FASB Embedded Derivatives Accounting for Remarketable Put Bonds

FASB: Embedded Derivatives: Accounting for Remarketable Put Bonds

Derivatives Implementation Group

Statement 133 Implementation Issue No. B13

Title: Embedded Derivatives: Accounting for Remarketable Put Bonds
Paragraph references:

12, 13, 17, 18, 61(d)

Date cleared by Board: May 17, 2000
Date revision posted to website: February 28, 2007
Affected by: FASB Statement No. 157, Fair Value Measurements
Revised September 15, 2006

QUESTIONS

In remarketable put bond structures involving three parties -- a debtor, an investor (creditor), and an investment bank -- what is the required accounting by the debtor and the investor for each of the following features:

  • The call option written by the investor and obtained by the investment bank?

  • The put option held by the investor?

  • The "additional features" that may accompany certain structures?

In addition, if the call option held by the investment bank must be accounted for as a separate, freestanding derivative, how should the carrying value of that call option be determined?

BACKGROUND

In a standard put bond, a debtor issues a contract comprised of a bond and a written put option. The option allows the investor to put the bond back to the debtor at a specific date in exchange for the bond's par value. In exchange for giving the investor the right to redeem the bond at par before maturity, the debtor pays a lower effective interest rate than would be demanded for a non-putable bond. In addition, the rate on the bond may reset at the put date (resettable put bonds) and the bond may also involve a call option (callable, resettable put bonds).

A remarketable put bond is a putable bond that generally has the following additional features:

  • An investment bank obtains a call option-a right to buy the bond from the investor on the put date for the par amount. (The investment bank usually is either the underwriter of the bond issuance or an affiliate of the underwriter.)

  • The bond will automatically be put back to the debtor if the investment bank does not exercise its call option to purchase the bond.

  • The strike prices and the exercise dates of the investor's written call option and purchased put option are the same. The exercise dates are prior to the stated maturity of the bond.

  • The bond has an interest-rate-reset feature. If the bond is not put, the bond's contractual interest rate for the remaining term to maturity will reset at the put date based on (a) the yield, at the issuance date of the putable bond, of Treasury bonds of the same remaining maturity as the bond plus (b) the debtor's credit spread as of the put date. (It is assumed for purposes of this issue that the interest-rate-reset feature does not trigger the condition in paragraph 13(a).)

  • The proceeds from issuance exceed the par amount of the bond, net of issuance costs. This premium over par compensates the debtor for the interest-rate-reset feature. The premium generally is less than 10 percent of the par amount.

Economically, one of two scenarios will occur:

  • If market interest rates increase, the fair value of the bond (absent the effect of the put option) will decrease. The put option is in the money; therefore, the investors will put the bonds to the debtor.

  • If market interest rates decrease, the fair value of the bond (absent the effect of the call option) will increase. The call option is in the money; therefore, the investment bank will call the bonds from investors and resell the repriced bonds in the market at a premium.

RESPONSE

This section separately describes six remarketable put bond structures and three "additional features" that may accompany certain structures and responds to the questions relevant to each.

Structure 1

A debtor issues a resettable, putable bond to an investment bank. The investment bank sells to an investor that resettable, putable bond with an attached call option. The attached call option is a written option from the perspective of the investor and a purchased option from the perspective of the investment bank. That is, the investor buys a resettable, putable bond and simultaneously writes a call option giving the investment bank the right to call the bond and take advantage of the interest-rate-reset feature.

Accounting for the call option obtained by the investment bank: The debtor should not account for the call option purchased by the investment bank from the investor. The debtor is not a party to the call option. The investor's accounting for Structure 1 is addressed in Statement 133 Implementation Issue No. B3, "Investor's Accounting for a Put or Call Option Attached to a Debt Instrument Contemporaneously with or Subsequent to Its Issuance" (refer to Example 1). Implementation Issue B3 requires that an option that is added to a debt instrument by a third party contemporaneously with or subsequent to the issuance of the debt instrument should be separately accounted for as a derivative under Statement 133 by the investor. That is, it must be reported at fair value with changes in value recognized currently in earnings. The investment bank must also account for a freestanding purchased call option.

Determination of the carrying value of the investor's freestanding call option: The carrying value of the investor's attached freestanding written call option to the investment bank should be its fair value in accordance with paragraph 17 of Statement 133. The remaining proceeds would be allocated to the carrying amount of the putable bond.

Accounting for the put option held by the investor: Neither the debtor nor the investor is required to account separately for the embedded put option written by the debtor to the investor. Under paragraph 61(d) of Statement 133, the put option is considered clearly and closely related to the economic characteristics of the bond because it simply accelerates the repayment of principal, involves no substantial premium or discount, and is not contingent.

