9.4 Classification
9.4.1 Characteristics That Trigger Temporary Equity Classification
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(2) ASR 268 requires
preferred securities that are redeemable for cash or
other assets to be classified outside of permanent
equity if they are redeemable (1) at a fixed or
determinable price on a fixed or determinable date, (2)
at the option of the holder, or (3) upon the occurrence
of an event that is not solely within the control of the
issuer. As noted in ASR 268, the Commission reasoned
that “[t]here is a significant difference between a
security with mandatory redemption requirements or whose
redemption is outside the control of the issuer and
conventional equity capital. The Commission believes
that it is necessary to highlight the future cash
obligations attached to this type of security so as to
distinguish it from permanent capital.”
S99-3A(4) ASR 268 requires
equity instruments with redemption features that are not
solely within the control of the issuer to be classified
outside of permanent equity (often referred to as
classification in “temporary equity”). . . .
S99-3A(5) Determining whether
an equity instrument is redeemable at the option of the
holder or upon the occurrence of an event that is solely
within the control of the issuer can be complex. The SEC
staff believes that all of the individual facts and
circumstances surrounding events that could trigger
redemption should be evaluated separately and that the
possibility that any triggering event that is not
solely within the control of the issuer could
occur — without regard to probability — would require
the instrument to be classified in temporary equity.
Paragraphs 6–11 provide examples of the application of
ASR 268.
Unless an exception applies, an equity-classified instrument must be presented as temporary equity if the issuer could be required to redeem it for cash or other assets in any circumstance not under the issuer’s sole control. Informally, the SEC staff has indicated that this guidance should be “strictly and rigidly applied.”
Example 9-1
Preferred Stock With Embedded Put Option
Company U, an SEC registrant, issued, for $33 million, a 6.5 percent convertible
preferred stock with an embedded put option. If
exercised, the put option requires U to repurchase the
shares for $33 million. Because U’s repurchase of the
shares is conditioned upon exercise of the put option,
the shares do not meet the definition of a mandatorily
redeemable financial instrument in ASC 480 (see
Chapter 4). Further, the issuer has
determined that the put option is not required to be
bifurcated as a derivative instrument under ASC 815-15.
Because the redemption of the shares of preferred stock
is outside the issuer’s control, these shares must be
classified as temporary rather than permanent equity.
Note that classification of the convertible preferred
stock in temporary equity would also have been required
even if the put option had been separated as an embedded
derivative under ASC 815-15.
According to ASC 480-10-S99-3A(2), which contains interpretations of the requirements of Regulation S-X, Rule 5-02.27(a) (as amended by ASR 268), an equity-classified instrument is presented as temporary equity if it is redeemable for cash or other assets in any of the following circumstances:
- “[A]t a fixed or determinable price on a fixed or determinable date” (e.g., convertible preferred shares that are mandatorily redeemable for cash on a specified date in the future if not previously converted by the holder).
- “[A]t the option of the holder” (e.g., preferred shares that the holder can elect to redeem for cash, assets, or the issuer’s debt securities).
- “[U]pon the occurrence of an event that is not solely within the control of the issuer” (e.g., preferred shares that become redeemable for cash upon a change in control, the violation of financial statement covenant, a change in law, or the occurrence of a deemed liquidation event).
Further, instruments that are redeemable for cash or other assets in any of the circumstances described above are classified as temporary equity:
- “[R]egardless of their other attributes such as voting rights, dividend rights or conversion features” (see CFRP 211.02).
- “[W]ithout regard to probability” (see ASC 480-10-S99-3A(5)). As noted by the SEC staff at the 1991 AICPA Conference on Current SEC Developments, temporary equity classification is required even if the likelihood of redemption is “insignificant, unlikely, or remote.” (Although an instrument’s likelihood of becoming redeemable does not affect its classification, such likelihood may affect its subsequent measurement; see Section 9.5.2.)
- Even if redemption is outside the control of the holder. It is sufficient that redemption “not [be] solely within the control of the issuer” (see ASC 480-10-S99-3A(5)).
In a letter dated April 12, 1990, and addressed to the SEC staff, Donald Moulin,
then chairman of the AICPA SEC Regulations Committee, provided the following
observations about common misconceptions in the application of the SEC’s
temporary equity guidance:
Our practice experience indicates that the following are
the two aspects of ASR No. 268 that are most commonly misunderstood:
-
The probability that the event triggering redemption (or the holder’s right to demand redemption) will occur is not a factor in deciding whether redeemable equity treatment is required under ASR No. 268; and
-
The condition or event that will trigger redemption (or the holder’s right to demand redemption) does not have to be within the control of the holder, but merely outside the control of the issuer.
Connecting the Dots
The SEC’s temporary equity guidance
must be applied on the basis of the unit of account for the equity
instrument under U.S. GAAP. For example, assume that an entity issues 1
million shares of $1,000 stated value per share of preferred stock. The
gross proceeds from the issuance therefore total $1 billion. Further
assume that each share is puttable by the holder upon the mere passage
of time for $1,000; however, in no circumstance is the issuer required
to redeem more than $500 million of such preferred stock. In this
example, all 1 million shares of the preferred stock (or $1 billion
aggregate stated value) must be classified in temporary equity. This is
because the unit of account is each $1,000 stated value of preferred
stock (i.e., each share). Each share of preferred stock is fungible and
redeemable; the issuer cannot identify specific shares that are not
redeemable. Therefore, on the basis of the unit of account, all of the
preferred stock must be classified in temporary equity. This conclusion
is consistent with views expressed by the SEC staff on the
classification of publicly traded common shares of SPACs. For example,
the SEC staff has objected to a registrant’s conclusion that because a
SPAC must maintain a minimum level of net tangible capital, some portion
of its publicly traded redeemable common shares may be classified in
permanent equity. The staff indicated that since the unit of account was
an individual share, and all such shares were redeemable, it was
inappropriate for a SPAC to report an amount in temporary equity that
was less than the aggregate redemption amount of such shares.
A feature does not need to be explicitly described as a cash-settled redemption
or put-option feature to potentially trigger temporary equity classification.
For example, a redemption feature that causes temporary equity classification
may be established through contractual terms that are described as a call option
(see Section
9.4.4), conversion feature (see Sections 9.4.6, 9.4.7, and 9.4.8), or liquidation provision (see
Section 9.4.5).
Further, a feature does not necessarily need to explicitly provide for
settlement in cash or other assets. If an issuer could be forced to settle all
or part of a share-settled feature (e.g., a conversion feature) in cash or other
assets, temporary equity classification may be required (see Section 9.4.6).
When an entity issues shares or other equity instruments without complying with applicable registration or qualification requirements (e.g., under federal securities laws or certain state laws), the holder may have a legal right to rescind its purchase of those equity instruments. If a legal determination has been made that the holder has in fact the right to rescind its purchase, redemption will be outside the issuer’s control. The SEC staff has indicated that equity instruments subject to rescission rights should be presented in temporary equity. The SEC’s Division of Corporation Finance: Frequently Requested Accounting and Financial Reporting Interpretations and Guidance (March 31, 2001) states, in part:
The staff considers [the temporary equity] guidance to be applicable to all equity securities (not only preferred stock) the cash redemption of which is outside the control of the issuer, including stock subject to rescission rights.
ASC 480-10-S99-3A contains a number of exceptions that permit an issuer to disregard certain types of redemption features in evaluating whether the related equity instrument (or component) should be classified as temporary equity. These include the following obligations and features:
- Redemption features that are contingent on an event that is under the sole control of the issuer (see Section 9.4.2).
- Redemption obligations upon the death or disability of the holder if the redemption amount will be funded from the proceeds of an insurance policy that meets certain criteria (see Section 9.4.3).
- Redemption obligations upon an ordinary liquidation event (see Section 9.4.5).
- Redemption obligations upon a deemed liquidation event “if all of the holders of equally and more subordinated equity instruments of the entity would always be entitled to also receive the same form of consideration (for example, cash or shares) upon the occurrence of the event that gives rise to the redemption (that is, all subordinate classes would also be entitled to redeem)” (see Section 9.4.5).
- Redemption obligations associated with the equity component of certain convertible debt that is not currently redeemable or convertible for cash or other assets on the balance sheet date (see Section 9.4.8).
- Certain features in share-based payment arrangements (see Section 9.4.9).
9.4.2 Evaluation of Whether an Event Is Under the Sole Control of the Issuer
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(9)
[Examples in which temporary equity classification is
appropriate] Example 4. An equity instrument may
contain provisions that allow the holder to redeem the
instrument for cash or other assets upon the occurrence
of events that are not solely within the issuer’s
control. Such events may include:
-
The failure to have a registration statement declared effective by the SEC by a designated date
-
The failure to maintain compliance with debt covenants
-
The failure to achieve specified earnings targets
-
A reduction in the issuer’s credit rating.
