all over the web to find any discussion of this and have found nothing. It is not addressed in the many whitepapers published on this area of accounting. I have asked audit firms who as a group respond that it is a matter of firm policy to conclude that net settlement exists if the company is listed, regardless of whether the shares in question can be sold.

I’d love to hear some thoughts on this.

Posted by & filed under Derivatives.

If a loan is callable by the lender upon an event of default, there may be an embedded derivative.

The call provision is in effect a contingent put exercisable by the lender. This provision meets the definition of a derivative under ASC 815. Next test is whether the provision is clearly and closely related to the debt-host contract. At first glance, a default clause would be considered clearly and closely related. However, when you apply the 4-step process outlined in DIG No. B16 and IF the contingent put is exercisable at a substantial premium, you’ll find yourself with an embedded derivative requiring bifurcation.

Note that the premium is measured by reference to the debt’s carrying value, so any discount arising at inception must be factored into the calculation. There is frequently a discount when debt is issued with other securities such as detachable stock purchase warrants or when the debt has a beneficial conversion feature. Even if there is no premium, you must also determine if there is an unusually high rate of return to the lender as a result of the default.

Posted by & filed under Derivatives.

Every debt instrument includes events of default. Certain of these may be embedded derivatives.

Recall that a financial instrument will fall into one of two types…a debt-host contract or an equity-host contract. Predictably, most loans will fall into the former. The embedded derivative issue arises when certain events of default are not debt-like in nature. FAS 133 considers these to have economic risks and characteristics that are not clearly and closely related to the debt host contract. Such events of default must be bifurcated and accounted for separately from the host contract.

Generally, to trigger this treatment such events must be themselves a trigger. That is, occurrence must be beyond the control of the company. The most common example is the requirement to deliver audited financial statements to the lender with failure to deliver causing payment of a financial penalty such as a default rate of interest (see Definition of a Derivative for further explanation). Delivery of audited statements does not affect the creditworthiness of the borrower and the borrower does not control issuance of the auditors’ report on such statements. This result has a potentially significant impact across a broad range of companies. It is rare that a loan agreement will not have such a requirement.

The valuation implications are equally problematic but the ‘out’ may be materiality. The lower the probability of the event occurring, the lower the value of the feature.

Posted by & filed under Derivatives, Equity-Linked Transactions.

I had a lengthy conversation with a client’s securities lawyer a while back. The topic was a detachable stock purchase warrant that was subject to a registration rights agreement (RRA). Under the terms of the warrant agreement the company is required to file a registration statement covering resale of common shares issued to settle exercise of the warrant.

One of the (many) tests for equity classification in ASC 815 starts at ASC 815-40-25-11 and basically says that if the company is required to settle the derivative (in this case, exercise of the warrant) in registered shares and there are no provisions in the agreement for any other settlement alternative, then it is assumed that share settlement is not within the control of the company and, therefore, the company has not met the criteria for classifying the warrant in equity. This results in a liability that must be measured at fair value. A very bad result if you are trying to avoid fair value accounting of the warrant.

However, the securities attorney pointed out that a registration statement covering RESALE is required only when the shares issued upon settlement are not already registered. His position is that the company has no choice but to settle the warrant exercise in unregistered shares as a matter a law. The registration statement does NOT register the shares; rather, the registration statement permits RESALE of the shares once the unregistered shares have been issued to the warrant holder. Thus, the warrant can ONLY be settled in unregistered shares and the criteria for equity classification in ASC 815 is met (assuming all of the other conditions for equity classification have been met, of course), in his opinion. Failure to file the registration statement, or failure to maintain its effectiveness, has NO EFFECT on the settlement of the warrant is always settled in unregistered shares, with or without registration.

Typically, a RRA will incorporate liquidated damages payable should the company not meets its registration obligation. This is generally the only remedy available to the warrant holder and is evaluated as a contingent liability, not net cash settlement of the warrant.