Structure 2

A debtor issues a resettable, putable bond to an investor. Contemporaneously, the investor writes a freestanding call option that permits the debtor to call the bond on the put date. The debtor immediately sells the purchased call option to an investment bank.

Accounting for the call option obtained by the investment bank: The debtor should not account separately for the call option that is purchased from the investor after it is transferred to the investment bank. The debtor is no longer a party to the call option. The investor's accounting for Structure 2 is addressed in Implementation Issue B3 (refer to Example 2), which indicates that the investor's written call option is a separate freestanding derivative that must be reported at fair value with changes in value recognized currently in earnings. The investment bank must also account for a freestanding purchased call option.

Determination of the carrying value of the investor's freestanding written call option: The carrying value of the investor's freestanding written call option to the investment bank should be its fair value in accordance with paragraph 17 of Statement 133. The remaining proceeds would be allocated to the carrying amount of the putable bond.

Accounting for the put option held by the investor: Neither the debtor nor the investor is required to account separately for the embedded put option written by the debtor to the investor. Under paragraph 61(d) of Statement 133, the put option is considered clearly and closely related to the economic characteristics of the bond because it simply accelerates the repayment of principal, involves no substantial premium or discount, and is not contingent.

Structure 3

A debtor issues a resettable bond to an investor. The bond is putable by the investor and callable by the debtor. The terms of the agreement stipulate that if the debtor does not exercise its purchased call option, the investor's purchased put option is automatically exercised. Contemporaneously, the debtor writes a separate, freestanding call option to an investment bank giving the investment bank the right to require the debtor to call the bond from the investor and deliver the bond to the investment bank. In order to deliver the bond to the investment bank, the debtor must obtain the bond from the investor pursuant to either its purchased call option or its written put option. As a result, the debtor has an obligation to make the investment bank whole if it fails to deliver the bond, and the investment bank has no right to pursue the investor if the investor fails to deliver the bond to the debtor.

Accounting for the call option obtained by the investment bank: The debtor must account separately for the freestanding call option written to the investment bank, and the investment bank must account for a freestanding purchased call option, in accordance with paragraphs 17 and 18 of Statement 133. The investor is not a party to that freestanding written call option and therefore should not account for that option. (In addition to the freestanding call option held by the investment bank, Structure 3 also involves an embedded call option written by the investor to the debtor. That embedded call option is not required to be accounted for separately by either the debtor or the investor. Under paragraph 61(d) of Statement 133, that embedded call option is considered clearly and closely related to the economic characteristics of the bond.)

Consistent with the conclusion in Statement 133 Implementation Issue No. K3, "Determination of Whether Combinations of Options with the Same Terms Must Be Viewed as Separate Option Contracts or as a Single Forward Contract," the debtor may not designate its freestanding call option written to the investment bank as a hedge of its embedded call option purchased from the investor. Because the terms of the contractual agreement require the debtor to settle its obligation to the investor on the embedded options' exercise date, that "exercise date" is essentially the bond's actual maturity date. Thus, in this structure, there is no embedded option in the bond that would qualify as the hedged item in a fair value hedge in which the hedging instrument is the debtor's freestanding written call option to the investment bank. However, the debtor may designate its freestanding written call option as a hedge of another asset or liability provided that all applicable requirements, including those in paragraph 20(c), are met.

Accounting for the put option held by the investor: Neither the debtor nor the investor is required to account separately for the embedded put option written by the debtor to the investor. Under paragraph 61(d) of Statement 133, the put option is considered clearly and closely related to the economic characteristics of the bond because it simply accelerates the repayment of principal, involves no substantial premium or discount, and is not contingent.

Structure 4 (Trust-Based Format)

A debtor issues resettable, putable bonds to a trust. The trust issues beneficial interests that mature on the put date. The trust also writes a call option to an investment bank giving the investment bank the right to call the bonds on the put date. If market interest rates fall, the investment bank will call the bonds and the trust will pay the call proceeds (the par amount) to investors to settle the maturing beneficial interests. If market interest rates increase, the trust will put the bonds back to the debtor and will pay the put proceeds (the par amount) to investors to settle the maturing beneficial interests.

Accounting for the call option obtained by the investment bank: Neither the debtor nor the investor should account for the call option purchased by the investment bank from the trust because neither is a party to that call option. (However, if either the debtor or the investor is required to consolidate the trust, that consolidation will require recognition of the call option written by the trust to the investment bank.) The investment bank must account for a freestanding purchased call option.

