Warrant Exercise Price Adjustment Ok Under EITF 07-5?

EITF 07-5 sets forth criteria to help determine when an instrument is considered indexed to the entity’s own stock.  One of the disqualifying characteristics in a warrant is an exercise price adjustment.  The type of price adjustment that you need to be wary of is one that would not be considered an input to a fair value calculation.  For example, a “down round” exercise price adjustment that provides price protection to a warrant holder is a disqualifying adjustment.  In this case, fair value models do not use as an input such company-controlled transactions in determining fair value.  An example of an adjustment that would not be disqualifying is a contractual increase or decrease in the exercise price written into the warrant agreement.  In this case, the terms and conditions of the adjustment are known and can be factored into the fair value calculation using stock price simulation and lattice valuation models.  So, the way I see it, the easiest way to determine if an exercise price adjustment or any other provision within a warrant (or any other agreement) will pass the EITF 07-5 test is to discuss the valuation methodology with a valuation expert.  If the provision is not an input to fair value at the time the instrument was issued, it’s probably a problem.

Language to Avoid Derivative Treatment of a Warrant?

Here’s a thought…add the following language to a warrant (or any other freestanding agreement or embedded feature):

“In no circumstances will the Issuer pay cash in connection with the Holder’s ownership and/or exercise of this Warrant.“

Doesn’t this solve many of the equity classification criteria addressed by EITF 00-19?  EITF 00-19 is all about disqualifying equity classification of an instrument when there is the possibility, no matter how remote, of the instrument being settled in cash.  Assuming no conflicting cash settlement provisions exist (such as a cash-settled put in the event of a change of control), doesn’t this solve the problem?  Just a thought…and probably causes all sorts of problems that I haven’t considered…but still…

“Top-off” Provision Falls Within Derivative Accounting

A “top-off” provision is not uncommon and needs to be evaluated carefully.  The most frequent purpose of a top-off provision is to protect an investor from declines in market value of stock from the time that he takes possession of the stock to the time he sells the stock on the open market.  The provision is typically found in PIPE financing structures where the investor advances funds to the “borrower” under a convertible debt instrument or an equity line of credit.  The investor is “repaid” by selling the underlying stock once converted (in the case of the convertible debt instrument) or delivered by the company (in the case of an equity line of credit).  There are of course many other forms, but these are good examples.  Anyway, if the stock drops in price from the time that the investor takes possession to the time that he sells, the top-off provision will compensate him either in cash or additional shares.  Either method causes a problem.  The usual scope exception relied upon by most companies is in para 11a of FAS 133 (see more detailed explanation below and in other areas of this blog) which ultimately uses EITF 00-19 to determine if equity classification is appropriate.  If not, then the instrument (or embedded feature) must be accounted for as a derivative.  EITF 00-19 has a number of criteria that must be met among them being the requirement that there be no cash payment made to the investor to compensate him for a decline in market value (see paragraph 26 of EITF 00-19).  EITF 00-19 also requires that there be an explicit limit on the number of shares deliverable at settlement (paragraph 20) and that the company have sufficient authorized shares to settle all obligations.  This is very difficult to do if the top-off provision has to be settled in additional shares.  How can the company ever know when and how many shares will actually be issued?

Conversion to FASB Accounting Standards Codification

FASB has issued and adopted its Accounting Standards Codification.  Great.  But I’m old school.  I still refer to FASBs, EITFs, DIGs, FINs, etc.  It’s hard to change and, frankly, most people who care understand what I’m talking about when I refer to FAS 133 or FAS 150.  ASC 815 and ASC 480 just don’t have much charm.  But, I’m a technician and ASC 105 says that the old Accounting Standards (with certain notable exceptions pending inclusion in the Codification) have been superseded so I guess I have to abide.  I’ll attempt to refer to the Codification topics, subtopics, sections and paragraphs going forward (frequently with the now-superseded FASBs, etc. in parentheses).  We might as well all start getting use to it.  Ick.

Examples of Tainting Language in Warrants

Yesterday I published a post about problem features lurking within warrants.  I’ve been asked to provide some examples.

