EITF Issue No. 13-G FASB Emerging Issues Task Force Issue No. 13-G Title: Determining Whether the Host Contract in a Hybrid Financial Instrument Issued in the Form of a Share Is More Akin to Debt or to Equity Document: Issue Summary No. 1, Supplement No. 2 Date prepared: May 29, 2014 FASB Staff: Milone (203.956.5344) / Or (203.956.5212) EITF Liaison: Mark Bielstein Date previously discussed: September 13, 2013; March 13, 2014; May 15, 2014 (Education Session) Previously distributed EITF materials: Issue Summary No. 1, dated August 30, 2013; Issue Summary No. 1, Supplement No. 1, dated February 27, 2014; EITF 13-G Education Session held on May 15, 2014 Background 1. At the September 13, 2013 EITF meeting, the Task Force reached a consensus-for-exposure that for a hybrid financial instrument issued in the form of a share, an entity would determine the nature of the host contract by considering all stated and implied substantive terms and features of the hybrid financial instrument, weighing each term and feature on the basis of relevant facts and circumstances. That is, the determination of the nature of the host contract would be based on a consideration of economic characteristics and risks of the entire hybrid financial instrument, including the embedded derivative feature that is being evaluated for separate accounting from the host contract (the whole-instrument approach). The alternative views presented in this Issue Summary Supplement are for purposes of discussion by the EITF. No individual views are to be presumed to be acceptable or unacceptable applications of Generally Accepted Accounting Principles until the Task Force makes such a determination, exposes it for public comment, and it is ratified by the Board. EITF Issue No. 13-G Issue Summary No. 1, Supplement No. 2, p. 1
2. The Task Force reached a consensus-for-exposure that in evaluating the terms and features of a hybrid financial instrument issued in the form of a share, the existence or omission of any single term or feature, including a fixed-price, noncontingent redemption feature held by the investor, would not necessarily determine the economic characteristics and risks of the host contract. Although the consideration of an individual term or feature may be weighted more heavily in the evaluation on the basis of facts and circumstances, judgment would be required based on an evaluation of all of the relevant terms and features. 3. Furthermore, the Task Force reached a consensus-for-exposure that the effects of initially adopting the proposed amendments would be applied on a modified retrospective basis to existing hybrid financial instruments issued in the form of a share as of the beginning of the annual reporting period for which the proposed amendments are effective, with an option for full retrospective application. 4. A proposed Update was issued on October 23, 2013, with a December 23, 2013 comment letter deadline. 5. At the March 13, 2014 EITF meeting, the FASB staff presented the feedback received through comment letters and the FASB staff's outreach. See Issue Summary No. 1, Supplement No. 1, for a detailed discussion of the feedback received. 6. At the March 13, 2014 EITF meeting, the Task Force affirmed its consensus-for-exposure that the determination of the nature of the host contract would be based on a consideration of economic characteristics and risks of the entire hybrid financial instrument, including the embedded derivative feature that is being evaluated for separate accounting from the host contract (the whole-instrument approach). However, certain Task Force members expressed concern regarding the lack of guidance in the proposed Update with respect to how an entity would weigh and consider specific terms and features under the whole-instrument approach. Without providing such guidance, those Task Force members argued that diversity in practice with respect to determining the nature of the host contract (that is, debt or equity) may not be effectively reduced. In addition, those Task Force members argued that if the Task Force is EITF Issue No. 13-G Issue Summary No. 1, Supplement No. 2, p. 2
going to ask entities to make a judgment regarding the nature of the host contract, the Task Force should provide a basis on which to make that judgment. As a result, the Task Force (and certain FASB Board members) requested that the FASB staff explore the possibility of introducing guidance to assist entities in evaluating the specific terms and features of a hybrid financial instrument issued in the form of a share under the whole-instrument approach. 7. On May 15, 2014, the FASB staff conducted an Education Session with the Task Force members to discuss alternatives related to potential guidance aimed at assisting entities in evaluating the specific terms and features of a hybrid financial instrument issued in the form of a share. See the discussion materials from the Education Session for a detailed discussion of the alternatives presented. Accounting Issues and Alternatives Issue 1: Whether (and if so, how) to provide additional guidance to assist entities in evaluating the specific terms and features of a hybrid financial instrument issued in the form of a share when determining the nature of the host contract. 