6.5 Call, Put, and Other Redemption Features in Equity Hosts
6.5.1 Background
Redemption features in an equity host can take many potential forms, including
put and call options and share-settled redemption options. Such redemption
features could be exercisable (1) at the option of the holder or the issuer or
(2) automatically upon the occurrence of certain contingent events. An entity
should understand the specific terms and provisions of the redemption feature
before evaluating whether it is clearly and closely related to the equity host.
We discuss application issues related to such features embedded in debt host
contracts in Section 6.4.
Equity host contracts often contain a provision related to liquidation
preference, which stipulates the amount of cash or other assets a holder of the
equity shares would receive upon the final liquidation or winding up of the
entity (i.e., an “ordinary liquidation”). The existence of a liquidation
preference provision does not in itself represent an embedded feature that must
be evaluated for possible bifurcation. However, if redemption would occur upon
certain “deemed liquidation events” that do not result in the cessation of the
entity’s operations, such as a change of control or sale of the issuer, the
entity would be required to evaluate the provision as a possible embedded
derivative.
6.5.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis of redemption
features embedded in an equity host contract. An entity should always consider
the terms and conditions of a specific feature in light of all the relevant
accounting guidance before reaching a conclusion.
Bifurcation Condition
|
Condition Met?
|
Analysis
|
---|---|---|
Not clearly and closely related
|
Yes
|
Put and call options are not considered clearly and
closely related to an equity host contract since the
risks and rewards of a fixed settlement upon redemption
are not clearly and closely related to the risks and
rewards of an equity interest. In the evaluation of this
criterion, an entity should consider the payoff profile
of the settlement (see Section 4.2.2) rather than the form of
settlement (i.e., cash versus shares).
|
Hybrid instrument not measured at fair value through
earnings on a recurring basis
|
Yes
|
From the issuer’s perspective, equity
host contracts are not measured at fair value on a
recurring basis since they are not eligible for the fair
value option in ASC 815-15 or ASC 825-10. Legal form
equity contracts that require liability classification
(and thus are potentially subject to recurring fair
value measurement) would not typically be considered
equity hosts in the evaluation of embedded features.
From the holder’s perspective, the determination of
whether the hybrid instrument is measured at fair value,
with changes in fair value recorded through earnings,
depends on whether the instrument is (1) an equity
method investment, (2) considered a debt security in the
scope of ASC 320 (and whether the holder has elected to
apply the fair value option), or (3) an equity security
in the scope of ASC 321.
|
Meets the definition of a derivative
|
It depends
|
The determination of whether a
redemption feature embedded in an equity host meets the
definition of a derivative often depends on whether the
feature meets the net settlement criterion —
specifically, whether the underlying instrument (e.g.,
preferred stock) is RCC. The gross exchange of an equity
host instrument that is not RCC for cash does not
inherently meet the net settlement criterion.
|
Meets a scope exception
|
No
|
From the issuer’s perspective, the issuer should evaluate
whether the redemption feature meets the scope exception
for certain contracts on an issuer’s own equity. For
example, a redemption feature that allows the issuer to
call an equity instrument at a fixed price (i.e., a
physically settled reacquisition of its own equity) may
meet this exception if the option doesn’t fail any of
the criteria in ASC 815-40 (see Section 2.3.11).
From the holder’s perspective, a scope exception is not
applicable.
|
6.5.3 Clearly-and-Closely-Related Analysis
ASC 815-15
25-20 A put option that
enables the holder to require the issuer of an equity
instrument (which has been deemed to contain an equity
host contract in accordance with paragraphs
815-15-25-17A through 25-17D) to reacquire that equity
instrument for cash or other assets is not clearly and
closely related to that equity instrument. Thus, such a
put option embedded in a publicly traded equity
instrument to which it relates shall be separated from
the host contract by the holder of the equity instrument
if the criteria in paragraph 815-15-25-1(b) through (c)
are also met. That put option also shall be separated
from the host contract by the issuer of the equity
instrument except in those circumstances in which the
put option is not considered to be a derivative
instrument pursuant to paragraph 815-10-15-74(a) because
it is classified in stockholders’ equity. A purchased
call option that enables the issuer of an equity
instrument (such as common stock) to reacquire that
equity instrument would not be considered to be a
derivative instrument by the issuer of the equity
instrument pursuant to that paragraph. Thus, if the call
option were embedded in the related equity instrument,
it would not be separated from the host contract by the
issuer. However, for the holder of the related equity
instrument, the embedded written call option would not
be considered to be clearly and closely related to the
equity instrument, if the criteria in paragraph
815-15-25-1(b) through (c) were met, and shall be
separated from the host contract.
Put and call options are not considered clearly and closely related to an equity
host contract because the economic risks and characteristics of redemption
features are not the same as the economic risks and characteristics of an equity
instrument. In determining whether a put or call option is considered clearly
and closely related to an equity host, an entity should consider the payoff
profile of the settlement (see Section
4.2.2) rather than whether the redemption is settled in cash or
shares.
