FASB Definition of a Derivative Contracts That Provide for Net Share Settlement

FASB: Definition of a Derivative: Contracts That Provide for Net Share Settlement

Derivatives Implementation Group

Statement 133 Implementation Issue No. A17

Title: Definition of a Derivative: Contracts That Provide for Net Share Settlement
Paragraph references: 9(a), 57(c)(1)
Date cleared by Board: March 21, 2001
Date posted to website: April 10, 2001
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)

QUESTION

If an option, warrant, or other contract provides for net share settlement as a settlement alternative, would that provision meet the net settlement criterion in paragraphs 6(c), 9(a) and 57(c)(1) as delivery of "any other asset, whether or not it is readily convertible to cash"?

BACKGROUND

Some contracts contain provisions that provide for net share settlement as a settlement alternative. Under net share settlement of an option or warrant to purchase common stock, the party with a loss delivers to the party with a gain an amount of common shares (which is the asset related to the underlying) with a current fair value equal to the gain. In some instances, the shares delivered in a net share settlement are restricted from sale for a period of at least 32 days.

For example, Company A has a warrant to buy 100 shares of the common stock of Company X at $10 a share. Company X is a privately held company. The warrant provides Company X with the choice of settling the contract on a physical basis (gross 100 shares) or a net share basis. The stock price increases to $20 a share. Instead of Company A paying $1,000 cash and taking full "physical" delivery of the 100 shares, the contract is net share settled and Company A receives 50 shares1 of stock without having to pay any cash for them. (Net share settlement is sometimes described as a "cashless" exercise.)

Paragraph 6(c) states the net settlement characteristic of a derivative instrument as follows:

    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 not substantially different from net settlement.

Paragraph 9 states, in part:

    Net settlement. A contract fits the description in paragraph 6(c) if its settlement provisions meet one of the following criteria:
  1. 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 (or the notional amount plus a premium or minus a discount).

RESPONSE

Yes. The net settlement criterion as described in paragraph 6(c) and related paragraphs of Statement 133 is met if the contract provides for net share settlement at the election of either party. Paragraph 57(c)(1) clarifies the definition of net settlement in paragraph 9(a) by stating, in part:

    [The contract's] terms implicitly or explicitly require or permit net settlement....Net settlement may be made in cash or by delivery of any other asset, whether or not it is readily convertible to cash. [Emphasis added.]

Therefore, if either counterparty could net share settle the contract, then it would be considered a derivative, regardless of whether the net shares received were readily convertible to cash as described in paragraph 9(c) or were restricted for more than 31 days. Paragraph 57(c)(1) is explicit in stating that any form of net settlement, which would include net share settlement of an option on a nonpublic company's common stock, would satisfy the net settlement requirement of a derivative.

While this conclusion applies to both investors and issuers of contracts, issuers of those net share settled contracts should consider whether such contracts qualify for the scope exception in paragraph 11(a) of Statement 133.

_____________________
1Computed as the warrant's $1,000 fair value upon exercise divided by the $20 stock price at that date.


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.