Applying EITF 00-19 to Embedded Derivatives

Derivative accounting does not apply to a contract, or a term embedded in a contract, if it qualifies for equity classification.  Equity classification for derivative instruments is determined by reference to EITF 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.  This paper provides EITF 00-19 application guidance based on our experience on a variety of projects involving complex financial instruments containing embedded derivatives.  There is, however, much disparity in practice around the application of derivative accounting guidance, including EITF 00-19, due to the complexity of the both the guidance itself and the instruments to which that guidance is applied.  Companies should use this paper only as a guide and should at all times apply their own judgment in implementing derivative accounting.

Scope of EITF 00-19

The scope of EITF 00-19 is established in paragraphs 3 and 4.  These scope paragraphs cover quite a bit of territory and, at least on the surface, appear to be contradictory.  For purposes of this paper, we are concerned only with the application of EITF 00-19 to embedded derivatives.  With respect to embedded derivatives, paragraph 3 states, in part “This Issue does not address the accounting for either the derivative component or the financial instrument when the derivative component is embedded in and not detachable from the financial instrument.”  However, in paragraph 4, the Issues states, “The Task Force observed that, pursuant to paragraphs 11(a) and 12(c) of Statement 133, if an embedded derivative is indexed to the reporting entity’s own stock and would be classified in stockholders’ equity if it was a freestanding derivative, that embedded derivative is not considered a derivative for purposes of Statement 133.  The Task Force reached a consensus that for purposes of evaluating under Statement 133 whether an embedded derivative indexed to a company’s own stock would be classified in stockholders’ equity if freestanding, the requirements of paragraphs 12–32 of this Issue do not apply if the hybrid contract is a conventional convertible debt instrument in which 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 (at the discretion of the issuer).  However, the Task Force observed that the requirements of paragraphs 12–32 of this Issue do apply when an issuer is evaluating whether any other embedded derivative instrument is an equity instrument and thereby excluded from the scope of Statement 133.”

Boiling this down to plain English, paragraph 4 tells us that EITF 00-19 must be applied to an embedded derivative that is not included in a “conventional convertible debt instrument” for the sole purpose of determining the classification of the embedded derivative. If all criteria set forth in paragraphs 12-32 are met, then the embedded derivative qualifies for equity classification and is, therefore, not subject to derivative accounting under FAS 133.

An embedded derivative included in a conventional convertible debt instrument is scoped out of EITF 00-19 because that type of instrument is covered by the guidance in APB 14, Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants.  A conventional convertible debt instrument is defined in EITF 05-2, The Meaning of “Conventional Convertible Debt Instrument” in Issue No. 00-19, which states, “…instruments that provide the holder with an option to convert into a fixed number of shares (or equivalent amount of cash at the discretion of the issuer) for which the ability to exercise the option is based on the passage of time or a contingent event should be considered “conventional” for purposes of applying Issue 00-19. Instruments that contain “standard” antidilution provisions would not preclude a conclusion that the instrument is convertible into a fixed number of shares. Standard antidilution provisions are those that result in adjustments to the conversion ratio in the event of an equity restructuring transaction (as defined in the glossary of Statement 123(R)) that are designed to maintain the value of the conversion option.”  EITF 05-2 further states that, “convertible preferred stock with a mandatory redemption date may qualify for the exception included in paragraph 4 of Issue 00-19 if the economic characteristics indicate that the instrument is more akin to debt than equity. An entity should consider the guidance in subparagraph 61(l) of Statement 133 in assessing whether the instrument is more akin to debt or equity.”

Application of EITF 00-19

Evaluating an embedded derivative under FAS 00-19 is generally the last step in an embedded derivative analysis.  Reaching this point means that none of the scope limitations or exceptions available in FAS 133 are applicable.  The only remaining possible exception is in FAS 133, paragraph 12a; specifically, the embedded feature is indexed to the company’s own dock (see EITF 01-6 which has been superseded by EITF 07-5) and is classified in equity.

The sole purpose of an EITF 00-19 analysis with respect to an embedded derivative is to determine classification.  The measurement provisions of the Issue can be ignored since they are addressed by FAS 133.

The overall premise of EITF 00-19 is that any embedded derivative that has the potential of having to be settled in cash, no matter how remote that possibility may be, is not eligible for equity classification.  EITF 00-19 stipulates eight criteria that must be met for equity classification that are spelled out in paragraphs 14 – 32.  Failure to meet any one of these criteria has the effect of a poison pill.

Criteria 1 – The contract permits the company to settle in unregistered shares (paragraphs 14 – 18)

The company must be able to settle the embedded derivative feature in unregistered shares or equity classification is prohibited.  Settling in unregistered shares is within the company’s control since issuance generally requires only the approval of its board of directors.  A requirement to issue registered shares, on the other hand, is beyond the control of the company since approvals are generally required by both shareholders, and regulatory entities (e.g., SEC, listing exchange, etc.).  Obtaining such approvals is not assured.  In this circumstance, EITF 00-19 requires the presumption that the counterparty will demand cash settlement if registered shares can not be delivered.  The one exception to this presumption is provided in paragraph 18 which states that, “…if a derivative involves the delivery of shares at settlement that are registered as of the inception of the derivative transaction and there are no further timely filing or registration requirements, the requirement of Issue 00-19 that share delivery be within the control of the company is met, notwithstanding the Task Force’s consensus in paragraph 14, above.”  In other words, if registered shares are available to satisfy settlement of the embedded derivative at inception, and if the embedded derivative does not impose any timely filing or other registration requirements on the company, then delivery of registered shares is deemed to be within the control of the company.

