8.5 Own-Share Lending

8.5.1 Background

ASC 470-20

Own-Share Lending Arrangements Issued in Contemplation of Convertible Debt Issuance or Other Financing

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.

Own-Share Lending Arrangements Issued in Contemplation of Convertible Debt Issuance

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 provides recognition and measurement guidance on the issuer’s accounting for equity-classified share-lending arrangements that are executed in contemplation of a convertible debt issuance or other financing. Therefore, for loaned share transactions, an entity must first evaluate whether the lending arrangement meets the conditions for equity classification in ASC 480-10 and ASC 815-40. The example below illustrates an own-share lending arrangement entered into with a convertible debt offering.

Example 8-7

Share-Lending Arrangement Entered Into With Convertible Debt Offering

Entity A is in the process of issuing convertible debt. Before they agree to buy the convertible debt, certain prospective investors would like to ensure that they are able to economically hedge their exposure to A’s share price risk associated with the conversion option embedded in the debt. Accordingly, they seek to enter into derivative contracts on the underlying shares with Bank B (such as options, forwards, or total return swaps) that offset the “long” position in A’s share price risk that would result from an investment in the convertible debt. To economically hedge its exposure from writing such derivatives, B in turn seeks to borrow the underlying shares. By borrowing the shares, B can sell them short in the market to offset its “long” position in A’s share price risk that would be created by its derivative contracts with the investors.

Because a sufficient number of A’s underlying shares is not readily available to market participants (or the lending price is too high), B borrows the underlying shares by entering into a share-lending arrangement directly with A. The terms of the share-lending arrangement require B to pay a nominal processing fee to A (e.g., the par value of the shares) that is significantly less than the fair value of the share-lending arrangement. Entity 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 from A. During the period the shares are on “loan,” the shares are legally outstanding and the holder is legally entitled to dividends paid on the shares, although it must reimburse A for any dividends paid on the loaned shares. Upon conversion or maturity of the convertible debt, B must physically return the loaned shares to A for no consideration. If B defaults in returning the loaned shares, A is contractually entitled to a cash payment equal to the fair value of the loaned shares.

If an own-share lending arrangement meets the conditions for equity classification, the entity is required to recognize the lending arrangement at fair value in APIC, with an offsetting entry recognized as a debt issuance cost on the convertible debt issued in conjunction with the arrangement (i.e., a debit for the convertible debt liability and a credit for the APIC). The entity subsequently accounts for the convertible debt, including the discount created by the issuance costs recognized in accordance with other U.S. GAAP, and does not remeasure the amount initially recognized in equity as long as (1) the share-lending arrangement continues to qualify for equity treatment 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 equity (i.e., a debit for the loss and a credit for the APIC). The amount of the loss (i.e., the fair value of the unreturned shares adjusted for probable recoveries) is remeasured in each period 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.

8.5.2 EPS Accounting

8.5.2.1 Equity-Classified Own-Share Lending Arrangements

ASC 470-20

Own-Share Lending Arrangements Issued in Contemplation of Convertible Debt Issuance

Under ASC 470-20, loaned shares are excluded from the denominator of both basic and diluted EPS unless the counterparty to a share-lending arrangement defaults on its obligation to return the loaned shares (or an equivalent amount of consideration). If the counterparty defaults, the loaned shares are included in both basic and diluted EPS.

As discussed above, the threshold for including the loaned shares in the denominator in the calculations of basic and diluted EPS is counterparty default. This threshold differs from the requirement in ASC 470-20-35-11A for the issuer to recognize an expense equal to the then fair value of the unreturned shares, net of the fair value of recoveries, when it becomes probable that the counterparty to the share-lending arrangement will default. These threshold recognition differences create a difference between the timing of recognition in the numerator of the EPS calculation (i.e., the expense for probable losses) and that in the denominator of the EPS calculation (i.e., the shares when default actually occurs). However, this timing difference can also exist for contingently issuable shares.

In practice, own-share lending arrangements generally require the counterparty to reimburse the issuer for any dividends paid on the loaned shares. If the counterparty does not reimburse the issuer for any dividends paid on the loaned shares, the share-lending arrangement is treated as a participating security and the two-class method of EPS must be applied.

8.5.2.2 Liability-Classified Own-Share Lending Arrangements

ASC 470-20 does not provide any recognition, measurement, or EPS accounting guidance related to situations in which a share-lending arrangement is classified as a liability by the issuer of the shares. Therefore, the EPS accounting will depend on the reason the contract is classified as a liability. If the issuing entity classifies an own-share lending arrangement as a liability solely because the contract is not considered indexed to the issuing entity’s stock, it is generally appropriate for the guidance on basic and diluted EPS relevant to equity-classified own-share lending arrangements to be applied to the denominator. The EPS accounting when the contract is liability-classified for other reasons will depend on the facts and circumstances. With respect to diluted EPS, the guidance on contracts that may be settled in cash or stock may be relevant. See Section 4.7 for more information.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.