The following language is commonly found in a warrant agreements “adjustments” section.  Typically, this section will address warrant exercise price and warrant share adjustments to prevent dilution in the event of certain capital events such as stock splits, reverse splits, stock dividends, and so forth.  Common anti-dilution provisions are fine under EITF 07-5 since they do not impact the settlement value of the warrant.  The following language contained in a warrant agreement for a fixed number of shares at a fixed exercise price, however, is a problem:

“If, at any time while this Warrant is outstanding, the Company or any Subsidiary issues additional shares of Common Stock or rights, warrants, options or other securities or debt convertible, exercisable or exchangeable for shares of Common Stock or otherwise entitling any Person to acquire shares of Common Stock (collectively, “Common Stock Equivalents”) at an effective net price to the Company per share of Common Stock (the “Effective Price”) less than the Exercise Price (as adjusted hereunder to such date), then the Exercise Price shall be reduced to equal the Effective Price.”

Why?  This is a classic price protection mechanism that serves to protect the investor from subsequent “down round” issuances of stock or stock equivalents at an effective price lower than that of the investor’s warrant.  If this warrant has an exercise price of $1.00 and the company subsequently issues warrants with an exercise price of $.90, the exercise price of this warrant is reduced to $.90.  This violates EITF 07-5 since such price protection is not an input to the determination of fair value of a “fixed-for-fixed” instrument.

An example of a provision that violates EITF 00-19 is as follows (and also usually fund in the “adjustments” section of the warrant agreement):

“Notwithstanding anything to the contrary, in the event of a Fundamental Transaction that is (1) an all cash transaction, (2) a “Rule 13e-3 transaction” as defined in Rule 13e-3 under the Exchange Act, or (3) a Fundamental Transaction involving a person or entity not traded on a national securities exchange, including, but not limited to, the Nasdaq Global Select Market, the Nasdaq Global Market, or the Nasdaq Capital Market, the Company or any Successor Entity (as defined below) shall, at the Holder’s option, exercisable at any time concurrently with, or within 30 days after, the consummation of the Fundamental Transaction, purchase this Warrant from the Holder by paying to the Holder an amount of cash equal to the Black Scholes Value of the remaining unexercised portion of this Warrant on the date of the consummation of such Fundamental Transaction.”

The warrant agreement from which this was extracted defined a “Fundamental Transaction” as basically any transaction that resulted in a change of control.  Under this provision, the holder of the warrants has the right to put the warrant back to the company for cash in an amount equal to its then Black-Scholes value.  This violates EITF 00-19.

In both cases above, the warrant would not meet the exception criteria in FAS 133 paragraph 11a and, assuming no other scope exceptions applied, the warrant would have to be recorded at fair value upon issuance and at each reporting date thereafter, with changes in fair value included in income.

One very odd result arising from this accounting is that the warrant’s fair value is based on the value of the underlying stock (under any traditional valuation model such as Black-Scholes or binomial).  Accordingly, as the underlying stock price moves, so moves the fair value of the warrant.  Since a warrant represents an obligation of the company to issue shares upon exercise, the fair value is reported as a credit, i.e., liability, on the balance sheet.  When the stock price increases, the liability increases (all other things being equal) and the company reports a derivative loss (debit) on its income statement.  See the weirdness?  Stock price goes up, reported earnings goes down.  Nice.  But the alternative is also true…when the underlying stock price falls, the company’s derivative liability fair value also falls and the company reports a derivative gain.  Sublime.

Warrants May Fall Within FAS 133…Here’s How.

One of the most common structures of a private investment in public equity (PIPE) financing is a debt-like instrument issued together with warrants.  The debt-like instrument is usually in the form of a convertible note or convertible redeemable preferred stock.  There are a number of landmines hidden in these instruments including embedded derivatives (specifically, equity like features embedded in the debt-host contract), beneficial conversion features, or provisions that force the instrument to fall within the scope of FAS 150.

This is highly technical stuff and tends to receive the bulk of the accounting attention by management and auditors.  The real problem, however, may not be the primary instrument at all.  Very often the warrants contain provisions that run afoul of either EITF 07-5 or EITF 00-19 (there’s quite a bit on various pages of this blog on both matters…and a bit more below).

A warrant is by definition a derivative instrument.  FAS 133 provides certain exceptions that scope out most plain vanilla warrants.  The exception used most frequently is found in paragraph 11 which states, in part, “Notwithstanding the conditions of paragraph 6-10, the reporting entity shall not consider the following contracts to be derivative instruments for purposes of this Statement: a) Contracts issued or held by that entity that are both (1) indexed to its own stock and (2) classified in stockholders’ equity in its statement of financial position…”  To apply this exception to a warrant, you must evaluate its terms under the guidance provided in EITF 07-5, Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock, and EITF 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.