Accounting for the put option held by the investor: Neither the debtor nor the investor should account separately for the embedded put option written by the debtor to the trust. From the debtor's perspective, the put option is considered clearly and closely related to the economic characteristics of the bond under paragraph 61(d) of Statement 133 because it simply accelerates the repayment of principal, involves no substantial premium or discount, and is not contingent. The investor is not a party to the embedded put option; rather, the investor simply purchased beneficial interests that mature on the put date.

Structure 5 (Remarketing Format)

A debtor issues to an investor a bond that is both putable (by the investor) and callable (by the holder of the option). As part of the transaction, the investment bank acquires the exclusive right to purchase the bond from the investor in the future and to remarket the repriced bond. The investment bank's right to purchase the bond from the investor is set forth in the note or the indenture itself and in a separate document (a remarketing agreement) that is not part of the indenture, and is also described in the prospectus supplement. The explicit inclusion in the indenture of the investment bank's right to purchase the bond is designed to obligate initial and future investors to deliver the bond in response to the investment bank's exercise of its right. When the bond is issued, the trustee, in conformity with the transaction documents, must view the investment bank as the only party with a right to call the bond from the investor at the call/put date. Thus, the trustee does not require any involvement by the debtor when enforcing the investment bank's right to purchase the bond from the investor. The debtor's only remaining obligation is to pay interest at the reset rate if the bond remains outstanding.

Accounting for the call option obtained by the investment bank: The debtor should not account separately for the call option held by the investment bank. For accounting purposes, the transaction should be viewed as a purchase of a transferable, freestanding call option by the debtor from the investor and a concurrent transfer by the debtor of that option to the investment bank. Upon that transfer, the debtor is no longer a party to the call option and has surrendered its right to prepay the debt. The investment bank acquired the debtor's right to call the bond and relieved the debtor of the obligation to pay the investor the par amount of the bond upon exercise of the call. The call option is a contract between the investment bank and the investor that permits the investment bank to purchase the bonds from the investor at par. From the investor's perspective, that contract is a freestanding written call option that must be accounted for in accordance with paragraphs 17 and 18 of Statement 133. That is consistent with the guidance in Statement 133 Implementation Issue No. K2, "Are Transferable Options Freestanding or Embedded?" - an option on a bond incorporated into the terms of the bond at inception that, by the terms of the agreement, is exercisable by a party other than either the debtor or the investor should be considered an attached freestanding derivative instrument. The investment bank must also account for a freestanding purchased call option.

Determination of the carrying value of the investor's freestanding written call option: The carrying value of the investor's freestanding written call option to the investment bank should be its fair value in accordance with paragraph 17 of Statement 133. In the remarketing format, the transfer of the purchased call option is concurrent with the issuance of the bond. The remaining proceeds would be allocated to the carrying amount of the putable bond. The debtor recognizes no gain or loss upon the transfer of the option to the investment bank.

Accounting for the put option held by the investor: Neither the debtor nor the investor should account separately for the embedded put option written by the debtor to the investor. Under paragraph 61(d) of Statement 133, the put option is considered clearly and closely related to the economic characteristics of the bond because it simply accelerates the repayment of principal, involves no substantial premium or discount, and is not contingent.

Structure 6 (Assignment Format)

A debtor issues to an investor a bond that is both putable (by the investor) and callable (by the holder of the option). The indenture and the note itself create an assignable right to purchase the bond from the investor and remarket the repriced bond. A legal assignment of that right by the debtor to an investment bank, in exchange for a payment to the debtor, is executed as part of the underwriting process as an amendment to the note. The assignment typically occurs at the time the bond is issued. Upon receipt of the notice of assignment (which typically occurs upon issuance of the bonds), the indenture trustee must view the assignee (that is, the investment bank) as the call holder and does not require any involvement of the debtor when enforcing the assignee's right to call the bond from the investor. The debtor's only remaining obligation is to pay interest at the reset rate.

Accounting for the call option obtained by the investment bank: The debtor is not required to account separately for the call option after its transfer to the investment bank. The debtor purchased a transferable freestanding call option from the investor and transferred that option to the investment bank. Therefore, after the transfer, the debtor is no longer a party to the call option and has surrendered its right to prepay the debt. The investment bank acquired the debtor's right to call the bond and relieved the debtor of the obligation to pay the investor the par amount of the bond upon exercise of the call. Ultimately, the call option is a contract between the investment bank and the investor that permits the investment bank to purchase the bond from the investor at par. From the investor's perspective, that contract is a freestanding written call option that must be accounted for in accordance with paragraphs 17 and 18 of Statement 133. That is consistent with the guidance in Implementation Issue K2 that an option on a bond incorporated into the terms of the bond at inception that is explicitly transferable should be considered an attached, freestanding derivative instrument. The investment bank must also account for a freestanding purchased call option.

