6.11 Illustrative Example: Convertible Preferred Stock With Multiple Features (Debt and Equity Host Considerations)

Entity R, a private company, issues redeemable convertible preferred stock at par to multiple investors with the following features:

• Redemption option — After the third anniversary of the issuance, investors may redeem the security for an amount of cash equal to the greater of (1) the face value of the security or (2) the fair value of the underlying common stock.
• Conversion option — Investors may convert the security at any time into the issuer’s common stock on a one-for-one basis.

The below evaluation of the embedded features will contemplate two scenarios — one in which the preferred stock has an equity host and one in which it has a debt host (see Section 4.3.2.3.2 for details on the determination of the host contract nature). In both scenarios, the preferred stock qualifies for equity classification in accordance with ASC 480 in R’s financial statements.

As stated above, after the third anniversary, the redemption option allows the holder to put the security to the issuer for cash equal to the greater of (1) the security’s face value or (2) the underlying common stock’s fair value. Effectively, this “greater of” redemption option gives the holder of the security the ability to either net cash settle the conversion option or obtain a return of the originally invested amount. When the embedded features are identified under an economic payoff approach, the right to redeem the preferred stock for cash equal to the fair value of the underlying common stock would be attributed to a conversion feature rather than a redemption feature. Entity R would separately evaluate the redemption feature as only the right to redeem the security for cash equal to the security’s face value.

The preferred stock cannot contractually be settled in such a way that the holder would not recover substantially all of its initial recorded investment. Further, there is no potential scenario in which the holder could achieve a rate of return on the preferred stock that at least doubles its initial rate of return and is twice what would otherwise be the market return.

In this scenario, the preferred stock contains two payoff profiles that should be evaluated as embedded features: (1) the holder’s right to redeem the security at its face value for cash (the “redemption feature”) and (2) the holder’s right to convert the security into equity that can be settled in cash or in shares (the “conversion feature”). The redemption feature and the conversion feature must be analyzed separately under ASC 815-15-25-1.

Both R and the investor would apply the not-clearly-and-closely-related criterion to the redemption and conversion features, as described separately below.

Redemption Feature

• Equity host — If the host contract is an equity host, the redemption feature that enables the holder to require the issuer to reacquire that equity instrument for cash (at face value) is not considered clearly and closely related to that equity host under ASC 815-15-25-20. Evaluation of the additional bifurcation criteria would be required.
• Debt host — If R concludes that the host contract is a debt host, it would look to ASC 815-15-25-26 and ASC 815-15-25-41 through 25-43 in determining whether the redemption feature is clearly and closely related to that debt host, as follows:
  • Consider the four-step decision sequence in ASC 815-15-25-42:
    • “Step 1: Is the amount paid upon settlement (also referred to as the payoff) adjusted based on changes in an index? If yes, continue to Step 2. If no, continue to Step 3.”
      Answer: No. The redemption is at the security’s face value and is not adjusted on the basis of changes in an index.
    • “Step 2: Is the payoff indexed to an underlying other than interest rates or credit risk? If yes, then that embedded feature is not clearly and closely related to the debt host contract and further analysis under Steps 3 and 4 is not required. If no, then that embedded feature shall be analyzed further under Steps 3 and 4.”
      Answer: Not applicable because of the answer in step 1.
    • “Step 3: Does the debt involve a substantial premium or discount? If yes, continue to Step 4. If no, further analysis of the contract under paragraph 815-15-25-26 is required, if applicable.”
      Answer: No substantial premium or discount exists in the consideration of any premium or discount that exists upon both (1) issuance and (2) settlement of this feature. Accordingly, further evaluation under ASC 815-15-25-26 is required.
    • “Step 4: Does a contingently exercisable call (put) option accelerate the repayment of the contractual principal amount? If yes, the call (put) option is not clearly and closely related to the debt instrument. If not contingently exercisable, further analysis of the contract under paragraph 815-15-25-26 is required, if applicable.”
      Answer: Not applicable because of the answer in step 3.
  • Evaluate the guidance in ASC 815-15-25-26:
    • Does the feature pass the negative yield and double-double tests (see Sections 5.2.3.3 and 5.2.3.4 for the applicable guidance)?
      Answer: On the basis of the background information provided, the preferred stock cannot contractually be settled in such a way that the holder would not recover substantially all of its initial recorded investment. There is also no potential scenario in which the holder could achieve a rate of return on the preferred stock through the redemption feature that at least doubles its initial rate of return and is twice what would otherwise be the market return. The upside provided by the redemption equal to the fair value of the underlying common stock is evaluated as a potential cash settlement of the conversion option. Thus, the feature would not pass the negative yield or double-double test.