Since these events are not solely within the control of the issuer, the equity instrument is required to be classified in temporary equity.
If the terms of an equity instrument require or may require the issuer to redeem
the instrument for cash or other assets upon the occurrence of an event that is
not solely within the issuer’s control, it is classified as temporary equity,
irrespective of the likelihood that the event will occur. Conversely, a term
that requires or may require redemption upon an event that is solely within the
issuer’s control does not result in temporary equity classification, since the
issuer has the discretion to avoid redemption by preventing the event from
occurring. In prepared remarks before the 2009 AICPA Conference on Current SEC and
PCAOB Developments, then SEC Professional Accounting Fellow Brian Fields stated
the following:
A key question . . . is whether the company can avoid
settling the instrument in cash or other assets even in contingent
scenarios that may be improbable. [An] equity share is generally
presented as mezzanine temporary equity if it could require cash
settlement for reasons beyond the company’s control.
Moreover, at the 2000 AICPA Conference on Current SEC Developments, then SEC
Professional Accounting Fellow Dominick J. Ragone III said, in part:
The [SEC] staff believes that securities with redemption
features that are “outside of the control of the issuer” include those
securities that are redeemable either based on mandatory or certain events
(for example, the death or retirement of the holder) or on uncertain events
(for example, change in control of the company, violation of specified
financial covenants, or the attainment of specific earnings or a stock
market price).
Accordingly, temporary equity classification is required if an equity instrument
must be redeemed or becomes redeemable at the election of the holder upon any
event not solely within the issuer’s control. The table below provides examples
of events that may be considered solely within and not solely within the
issuer’s control when an instrument becomes redeemable upon the occurrence of
the event. Note, however, that the determination of whether an event is within
the issuer’s control may differ from that indicated in the table depending on
the facts and circumstances. An event that would ordinarily be deemed solely
within the issuer’s control may not qualify as such if, for example, (1) the
holder controls the issuer’s decision to cause the event to occur through board
representation or other rights (see Section 9.4.4) or (2) the issuer is firmly
committed to undertaking an action that will cause the event to occur.
Solely Within the Issuer’s Control | Not Solely Within the Issuer’s Control |
|---|---|
|
|
In determining whether redemption may be required because of circumstances
outside the issuer’s control, the issuer should consider the interaction between
different contractual provisions. For example, one of the terms of an
outstanding perpetual equity share may permit the issuer to call the instrument
for a stated amount of cash at any time. By itself, such a term typically would
not cause the instrument to be classified in temporary equity (unless, for
example, the holder controls the issuer’s decision; see Section 9.4.4) since the
issuer could not be forced to exercise the call. Further, the holder may have no
right to put the instrument to the issuer for cash unless the issuer elects not
to exercise its call option by a specified date in the future. Typically, a put
right that is contingent on a discretionary decision of the issuer would not
result in temporary equity classification since the issuer could prevent the put
right from becoming exercisable. In such a scenario, however, the instrument
would be classified in temporary equity because the only event that prevents the
holder from being able to redeem the instrument is the issuer’s election to
redeem it by a certain date. In other words, either it will be redeemed by the
issuer or it will become redeemable by the holder by the specified date.
The issuer should also consider any applicable legal requirements that may affect whether redemption is within its control. For example, a provision in an instrument may require the instrument’s redemption upon the issuer’s merger with another entity. Further, state law may require approval of the issuer’s board of directors before any merger can occur. If the holders of the instrument are not able to control the board’s vote through direct representation or other rights, the decision to merge with another entity may be within the issuer’s control.
9.4.3 Redemption Features Triggered by Holder’s Death or Disability
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(3)(g)
Certain redemptions covered by insurance
proceeds. As a limited exception that should not be
analogized to, an equity instrument that becomes
redeemable upon the death of the holder (at the option
of the holder’s heir or estateFN9) or upon
the disability of the holder is not subject to ASR 268
if the redemption amount will be funded from the
proceeds of an insurance policy that is currently in
force and which the registrant has the intent and
ability to maintain in force.
__________________________________
FN9 If an equity instrument is
required to be redeemed for cash or other assets
upon the death of the holder, the instrument is
classified as a liability pursuant to Subtopic
480-10 even if an insurance policy would fund the
redemption.
As a general rule, an equity-classified instrument that becomes redeemable for
cash or other assets upon the death or disability of the holder must be
classified in temporary equity because those events are outside the issuer’s
control (see Section
9.4.2). However, the SEC does not require temporary equity
classification if upon death or disability a redemption “will be funded from the
proceeds of an insurance policy that is currently in force,” provided that the
issuer has the intent and ability to maintain the policy in force. This guidance
does not apply to nonconvertible stock that is mandatorily (as opposed to
optionally) redeemable for cash or other assets upon the holder’s death because
ASC 480 requires liability classification for an instrument that is certain to
be redeemed. (Unlike disability, death is certain to occur; see Section 4.1.) Further, if
a nonconvertible equity instrument becomes mandatorily redeemable upon the
disability of the holder, the instrument would need to be reclassified from
equity to a liability (see Section 4.4.1).
9.4.4 Special Considerations When the Holder Has the Ability to Control Issuer Decisions
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(7)
[Examples in which temporary equity classification is
appropriate] Example 2. A preferred security
that is not required to be classified as a liability
under other applicable GAAP may have a redemption
provision that states it may be called by the issuer
upon an affirmative vote by the majority of its board of
directors. While some might view the decision to call
the security as an event that is within the control of
the company because the governance structure of the
company is vested with the power to avoid redemption, if
the preferred security holders control a majority of the
votes of the board of directors through direct
representation on the board of directors or through
other rights, the preferred security is redeemable at
the option of the holder and classification in temporary
equity is required. In other words, any provision that
requires approval by the board of directors cannot be
assumed to be within the control of the issuer. All of
the relevant facts and circumstances should be
considered.
S99-3A(10)
[Examples in which permanent equity classification is
appropriate] Example 5. A preferred security may
have a provision that the decision by the issuing
company to sell all or substantially all of a company’s
assets and a subsequent distribution to common
stockholders triggers redemption of the security. In
this case, the security would be appropriately
classified in permanent equity if the preferred
stockholders cannot trigger or otherwise require the
sale of the assets through representation on the board
of directors, or through other rights, because the
decision to sell all or substantially all of the
issuer’s assets and the distribution to common
stockholders is solely within the issuer’s control. In
other words, if there could not be a “hostile” asset
sale whereby all or substantially all of the issuer’s
assets are sold, and a dividend or other distribution is
declared on the issuer’s common stock, without the
issuer’s approval, then classifying the security in
permanent equity would be appropriate.
S99-3A(11)
Example 6. A preferred security may have a
provision that provides for redemption in cash or other
assets if the issuing company is merged with or
consolidated into another company, and pursuant to state
law, approval of the board of directors is required
before any merger or consolidation can occur. In that
case, assuming the preferred stockholders cannot control
the vote of the board of directors through direct
representation or through other rights, the security
would be appropriately classified in permanent equity
because the decision to merge with or consolidate into
another company is within the control of the issuer.
Again, all of the relevant facts and circumstances
should be considered when determining whether the
preferred stockholders can control the vote of the board
of directors.
Sometimes, equity instruments contain a stated redemption feature that is
ostensibly controlled by the issuer, such as a call option or redemption
requirement upon the issuer’s decision to undertake a specified action (e.g.,
through an affirmative vote of the majority of its shareholders or board of
directors). Even though such a feature may appear to be controlled by the
issuer, temporary equity classification is required if the instrument’s holder
(or the holders acting together as a class) has the ability to control whether
the issuer will redeem the instrument or cause the instrument to become
redeemable under the redemption feature through board representation, voting
rights, or other rights. Accordingly, an equity instrument that contains any of
the following features would be classified in temporary equity:
-
A call option permitting the issuer to call the instrument for cash when the holder controls the issuer’s decision to call the instrument through board representation or other rights.
-
A redemption feature requiring the issuer to redeem the instrument upon a vote by a majority of the holders of the instrument.
-
A redemption feature requiring the issuer to redeem the instrument upon the occurrence of a specified corporate transaction (e.g., sale of assets) if the holder controls whether the issuer will undertake the transaction through board representation or other rights.
-
A conversion feature if the holder could prevent the issuer from having a sufficient number of authorized and unissued shares available to share settle the feature (i.e., authorization of additional shares requires approval of the issuer’s board of directors and the holder controls the issuer’s board of directors). (As discussed in Section 9.4.6, share-settled features are assumed to be cash-settled if the issuer does not have a sufficient number of authorized and unissued shares to settle the feature in shares.)
-
A conversion feature that is subject to a down-round feature (see Section 4.3.7.2 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity) if the holder controls the issuer’s decision to sell shares for an amount less than the currently stated conversion price and the issuer could potentially not have a sufficient number of authorized and unissued shares to settle the conversion. See also Example 9-17.