For example, a share-settled redemption that results in the delivery of a
variable number of shares on the basis of a fixed value would be evaluated as a
redemption feature (and not as a conversion feature). A share-settled redemption
feature would not be considered clearly and closely related to an equity host
contract, even though the contract is settled by delivery of the entity’s equity
shares. Since the share-settled redemption would be based on a fixed monetary
value payable in a variable number of shares, the economic risks and
characteristics of such feature does not expose the holder to the variability of
the underlying equity. Inversely, a cash conversion feature would typically be
considered clearly and closely related to an equity host because the conversion
value exposes the holder to similar risks and characteristics as those of an
equity holder.
6.5.4 Derivative Analysis
ASC 815-10
15-107 The potential
settlement of the debtor’s obligation to the creditor
that would occur upon exercise of a put option or call
option embedded in a debt instrument meets the net
settlement criterion as discussed beginning in paragraph
815-10-15-100 because neither party is required to
deliver an asset that is associated with the underlying.
Specifically:
-
The debtor does not receive an asset when it settles the debt obligation in conjunction with exercise of the put option or call option.
-
The creditor does not receive an asset associated with the underlying.
15-109 The guidance in
paragraph 815-10-15-107 shall not be applied under
either of the following circumstances:
-
To put or call options that are added to a debt instrument by a third party contemporaneously with or after the issuance of a debt instrument. (In that circumstance, see paragraph 815-10-15-6.)
-
By analogy to an embedded put or call option in a hybrid instrument that does not contain a debt host contract.
As outlined in ASC 815-10-15-109, it would be inappropriate to analogize the
guidance on net settlement of a “debtor’s obligation to the creditor that would
occur upon exercise of a put or call option embedded in a debt instrument” to “a
hybrid instrument that does not contain a debt host.”
The table below presents an analysis of whether a redemption
feature embedded in an equity host contract meets the definition of a
derivative. However, an entity should always consider the terms and conditions
of a specific feature in light of the applicable accounting guidance before
reaching a conclusion.
Characteristics of a Derivative
|
Characteristic Present?
|
Analysis
|
---|---|---|
Underlying and notional amount or payment provision (see
Section
1.4.1)
|
Yes
|
A redemption feature has both an underlying (the fair
value of the shares to be redeemed) and a notional
amount (the number of shares to be redeemed) or payment
provision.
|
Initial net investment (see Section 1.4.2)
|
Yes
|
The initial net investment in an embedded feature is its
fair value (i.e., the amount that would need to be paid
to acquire the redemption feature on a stand-alone basis
without the host contract). Generally, a redemption
feature has an initial net investment that is smaller
than would be required for a direct investment that pays
the redemption amount (since the investment in the
equity host contract does not form part of the initial
net investment for the embedded feature).
|
Net settlement (see Section
1.4.3)
|
It depends
|
Typically, the entity would evaluate whether the equity
contract is RCC (see below).
|
As presented in the table above, the determination of whether a redemption
feature meets the definition of a derivative is generally focused on the net
settlement characteristic.
Importantly, as noted in ASC 815-10-15-109, redemption features
embedded in equity host contracts do not inherently meet the net settlement
criterion since the issuer is delivering assets associated with an underlying.
Whether the redemption feature meets the net settlement characteristic in the
definition of a derivative generally depends on whether the hybrid contract
qualifies as RCC. A publicly traded equity instrument that may be sold in
increments that can be rapidly absorbed by the market without significantly
affecting the price would be RCC. By contrast, equity shares of a private
company that are not publicly traded would not be considered RCC, and the
redemption feature would typically not meet the definition of a derivative. (See
Section 1.4.3
for further discussion of how to determine whether an instrument is RCC.)
Example 6-8
Redemption Feature in a Preferred Stock
Agreement
Company ABC issues convertible preferred stock, which is
not publicly traded, to investors. The convertible
preferred stock contains a provision that allows holders
to redeem the preferred stock for cash in the event of a
deemed liquidation event, which is defined in the
underlying agreement as “a sale, merger, acquisition, or
change in control” of ABC. Upon the occurrence of a
deemed liquidation event, the preferred stockholders are
entitled to be paid out of the assets of ABC that are
available for distribution to its stockholders an amount
per share equal to the applicable original issuance
price, plus any dividends declared but unpaid (the
“deemed liquidation contingent redemption feature”).
In determining whether the deemed liquidation contingent
redemption feature requires bifurcation from the host
contract, ABC considers the guidance in ASC 815-15-25-1.
Because the redemption of an equity instrument for cash
is not considered clearly and closely related to the
host contract and the convertible preferred stock is not
a hybrid instrument remeasured at fair value, ABC
considers whether the deemed liquidation contingent
redemption feature meets the definition of a derivative
in accordance with ASC 815-10-15-83.
The settlement of the deemed liquidation contingent
redemption feature requires the gross exchange of the
preferred stock (which is not RCC since it is not
publicly traded) in return for cash or other assets. In
other words, the deemed liquidation contingent
redemption feature does not allow for net settlement,
and the net settlement criterion in the definition of a
derivative is not met. (As noted in ASC 815-10-15-109,
redemption features embedded in equity host contracts do
not inherently meet net settlement.) Because the deemed
liquidation contingent redemption feature would not meet
the definition of a derivative if it were freestanding,
the embedded feature should not be bifurcated from the
host contract.