If the embedded derivative is covered by a penalty provision that is payable in the event that the company fails to deliver registered shares, such penalty may help mitigate the presumption of cash settlement.  A penalty should be evaluated in two different ways.

First, is the penalty in effect a cash settlement for failure to deliver registered shares?  EITF 00-99 allows this to be disregarded if the embedded derivative provides for other settlement alternatives and is “uneconomic”.  In other words, if the “uneconomic” penalty can be avoided by using a different settlement alternative, EITF 00-19 permits the presumption that the “economic” settlement alternative available to the company will be used and the penalty can be ignored as a potential cash settlement of the embedded derivative.

Second, is the penalty approximately equal to the difference in fair value between registered and unregistered shares?  If so, EITF 00-19 allows the company to presume settlement in unregistered shares plus payment of the penalty to compensate the counterparty for the difference in fair value which is in effect a discount, not a penalty.

Please note that an embedded derivative that is settled in the company’s stock (e.g., a conversion provision in preferred stock) is frequently subject to a registration rights agreement that provides for liquidated damages (a so-called “registration payment provision”) payable if the company fails to meet certain conditions such as registration of shares, maintaining an exchange listing, and so forth.  In FASB Staff Position (FSP) EITF-00-19-2, the FASB declared that such a provision is not a penalty for purposes of evaluating a derivative under EITF 00-19.  Instead, the registration payment provision should be evaluated as a FAS 5 contingent liability.

Criteria 2 – The company has sufficient authorized and unissued shares available to settle the contract after considering all other commitments that may require the issuance of stock during the maximum period the derivative contract could remain outstanding.

Upon issuance and at all times during the life of the embedded derivative, the company must have sufficient authorized and unissued shares to satisfy share settlement of the provision.  All contracts that are potentially settled in stock must be evaluated and there must be sufficient authorized and unissued shares for all such contract or this criteria is not met.  For example, if the company has a warrant whose exercise price is variable based upon changes in fair value of the company’s stock, an outside index or some other variable, there is no means of determining how many shares will be required to satisfy the warrant.  Since the number of shares can not be determined, the is likewise not way for the company to determine whether it has sufficient authorized and unissued shares to satisfy the embedded derivative.  The company must continuously evaluate this during the life of the embedded derivative since new contracts entered into by the company may taint the classification determination made at inception.

Criteria 3 – The contract contains an explicit limit on the number of shares to be delivered in a share settlement.

As noted in Criteria 2 above, the number of shares issuable upon settlement of a contract or an embedded derivative may be variable.  If, however, the number of shares that can be issued upon settlement is capped by a contractual or regulatory limit, then the maximum number of shares issuable is determinable and can be compared to the company’s authorized and unissued shares to determine if a sufficient number of shares is available.

Criteria 4 – There are no required cash payments to the counterparty in the event the company fails to make timely filings with the SEC.

This is a fairly self-explanatory requirement.  A penalty for failure to make timely SEC filings does not fail this criteria since the derivative has not been cash settled if such payment is made.  Rather, the embedded feature continues its existence unaffected by the cash penalty.  What the EITF is looking for specifically is the requirement to cash-settle the derivative in the event of a failing to file timely hereby the cash payment actually settles the derivative and it is not longer considered outstanding.

Criteria 5 – There are no required cash payments to the counterparty if the shares initially delivered upon settlement are subsequently sold by the counterparty and the sales proceeds are insufficient to provide the counterparty with full return of the amount due (that is, there are no cash settled “top-off” or “make-whole” provisions).

This is also self-explanatory.  Top-off and make-whole provisions, however, are particularly difficult to detect.  Companies should carefully evaluate any provision that results in a payment based upon trading prices of the company’s stock or a stock index.  These payments are often determine several months after settlement and may not be part of the primary embedded derivative language.

Criteria 6 – The contract requires net-cash settlement only in specific circumstances in which holders of shares underlying the contract also would receive cash in exchange for their shares.

There may be circumstances that require the company to cash-settle an embedded derivative.  If the holders of shares underlying the embedded derivative also receive cash in exchange for their shares, then equity classification is permitted.  An example of this is a conversion feature that must be net-cash settled if the company affects a change of control.  If the holders of the conversion feature are the only parties net-cash settled, then equity classification is not permitted.  If, however, holders of the underlying stock into which the instrument is convertible would also be net-cash settled upon a change of control, then this criterion is met.  Companies should be mindful to consider whether an embedded feature that requires net-cash settlement under certain circumstances is in fact two embedded features…the subject feature and a redemption feature.  In our example, a conversion feature subject to net-cash settlement may in fact be a conversion feature and a separate redemption feature whose exercise is mutually execlusive.

Criteria 7 – There are no provisions in the contract that indicate that the counterparty has rights that rank higher than those of a shareholder of the stock underlying the contract.

In other words, the embedded derivative may not convey creditors rights (e.g., collateral security on assets, priority claim to cash/assets upon liquidation, etc.) that rank higher than those of the underlying stock.

Criteria 8 – There is no requirement in the contract to post collateral at any point or for any reason.

Self-explanatory.  However, it should be noted that the collateral preclusion applies only to the embedded feature, not to the host contract.  Therefore, a convertible note (that is not conventional convertible debt) that is secured by financing statement does not necessarily fail this criterion.  The collateral would instead have to be posted in support of the embedded derivative itself.

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