In accordance with the steps above, including evaluating the guidance in ASC 815-15-25-26, the redemption feature is clearly and closely related to the host contract, so bifurcation of the redemption feature from a debt host would not be required. Evaluation of the additional bifurcation criteria is not necessary.

Conversion Feature

• Equity host — If the host contract is more akin to equity, the conversion feature and host contract would be clearly and closely related and this condition would not be met. Because all three criteria must be met for bifurcation, further evaluation would not be needed to conclude that no bifurcation is required.
• Debt host — If the host contract is more akin to debt, guidance in ASC 815-15-25-51 would be applicable, which indicates that conversion options are generally not clearly and closely related to debt hosts. In that case, R and the investor would conclude that the conversion feature is not clearly and closely related to the debt host and further analysis of the other criteria would be necessary to determine whether the feature requires bifurcation.

From R’s perspective, the preferred stock issued is not eligible to be measured at fair value, with changes in fair value recognized in earnings. ASC 815 and ASC 825 prohibit this election for equity instruments issued by an entity that are classified in stockholders’ equity (or mezzanine equity) in the issuer’s statement of financial position. From R’s perspective, the second criterion is met.

From the investors’ perspective, provided that the preferred stock investment is not accounted for under the equity method, the preferred stock would be classified as a debt security in accordance with ASC 320 because of the provision that allows the holder to redeem the shares. Depending on how the debt security is classified (i.e., trading, AFS, or HTM) and whether the investor has elected to apply the fair value option, the debt security may or may not be recorded at fair value, with changes in fair value recorded through earnings. If the investment is already recorded at fair value, with changes recognized through earnings, the second criterion would not be met and neither of the embedded features would be bifurcated from the host contract. If the investment is not recorded at fair value, with changes recorded through earnings (e.g., an AFS-classified debt security for which the fair value option has not been elected), the second criterion would be met.

To be bifurcated, an embedded feature in a hybrid instrument must, on a freestanding basis, meet the definition of a derivative in ASC 815-10-15-83. The determination of whether the definition is met often focuses on the definition’s third component (i.e., the net settlement characteristic). Usually, the other two components of the definition of a derivative (i.e., (1) an underlying and a notional amount or payment provision and (2) no or little initial net investment) are met for an embedded feature in a hybrid financial instrument.

Redemption Feature

• Equity host — Whether the redemption feature meets the net settlement characteristic in the definition of a derivative generally depends on whether the hybrid contract is publicly traded and RCC. For R, the preferred stock is not publicly traded and is not considered RCC. Therefore, this criterion is not met under this specific fact pattern because the redemption feature does not meet the definition of a derivative.
• Debt host — Evaluation is not required since the redemption feature is clearly and closely related to the host contract.

Conversion Feature

• Equity host — Evaluation is not required since the conversion feature is clearly and closely related to the host contract.
• Debt host — Because the conversion feature may be net-cash-settled, the holder is effectively able to realize the change in the conversion option’s fair value without physically settling the option in shares. As a result, the conversion feature is considered net-settleable and meets the definition of a derivative. There are no applicable scope exceptions from derivative accounting; specifically, since the conversion feature is settled in cash at the option of the holder, the conversion feature would not be eligible for the scope exception for contracts in an entity’s own equity under ASC 815-40. This exception would have never been applicable to the investor, regardless of the ability to settle the conversion feature in cash. As a result, the third criteria is met for the conversion feature.

As shown above, under the guidance in ASC 815-15-25-1, R’s determination of whether the conversion and redemption features require bifurcation depends largely on (1) the nature of the host contract and (2) whether the evaluation is performed from the issuer’s or holder’s perspective.

If the host contract has an equity host, the redemption feature will not require bifurcation because the feature on its own does not meet the definition of a derivative (since R is a private company and its equity securities are not RCC). The conversion feature would similarly not require bifurcation because the conversion feature and the equity host contract are clearly and closely related.

If the host contract has a debt host, the redemption feature would not require bifurcation because the feature is clearly and closely related to the host contract. However, from the issuer’s perspective, the conversion feature would require bifurcation because (1) the conversion feature would not be clearly and closely related to the host contract, (2) the preferred stock is not measured at fair value, and (3) the conversion feature meets the definition of a derivative because it can be settled net in cash at the holder’s option. From the holder’s perspective, the determination of whether the conversion feature requires bifurcation depends on how the ASC 320 debt security is classified.

As indicated in this example, the facts and circumstances surrounding a particular transaction significantly affect the determination of whether bifurcation of a particular feature is required.