FASB Definition of a Derivative Whether Settlement Provisions That Require a Structured Payout Constitute Net Settlement under Paragraph 9(a)

FASB: Definition of a Derivative: Whether Settlement Provisions That Require a Structured Payout Constitute Net Settlement under Paragraph 9(a)

Derivatives Implementation Group

Statement 133 Implementation Issue No. A13

Title: Definition of a Derivative: Whether Settlement Provisions That Require a Structured Payout Constitute Net Settlement under Paragraph 9(a)
Paragraph references: 6(c), 9(a), 57(c)(1)
Date cleared by Board: December 6, 2000
Date revision posted to website: May 1, 2003
Affected by: FASB Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities
(Revised March 26, 2003)

QUESTIONS

Question 1

Upon settlement of a contract, in lieu of immediate net cash settlement of the gain or loss under the contract, the holder may receive a financial instrument involving terms that would provide for the gain or loss under the contract to be received or paid over a specified time period. Does a contract meet the characteristic of net settlement in paragraph 9(a) (and related paragraph 57(c)(1)) of Statement 133 if it provides for a structured payout, rather than immediate payout, of the gain or loss resulting from that contract?

Question 2

Would the answer to Question 1 change if, instead, the holder were required to invest funds in or borrow funds from the other party so that the party in a gain position under the contract can obtain the value of that gain only over time as an adjustment of either the yield on the amount invested or the interest element on the amount borrowed?

BACKGROUND

Paragraph 6 of Statement 133 states, in part:

A derivative instrument is a financial instrument or other contract with all three of the following characteristics...

  1. Its terms require or permit net settlement, it can readily be settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position that is not substantially different from net settlement.

Paragraph 9(a) states, in part: "Neither party is required to deliver an asset that is associated with the underlying and that has a principal amount, stated amount, face value, number of shares, or other denomination that is equal to the notional amount...."

Paragraph 57(c)(1) states, in part: "Net settlement may be made in cash or by delivery of any other asset, whether or not it is readily convertible to cash."

RESPONSES

Question 1

Yes. A contract that provides for a structured payout of the gain (or loss) resulting from that contract meets the characteristic of net settlement in paragraph 9(a) (and related paragraph 57(c)(1)) of Statement 133 if the fair value of the cash flows to be received (or paid) by the holder under the structured payout are approximately equal to the amount that would have been received (or paid) if the contract had provided for an immediate payout related to settlement of the gain (or loss) under the contract. The fact that a contract accomplishes settlement by requiring the party in a loss position under the contract to make cash payments over a specified timeframe to the party in a gain position (in lieu of immediate cash settlement of the gain) does not preclude the contract from meeting the characteristic of net settlement in paragraph 9(a). Paragraph 57(c)(1) contemplates that net settlement may be made in the form of cash or any other asset (such as the right to receive future payments), which need not be readily convertible to cash.

Question 2

Generally, yes, the different facts assumed under Question 2 results in a conclusion that differs from the answer to Question 1. The structured payout discussed in Question 1 is substantively different from contractual terms that require one party to the contract to invest funds in or borrow funds from the other party so that the party in a gain position under the contract can obtain the value of that gain only over time as a traditional adjustment of the yield on the amount invested or the interest element on the amount borrowed. A fixed-rate mortgage loan commitment is an example of a contract that requires the party in a gain position under the contract to borrow funds at a below-market interest rate at the time of the borrowing in order to obtain the benefit of that gain. A contract that requires such additional investing or borrowing to obtain the benefits of the contract's gain only over time as a traditional adjustment of the yield on the amount invested or the interest element on the amount borrowed does not meet the characteristic of net settlement in paragraph 9(a).

Contracts that require one party to the contract to invest funds in or borrow funds from the other party so that the party in a gain position under the contract can obtain the value of that gain over time as a nontraditional adjustment of the yield on the amount invested or the interest element on the amount borrowed may meet the characteristic of net settlement in paragraph 9(a). A structured payout of the gain on a contract (as discussed in Question 1) could also be described as an abnormally high yield on a required investment or borrowing in which the overall return is related to the amount of that contract's gain, in which case the contract would be considered to have met the characteristic of net settlement in paragraph 9(a). For example, if a contract required the party in a gain position under the contract to invest $100 in the other party's debt instrument that paid an abnormally high interest rate of 5,000 percent per day for a term whose length is dependent on the changes in the contract's underlying, an analysis of those terms would lead to the conclusion that the contract's settlement terms were in substance a structured payout of the contract's gain (as discussed in the Response to Question 1) and thus that contract would be considered to have met the characteristic of net settlement in paragraph 9(a).

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.