Chapter 8 — Own-Share Lending Arrangements in Connection With Convertible Debt Issuance

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.

8.2 Scope

The guidance on the issuer’s accounting for own-share lending arrangements in ASC 470-20 applies to arrangements that have the following terms and characteristics:

The issuer is lending its equity shares to the counterparty (i.e., it has issued its equity shares on loan).
The issuer receives a nominal fee that is significantly less than the fair value of the shares and of the arrangement.
The counterparty will return the loaned shares to the issuer on 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.
The arrangement qualifies as equity under GAAP.
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 480-10 and ASC 815-40.

Connecting the Dots

For a discussion of the evaluation of whether an own-share lending arrangement qualifies as equity under ASC 815-40, see Deloitte’s Roadmap Contracts on an Entity’s Own Equity, in particular Sections 2.9, 4.3.5.11, and 5.2.3.6.

8.3 Initial Accounting

ASC 470-20

25-20A At the date of issuance, a share-lending arrangement entered into on an entity’s own shares in contemplation of a convertible debt offering or other financing shall be measured at fair value (in accordance with Topic 820) and recognized as an issuance cost, with an offset to additional paid-in capital in the financial statements of the entity.

30-26A At the date of issuance, a share-lending arrangement entered into on an entity’s own shares in contemplation of a convertible debt offering or other financing shall be measured at fair value in accordance with Topic 820.

Own-share lending arrangements within the scope of this guidance (see Section 8.2) are initially recorded at fair value and recognized as a debt issuance cost with an offset to APIC in the issuer’s financial statement (i.e., Dr: Debt; Cr: Equity — APIC).

The terms of a share-lending arrangement entered into 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 was not entered into in contemplation of a convertible debt issuance. To promote the issuance of the debt, the issuer may sometimes accept less than the market rate on the share-lending arrangement. The fair value of the share-lending arrangement will be determined on the basis of the difference between the contractual processing fee and a market-based fee that would typically be charged for lending such shares, adjusted as necessary to reflect the nonperformance risk of the share borrower.

Example 8-2

Initial Accounting for Own-Share Lending Arrangement

Issuer A issues convertible debt at par for cash proceeds of $250 million. The stated interest rate on the debt is 2.5 percent per annum. The debt is due five years from the issuance date and is convertible into A’s equity shares at the holder’s option. Issuer A determines that the convertible debt should be accounted for as traditional convertible debt under ASC 470-20 (see Chapter 4). Accordingly, the equity conversion option is not separately recognized as an equity component under ASC 470-20.

In contemplation of the convertible debt issuance, A executes a share-lending arrangement with Bank B to help ensure the successful completion of the debt offering, and A receives $100,000 for the arrangement (which is also the par amount of the shares issued). However, the fair value of the arrangement is $15 million. Issuer A evaluates the share-lending arrangement under ASC 470-20 and ASC 815-40 and determines that it qualifies as equity.

On the date that both the debt issuance and the share-lending arrangement occur, A makes the following journal entry:

8.4 Subsequent Accounting

ASC 470-20

35-11A If it becomes probable that the counterparty to a share-lending arrangement will default, the issuer of the share-lending arrangement shall recognize an expense equal to the then fair value of the unreturned shares, net of the fair value of probable recoveries, with an offset to additional paid-in capital. The issuer of the share-lending arrangement shall remeasure the fair value of the unreturned shares each reporting period through earnings until the arrangement consideration payable by the counterparty becomes fixed. Subsequent changes in the amount of the probable recoveries should also be recognized in earnings.

Unless an issuer elects to account for debt arising from an own-share lending arrangement at fair value under the fair value option in ASC 825-10 (see Section 2.5), it uses the effective interest method to amortize any debt discount (or reduced premium) that is created by recognizing the arrangement. The amount recognized in equity is not remeasured as long as (1) the share-lending arrangement qualifies as equity under ASC 815-40 and (2) it is not probable that the counterparty to the share-lending arrangement will default in returning the loaned shares (or an equivalent amount of consideration).

If it becomes probable that the counterparty to the share-lending arrangement will default in returning the loaned shares (or an equivalent amount of consideration), the issuer must recognize an expense equal to the fair value of the unreturned shares adjusted for the fair value of any probable recoveries. The offsetting entry for the expense is to APIC (i.e., Dr: Loss; Cr: Equity — APIC). The EITF stated the following related to Issue 09-1 at its June 18, 2009, meeting:

Some Task Force members observed that equity-classified instruments do not generally result in expense charges. However, the Task Force concluded that an expense was appropriate in this situation because it relates to a counterparty default and not changes in the entity’s share price.