The determination of whether the holders of an equity instrument (e.g.,
convertible preferred stock) control the ability to direct corporate actions
depends on the facts and circumstances (e.g., relevant provisions of shareholder
and other agreements, contracts, and state laws). Even if the holder of an
equity-classified instrument currently has no power to direct the issuer to
redeem the instrument, an entity should consider whether the holder would obtain
such power if an event not solely within the issuer’s control were to occur.
Example 9-2
Evaluation of the Issuer’s Ability to Avoid a
Redemption of Preferred Stock
For example, a perpetual preferred share with a stated perpetual dividend rate payable in cash and a redemption feature may permit the issuer to call the instrument for cash. However, if the holder does not hold voting stock or sit on the board, and the issuer fails to pay the stated dividend on the preferred stock for four consecutive quarters, the holder will obtain the right to appoint a majority of the directors on the board and thereby direct the issuer’s decision of whether to call the share. The share would be classified in temporary equity because the issuer does not control whether it always will have sufficient cash to pay the dividend (see Section 9.4.2). If the issuer does not have sufficient cash, the holder will obtain the ability to direct the issuer’s decision of whether to call the instrument by taking control of the board.
A board of directors’ fiduciary duty under state law to act prudently and in the best interests of the company is not by itself sufficient to cause a redeemable equity instrument to be classified as permanent equity.
Example 9-3
Consideration of Fiduciary Responsibilities of a Board
of Directors
Company A has issued preferred stock that is redeemable for cash at the option of the holder (Investor B) if A’s board of directors agrees to such redemption. Under state law applicable to the preferred stock, the directors have a fiduciary responsibility to the company, which requires that they act prudently and in the best interests of the company. The board includes directors appointed by B as well as independent directors who would need to consent to any cash redemption. However, B is contractually able to replace any directors who object to a cash redemption. There are no specific contractual safeguards to protect other shareholders (e.g., there is no requirement for other shareholders to approve a redemption). In the evaluation of whether the preferred stock should be classified as temporary equity, the existence of fiduciary responsibility under state law does not take precedence over the redemption terms of the contractual agreements. Accordingly, the preferred stock should be classified as temporary equity.
Mr. Fields stated the following at the 2009 AICPA Conference on Current SEC and PCAOB Developments:
[The] SEC staff guidance on redeemable shares . . . notes that there may be situations in which control by the governance structure of an entity, such as the Board of Directors, may be insufficient to demonstrate that a settlement option is within the company’s control. These are often situations in which specific shareholders have the ability to seize control of the governance structure and require redemption of their interests in a preferential manner using another feature of the instrument. A typical example is a provision whereby a class of preferred shareholders can take control of the Board upon failure to pay dividends and thereby exercise a preexisting embedded call option on their preferred stock. Unless there were a third provision that makes the call inoperable when the preferred shareholders are in control, the shares would be classified in temporary equity because the combination of the contingent control right and the call could be used in the same manner as a put option by the preferred shareholder. Of course, whenever the analysis becomes this involved a healthy attention to appropriate disclosure is probably in order.
Connecting the Dots
As noted above, equity instruments, such as callable
preferred stock, may need to be classified in temporary equity even if
the holder or holders do not have a stated right to put (redeem) them.
In evaluating whether callable preferred stock must be classified in
temporary equity, an issuer should consider whether its holder or
holders control the decision to exercise the call option through board
representation or other voting rights provided by the preferred stock.
For example, if the agreements for callable preferred stock entitle the
holders to elect three out of five seats on the issuer’s board of
directors, the preferred stockholders control the ability to require the
issuer to redeem the preferred stock unless specific contractual
provisions exist that prevent the holders from doing so (e.g., the
contractual terms of the preferred stock stipulate that only independent
directors elected by common shareholders that are not preferred
stockholders can choose to exercise the call right in the preferred
stock).
In addition, even if the holder or holders of callable
preferred stock do not control the right to force the issuer to exercise
the call option as a result of the rights and privileges given to such
investors as a result of the ownership of the preferred stock, the
callable preferred stock may still need to be classified in temporary
equity. For example, if callable preferred stock is held by an investor
that separately holds a majority of the issuer’s common stock, the
investor can force the issuer to redeem the preferred stock unless
specific contractual provisions in the preferred stock or the entity’s
governance documents prevent the investor from doing so.
Some entities have multiple classes of outstanding equity instruments with
stated redemption features that cannot be triggered without the issuer’s
involvement (e.g., the issuer’s exercise of a call feature or its decision to
undertake a specified corporate transaction that would activate a holder put
feature). Sometimes, no single class of holders of such instruments controls the
issuer’s decision to trigger the redemption feature in any individual class of
equity instruments. However, if some or all classes of holders can force the
issuer to trigger a redemption feature in any or all classes by acting in
concert (e.g., by voting together or giving their consent), the entity should
consider whether holders of different classes would be aligned in any action to
trigger the redemption feature (e.g., by considering the dividend rights and
liquidation preferences of each class). If the holders of more than one class
are able to trigger a redemption of one or more classes by acting together and
their economic interests related to such redemptions do not conflict, temporary
equity classification is required for all classes of outstanding equity
instruments that would become subject to redemption upon such action, since the
redemption feature would be considered not solely within the issuer’s control.
Generally, this situation occurs when entities have issued multiple classes of
preferred stock. Except in rare cases, the investors in the various classes of
preferred stock do not have conflicting economic interests. As a result, if the
issuer does not control the decision to exercise an option to redeem the
preferred shares because, for example, the holders of all the classes as a group
control the majority of the representation on the entity’s board of directors,
all such classes must be classified in temporary equity.
In the absence of a stated redemption feature (regardless of whether it is
described as a call, put, liquidation, redemption, or conversion feature), an
issuer is not required to classify an instrument as temporary equity even though
the holder might be able to use its influence to compel the issuer to purchase
the instrument (e.g., through board representation or voting rights). Further,
temporary equity classification is not required, in the separate financial
statements of a subsidiary, for a redeemable equity instrument if, upon
redemption, the redemption amount will be paid by the parent and not the
subsidiary (see Section 9.3.10).
Questions sometimes arise related to whether temporary equity
classification is required for preferred securities on the basis that while the
preferred stockholders do not currently control the issuing entity’s board of
directors or vote of its stockholders, they could potentially obtain such
control by purchasing shares of common stock from third parties. The example
below addresses this scenario.
Example 9-4
Preferred Stock Redeemable at Holder’s Option Upon
Certain Events That Require Approval of the Issuing
Entity’s Board of Directors
Entity D issues preferred stock that is only redeemable,
at the option of the holders, upon (1) a merger or
consolidation for which D is a constituent party (a
“merger”) or (2) a sale of all or substantially all of
D’s assets (an “asset sale”). Both a merger and an asset
sale can occur only with approval of D’s board of
directors. The preferred security is not redeemable upon
what is often referred to in practice as a “change of
control” (which is generally outside an entity’s
control) because any redemption can occur only with
approval of D’s board of directors.
The holders of the preferred stock do not currently
control (1) D’s board of directors through direct
representation or other rights or (2) the vote on
matters submitted to D’s stockholders. Furthermore, in
accordance with the terms of the preferred stock, the
holders do not have the ability to obtain control of D’s
board of directors or the vote of D’s stockholders. The
holders of the preferred stock could only possibly
obtain control over D’s board of directors or the vote
of D’s stockholders by acquiring D’s common shares from
third-party holders (i.e., by purchasing shares from
other common stockholders that do not own the preferred
stock).
The preferred stock does not have to be
classified in temporary equity on the basis that D may
be unable to prevent the preferred stockholders from
obtaining control over D’s board of directors or the
vote of D’s stockholders by acquiring common shares of D
from third-party investors (e.g., by acquiring a
controlling interest in D’s common stock from
third-party holders of common stock). Decisions that
require approval of an entity’s board of directors are
considered to be within the issuing entity’s control
unless the holders of preferred stock (or other equity
instruments that are being evaluated for temporary
equity classification) currently control or could obtain
control of the entity’s board of directors or vote of
the entity’s stockholders through direct representation
or other contractual rights that arise from the terms of
the preferred stock instrument or any other instrument
that the preferred stockholders otherwise own. For
example, if the terms of the preferred stock allow the
preferred stockholders to obtain control of the issuing
entity’s board of directors if the entity fails to
timely pay dividends on the preferred stock, the entity
would not be able to conclude that decisions of its
board of directors are within its control because it is
outside an entity’s control to timely pay dividends. (In
that circumstance, temporary equity classification is
required.) However, an entity is not required to
consider the possibility that holders of preferred stock
(or other equity instruments) could seize control over
the entity’s board of directors or vote of its
stockholders by purchasing common stock or other
securities from third-party investors. Such a view would
result in the classification as temporary equity of all
equity securities with any redemption feature
(conditional or otherwise) that does not meet the
limited exception in ASC 480-10-S99-3A(3)(f) for deemed
liquidation events, which is inconsistent with the
application of ASC 480-10-S99-3A in practice. This view
is supported by ASC 480-10-S99-3A(7), (10), and (11).
