8.1 Overview
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 guidance on an issuer’s accounting for equity-classified share-lending arrangements on its own shares that are executed in contemplation of a convertible debt issuance. In practice, an issuer may enter into such an arrangement to help ensure the successful completion of the convertible debt offering by facilitating investors’ ability to economically hedge their exposure to the share price risk associated with the issuer’s stock that is inherent in the convertible instrument.
Example 8-1
Own-Share Lending in Conjunction With Convertible Debt Issuance
Issuer A is issuing convertible debt. However, before agreeing to buy the debt, certain prospective investors would like to ensure that they can economically hedge their exposure to the share price risk related to A’s stock that is associated with the embedded conversion option. Accordingly, the prospective investors enter into derivative contracts on the underlying shares (e.g., options, forwards, or total return swaps) with Bank B that offset the exposure related to the “long” position in A’s stock that would result from the convertible debt investment. To economically hedge its own exposure from writing such derivatives, B borrows the underlying shares and sells them short in the market.
Because B cannot secure a sufficient number of underlying shares in the market (i.e., they are not readily available to market participants) or the price is too high, it borrows the underlying shares by entering into a share-lending arrangement directly with A. The terms of the 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 depends on B’s ability to borrow the shares.
During the period in which the shares are on “loan,” they are legally outstanding and the holder is legally entitled to any dividends paid on them, although it must reimburse A for such payments. Upon the 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 shares’ fair value.
This chapter describes the scope of the guidance (Section 8.2), the initial and subsequent accounting (Sections 8.3 and 8.4), and specific presentation and disclosure considerations (Section 8.5) related to these types of arrangements.