2.9 Own-Share Lending Arrangements in Connection With Convertible Debt Issuance
ASC 470-20
05-12A An entity for which the cost to an investment banking firm (investment bank) or third-party investors
(investors) of borrowing its shares is prohibitive (for example, due to a lack of liquidity or extensive open
short positions in the shares) may enter into share-lending arrangements that are executed separately but
in connection with a convertible debt offering. Although the convertible debt instrument is ultimately sold to
investors, the share-lending arrangement is an agreement between the entity (share lender) and an investment
bank (share borrower) and is intended to facilitate the ability of the investors to hedge the conversion option in
the entity’s convertible debt.
05-12B The terms of a share-lending arrangement require the entity to issue shares (loaned shares) to
the investment bank in exchange for a nominal loan processing fee. Although the loaned shares are legally
outstanding, the nominal loan processing fee is typically equal to the par value of the common stock, which is
significantly less than the fair value of the loaned shares or the share-lending arrangement. Generally, upon
maturity or conversion of the convertible debt, the investment bank is required to return the loaned shares to
the entity for no additional consideration.
05-12C Other terms of a share-lending arrangement typically require the investment bank to reimburse the
entity for any dividends paid on the loaned shares. Typically, the arrangement precludes the investment bank
from voting on any matters submitted to a vote of the entity’s shareholders to the extent the investment bank
is the owner of the shares.
ASC 470-20 provides recognition, measurement, EPS, and disclosure guidance
related to an issuer’s accounting for equity-classified share-lending arrangements
that are executed in contemplation of a convertible debt issuance. This guidance is
designed for arrangements that have the following terms and characteristics:
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The issuer is lending its equity shares to the counterparty (i.e., it has issued its equity shares on loan).
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The issuer receives a nominal fee that is significantly less than the fair value of the shares and of the arrangement.
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The counterparty will return the loaned shares to the issuer by the arrangement’s maturity date for no additional consideration. If the counterparty is unable to return the loaned shares, it may be required to reimburse the issuer in cash.
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The arrangement qualifies as equity under GAAP.
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The arrangement was executed in contemplation of a convertible debt issuance or other financing.
In evaluating whether the contract qualifies as equity under GAAP, the issuer
should consider the requirements in ASC 480 and ASC 815-40 (see Sections 4.3.5.12, 5.2.3.6, and 6.1.6).
Own-share lending arrangements usually derive their fair value from the difference between the
contractual processing fee and a market-based rate that would typically be charged for lending such
shares, adjusted as necessary to reflect the nonperformance risk of the share borrower. The terms of a
share-lending arrangement issued in contemplation of a convertible debt issuance typically require an
entity to issue its common shares to a counterparty (e.g., the bank) in exchange for a nominal processing
fee. The processing fee is significantly less than the fair value of the shares and is typically less than a
market fee that would be charged in a share-lending arrangement that is not issued in contemplation
of a convertible debt issuance. The issuer may accept less than a market rate on the arrangement to
promote the issuance of the convertible debt.
Example 2-9
Own-Share Lending Arrangement
Issuer A is in the process of issuing convertible debt. Before certain prospective investors agree to buy the
convertible debt, however, they would like to ensure that they are able to economically hedge their exposure
to A’s share price risk associated with the conversion option embedded in the debt. Accordingly, they seek
to enter into derivative contracts on the underlying shares (such as options, forwards, or total return swaps)
with Bank B that offset the “long” position in A’s share price risk that would result from an investment in the
convertible debt. To economically hedge its exposure from writing such derivatives, B in turn seeks to borrow
the underlying shares. By borrowing the shares, B can sell them short in the market to offset its “long” position
in A’s share price risk that would be created by its derivative contracts with the investors.
Because a sufficient amount of underlying shares is not readily available to market participants (or the price
is too high), B borrows the underlying shares by entering into a share-lending arrangement directly with A.
The terms of the share lending arrangement require B to pay a nominal processing fee to A (e.g., the par
value of the shares) that is significantly less than the agreement’s fair value. Issuer A is motivated to enter
into the agreement because the pricing and successful completion of the convertible debt offering depend
on the investors’ ability to enter into derivative contracts to hedge their equity price exposure, which in turn
depend on B’s ability to borrow the shares from A. During the period that the shares are on “loan,” they are
legally outstanding and the holder is legally entitled to dividends paid on them, although it must reimburse
A for any dividends paid on the loaned shares. Upon conversion or maturity of the convertible debt, B must
physically return the loaned shares to A for no consideration. If B defaults in returning the loaned shares, A is
contractually entitled to a cash payment equal to the fair value of the loaned shares.