While the above fact pattern involves
preferred stock that is redeemable upon a merger or
asset sale, which is considered to be within D’s
control, the same conclusion would apply if the
preferred stock was redeemable upon the occurrence of
other events that are within D’s control, including:
-
A call option that permits but does not require D to repurchase the instrument for cash.
-
An equity conversion feature that D has the ability to settle in common shares but can elect to settle in cash.
-
A redemption feature that requires D to redeem the instrument if D’s board of directors decides to undertake an IPO of common stock.
However, if the preferred stockholders
currently own a majority of D’s common stock and thereby
control the election of D’s board of directors,
classification of the preferred stock in temporary
equity would be required unless specific contractual
provisions support a conclusion that such holders could
not require the preferred stock to be redeemed (i.e.,
the decisions that would lead to any such redemption
must be approved by independent common stockholders or
directors appointed by those common stockholders).
9.4.5 Evaluation of Liquidation Provisions
9.4.5.1 Overview
Sometimes, a feature of an equity instrument that makes it redeemable is characterized as a liquidation provision. Even if an equity instrument (e.g., convertible preferred stock) does not contain an explicit redemption feature (i.e., a stated call option or stated put option), an entity must evaluate the instrument’s liquidation provisions to determine whether the instrument should be classified as temporary equity. The liquidation provisions applicable to an instrument may be contained in the contractual agreement or in the entity’s bylaws, shareholder agreements, charter, or certificate of incorporation. Practitioners should consider all of the pertinent agreements that contain liquidation provisions related to the instrument.
ASC 480-10-S99-3A(3)(f) distinguishes between an “ordinary” and a “deemed” liquidation and provides separate requirements for each:
- A provision whose application will result in the redemption or liquidation of an equity instrument upon an event that qualifies as an ordinary liquidation does not cause the instrument to be classified in temporary equity (see Section 9.4.5.2).
- A provision whose application will result in the redemption of an equity instrument upon an event that does not represent an ordinary liquidation (i.e., a deemed liquidation) typically causes the instrument to be classified in temporary equity (see Section 9.4.5.3) unless a narrow and limited exception applies (see Section 9.4.5.4) or the events that could trigger a liquidation are solely within the entity’s control (see Section 9.4.2).
The SEC’s Division of Corporation Finance: Frequently Requested Accounting
and Financial Reporting Interpretations and Guidance (March 31,
2001) states, in part:
[Clauses] describing [deemed liquidation] events are
commonly included in the “Liquidation” section of the preferred
stock indentures. By characterization of the provisions as
liquidation provisions, registrants have sought to avoid ASR 268
treatment. However, the staff believes that these types of
provisions are equivalent to ordinary redemption clauses that would
cause the securities to be classified outside of permanent
equity.
9.4.5.2 Ordinary Liquidation Events
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(3)(f)
Certain redemptions upon liquidation events.
Ordinary liquidation events, which involve the
redemption and liquidation of all of an entity’s
equity instruments for cash or other assets of the
entity, do not result in an equity instrument being
subject to ASR 268. In other words, if the payment
of cash or other assets is required only from the
distribution of net assets upon the final
liquidation or termination of an entity (which may
be a less-than-wholly-owned consolidated
subsidiary), then that potential event need not be
considered when applying ASR 268. . . .
Classification in temporary equity is not required if redemption is contingent only upon the occurrence of an ordinary liquidation event. An ordinary liquidation involves the redemption and liquidation of all of an entity’s equity instruments for cash or other assets of the entity and represents the termination, dissolution, and winding up of the entity’s affairs (i.e., the final liquidation of the issuer). ASC 205-30-20 defines a liquidation as follows:
The process by which an entity converts its assets to cash or other assets and settles its obligations with creditors in anticipation of the entity ceasing all activities. Upon cessation of the entity’s activities, any remaining cash or other assets are distributed to the entity’s investors or other claimants (albeit sometimes indirectly). Liquidation may be compulsory or voluntary. Dissolution of an entity as a result of that entity being acquired by another entity or merged into another entity in its entirety and with the expectation of continuing its business does not qualify as liquidation.
In the evaluation of whether an event qualifies as an ordinary liquidation, the following factors are typically not relevant:
- Whether the holders of the instrument have control over the entity (i.e., whether the holders can force an ordinary liquidation).
- The preference in liquidation.
- The form of consideration that will be received by the holders of the instrument.
However, entities should consider all relevant facts and circumstances in assessing the substance of the instrument’s provisions.
If an equity instrument does not contain any stated redemption features (e.g.,
call options or put options) or deemed liquidation provisions and therefore
is redeemable only upon an ordinary liquidation of the entity,
classification in temporary equity is not required even if the holders of
the instrument have control over the entity. That is, if, under the stated
terms of the instrument and other pertinent agreements (i.e., the entity’s
bylaws, shareholder agreements, charter, or certificate of incorporation),
the instrument is redeemable only upon an ordinary liquidation, temporary
equity classification is not required even if the holders of the instrument
may have the ability to effectuate a liquidation of only the instrument
(outside its contractual terms) by virtue of the holder’s control over the
entity. Any such redemption of an instrument outside its contractual terms
is a modification of the contractual terms that would be recognized only
upon its occurrence.
9.4.5.3 Deemed Liquidation Events
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(3)(f) . . . Other
transactions are considered deemed liquidation
events. For example, the contractual provisions of
an equity instrument may require its redemption by
the issuer upon the occurrence of a
change-in-control that does not result in the
liquidation or termination of the issuing entity, a
delisting of the issuer’s securities from an
exchange, or the violation of a debt covenant.
Deemed liquidation events that require (or permit at
the holder’s option) the redemption of only one or
more particular class of equity instrument for cash
or other assets cause those instruments to be
subject to ASR 268. . . .
S99-3A(8)
[Examples in which temporary equity
classification is appropriate] Example 3. A
preferred security that is not required to be
classified as a liability under other applicable
GAAP may contain a deemed liquidation clause that
provides that the security becomes redeemable if the
common stockholders of the issuing company (that is,
those immediately prior to a merger or
consolidation) hold, immediately after such merger
or consolidation, common stock representing less
than a majority of the voting power of the
outstanding common stock of the surviving
corporation. This change-in-control provision would
require the preferred security to be classified in
temporary equity if a purchaser could acquire a
majority of the voting power of the outstanding
common stock without company approval, thereby
triggering redemption.
An equity instrument that includes a deemed liquidation provision is presented in temporary equity unless the limited exception discussed in Section 9.4.5.4 is met or the events that could trigger a liquidation are solely within the issuer’s control (see Section 9.4.2). A deemed liquidation encompasses the redemption and liquidation of one or more classes of an entity’s equity instruments in a transaction that does not result in the final liquidation of the entity (i.e., transactions that do not qualify as ordinary liquidation events; see Section 9.4.5.2).
The table below illustrates some examples of transactions or events that might be identified in a deemed liquidation provision.
|
Transaction or Event
|
Solely Within the Entity’s
Control?2
|
ASC 480-10-S99-3A
|
|---|---|---|
|
A change in control of the
entity
|
No. An entity cannot prevent its
equity holders from transferring a controlling
interest.
|
(3)(f) and (8)
|
|
A merger or consolidation of the
entity with or into another entity
|
It depends. If the applicable state
law requires board approval for a merger or
consolidation, such an event may be within the
entity’s control unless the board is controlled by
the instrument holder (see Section
9.4.4).
|
(8) and (11)
|
|
A sale, lease, or license of all or
substantially all of the entity’s assets
|
Yes, unless the Board is controlled
by the instrument holder (see Section
9.4.4).
|
(10)
|
|
A delisting of the entity’s
securities
|
No. An entity cannot control whether
its securities will continue to be listed.
|
(3)(f)
|
|
The entity’s compliance with a debt
covenant
|
It depends on the nature of the debt
covenant (see Section
9.4.2).
|
(3)(f) and (9)
|
|
The entity’s ability to issue a
specified monetary amount of securities (e.g., a
securities offering with proceeds in excess of a
specified dollar amount)
|
No, unless investors are already
firmly committed to purchase securities for the
specified amount.
|
N/A
|
|
The entity’s ability to have an IPO
registration statement declared effective by a
particular date
|
No. An entity cannot control whether
the SEC will declare its registration statement
effective.
|
(9)
|
|
The ability to deliver common shares
under a conversion provision
|
It depends on whether share
settlement is within the entity’s control (see
Section 9.4.6).