8. The FASB staff notes that a number of accounting firms have published guidance outlining certain common features in hybrid financial instruments issued in the form of a share and whether such features are more debt-like or equity-like in the context of determining the nature of the host contract. In addition, in remarks before the 2006 AICPA National Conference on Current SEC and PCAOB Developments, the SEC staff noted that there are certain attributes that the SEC staff would consider to be a part of the analysis performed to determine the nature of the host contract in a preferred share (those attributes are similar to the terms and features outlined later in the Issue Summary under Alternative A). 9. Based on its outreach, the FASB staff observes that, in the context of the embedded derivative analysis in Topic 815, there is little diversity in practice regarding which features are deemed to be more debt-like (for example, redemption features) and which are deemed to be more equity-like (for example, conversion options). The diversity appears to arise in the next step of the analysis. That is, once an entity compiles a list of debt-like and equity-like features EITF Issue No. 13-G Issue Summary No. 1, Supplement No. 2, p. 3
within the hybrid financial instrument, entities may use different frameworks for evaluating the nature of the host contract. In other words, once an entity comes up with the list of debt-like and equity-like features, how should the entity analyze that list to arrive at a determination regarding the nature of the host contract? 10. The FASB staff has considered various alternatives for providing additional guidance to help entities in determining the nature of the host contract under the whole-instrument approach. Ultimately, based on its analysis and the feedback received during the May 15, 2014 Education Session, the staff has decided to bring forward the following alternatives for the Task Force's consideration: Alternative A: Reaffirm the Task Force's original consensus-for-exposure, but provide additional implementation guidance to assist entities in evaluating the relative weighting to apply to the specific terms and features of a hybrid financial instrument issued in the form of a share under the whole-instrument approach. Alternative B: Establish a rebuttable presumption that a fixed-price, noncontingent redemption option held by the investor leads to a determination that the host contract is debt-like. Alternative C: Reaffirm the Task Force's original consensus-for-exposure without providing additional implementation guidance. 11. The FASB staff notes that under all three alternatives, consistent with the current concepts in Topic 815, the determination of the nature of the host contract would be assessed at the date the hybrid financial instrument issued in the form of a share is acquired (or incurred) by the reporting entity, and that determination would not be reassessed on an ongoing basis. Alternative A (see Appendix 13G-A for a sample staff draft of the guidance related to Alternative A) 12. Alternative A would reaffirm the Task Force's original consensus-for-exposure, but would also provide additional implementation guidance to assist entities in evaluating the specific terms EITF Issue No. 13-G Issue Summary No. 1, Supplement No. 2, p. 4
and features of a hybrid financial instrument issued in the form of a share under the wholeinstrument approach. 13. Under Alternative A, the implementation guidance would incorporate a list of common debt-like and equity-like features in hybrid financial instruments issued in the form of a share. The list would be supplemented with additional guidance focused on providing a framework in which the relative importance of those terms and features can be analyzed. 14. The following are examples of terms and features in hybrid financial instruments issued in the form of a share that typically would be considered debt-like in the context of determining the nature of the host contract in Topic 815: a. Redemption provisions b. Nature of returns (that is, dividends) is stated c. Returns are mandatory (that is, dividends are contractually required) d. Collateral requirements, creditor rights, or other protective covenants e. Preference in liquidation. 15. The following are examples of terms and features in hybrid financial instruments issued in the form of a share that typically would be considered equity-like in the context of determining the nature of the host contract in Topic 815: a. Conversion rights b. Nature of returns (that is, dividends) is participating c. Returns are discretionary (that is, dividends are paid if and when declared by the issuer) d. Voting rights e. Perpetual maturity. 16. When evaluating the specific terms and features of a hybrid financial instrument issued in the form of a share under the whole-instrument approach, an entity would consider how to EITF Issue No. 13-G Issue Summary No. 1, Supplement No. 2, p. 5