EITF 07-5 addresses the requirement that the contract be indexed to the entity’s own stock.  EITF 07-5 provides a two part test that evaluates the contingent features of the instrument, if any, and its settlement terms.  Warrants issued as part of a PIPE transaction often have both contingency features, and, almost always, settlement terms that violate EITF 07-5.  And, since most investors in these instruments are private equity firms and hedge funds that structure deals the same way every time, you can count on finding an EITF 07-5 problem just about every time.

EITF 00-19 addresses the requirement that the contract be classified in equity (by definition, a derivative must be either an asset or a liability).  If your warrant does not meet the criteria of EITF 07-5 above, don’t even bother evaluating it under EITF 00-19 since you have to pass both tests.  However, if you do get through EITF 07-5, EITF 00-19 offers a few significant hurdles.  Two that you need to be careful of are: 1) if the warrant must be settled in registered shares upon exercise, it probably does not pass paragraphs 14 – 18 of EITF 00-19, and 2) if the warrant provides that holder (investor) a cash settlement alternative, such as the option of putting the warrant back to the company for cash upon a change of control, it probably violates paragraphs 27 – 28.

Folks, these problems are just about always there.  Be careful and be thorough. – mbl

EITF 07-05, Determining Whether in Instrument (or Embedded Feature) is Indexed to An Entity’s Own Stock

In June 2008, the Emerging Issues Task Force issued EITF 07-5, Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity’s Own Stock.  EITF 07-5 replaces EITF 01-6 and  significantly modifies the analysis process used to determine whether an instrument or embedded feature is indexed to the company’s own stock.  EITF 07-5 effectively serves as a gatekeeper to EITF 00-19.  Recall that EITF 00-19 is the guidance for determining the classification of an instrument or embedded feature that is indexed to a company’s own stock and serves as the last resort for getting out of derivative accounting under FAS 133 for many embedded derivaitves.  An instrument that can be classified in equity is by definition not a derivative and EITF 00-19 is the guidance that gets you there.  From now on you will have to get by EITF07-5 first.

Look for a full analysis of EITF 07-5 a tour web site www.bennettpoint.com in the near future.  Its a bit of a beast and is taking a little while to render into plain English while still retaining its meaning.  In a nutshell, EITF 07-5 can take the most insignificant of features of an otherwise clearly equity-qualifying feature and completely taint the feature thereby disqualifying it from equity classification.  I believe EITF 07-5 is aimed primarily at instruments that have features risks and characteristics of equity (i.e., equity-host contracts) but that contain certain features that are very slightly debt-like.  These slightly debt-like features can taint the entire instrument. – mbl

Effect of an embedded contingent put in debt (e.g., due on default)

Your loan is callable by the lender upon an event of default. You may have an embedded derivative. Problem? Well, the call provision is in effect a contingent put exercisable by the lender. Go through the definition of derivative in para. 6 of FAS 133 and you’ll find that this qualifies. Next test is whether the provision is clearly and closely related to the debt-host contract. At first glance, no problem. But you should go through the 4-step process outlined in DIG No. B16. If the embedded contingent put is exercisable at a substantial premium, you have 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. And, even if there is no premium, you must also determine if there is an unusually high rate of return to the lender. Appears difficult but if you follow B16, you’ll get the right answer. And, of course, you can pose any questions here. —mbl

Debt default provisions may be embedded 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. —mbl

Can a derivative really ever be settled in registered shares?

I had a lengthy conversation with a client’s securities lawyer a few weeks ago. The topic was a warrant subject the 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 EITF 00-19 starts at paragraph 14 and basically says that if the company is required to settle the derivative (in this case, exercise of the warrant) in registered shares, 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. However, the securities attorney correctly points out that a registration statement covering RESALE is required only when the shares issued upon settlement are not already registered. Under this scenario, the company has no choice but to settle the warrant exercise in unregistered shares. The registration statement does NOT register the shares. Rather, the registration statement permits RESALE of the shares once issued to the warrant holder. Thus, the warrant can only be settled in unregistered shares and the criteria for equity classification in EITF 00-19 is met (assuming none of the many other requirements of EITF 00-19 have been violated, of course). It is important to further note that failure to file the registration statement, or failure to maintain its effectiveness, has NO EFFECT on the settlement of the warrant. The warrant is always settled in unregistered shares. 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 FAS 5 contingent liability per FSP EITF 00-19-2. As always, comments and questions are welcome! —mbl