|
(6)
|
In certain situations, the relevant liquidation
provisions will include the entity’s definition of a deemed liquidation. For
example, the entity’s certificate of incorporation may include a provision
such as the following:
Example 9-5
Sample Deemed Liquidation Clause
Amount Payable in Mergers, etc. Upon, and in all cases subject to, the closing of (each of the following, a “Deemed Liquidation Event”): (i) any merger or consolidation of the Corporation with or into another corporation or entity (except a merger or consolidation in which the holders of capital stock of the Corporation immediately prior to such merger or consolidation continue to hold at least a majority of the voting power of the capital stock of the surviving or resulting corporation or entity following such merger or consolidation); (ii) any sale, lease, license, or transfer of all or substantially all of the Corporation’s assets or sale or exclusive license of all or substantially all of the Corporation’s intellectual property (an “Asset Sale”); or (iii) any other transaction pursuant to, or as a result of which, a single person (or group of Affiliated persons), other than holders of Preferred Stock or Common Stock prior to such transaction, acquires or holds capital stock of the Corporation representing a majority of the Corporation’s voting power, all consideration payable to the stockholders of the Corporation in connection with any such Deemed Liquidation Event, or all consideration payable to the Corporation and distributable to its stockholders, together with all other available assets of the Corporation (net of obligations owned by the Corporation that are senior to the Preferred Stock), in connection with any such Deemed Liquidation Event, shall be, as applicable, paid by the purchaser to the holders of, or distributed by the Corporation in redemption (out of funds legally available therefor) of, the Preferred Stock, in accordance with the preferences and priorities set forth above, with such preferences and priorities specifically intended to be applicable in any such Deemed Liquidation Event as if such transaction were a Liquidation Event.
In other situations, the relevant liquidation provisions do not include a
definition of, and may not explicitly refer to, a deemed liquidation.
Irrespective of whether the term “deemed liquidation” is used, however,
entities must carefully consider all relevant liquidation provisions to
distinguish ordinary liquidation events from deemed liquidation events. The
inclusion of any deemed liquidation redemption feature in an instrument
triggers temporary equity classification (unless the exception discussed in
Section
9.4.5.4 is met or the events that could trigger a redemption
are solely within the issuer’s control, as discussed in Section 9.4.2) even
if all the other redemption provisions in the instrument qualify as ordinary
liquidation provisions.
9.4.5.4 Limited Exception Applicable to Certain Deemed Liquidation Provisions
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable
Securities
S99-3A(3)(f) . . . However,
as a limited exception, a deemed liquidation event
does not cause a particular class of equity
instrument to be classified outside of permanent
equity if all of the holders of equally and more
subordinated equity instruments of the entity would
always be entitled to also receive the same form of
consideration (for example, cash or shares) upon the
occurrence of the event that gives rise to the
redemption (that is, all subordinate classes would
also be entitled to redeem).
Although deemed liquidation redemption features typically cause an instrument to be classified as temporary equity, there is a narrow and limited exception under ASC 480-10-S99-3A(3)(f) for equity instruments that are subject to a deemed liquidation provision “if all of the holders of equally and more subordinated equity instruments of the entity would always be entitled to also receive the same form of consideration (for example, cash or shares) upon the occurrence of the event that gives rise to the redemption (that is, all subordinate classes would also be entitled to redeem).”
Given the types of deemed liquidation provisions that are common in practice,
the narrow and limited exception to temporary equity classification as a
result of a deemed liquidation does not apply to preferred securities. For
an entity to apply the exception in ASC 480-10-S99-3A(3)(f) to preferred
securities, the following two conditions must be met:
-
The agreements pertaining to the equity instrument contain a provision explicitly stating that upon a deemed liquidation event, all of the holders of equally and more subordinated equity instruments of the entity are always entitled to receive the same form of consideration (e.g., cash or shares) upon the occurrence of the event that gives rise to the redemption (i.e., all subordinate classes would also be entitled to redemption). It must also be objectively determinable under the agreements’ explicit terms that there are no possible circumstances in which the holders of equally or more subordinated equity instruments of the entity may not be entitled to receive, wholly or in proportion, the same form of consideration that the holders of the equity instrument are entitled to receive.
-
The provisions related to the same form of consideration that is payable upon the occurrence of a deemed liquidation event are substantive. If, under the terms of the agreements, the holders of the instrument can “override” a provision related to the same form of consideration, the provision regarding the form of consideration that is payable upon a deemed liquidation may not be substantive. In addition, if the amount of consideration payable to the holders of the instrument is leveraged to such an extent that there is no reasonable possibility that consideration will remain after distribution to the holders of the instrument, any explicit provisions regarding the form of consideration may be deemed nonsubstantive.
Since deemed liquidations often involve a change in control (i.e., 50 percent or more of the voting control over an entity is held by new investors, which is typically considered outside the control of the issuing entity), the relevant liquidation provisions will rarely qualify for the narrow and limited exception in ASC 480-10-S99-3A(3)(f). For that exception to apply, the provisions must clearly indicate that the holders of the instrument would be entitled to a form of consideration only on a basis that is proportionate to the consideration that each holder of equally or more subordinated equity instruments is entitled to receive.
Connecting the Dots
The conditions for meeting the deemed liquidation exception are not
the same as those for equity classification in ASC 815-40-25. An
instrument that is classified as equity under ASC 815-40-25 may not
qualify for the deemed liquidation exception. This is because in
accordance with ASC 480-10-S99-3A(3)(f), all the holders of equally
and more subordinated equity instruments of the entity must always
be entitled to receive the same form of consideration (e.g., cash or
shares) upon the occurrence of the event that gives rise to the
redemption. This requirement does not exist in ASC 815-40-25. We
have confirmed this view in informal discussions with the OCA staff.
See also Examples 9-6 and
9-7 below.
In practice, it is common for the liquidation provisions of convertible preferred stock to fall into one of three categories. That is, they often specify one of the following:
- That the holders of the convertible preferred stock are entitled to receive cash (with respect to the liquidation preference, the if-converted value, or both) upon the occurrence of a deemed liquidation event.
- That, upon the occurrence of a deemed liquidation event, all holders of each preferred share class are entitled to receive the same form of consideration, and all holders of each common share class are entitled to receive the same form of consideration, as opposed to specifying that all holders of equity instruments are entitled to receive the same form of consideration.
- The amount of consideration to which the holders of convertible preferred stock are entitled to receive upon the occurrence of a deemed liquidation event is specified, but the provisions are silent regarding the form of consideration.
In each circumstance, the convertible preferred stock should be classified in
temporary equity because the exception in ASC 480-10-S99-3A(3)(f) is
inapplicable. It would generally be inappropriate for an entity to conclude,
on the basis of an interpretation by legal counsel or consideration of
fiduciary obligations (as opposed to an explicit provision addressing the
form of consideration to be distributed to equity holders in all possible
deemed liquidation events), that a deemed liquidation provision qualifies
for the narrow and limited exception in ASC 480-10-S99-3A(3)(f). Rather, in
a manner consistent with the SEC staff’s views on the effect of a contract’s
silence on an entity’s ability to settle in unregistered shares or defer
settlement until registered shares could be delivered (see Section 5.3.2.1 of Deloitte’s Roadmap Contracts on an Entity’s Own
Equity), it is appropriate to apply this exception to
temporary equity classification only when there is language in the pertinent
agreements that explicitly provides for the distribution of consideration to
equity holders upon the occurrence of a deemed liquidation event in the
manner described above.
Note that shares of the most subordinate class of equity
instruments (e.g., common stock) are generally not classified as temporary
equity because, other than in a final liquidation of the issuing entity,
they typically do not contain any redemption features.
Example 9-6
Convertible
Preferred Stock — Holders Entitled to Full Cash
Settlement Upon a Change in Control
Entity A has issued preferred stock that the holder
may elect to convert into shares of A’s common stock
at any time. Upon conversion, A must deliver a
number of common shares equal to the greater of (1)
the liquidation preference divided by a fixed
conversion price (a conversion feature) or (2) the
liquidation preference divided by the current fair
value of A’s common stock subject to a cap on the
maximum number of shares deliverable (a
share-settled redemption feature). The liquidation
preference is a stated amount plus unpaid cumulative
dividends.
The convertible preferred stock agreement specifies
that in the event of a change in control of A in
which the consideration paid for A’s common stock is
only cash, the holders of the convertible preferred
stock are entitled to receive cash for all the
common shares that would otherwise be issuable
according to the stated conversion terms described
above. That is, in a change in control, the holders
of the convertible preferred stock are “cashed out”
for all their convertible preferred shares on the
basis of the stated conversion terms described
above. A change of control includes any transaction
or series of related transactions in which a person
or group of related persons acquires capital stock
of A that represents more than 50 percent of the
voting power of A. Entity A has determined that it
does not control the ability to avoid a change in
control.
The convertible preferred stock must be classified in
temporary equity for the following reasons:
- It is redeemable for cash upon a change in control, which is outside of A’s control.
- The settlement provision in the event of a change in control does not qualify for the narrow and limited exception in ASC 480-10-S99-3A(3)(f) for deemed liquidation events. This is because a change in control can involve less than all of A’s common stock (the most residual class of shares), in which case all of A’s common stockholders are not entitled to receive cash for their shares.
Entity A is required to classify the convertible
preferred stock in temporary equity even if the
settlement provision discussed above would meet the
equity classification conditions in ASC 815-40-25
(i.e., it would qualify for the exception in ASC
815-40-55-5, which is discussed in Section 5.2.3.4 of
Deloitte’s Roadmap Contracts on an Entity’s Own
Equity).
Example 9-7
Convertible
Preferred Stock — Holders Not Entitled to Full
Cash Settlement Upon a Change in Control
Entity B has issued preferred stock
that the holder may elect to convert into shares of
B’s common stock at any time. Upon conversion, B
must deliver a number of common shares equal to the
greater of (1) the liquidation preference divided by
a fixed conversion price (a conversion feature) or
(2) the liquidation preference divided by the
current fair value of B’s common stock subject to a
cap on the maximum number of shares deliverable (a
share-settled redemption feature). The liquidation
preference is a stated amount plus unpaid cumulative
dividends.
The convertible preferred stock
agreement specifies that in the event of a change in
control of B in which the consideration paid for B’s
common stock is only cash, the holders of the
convertible preferred stock are entitled to receive
common shares according to the stated conversion
terms described above by electing to convert their
convertible preferred shares into common stock
immediately before the consummation of the change in
control. Electing this conversion would not ensure
that the convertible preferred stockholders would
receive cash for their shares because the
convertible preferred stockholders do not have
priority over the common stockholders regarding the
receipt of cash in a change in control. A change of
control includes any transaction or series of
related transactions in which a person or group of
related persons acquires capital stock of B that
represents more than 50 percent of the voting power
of B. Entity B has determined that it does not
control the ability to avoid a change in
control.
Assuming that there are no other
features that result in temporary equity
classification, B would not be required to classify
the convertible preferred stock instrument in
temporary equity for the following reasons:
- The holders of the convertible preferred stock do not have priority over other common stockholders regarding the receipt of cash in a change in control. Rather, after converting their shares into common stock immediately before the change in control, the holders of the convertible preferred stock would have the same rights as all other holders of B’s common stock (i.e., they would “stand in line” and participate with all other common stockholders regarding the receipt of cash for their shares in a change in control). Therefore, in a change in control that involves less than all of B’s common shares, the holders of the convertible preferred stock would not be entitled to receive cash for all of their convertible preferred shares.
- The settlement provision in the event of a change in control is not subject to evaluation under the narrow and limited exception for deemed liquidation events in ASC 480-10-S99-3A(3)(f). This is because the convertible preferred stock is merely converted into common shares before a change in control according to the stated conversion terms described above. (Note that the settlement provision in this example only allows the convertible preferred stockholders to elect to convert their shares into common stock solely on the basis of whether the change in control is complete.)
9.4.5.5 Convertible Preferred Stock With a Liquidation Provision Upon a Change in Control
Example 9-8
Convertible Preferred Stock That Contains a Deemed
Liquidation Provision
Company X, an SEC registrant, has issued convertible
preferred stock. As part of the preferred stock
agreement, the investors in preferred stock are
entitled to a liquidation preference upon any
voluntary or involuntary liquidation, dissolution,
or winding down of X. The agreement defines
liquidation as including mergers, reorganizations,
transfers of a majority of the voting rights of
outstanding common stock, and other transactions
that result in a change in control and would not
cause the legal dissolution of X with the redemption
and liquidation of all of its outstanding equity
securities.
Further, X’s ordinary equity
securities do not become redeemable upon a change in
control. The investors in the preferred stock do not
control the board’s vote, and the board does not
have to approve a change of control. Company X has
determined that the convertible preferred stock is
not required to be accounted for as a liability
under ASC 480 and that it contains no embedded
feature that requires bifurcation as a derivative
instrument under ASC 815-15.
In this scenario, the convertible
preferred stock would be classified as temporary
equity. Under the temporary equity guidance, X must
assess whether the preferred stock is redeemable
upon the occurrence of an event that is not solely
within its control. Redemption is not solely within
X’s control because a purchaser could acquire a
majority of the voting power of the outstanding
common stock without company approval, thereby
giving the preferred shareholders a right to require
redemption of their preferred shares. A change in
control is considered outside the control of the
issuer even if the preferred shareholders do not
control the shareholder vote. The liquidation
feature does not qualify as an “ordinary
liquidation” feature because a change in control
will not result in the legal dissolution of X with
the redemption and liquidation of all of its
outstanding equity securities.
Under the “deemed liquidation exemption” (see
Section
9.4.5.4), upon the occurrence of the
event that gives rise to the redemption (change in
control), if one or more classes of equity security
become redeemable, all of the holders of equally and
more subordinated equity securities of the entity
would need to be entitled to the same form of
consideration. Company X’s preferred securities do
not qualify for this exemption because its ordinary
securities do not become redeemable in the event of
a change in control.
A preferred stock agreement’s provision for redemption of the preferred security
if the issuing company is merged with another company may not by itself
trigger classification of the preferred stock outside of permanent equity.
If state law requires approval of the board of directors before any merger
can occur, and preferred stockholders cannot control the board’s vote
through direct representation or other rights, the decision to merge with
another company may be within the control of the issuer. See also Examples 9-6 and
9-7.
9.4.6 Features That the Issuer Must or May Settle in Its Equity Shares
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(6)
[Examples in which temporary equity classification is
appropriate] Example 1. A preferred security
that is not required to be classified as a liability
under other applicable GAAP may be redeemable at the
option of the holder or upon the occurrence of an event
that is not solely within the control of the issuer.
Upon redemption (in other than a liquidation event that
meets the exception in paragraph 3(f)), the issuer may
have the choice to settle the redemption amount in cash
or by delivery of a variable number of its own common
shares with an equivalent value. For this instrument,
the guidance in Section 815-40-25 should be used to
evaluate whether the issuer controls the actions or
events necessary to issue the maximum number of common
shares that could be required to be delivered under
share settlement of the contract. If the issuer does not
control settlement by delivery of its own common shares
(because, for example, there is no cap on the maximum
number of common shares that could be potentially
issuable upon redemption), cash settlement of the
instrument would be presumed and the instrument would be
classified as temporary equity.
The redeemable-equity guidance applies to equity instruments that are redeemable for cash or other assets in circumstances not under the sole control of the issuer. It does not apply to equity-classified instruments that require or permit the issuer to settle a redemption feature in its equity shares as long as (1) those shares qualify as permanent equity and (2) the issuer could not be forced to deliver cash or other assets to settle the feature. (If the obligation is unconditional, liability classification may be required for the share under ASC 480-10-25-14 even if the issuer has the right and is able to settle the redemption obligation in a variable number of its equity shares; see Chapter 6.)
An equity-classified instrument may specify that the issuer must or may settle a
redemption feature in its equity shares (e.g., because the contract permits the
issuer to settle the feature in either cash or shares of equivalent value). If
those shares qualify as permanent equity (see Section 9.4.7), ASC 480-10-S99-3A(6)
requires the issuer to evaluate whether it has the ability to settle the
instrument in its equity shares. If the issuer could ever be forced to cash
settle the feature (e.g., because of the lack of a share cap in the contract),
the equity instrument should be classified as temporary equity even if the
contract ostensibly requires or permits the issuer to settle in its equity
shares. (See Section
9.4.9 for guidance on evaluating whether an issuer could be
forced to cash settle a share-based payment arrangement within the scope of ASC
718.)
In evaluating whether it controls the ability to share settle a redemption or
another feature, an entity should consider all facts and circumstances,
including but not limited to the equity classification conditions in ASC
815-40-25. The issuer should reassess whether it could be forced to cash settle
the feature under ASC 815-40 as of each balance sheet date and whenever
circumstances change.
Further, the issuer should evaluate whether it controls the ability to share
settle a feature irrespective of whether it is described as a redemption feature
or a conversion feature (including a conversion feature that requires the issuer
to deliver a fixed number of equity shares upon conversion). For example, a
perpetual convertible preferred share may have no explicit redemption feature.
Upon the holder’s election to convert the preferred stock into common stock, the
issuer may be required to deliver a variable number of equity shares that is
determined by using a formula. There is no contractual cap on the number of
common shares that the issuer could be required to deliver. Because the contract
contains no explicit share limit, the issuer must assume that it might be forced
to cash settle the conversion feature in accordance with the accounting analysis
under ASC 815-40-25. Accordingly, the preferred stock would be classified in
temporary equity. (See Section 5.3.4 of Deloitte’s Roadmap
Contracts on an
Entity’s Own Equity for further discussion.)
Speaking before the 2000 AICPA Conference on Current SEC Developments, Mr. Ragone provided the following example:
A company issues preferred stock that is redeemable for common shares upon receipt by the company of a conversion notice from the holders of the preferred securities. The legal agreements state that if the company is unable to fully convert the preferred shares into common stock, it would be required to redeem the securities for cash. That is, if the company does not have enough shares authorized to convert the preferred securities to common stock, the company would be required to deliver cash. Further assume that as of the preferred stock issuance date, there were not enough shares authorized to convert the preferred stock to common stock and that a shareholder meeting would be required to authorize additional shares. . . .
The staff believes that the requirement to obtain shareholder approval to authorize additional shares is outside of the control of the issuer. The staff therefore would conclude that because the redemption of the preferred security for cash could be triggered by an event that is outside of the control of the issuer, the preferred securities would be required to [be] classified outside of permanent equity.
Changing Lanes
Before ASC 815-40-25 was amended by ASU 2020-06,
an equity-linked instrument could not be classified in stockholders’
equity unless the following conditions were met:
-
The contract permitted the entity to settle it in unregistered shares.
-
No counterparty rights ranked higher than shareholder rights.
-
There was no requirement in the contract for the issuing entity to post collateral at any point for any reason.
Even though these conditions no longer need to be met for an
equity-linked instrument to qualify as equity under ASC 815-40, a
contract that does not satisfy any of them would generally need to be
classified as temporary equity. For example, assume that an entity must
settle a convertible preferred stock instrument in shares of common
stock that are registered for resale. Since the entity does not control
the ability to issue registered shares, temporary equity classification
is required for this instrument. That is, in the absence of preclearance
with the SEC, an entity should classify a contract as temporary equity
if it does not meet one of the three conditions in ASC 815-40-25 that
ASU 2020-06 removed.
9.4.7 Features That the Issuer Must or May Settle in Redeemable Instruments
Sometimes an outstanding equity share does not contain any redemption feature
that meets the temporary equity classification criteria except that it is
convertible or exchangeable — at the election of the holder or upon the
occurrence of an event that is not solely within the control of the issuer or at
a fixed or determinable date — into an instrument that contains such a
redemption feature (e.g., a redeemable share or a debt instrument). If the
issuer cannot prevent the conversion or exchange, the currently outstanding
equity share should be classified as temporary equity because the conversion or
exchange feature makes the instrument redeemable.
For example, a class of nonredeemable preferred shares (Series A) may be
convertible, at the holder’s option, into a different class of preferred shares
(Series B) that are redeemable in cash, at the holder’s option, upon an event
that is outside the issuer’s control. Even though the Series A shares — when
viewed in isolation — do not contain an explicit redemption feature, the issuer
cannot prevent the holder from converting the Series A shares into Series B
shares, which do contain a redemption feature that meets the temporary equity
classification criteria. Accordingly, the Series A shares are classified as
temporary equity.
9.4.8 Convertible Debt Instruments Separated Into Liability and Equity Components
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(3)(e)
Convertible debt instruments that contain a
separately classified equity component. Other
applicable GAAP may require a convertible debt
instrument to be separated into a liability component
and an equity component.FN8 In these
situations, the equity-classified component of the
convertible debt instrument should be considered
redeemable if at the balance sheet date the issuer can
be required to settle the convertible debt instrument
for cash or other assets (that is, the instrument is
currently redeemable or convertible for cash or other
assets). For these instruments, an assessment of whether
the convertible debt instrument will become redeemable
or convertible for cash or other assets at a future date
should not be made. For example, a convertible debt
instrument that is not redeemable at the balance sheet
date but could become redeemable by the holder of the
instrument in the future based on the passage of time or
upon the occurrence of a contingent event is not
considered currently redeemable at the balance sheet
date.
__________________________________
FN8 See Subtopics 470-20 and 470-50;
and Paragraph 815-15-35-4.
The SEC’s temporary equity guidance applies to the equity-classified component
of convertible debt instruments that are separated into liability and equity
components (see Section
9.3.5), only if the instruments are currently redeemable as of
the balance sheet date. A convertible debt instrument is currently redeemable if
the issuer could be forced to settle all or part of the instrument in cash or
other assets upon a redemption or conversion as of the balance sheet date. For
instance, an instrument would be considered currently redeemable if it contains
a cash-settled embedded put option that permits the holder to redeem the
instrument at any time or if the instrument is convertible as of the balance
sheet date and the issuer could be required to settle all or part of its
obligation in cash upon conversion (e.g., if the issuer has an obligation upon
conversion to pay the principal amount in cash and the excess conversion spread
in shares).
If a convertible debt instrument is not currently redeemable, the instrument is
exempt from the scope of the temporary equity guidance under ASC
480-10-S99-3A(3)(e) even if the equity component meets the temporary equity
classification criteria (e.g., because the instrument will become redeemable as
of a specified date in the future or is redeemable upon the occurrence of an
uncertain future event that is not solely within the control of the issuer; see
Section 9.4.1).
The special guidance described in ASC 480-10-S99-3A(3)(e) applies only to
convertible debt instruments (i.e., it does not apply to convertible preferred
securities that are classified in equity).
Connecting the Dots
Convertible debt instruments will have a separately
recognized equity component when (1) they are issued at a substantial
premium, (2) they are modified or exchanged in a transaction that does
not qualify as an extinguishment for accounting purposes and there is an
increase in the fair value of the embedded conversion option, and (3) an
embedded conversion option must no longer be bifurcated under ASC
815-15-25-1.
9.4.9 Share-Based Payment Arrangements
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(3)(d)
Share-based payment awards. Equity-classified
share-based payment arrangements with employees are not
subject to ASR 268 due solely to either of the
following:
-
Net cash settlement would be assumed pursuant to Paragraphs 815-40-25-11 through 25-16 solely because of an obligation to deliver registered shares.FN7
-
A provision in an instrument for the direct or indirect repurchase of shares issued to an employee exists solely to satisfy the employer’s statutory tax withholding requirements (as discussed in Paragraph 718-10-25-18).
__________________________________
FN7 See footnote 84 of Section
718-10-S99.
SEC Staff Accounting Bulletins
SAB Topic 14.E, FASB ASC Topic 718,
Compensation — Stock Compensation, and Certain
Redeemable Financial Instruments [Reproduced in ASC
718-10-S99-1.]
Certain financial instruments awarded in
conjunction with share-based payment arrangements have
redemption features that require settlement by cash or
other assets upon the occurrence of events that are
outside the control of the issuer.FN77 FASB
ASC Topic 718 provides guidance for determining whether
instruments granted in conjunction with share-based
payment arrangements should be classified as liability
or equity instruments. Under that guidance, most
instruments with redemption features that are outside
the control of the issuer are required to be classified
as liabilities; however, some redeemable instruments
will qualify for equity classification.FN78
SEC Accounting Series Release No. 268, Presentation in
Financial Statements of “Redeemable Preferred Stocks,”
FN79 (“ASR 268”) and related
guidanceFN80 address the classification
and measurement of certain redeemable equity
instruments.
Facts: Under a
share-based payment arrangement, Company F grants to an
employee shares (or share options) that all vest at the
end of four years (cliff vest). The shares (or shares
underlying the share options) are redeemable for cash at
fair value at the holder’s option, but only after six
months from the date of share issuance (as defined in
FASB ASC Topic 718). Company F has determined that the
shares (or share options) would be classified as equity
instruments under the guidance of FASB ASC Topic 718.
However, under ASR 268 and related guidance, the
instruments would be considered to be redeemable for
cash or other assets upon the occurrence of events
(e.g., redemption at the option of the
holder) that are outside the control of the issuer.
Question 1:
While the instruments are subject to FASB ASC Topic 718,
is ASR 268 and related guidance applicable to
instruments issued under share-based payment
arrangements that are classified as equity instruments
under FASB ASC Topic 718?
Interpretive
Response: Yes. The staff believes that
registrants must evaluate whether the terms of
instruments granted in conjunction with share-based
payment arrangements that are not classified as
liabilities under FASB ASC Topic 718 result in the need
to present certain amounts outside of permanent equity
(also referred to as being presented in “temporary
equity”) in accordance with ASR 268 and related
guidance.FN81
When an instrument ceases to be subject
to FASB ASC Topic 718 and becomes subject to the
recognition and measurement requirements of other
applicable GAAP, the staff believes that the company
should reassess the classification of the instrument as
a liability or equity at that time and consequently may
need to reconsider the applicability of ASR 268.
__________________________________
FN77 The terminology “outside the
control of the issuer” is used to refer to any of
the three redemption conditions described in Rule
5-02.28 of Regulation S-X that would require
classification outside permanent equity. That rule
requires preferred securities that are redeemable
for cash or other assets to be classified outside
of permanent equity if they are redeemable (1) at
a fixed or determinable price on a fixed or
determinable date, (2) at the option of the
holder, or (3) upon the occurrence of an event
that is not solely within the control of the
issuer.