weight debt-like or equity-like terms and features. That is, it is not only important to determine which terms and features are debt-like versus equity-like, but also the extent to which those terms and features are debt-like or equity-like. Proponents of Alternative A believe that such incremental guidance would help articulate when certain features would carry more or less weight in the analysis of the nature of the host contract. 17. For example, the following guidance could be provided by the Task Force relating to voting rights, redemption features, and conversion features: a. The ability to exercise voting rights is generally viewed as an equity-like characteristic. However, not all voting rights are created equal. Voting rights that allow an investor to vote on all significant matters may be given more weight than voting rights that are only protective in nature. b. The ability for the investor to redeem a preferred share is generally viewed as a debtlike characteristic. However, a date-certain or noncontingent redemption option may be given more weight than a contingent redemption option. c. The ability for an investor to convert a preferred share into common shares is generally viewed as an equity-like characteristic. However, a conversion option that is noncontingent or deeply in-the-money may be given more weight than a conversion option that is contingent or deeply out-of-the-money. 18. When performing the evaluation of how to weight debt-like or equity-like terms and features in the context of the host contract analysis under Alternative A, entities may consider the circumstances under which the preferred share was issued, as well as the expected "end game." 19. With respect to the circumstances under which the preferred share was issued, an entity could consider whether the preferred share is effectively the residual interest in the issuer (due to the entity being thinly capitalized or the common equity of the entity having already incurred losses), or whether the preferred share was issued by a well-capitalized, profitable company. Those factors may help an entity determine, for example, whether a fixed-price, noncontingent, EITF Issue No. 13-G Issue Summary No. 1, Supplement No. 2, p. 6
redemption option held by the investor is providing substantive downside protection to that investor (which would be a debt-like characteristic). 20. With respect to the expected "end game," an entity could look at the relative probabilities that either the conversion option or the redemption option will ultimately be exercised in order to help determine which feature should be weighted more heavily in the host contract analysis. The probability analysis could consider the following factors: a. Is the redemption option or conversion option date-certain? b. Is the redemption option or conversion option contingent? c. Is the conversion option deeply in-the-money or out-of-the-money? d. Is conversion more likely to occur before redemption, for example, because of an expected initial public offering (IPO) or change-in-control event prior to the redemption option becoming exercisable? e. Is the redemption price (formula) more favorable to the investor than the conversion price (formula)? f. Are there laws that would significantly restrict the investor's ability to exercise the redemption feature (for example, if redemption would make the issuer insolvent)? g. Are there significant economic disincentives for the investor to exercise the redemption feature? 21. Proponents of Alternative A argue that entities should take the specific facts and circumstances of their transaction into consideration when determining the nature of the host contract, without presuming that one term or feature is inherently more important than the others. Proponents believe that such a framework is consistent with the principle behind the wholeinstrument approach, which is that all substantive terms and features be analyzed and weighted on the basis of relevant facts and circumstances. 22. Proponents acknowledge that Alternative A requires significant judgment, but they believe that potentially different judgments reached in good faith are a natural outcome of the wholeinstrument approach, and that such differences would be properly based on all of the instrument's EITF Issue No. 13-G Issue Summary No. 1, Supplement No. 2, p. 7
substantive features and the economic characteristics and risks of the entire hybrid financial instrument. 23. Opponents do not believe that Alternative A will provide sufficient guidance to effectively reduce diversity in practice. They argue that much of the diversity in practice arises as a result of entities considering all relevant terms and features, weighing each feature on the basis of relevant facts and circumstances, and coming to different conclusions. Therefore, opponents believe that more determinative guidance (such as a rebuttable presumption approach) would be needed to reduce diversity in determining the nature of the host contract. Alternative B (see Appendix 13G-A for a sample staff draft of the guidance related to Alternative B) 24. Alternative B would establish a rebuttable presumption that the presence of a fixed-price, noncontingent, redemption option held by the investor embedded in a hybrid financial instrument issued in the form of a share is determinative in concluding that the host contract is debt-like. 25. Proponents of Alternative B believe that the potential downside protection provided by a fixed-price, noncontingent redemption option held by the investor generally causes the economic characteristics and risks of the host contract to be more akin to debt even when the hybrid instrument includes other terms and features that are equity-like, such as dividend participation rights, voting rights, or a conversion option. That is, there should be a rebuttable presumption that the host contract is debt-like because the fixed-price redemption option