In other words, the EITF determined that even though the share-lending arrangement is classified in equity, it is appropriate to record an expense because the issuer incurs a loss from the counterparty’s failure to satisfy its obligation to return the loaned shares. Under the contractual terms of the instrument, the issuer should have received the shares back (or an equivalent amount of consideration), but instead it received no value or something of lesser value because of the counterparty’s default.

The amount of the loss (i.e., the fair value of the unreturned shares adjusted for probable recoveries) is remeasured each period (e.g., for changes in the fair value of the unreturned shares) until the consideration payable becomes fixed. The issuer recognizes changes in the amount of the loss in earnings with an offset to APIC.

8.5 Presentation and Disclosure

8.5.1 Presentation

As noted in Section 8.3, own-share lending arrangements within the scope of this guidance (see Section 8.2) are initially recognized as a debt issuance cost, with an offset to APIC. Under ASC 835-30-45-1A, debt issuance costs are reported as a direct deduction from the par amount of the debt on the face of the balance sheet. They are not classified as a deferred charge.

8.5.2 Earnings per Share

ASC 470-20

45-2A Loaned shares are excluded from basic and diluted earnings per share unless default of the share-lending arrangement occurs, at which time the loaned shares would be included in the basic and diluted earnings-per-share calculation. If dividends on the loaned shares are not reimbursed to the entity, any amounts, including contractual (accumulated) dividends and participation rights in undistributed earnings, attributable to the loaned shares shall be deducted in computing income available to common shareholders, in a manner consistent with the two-class method in paragraph 260-10-45-60B.

ASC 470-20 contains EPS guidance for own-share lending arrangements executed in contemplation of a convertible debt offering or other financing. Under this guidance, loaned shares are excluded from EPS unless the counterparty to the share-lending arrangement defaults on its obligation to return the loaned shares (or an equivalent amount of consideration). If the counterparty defaults, the shares are included in both basic and diluted EPS. (Note that in ASC 470-20-45-2A, the threshold for including the loaned shares in EPS is the counterparty’s default, whereas in ASC 470-20-35-11A, the threshold for recognizing a loss is that it is probable that the counterparty will default.)

In practice, own-share lending arrangements often require the counterparty to reimburse the issuer for any dividends paid on the loaned shares. If the counterparty does not reimburse the issuer for such dividends, however, the issuer must deduct the corresponding amount and any participation right in undistributed earnings from income available to common stockholders.

Connecting the Dots

For a discussion of the presentation and disclosure of EPS related to own-share lending arrangements, see Deloitte’s Roadmap Earnings per Share, in particular Sections 3.3.2.8, 4.8.3.5, 5.3.3.9, and 8.5.

8.5.3 Disclosure

ASC 470-20

50-2A An entity that enters into a share-lending arrangement on its own shares in contemplation of a convertible debt offering or other financing shall disclose all of the following. The disclosures must be made on an annual and interim basis in any period in which a share-lending arrangement is outstanding.

A description of any outstanding share-lending arrangements on the entity’s own stock
All significant terms of the share-lending arrangement including all of the following:
1. The number of shares
2. The term
3. The circumstances under which cash settlement would be required
4. Any requirements for the counterparty to provide collateral.
The entity’s reason for entering into the share-lending arrangement
The fair value of the outstanding loaned shares as of the balance sheet date
The treatment of the share-lending arrangement for the purposes of calculating earnings per share
The unamortized amount of the issuance costs associated with the share-lending arrangement at the balance sheet date
The classification of the issuance costs associated with the share-lending arrangement at the balance sheet date
The amount of interest cost recognized relating to the amortization of the issuance cost associated with the share-lending arrangement for the reporting period
Any amounts of dividends paid related to the loaned shares that will not be reimbursed.

50-2B An entity that enters into a share-lending arrangement on its own shares in contemplation of a convertible debt offering or other financing shall also make the disclosures required by Topic 505.

50-2C In the period in which an entity concludes that it is probable that the counterparty to its share-lending arrangement will default, the entity shall disclose the amount of expense reported in the statement of earnings related to the default. The entity shall disclose in any subsequent period any material changes in the amount of expense as a result of changes in the fair value of the entity’s shares or the probable recoveries. If default is probable but has not yet occurred, the entity shall disclose the number of shares related to the share-lending arrangement that will be reflected in basic and diluted earnings per share when the counterparty defaults.

ASC 470-20 includes disclosure requirements related to own-share lending arrangements executed in contemplation of a convertible debt offering or other financing. These supplement the general requirements for the issuer’s disclosure of information about securities in ASC 505-10 (see Section 4.6 of this Roadmap and Chapter 7 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity).