EITF Issue No. 15-E, Evaluation of Contingent Put and Call Options Embedded in Debt Instruments EITF Educational Meeting

Transcription

1 EITF Issue No. 15-E, Evaluation of Contingent Put and Call Options Embedded in Debt Instruments EITF Educational Meeting May 14,

2 Issue How existing guidance should be applied for assessing whether the economic characteristics and risks of an embedded put or call option in a debt instrument are clearly and closely related to the economic characteristics and risks of its debt host. Applicable guidance SFAS 133 paragraph 61(d) DIG Issue B16 2

3 Project Background Embedded derivatives must be assessed to determine whether bifurcation from the host contract is necessary Criteria for bifurcation from host contract: - The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract - The contract is not measured at fair value under other applicable GAAP with changes in fair value reported through earnings - A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative 3

4 Project Background Guidance that originated from FAS 133 paragraph 61(d) call (put) options that can accelerate the repayment of principal on a debt instrument are considered to be clearly and closely related to a debt instrument that requires principal repayments unless both of the following conditions exist: The debt involves a substantial premium or discount (which is common with zero-coupon bonds). The call (put) option is only contingently exercisable For contingently exercisable call (put) options to be considered clearly and closely related, they can be indexed only to interest rates or credit risk, not some extraneous event or factor 4

5 Project Background In response to questions on the application of paragraph 61(d), the Derivatives Implementation Group issued DIG Issue B16 in DIG Issue B16 provided a four-step decision sequence to assess whether puts and calls that can accelerate the settlement of debt instruments should be considered clearly and closely related to the debt host - DIG Issue B16 only included examples of instruments with a single embedded derivative although the guidance also applies to instruments with multiple embedded derivatives (e.g., callable convertible debt) 5

6 Four-Step Decision Sequence Step 1: Is the amount paid upon settlement (also referred to as the payoff) adjusted based on changes in an index (rather than simply being the repayment of principal at par, together with any unpaid accrued interest)? If yes, continue to Step 2. If no, continue to Step 3. Step 2: Is the payoff indexed to an underlying other than interest rates or credit risk? If yes, then that embedded feature is not clearly and closely related to the debt host contract and further analysis under Steps 3 and 4 is not required. If no, then that embedded feature shall be analyzed further under Steps 3 and 4 as well as under the provisions of paragraphs and Step 3: Does the debt involve a substantial premium or discount? If yes, continue to Step 4. If no, in accordance with paragraphs through 25-41, further analysis of the contract under paragraph ¹ is required to determine whether the call (put) option is clearly and closely related to the debt host contract if paragraph is applicable. Step 4: Does a contingently exercisable call (put) option accelerate the repayment of the contractual principal amount? If yes, the call (put) option is not clearly and closely related to the debt instrument. If not contingently exercisable, in accordance with paragraphs through 25-41, further analysis of the contract under paragraph is required to determine whether the call (put) option is clearly and closely related to the debt host contract. ¹Paragraph (the double double test) is not required when the put /call is contingent because it is only applicable if the instrument s underlying is interest rates. 6

7 Alternatives Alternative A The four-step decision sequence provides a framework for applying paragraphs through Alternative B The four-step decision sequence is only one step in the assessment of whether a put or call option is clearly and closely related to its debt host. A determination of whether the contingency itself is indexed to interest rates or credit risk, and not some extraneous factor, also is required. 7

8 Example Facts Bond issued at par for $100 Call option at $107 if price of gold is greater than $X Alternative A: Step 1: Is the amount paid upon settlement adjusted based on changes in an index? No Fixed at $107 Proceed to Step 3: Substantial premium or discount? No Less than 10% difference No further assessment under paragraph Conclusion: Call option is clearly and closely related to debt host do not bifurcate Alternative B: Step 1: Assess under paragraph Step 2: Consider whether the contingency trigger is deemed to be an extraneous event or factor Price of gold is deemed to be an extraneous event or factor Conclusion: Call option is not clearly and closely related to debt host bifurcate if other criteria are met 8

9 Alternative A The phrase indexed only to in paragraph refers to the payoff amount (and not the contingency itself) and is therefore captured in the fourstep decision sequence An example² in DIG Issue B16 implies that an assessment of whether the contingent event is indexed only to interest or credit risk is not required Instrument Index Payoff? Substantial Discount or Premium? 7.Debt that is issued at par is puttable at par in the event that the issuer has an IPO Contingently Exercisable? (Step 4) No No N/A Analysis not required Embedded Option Clearly and Closely Related? The embedded put option is clearly and closely related to the debt host contract because the debt was issued at par (not at a substantial discount) and is puttable at par. Paragraph does not apply. - Although the put option is contingently exercisable and that contingency is based on something other than credit or interest rates, the conclusion is that the put option is clearly and closely related to its debt host. ²Codified in implementation guidance and illustrations paragraph

10 Alternative B The guidance does not explicitly state that the phrase they [contingently exercisable call (put) options] can be indexed only to interest rates or credit risk refers to the payoff; not the contingent event The guidance does not state that the four-step decision sequence addresses paragraphs and The DIG Issue did not supersede paragraph 61(d) in Statement 133 While the amount of the payout may not be affected by the contingent event, the value of the overall instrument could be affected. 10

11 Implications Alternative A - Likely consistent with what the DIG was intending - Results in fewer embedded derivatives requiring bifurcation In the past, users have supported proposals to reduce bifurcation of embedded derivatives - Reduces the complexity of the analysis Alternative B - Having the term indexed only to refer to both the contingency and settlement is consistent with other guidance (e.g., EITF 07-05) - Likely to result in more embedded derivatives requiring bifurcation - Additional step of assessing the contingent event increases complexity 11

12 Questions? 12