held by the investor may change the pay-off profile of the instrument such that the investor is not exposed to the downside risks of an equity investment. For example, investors in a convertible preferred share may participate with the issuer's common shareholders in dividends (that is, through participating dividend rights) and positive movements in the issuer's stock price (that is, through a conversion option), but may not be exposed to all downside risks associated with a residual interest in the issuer because of the redemption feature. For the purposes of this assessment, the staff interprets "fixed-price, non-contingent redemption feature" to mean redeemable at a fixed or formula-based price at the discretion of the investor. For the purposes of this assessment, the staff does not believe that (a) laws restricting redemption, (b) time restrictions stated in the redemption terms, EITF Issue No. 13-G Issue Summary No. 1, Supplement No. 2, p. 8
or (c) non-substantive contingent events that are remote of occurring would cause the redemption feature to be considered contingent. 26. Paragraph 815-10-S99-3 (which originated in EITF Topic D-109) states in part that " the consideration of an individual term or feature may be weighted more heavily in the evaluation." Proponents of Alternative B believe that this guidance should be interpreted to indicate that certain features should be given more weight and that a fixed-price, noncontingent redemption option held by the investor should generally lead to concluding that the host contract is debt-like. 27. Proponents of Alternative B point to paragraph 815-15-25-16, which states: If the host contract encompasses a residual interest in an entity, then its economic characteristics and risks shall be considered that of an equity instrument and an embedded derivative would need to possess principally equity characteristics (related to the same entity) to be considered clearly and closely related to the host contract. However, most commonly, a financial instrument host contract will not embody a claim to the residual interest in an entity and, thus, the economic characteristics and risks of the host contract shall be considered that of a debt instrument. [Emphasis added.] 28. Further, proponents of Alternative B believe that the definition of "equity" in FASB Concepts Statement No. 6, Elements of Financial Statements, is relevant when evaluating whether the host contract "encompasses a residual interest" in the issuer. Specifically, paragraphs 50 and 60 of Concepts Statement 6 state, in part: The equity or net assets of both a business enterprise and a not-for-profit organization is the difference between the entity's assets and its liabilities. It is a residual, affected by all events that increase or decrease total assets by different amounts than they increase or decrease total liabilities. Thus, equity or net assets of both a business enterprise and a not-for-profit organization is increased or decreased by the entity's operations and other events and circumstances affecting the entity. [Footnote reference omitted.] Since equity ranks after liabilities as a claim to or interest in the assets of the enterprise, it is a residual interest: (a) equity is the same as net assets, the difference between the enterprise's assets and its liabilities, and (b) equity is EITF Issue No. 13-G Issue Summary No. 1, Supplement No. 2, p. 9
enhanced or burdened by increases and decreases in net assets from nonowner sources as well as investments by owners and distributions to owners. 29. Concepts Statement 6 indicates that a residual interest in an entity exposes the holder to both positive and negative changes in the entity's net assets. As a fixed-price, noncontingent redemption option potentially protects the investor from negative changes in the issuer's net assets, proponents of Alternative B believe that it would be difficult to argue that the host contract is considered a residual interest in the issuer and, therefore, believe that the host contract would generally be deemed a debt host pursuant to paragraph 815-15-25-16. 30. Proponents of Alternative B note that the rebuttable presumption that a fixed-price, noncontingent redemption option held by the investor would generally cause the host contract to be more akin to debt may be overcome depending on the facts and circumstances of the specific transaction. For example, the presumption may be overcome if exercise of the fixed-price, noncontingent redemption feature is deemed remote of occurring or is otherwise non-substantive. A non-exhaustive list of potential indicators that the presumption may be overcome could include: a. A likelihood assessment: An entity may look at the various circumstances in which the fixed-price, noncontingent redemption feature held by the investor would be exercised and make a determination as to how likely those circumstances are of occurring. If those circumstances are deemed remote of occurring, that may be an indicator that the presumption can be overcome. b. Residual claim: Under various state laws and corporate charters, a preferred share cannot be redeemed if it would cause the issuer to become insolvent. In other words, if the preferred share was redeemed, the investor would receive an unsecured obligation that is subordinated to all secured and unsecured creditors. Thus, in reality, the investor in such a security may potentially be exposed to the residual risks (that is, negative movements) of an equity investment. This may especially be true for some smaller issuers or start-up companies for which preferred shares are sometimes the only substantive source of equity financing. In such situations, legal restrictions that EITF Issue No. 13-G Issue Summary No. 1, Supplement No. 2, p. 10