FN78 FASB ASC paragraphs 718-10-25-6
through 718-10-25-19A.
FN79 ASR 268, July 27, 1979, Rule
5-02.27 of Regulation S-X.
FN80 Related guidance includes EITF
Topic No. D-98, Classification and Measurement
of Redeemable Securities, included in the FASB
ASC paragraph 480-10-S99-3A.
FN81 Instruments granted in
conjunction with share-based payment arrangements
with employees that do not by their terms require
redemption for cash or other assets (at a fixed or
determinable price on a fixed or determinable
date, at the option of the holder, or upon the
occurrence of an event that is not solely within
the control of the issuer) would not be assumed by
the staff to require net cash settlement for
purposes of applying ASR 268 in circumstances in
which FASB ASC Section 815-40-25, Derivatives and
Hedging — Contracts in Entity’s Own Equity —
Recognition, would otherwise require the
assumption of net cash settlement. See FASB
ASC paragraph 815-40-25-11 (See FASB ASC
paragraph 815-10-65-1 for the transition and
effective date information related to FASB ASU No.
2020-06, Debt — Debt With Conversion and Other
Options (Subtopic 470-20) and Derivatives and
Hedging — Contracts in Entity’s Own Equity
(Subtopic 815-40): Accounting for Convertible
Instruments and Contracts in an Entity’s Own
Equity, which superseded FASB ASC paragraph
815-40-25-11.), which states, in part: “ . . . the
events or actions necessary to deliver registered
shares are not controlled by an entity and,
therefore, except under the circumstances
described in FASB ASC paragraph 815-40-25-16, if
the contract permits the entity to net share or
physically settle the contract only by delivering
registered shares, it is assumed that the entity
will be required to net cash settle the contract.”
See also FASB ASC subparagraph
718-10-25-15(a).
The SEC has provided certain exceptions to the guidance in ASC 480-10-S99-3A on
determining whether share-based payment arrangements within the scope of ASC 718
should be classified as temporary equity. Specifically, temporary equity
classification is not required for such arrangements when:
-
“Net cash settlement would be assumed . . . solely because of an obligation to deliver registered shares.”
-
“A provision in an instrument for the direct or indirect repurchase of shares issued to an employee exists solely to satisfy the employer’s . . . statutory tax withholding requirements.”
These exceptions cease to apply when an arrangement is no longer within the
scope of ASC 718 (see Section
9.3.9). See Deloitte’s Roadmap Share-Based Payment Awards for
further discussion.
9.4.10 Classification of ESOP Shares Within Temporary Equity
9.4.10.1 Outstanding Shares
ASC 480-10-S99-3A(2) requires that equity securities be classified in temporary equity if they are redeemable at the option of the holder or upon the occurrence of an event not solely within the issuer’s control. Thus, shares of common stock or convertible preferred stock held by an ESOP, whether nonleveraged or leveraged, that are redeemable at the option of the participant or upon any event outside the sponsor’s control must be classified within temporary equity.
The shares of stock held by an ESOP may meet the requirements for classification in temporary equity because of various redemption features and terms. As discussed in EITF Issue 89-11, a sponsor of an ESOP is required to provide participants with a put option on their shares of stock when those shares are not readily tradable. EITF Issue 89-11 states, in part:3
Under federal income tax regulations, employer securities (such as convertible preferred stock) that are held by participants in an employee stock ownership plan (ESOP) and that are not readily tradeable on an established market must include a put option. The put option is a right to demand that the sponsor redeem shares of employer stock held by the participant for which there is no market for an established cash price. The employer may have the option to issue marketable securities for all or a portion of that option rather than to pay cash. The provisions of the ESOP may permit the ESOP to substitute for the sponsor as buyer of the employer stock; however, in no case can the sponsor require the ESOP to assume the obligation for the put option.
ASC 718-40-25-2 also discusses this put option requirement and other situations in which sponsors must repurchase shares of stock held by participants that withdraw their shares. ASC 718-40-25-2 states:
Regardless of whether an employee stock ownership plan is leveraged or nonleveraged, employers are required to give a put option to participants holding employee stock ownership plan shares that are not readily tradable, which on exercise requires the employer to repurchase the shares at fair value. Public entity sponsors sometimes offer cash redemption options to participants who are eligible to withdraw traded shares from their accounts, which on exercise requires the employer to repurchase the shares at fair value. Employers shall report the satisfaction of such option exercises as purchases of treasury stock.
In addition to the situations described above, shares of stock held by an ESOP may be redeemable as a result of various other features and terms, including, but not limited to, the following:
- Shares of convertible preferred stock held by the ESOP may be redeemable upon the occurrence of a change of control or another deemed liquidation event involving the sponsor.
- The sponsor may not have sufficient authorized and unissued shares of common stock to satisfy the conversion of convertible preferred stock. For example, upon withdrawal, the holder may be entitled to receive a variable number of shares of common stock based on a minimum stated value without any stated cap on the maximum number of shares of common stock that may need to be delivered. In the absence of a stated cap on the number of shares of common stock that must be delivered, the sponsor does not control the ability to deliver shares of common stock to satisfy such settlement requirements.
Connecting the Dots
The plan documents for an ESOP that holds common stock listed on a stock
exchange may contain a stated put option that becomes operable only
if the sponsor’s shares of common stock are no longer readily
tradable (e.g., the shares are delisted from the stock exchange). In
these situations, temporary equity classification of the shares of
common stock held by the ESOP is required because it is not within
an entity’s control to maintain the readily tradable status of its
common stock. However, when the plan documents for an ESOP that
holds common stock listed on a stock exchange do not contain a
stated put option in the event that the sponsor’s shares of common
stock are no longer readily tradable, additional consideration is
necessary. In these situations, the sponsor does not control the
ability to maintain the listing of its shares of common stock on a
stock exchange. If the sponsor’s shares of common stock are
delisted, they would no longer be considered readily tradable and
put options would be issued to ESOP participants or their
beneficiaries. However, an entity is not required to classify those
shares of common stock in temporary equity if the sponsor has not
yet legally conveyed a put option to the ESOP participants or their
beneficiaries and if, upon receipt of a delisting notice or another
event that would cause the sponsor’s shares to no longer be readily
tradable, the sponsor has the unilateral ability to (1) terminate
the ESOP, (2) accelerate the vesting of all shares of common stock
held by the ESOP, and (3) distribute all the shares of common stock
held by the ESOP participants or their beneficiaries before the
sponsor’s shares become no longer readily tradable. That is, if the
holder of the shares does not have a current redemption right and
the sponsor controls the ability to avoid the holder’s redemption of
the shares of common stock back to the sponsor under all
circumstances (i.e., the sponsor controls the ability to effect a
plan termination, which would avoid its requirement to provide a
redemption option to the holders), temporary equity classification
of the common stock held by the ESOP is not required. Note that
entities must carefully evaluate the facts and circumstances to
determine whether ESOP shares must be classified in temporary
equity. As part of this evaluation, it may be necessary to legally
interpret certain ERISA and IRC provisions related to the
requirement to provide put options on shares that are not readily
tradable.
In accordance with ASC 718-40-45-9, all shares held by a
nonleveraged ESOP are treated as outstanding except the suspense account
shares of a pension reversion ESOP, which are not treated as outstanding
until they are committed to be released for allocation to participant
accounts. Further, in accordance with ASC 718-40-45-3, shares held by a
leveraged ESOP that have either been allocated or committed for release (on
the basis of debt service payments) should be considered outstanding.
However, when shares of stock held by an ESOP are redeemable (i.e., subject
to a put option or other redemption upon the occurrence of events outside
the sponsor’s control), the sponsor must classify all such shares in
temporary equity. The SEC’s guidance does not distinguish between allocated
and unallocated shares. See Section 9.4.10.2 for discussion of
classification of the contra-equity account related to unearned ESOP shares.
This guidance would also apply to nonleveraged ESOPs with suspense pension
reversion shares.
Connecting the Dots
For both nonleveraged and leveraged ESOPs, the vested status of shares of stock held by the ESOP is not relevant to the classification of such shares within temporary equity.
9.4.10.2 Classification of Unearned ESOP Shares of Leveraged ESOP
When the outstanding shares of stock of a leveraged ESOP must be classified in temporary equity, it is also appropriate to classify all or a portion of the related contra-equity account for unearned ESOP shares in temporary equity. Although not codified, EITF Issue 89-11 states, in part:
The Task Force reached a consensus that when ASR 268 (as presented in Section 211 of the “Codification of Financial Reporting Policies”) requires some or all of the value of the securities to be classified outside of permanent equity, a proportional amount of the debit in the equity section of the sponsor’s balance sheet (sometimes described as loan to ESOP or deferred compensation), if any, should be similarly classified.
Footnotes
2
The entity’s specific facts
and circumstances may affect this determination
(see Section
9.4.2).
3
Although not codified, the guidance in EITF Issue 89-11 is still relevant.