FASB Definition of a Derivative Penalties for Nonperformance That Constitute Net Settlement

FASB: Definition of a Derivative: Penalties for Nonperformance That Constitute Net Settlement

Derivatives Implementation Group

Statement 133 Implementation Issue No. A5

Title: Definition of a Derivative: Penalties for Nonperformance That Constitute Net Settlement
Paragraph references:
6(c), 9(a), 57(c)(1)
Date cleared by Board: November 23, 1999

QUESTION

Does a contract contain a net settlement provision under paragraphs 9(a) and 57(c)(1) if it contains both (a) a variable penalty for nonperformance based on changes in the price of the items that are the subject of the contract and (b) a fixed incremental penalty for nonperformance that is sufficiently large to make the possibility of net settlement remote?

BACKGROUND

Certain contracts may require payment of (a) a variable penalty for nonperformance based on changes in the price of the items that are the subject of the contract and (b) an incremental penalty for nonperformance stated as a fixed amount or fixed amount per unit. The contract may or may not characterize the incremental payment upon nonperformance as a penalty.

Paragraph 57(c)(1) elaborates on the criterion in paragraph 6(c) regarding whether the terms of a contract require or permit net settlement which is discussed in paragraph 9(a). Paragraph 57(c)(1) states:

Its terms implicitly or explicitly require or permit net settlement. For example, a penalty for nonperformance in a purchase order is a net settlement provision if the amount of the penalty is based on changes in the price of the items that are the subject of the contract. Net settlement may be made in cash or by delivery of any other asset, whether or not it is readily convertible to cash. A fixed penalty for nonperformance is not a net settlement provision.

RESPONSE

No. A contract that contains a variable penalty for nonperformance based on changes in the price of the items that are the subject of the contract does not contain a net settlement provision under paragraphs 9(a) and 57(c)(1) if it also contains an incremental penalty of a fixed amount (or fixed amount per unit) that would be expected to be significant enough at all dates during the remaining term of the contract to make the possibility of nonperformance remote. If a contract includes such a provision, it effectively requires performance, that is, requires the party to deliver an asset that is associated with the underlying. Thus, the contract does not meet the criterion for net settlement under paragraphs 9(a) and 57(c)(1) of Statement 133. The assessment of the fixed incremental penalty in the manner described above should be performed only at the contract's inception.

The magnitude of the fixed incremental penalty should be assessed on a standalone basis as a disincentive for nonperformance, not in relation to the overall penalty.

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.