cause the hybrid financial instrument to be an in-substance residual claim may be an indicator that the presumption can be overcome. c. Conversion option: Cases in which the conversion option embedded in a convertible preferred share is deeply in-the-money or the conversion is highly probable of occurring before the redemption option is enforceable (for example, because of an expected IPO or change-in-control event), may be indicators that the presumption can be overcome. 31. Proponents of Alternative B argue that establishing a rebuttable presumption would help reduce complexity and diversity in practice, because it would establish the principle that a fixedprice, noncontingent redemption option is the most important feature when determining the nature of the host contract. Proponents believe that the lack of guidance regarding the potential weighting of various terms and features in hybrid financial instruments issued in the form of a share has led to and would continue to lead to different entities coming to different conclusions for similar instruments regarding the nature of the host contract. 32. Opponents of Alternative B argue that it is incorrect to presume that the redemption option will allow the holder of the preferred share to exercise the redemption option and collect the redemption amount. They argue that the level of downside protection provided by a redemption option held by the investor will vary depending on the specific facts and circumstances. 33. In addition, opponents of Alternative B argue that for many private issuers of preferred shares, in most cases, the issuer would either perform well and have a liquidity event (in which case the conversion option would be exercised) or the issuer would perform poorly (in which case the preferred shareholders would effectively be the residual interest holders). Therefore, opponents argue that in a vast majority of circumstances, the redemption option will not be exercised and/or will not provide the investor with substantive downside protection. 34. Opponents of Alternative B argue that the language in paragraph 815-10-S99-3, which reads, " the existence or omission of any single term or feature is not necessarily determinative of the economic characteristics and risks of the host contract," indicates that it should not be EITF Issue No. 13-G Issue Summary No. 1, Supplement No. 2, p. 11
presumed (whether the presumption is rebuttable or not) that a fixed-price, noncontingent redemption option held by the investor causes the host contract to be debt-like. Some weight must be given to the other relevant terms and features. Opponents also believe that an entity must consider all substantive terms and features of the host contract. For example, the equity-like economic characteristics in a convertible preferred share created by dividend participation rights, a conversion option, and voting rights would also be considered when evaluating whether the conversion option is clearly and closely related to the host contract under the whole-instrument approach. Opponents of Alternative B believe that to presume those features are inherently less important than a redemption option held by the investor would contradict the principle behind the whole-instrument approach and the guidance in paragraph 815-10-S99-3. 35. The FASB staff notes that as part of the Task Force's discussion at its September 13, 2013 meeting based on Issue Summary No. 1, the Task Force rejected an alternative that would have provided more determinative guidance, such as a rebuttable presumption approach. Paragraphs BC14 and BC15 of the proposed Update provide a discussion of the Task Force's basis for rejecting that alternative and not providing more determinative guidance. Alternative C 36. Alternative C would reaffirm the Task Force's original consensus for exposure and would not provide any additional implementation guidance with respect to the application of the wholeinstrument approach. 37. The Task Force may decide to choose this alternative if it determines that the evaluation of the specific terms and features of a hybrid financial instrument issued in the form of a share when determining the nature of the host contract is unique to each specific instrument and circumstance. The FASB staff notes that this alternative would still result in reduced diversity in practice as a result of (a) requiring the use of the whole-instrument approach (that is, it would eliminate other approaches used in current practice, such as the chameleon approach), and (b) clarifying that no single feature is determinative in the assessment. Question 1 for the Task Force: Which alternative does the Task Force support? EITF Issue No. 13-G Issue Summary No. 1, Supplement No. 2, p. 12
