FASB Asymmetrical Default Provisions

FASB: Asymmetrical Default Provisions

Derivatives Implementation Group

Statement 133 Implementation Issue No. A8

Title: Definition of a Derivative: Asymmetrical Default Provisions
Paragraph references: 6(c), 9(a), 57(c)(1)
Date cleared by Board: November 23, 1999
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

Does an asymmetrical default provision, which provides the defaulting party only the obligation to compensate its counterparty's loss but not the right to demand any gain from its counterparty, give a commodity forward contract the characteristic of net settlement under paragraph 9(a) of Statement 133?

BACKGROUND

Paragraph 6(c) of Statement 133 describes the following derivative characteristic:

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(a) provides the following additional guidance regarding the derivative characteristic in paragraph 6(c):

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).

Paragraph 57(c) and related subparagraph (1) provide the following additional guidance regarding the derivative characteristic in paragraphs 6(c) and 9(a):

A contract that meets any one of the following criteria has the characteristic described as net settlement:
  1. 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.

Many commodity forward contracts contain default provisions that require the defaulting party (the party that fails to make or take physical delivery of the commodity) to reimburse the nondefaulting party for any loss incurred as illustrated in the following examples:

  • If the buyer under the forward contract (Buyer) defaults (that is, does not take physical delivery of the commodity), the seller under that contract (Seller) will have to find another buyer in the market to take delivery. If the price received by Seller in the market is less than the contract price, Seller incurs a loss equal to the quantity of the commodity that would have been delivered under the forward contract multiplied by the difference between the contract price and the current market price. Buyer must pay Seller a penalty for nonperformance equal to that loss.

  • If Seller defaults (that is, does not deliver the commodity physically), Buyer will have to find another seller in the market. If the price paid by Buyer in the market is more than the contract price, Seller must pay Buyer a penalty for nonperformance equal to the quantity of the commodity that would have been delivered under the forward contract multiplied by the difference between the contract price and the current market price.

For example, Buyer agreed to purchase 100 units of a commodity from Seller at $1.00 per unit:

  • Assume Buyer defaults on the forward contract by not taking delivery and Seller must sell the 100 units in the market at the prevailing market price of $.75 per unit. To compensate Seller for the loss incurred due to Buyer's default, Buyer must pay Seller a penalty of $25.00 (that is, 100 units × ($1.00 - $.75)).

  • Similarly, assume that Seller defaults and Buyer must buy the 100 units it needs in the market at the prevailing market price of $1.30 per unit. To compensate Buyer for the loss incurred due to Seller's default, Seller must pay Buyer a penalty of $30.00 (that is, 100 units × ($1.30 - $1.00)).

Note that an asymmetrical default provision is designed to compensate the nondefaulting party for a loss incurred. The defaulting party cannot demand payment from the nondefaulting party to realize the changes in market price that would be favorable to the defaulting party if the contract were honored. Under the forward contract in the example, if Buyer defaults when the market price is $1.10, Seller will be able to sell the units of the commodity into the market at $1.10 and realize a $10.00 greater gain than it would have under the contract. In that circumstance, the defaulting Buyer is not required to pay a penalty for nonperformance to Seller, nor is Seller required to pass the $10.00 extra gain to the defaulting Buyer. Similarly, if Seller defaults when the market price is $0.80, Buyer will be able to buy the units of the commodity in the market and pay $20.00 less than under the contract. In that circumstance, the defaulting Seller is not required to pay a penalty for nonperformance to Buyer, nor is Buyer required to pass the $20.00 savings on to the defaulting Seller.

RESPONSE

No. A nonperformance penalty provision that requires the defaulting party to compensate the nondefaulting party for any loss incurred but does not allow the defaulting party to receive the effect of favorable price changes (herein referred to as an asymmetrical default provision) does not give a commodity forward contract the characteristic described as net settlement under paragraph 9(a) of Statement 133.

A derivative instrument can be described, in part, as allowing the holder to participate in the changes in an underlying without actually making or taking delivery of the asset related to that underlying. In a forward contract with only an asymmetrical default provision, neither Buyer nor Seller can realize the benefits of changes in the price of the commodity through default on the contract. That is, Buyer cannot realize favorable changes in the intrinsic value of the forward contract except (a) by taking delivery of the physical commodity or (b) in the event of default by Seller, which is an event beyond the control of Buyer. Similarly, Seller cannot realize favorable changes in the intrinsic value of the forward contract except (a) by making delivery of the physical commodity or (b) in the event of default by Buyer, which is an event beyond the control of Seller. However, a pattern of having the asymmetrical default provision applied in contracts between certain counterparties would indicate the existence of a tacit agreement between those parties that the party in a loss position would always elect the default provision, thereby resulting in the understanding that there would always be net settlement. In that situation, those kinds of commodity contracts would meet the characteristics described as net settlement in paragraph 9(a).

In contrast, a contract that permits only one party to elect net settlement of the contract (by default or otherwise), and thus participate in either favorable changes only or both favorable and unfavorable price changes in the underlying, meets the derivative characteristic described in paragraph 6(c) and discussed in paragraph 9(a) for all parties to that contract. Such a default provision allows one party to elect net settlement of the contract under any pricing circumstance and consequently does not require delivery of an asset that is associated with the underlying. That default provision differs from the asymmetrical default provision in the above example contract since it is not limited to compensating only the nondefaulting party for a loss incurred and is not solely within the control of the defaulting party.

If the commodity forward contract does not have the characteristic of net settlement under paragraphs 9(a) and 9(b) but has the characteristic of net settlement under paragraph 9(c) because it requires delivery of a commodity that is readily convertible to cash, the commodity forward contract may nevertheless be eligible to qualify for the normal purchases and normal sales exception in paragraph 10(b) and if so, would not be subject to the accounting requirements of Statement 133 for the party to whom it is a normal purchase or normal sale.

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.