Issue 2: Transition and Effective Date Transition 38. The FASB staff has considered the feedback provided and believes that for all entities, the Task Force should reaffirm its consensus-for-exposure that the effects of initially adopting the proposed amendments would be applied on a modified retrospective basis to existing hybrid financial instruments issued in the form of a share as of the beginning of the annual reporting period for which the proposed amendments are effective, with an option for full retrospective application. 39. While the FASB staff acknowledges that other methodologies currently exist in practice to determine the nature of the host contract in a hybrid financial instrument issued in the form of a share (for example, the chameleon approach), the staff believes that a vast majority of entities have been applying the whole-instrument approach in practice as a result of the SEC staff guidance in paragraph 815-10-S99-3. Therefore, a modified retrospective application of the proposed amendments (which are largely consistent with the SEC staff guidance in paragraph 815-10-S99-3) would not entail a significant amount of time and effort for most entities. 40. The FASB staff considered allowing a prospective transition alternative (particularly for nonpublic entities); however, the staff ultimately did not recommend such an alternative due to the availability of the modified retrospective alternative which the staff believes is a practical transition method for all entities and the fact that the guidance in the proposed Update is largely consistent with current practice. Question 2 for the Task Force: Does the Task Force wish to reaffirm its consensus-forexposure that the effects of initially adopting the proposed amendments would be applied on a modified retrospective basis, while also permitting entities to utilize a full retrospective basis? EITF Issue No. 13-G Issue Summary No. 1, Supplement No. 2, p. 13
Effective Date 41. The FASB staff believes that the feedback received with respect to the effective date of the proposed amendments establishes that an implementation period of at least one year from the time a final standard is issued is appropriate. Therefore, the staff believes that for public entities, the amendments in the proposed Update should be effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. For nonpublic entities the staff believes that the amendments in the proposed Update should be effective for annual periods beginning after December 15, 2015, and interim periods thereafter. 42. The FASB staff considered the guidance in the FASB's Private Company Decision-Making Framework, which recommends that, generally, (a) the amendments in an FASB Accounting Standards Update should be effective for nonpublic entities one year after the first annual period for which public companies are required to adopt them and (b) nonpublic entities should not be required to adopt amendments during an interim period within the initial fiscal year of adoption. The FASB staff believes that the latter approach (adopt in an annual period instead of interim periods) for nonpublic entities is appropriate. However, the FASB staff does not believe that a one year delay of the effective date for nonpublic entities is necessary. Given the length of time until the effective date, availability of the modified retrospective transition alternative, general consistency between the proposed amendments and current practice, and the fact that nonpublic entities would not have to adopt the proposed amendments during interim periods within the initial year of adoption, the FASB staff believes that nonpublic entities will have adequate time to go through their learning cycle. The FASB staff has considered the feedback provided and believes that all entities should be permitted to early adopt the amendments in the proposed Update. Specifically, entities would be permitted to apply the proposed amendments for any annual or interim period for which the entity's financial statements have not yet been issued. Question 3 for the Task Force: Does the Task Force agree with the effective date for the proposed Update and on permitting early adoption? EITF Issue No. 13-G Issue Summary No. 1, Supplement No. 2, p. 14
Issue 3: Re-exposure 43. If the Task Force chooses Alternatives A or C in Issue 1 of this Issue Summary, the FASB staff does not believe that re-exposure would be required. The staff notes that Alternative C would reaffirm the consensus-for-exposure in the proposed Update, while Alternative A would provide additional implementation guidance to support the main principles of the consensus-forexposure. 44. However, the FASB staff recommends re-exposure if the Task Force chooses Alternative B. Alternative B would establish a rebuttable presumption that the presence of a fixed-price, noncontingent, redemption option held by the investor embedded in a hybrid financial instrument issued in the form of a share is determinative in concluding that the host contract is debt-like. The proposed Update indicated that the existence or omission of any single term or feature would not necessarily determine the economic characteristics and risks of the host contract. Accordingly, the staff believes that some may view Alternative B as being inconsistent with the main principles of the proposed Update, and since stakeholders have not had the opportunity to comment on Alternative B, re-exposure would be necessary. As noted in the feedback summary prepared by the staff (Issue Summary No. 1, Supplement No. 1) and discussed at the March 13, 2014 Task Force meeting, seven of the eight respondents who commented on this specific issue agreed with the Task Force's consensus-for-exposure in the proposed Update. EITF Issue No. 13-G Issue Summary No. 1, Supplement No. 2, p. 15
APPENDIX 13G-A Staff Draft of Guidance under Alternatives A and B Alternative A Implementation Guidance under the Whole-Instrument Approach Main Principle (from the Exposure Draft) 815-15-25-17A For a hybrid financial instrument issued in the form of a share, an entity shall determine the nature of the host contract by considering all stated and implied substantive terms and features of the hybrid financial instrument, considering each term and feature on the basis of the relevant facts and circumstances. That is, in determining the nature of the host contract, an entity shall consider the economic characteristics and risks of the entire hybrid financial instrument including the embedded derivative feature that is being evaluated for potential bifurcation. In evaluating the stated and implied substantive terms and features, the existence or omission of any single term or feature does not necessarily determine the economic characteristics and risks of the host contract. Although the consideration of an individual term or feature may be weighted more heavily in the evaluation on the basis of the facts and circumstances, an entity should use judgment based on an evaluation of all of the relevant terms and features. For example, an entity shall not presume that the presence of a fixed-price, noncontingent redemption option held by the investor in a convertible preferred stock contract, in and of itself, determines whether the nature of the host contract is more akin to a debt instrument or more akin to an equity instrument. Rather, the nature of the host contract depends on the economic characteristics and risks of the entire hybrid financial instrument. 815-15-25-17B The guidance in the preceding paragraph is related to the determination of whether a host contract within a hybrid financial instrument issued in the form of a share is considered to be more akin to a debt instrument or more akin to an equity instrument for the purposes of evaluating one or more embedded derivative features for bifurcation under paragraph 815-15-25-1(a). It is not intended to address when an embedded derivative feature should be bifurcated from the host contract under Topic 815 or the accounting under Topic 815 when such bifurcation is required. In addition, the guidance in the preceding paragraph is not intended to prescribe the method to be used in determining the nature of the host contract in a hybrid instrument that is not issued in the form of a share. Implementation Guidance Staff Draft EITF Issue No. 13-G Issue Summary No. 1, Supplement No. 2, p. 16
815-15-55-XX When applying the provisions of paragraph 815-15-25-17A, entities shall determine the nature of the host contract by considering all stated and implied substantive terms and features of the hybrid financial instrument, considering each term and feature on the basis of the relevant facts and circumstances. The following is a non-exhaustive list of examples of common terms and features included within a hybrid financial instrument issued in the form of a share, and the types of information and indicators that an entity may consider when assessing the relative importance (and therefore, weighting) of those terms and features in the context of determining the nature of the host contract: a. Redemption rights. The ability for an issuer or investor to redeem a hybrid financial instrument issued in the form of a share is generally viewed as a debt-like characteristic. The relative importance (and therefore, weighting) of redemption rights among other terms and features in a hybrid financial instrument shall be evaluated based on information about the following (among other relevant) factors: i. Whether the redemption option is held by the issuer or investor ii. Whether or not the redemption is date-certain iii. Whether the redemption option is noncontingent or contingent iv. Whether there are any laws that would restrict the issuer or investor from exercising the redemption feature (for example, if redemption would make the issuer insolvent) v. Whether there are economic incentives or disincentives for the issuer or investor to exercise its redemption option vi. If the hybrid financial instrument also contains a conversion option, whether the redemption price (formula) is more favorable than the conversion price (formula). b. Conversion rights. The ability for an investor to convert, for example, a preferred share into common shares is generally viewed as an equity-like characteristic. The relative importance (and therefore, weighting) of conversion rights among other terms and features in a hybrid financial instrument shall be evaluated based on information about the following (among other relevant) factors: i. Whether or not the conversion is date-certain ii. Whether the conversion option is noncontingent or contingent iii. Whether the conversion option is deeply in-the-money or deeply out-of-themoney iv. If the hybrid financial instrument also contains a redemption right held by the investor, whether conversion is more likely to occur before redemption, for example, because of an expected initial public offering or change-in-control event prior to the redemption option becoming exercisable. c. Voting rights. The ability for an investor to exercise voting rights is generally viewed as an equity-like characteristic. The relative importance (and therefore, weighting) of EITF Issue No. 13-G Issue Summary No. 1, Supplement No. 2, p. 17
voting rights among other terms and features in a hybrid financial instrument shall be evaluated based on information about the following (among other relevant) factors: i. Which matters the voting rights allow an investor to vote on (relative to common stock shareholders) ii. How much influence the investor can exercise as a result of the voting rights. d. Dividend terms. The nature of dividends can be viewed as a debt-like or equity-like characteristic. The relative importance (and therefore, weighting) of dividend terms among other terms and features in a hybrid financial instrument shall be evaluated based on information about the following (among other relevant) factors: i. Whether the dividends are mandatory or discretionary ii. Whether the dividends are stated or participating iii. Whether the dividends are cumulative or non-cumulative. e. Protective covenants: Protective covenants are generally viewed as a debt-like characteristic. The relative importance (and therefore, weighting) of protective covenants among other terms and features in a hybrid financial instrument shall be evaluated based on information about the following (among other relevant) factors: i. Whether there are any collateral requirements akin to collateralized debt ii. Whether the instrument provides the investor with creditor rights (for example, the right to force bankruptcy). Alternative B Guidance under the "Rebuttable Presumption" Approach 815-15-25-17A There is a rebuttable presumption that a noncontingent, fixed-price redemption option held by the investor embedded in a hybrid financial instrument issued in the form of a share is determinative in concluding that the host contract is more akin to debt, even when the hybrid instrument includes equity-like terms and features such as dividendparticipation rights, voting rights, or a conversion option. Consistent with paragraph 815-15- 25-16, a host contract should encompass a residual interest in an entity for its economic characteristics and risks to be considered that of an equity instrument. As a result of the noncontingent, fixed-price redemption option held by the investor, it is presumed that the investor is not fully exposed to all downside risks associated with a residual interest in the issuer. 815-15-25-17B The presumption in paragraph 815-15-25-17A may be overcome if the noncontingent, fixed-price redemption provision held by the investor is deemed remote of occurring or is otherwise non-substantive. A non-exhaustive list of potential indicators that EITF Issue No. 13-G Issue Summary No. 1, Supplement No. 2, p. 18
the presumption in paragraph 815-15-25-17A can be overcome may include: a. A likelihood assessment. An entity may look at the various circumstances in which the noncontingent, fixed-price redemption feature held by the investor would be exercised and make a determination as to how likely those circumstances are of occurring. If those circumstances are deemed remote of occurring, that may be an indicator that the presumption in paragraph 815-15-25-17A can be overcome. b. Residual claim. Under various state laws and corporate charters, a preferred share cannot be redeemed if it would cause the issuer to become insolvent. In other words, if the preferred share was redeemed, the investor would receive an unsecured obligation that is subordinated to all secured and unsecured creditors. Thus, in reality, the investor in such a security may potentially be exposed to the residual risks (that is, negative movements) of an equity investment. This may especially be true for some smaller issuers or start-up companies for which preferred shares are sometimes the only substantive source of equity financing. In such situations, legal restrictions that cause the hybrid financial instrument to be an in-substance residual claim may be an indicator that the presumption in paragraph 815-15-25-17A can be overcome. c. Conversion option: Cases in which the conversion option embedded in a convertible preferred share is deeply in-the-money or the conversion is highly probable of occurring before the redemption option is enforceable (for example, because of an expected initial public offering or change-in-control event), may be indicators that the presumption in paragraph 815-15-25-17A can be overcome. 815-15-25-17C The guidance in paragraphs 815-15-25-17A and 815-15-25-17B is related to the determination of whether a host contract within a hybrid financial instrument issued in the form of a share is considered to be more akin to a debt instrument or more akin to an equity instrument for the purposes of evaluating one or more embedded derivative features for bifurcation under paragraph 815-15-25-1(a). It is not intended to address when an embedded derivative feature should be bifurcated from the host contract under Topic 815 or the accounting under Topic 815 when such bifurcation is required. In addition, the guidance in paragraphs 815-15-25-17A and 815-15-25-17B is not intended to prescribe the method to be used in determining the nature of the host contract in a hybrid instrument that is not issued in the form of a share. EITF Issue No. 13-G Issue Summary No. 1, Supplement No. 2, p. 19