Determination of the carrying value of the investor's freestanding written call option: The carrying value of the investor's freestanding written call option to the investment bank should be its fair value in accordance with paragraph 17 of Statement 133 with the remaining proceeds allocated to the carrying amount of the puttable bond. In the assignment format, the transfer of the purchased call option by the debtor to the investment bank may not be concurrent with the issuance of the bond. The debtor recognizes no gain or loss upon the transfer of the call option. In transactions involving a delay between the issuance of the bond and the transfer of the assignable call option to the investment bank, the allocation of the initial proceeds to the carrying value of the option would be equal to the fair value of the option. The remaining proceeds would be allocated to the carrying amount of the putable bond. During any period of time between the initial issuance of the bond and the transfer of the call option to the investment bank, the call option must be measured at fair value with changes in value recognized in earnings as required by paragraph 18 of Statement 133. As a result of the requirement to measure the call option at fair value during the time period before it is assigned to the investment bank, the debtor would not recognize a gain or loss upon the assignment because the proceeds paid by the investment bank would be the option's current fair value on the date of the assignment, which would be the option's carrying amount at that point in time. Any change in the fair value of the option during the time period before it is assigned to the investment bank would be attributable to the passage of time and changes in market conditions.

Accounting for the put option held by the investor: Neither the debtor nor the investor should account separately for the embedded put option written by the debtor to the investor. Under paragraph 61(d) of Statement 133, the put option is considered clearly and closely related to the economic characteristics of the bond because it simply accelerates the repayment of principal, involves no substantial premium or discount, and is not contingent.

Possible Additional Feature 1 to Structure 5 or 6

A separate agreement may exist that allows the debtor to avoid the remarketing of the bond. That agreement permits the debtor, as of the reset date, to purchase either (a) the repriced bond from the investment bank at its then fair value or (b) the unexercised call option held by the investment bank at its then fair value, which in turn would permit the debtor to purchase the bond at par from the investor.

Accounting for the additional feature: The additional feature is a separate contract between the debtor and the investment bank. Specifically, it is a freestanding call option purchased by the debtor from the investment bank that permits the debtor to purchase either the repriced bond or the unexercised call option from the investment bank at its then fair value. Paragraphs 17 and 18 of Statement 133 require that all freestanding derivatives be measured at fair value with changes in value recognized in earnings. However, because the exercise price of the debtor's call option is the then fair value of the repriced bonds or the unexercised call option at the date of exercise, the option itself has a zero fair value. As a result, the asset or liability related to the derivative that would be recognized by the debtor as a result of applying the requirements of paragraphs 17 and 18 of Statement 133 has a value of zero.

Possible Additional Feature 2 to Structure 5 or 6

A separate agreement may exist under which the debtor writes an option to the investment bank that permits the investment bank to put its call option to the debtor at fair value if a specified contingency occurs (for example, a failed remarketing). That feature provides loss protection to the investment bank.

Accounting for the additional feature: The additional feature is a separate contract between the debtor and the investment bank. Specifically, it is a freestanding put option written by the debtor to the investment bank. Accordingly, the feature should be accounted for as a freestanding derivative measured at fair value with changes in value recognized in earnings in accordance with the requirements of paragraphs 17 and 18 of Statement 133. However, because the exercise price of the debtor's put option is the then fair value of the unexercised call option at the exercise date, the option itself has a zero fair value. As a result, the asset or liability related to the derivative that would be recognized by the debtor as a result of applying the requirements of paragraphs 17 and 18 of Statement 133 has a value of zero.

Possible Additional Feature 3 to Structure 5 or 6

Some arrangements provide recourse to the investment bank against the debtor for the fair value of the call option if the investor fails to deliver the bonds to the investment bank upon exercise of its call option. That feature provides loss protection to the investment bank.

Accounting for the additional feature: The additional feature is a separate contract between the debtor and the investment bank. Although it is structured as a recourse agreement, the substance of the feature is similar to additional feature 2 in that it is a put option written by the debtor to the investment bank. Accordingly, the feature should be accounted for as a freestanding written put option measured at fair value with changes in value recognized in earnings in accordance with the requirements of paragraphs 17 and 18 of Statement 133. However, because the exercise price of the debtor's put option is the then fair value of the unexercised call option at the date of exercise, the option itself has a zero fair value. As a result, the asset or liability related to the derivative that would be recognized by the debtor as a result of applying the requirements of paragraphs 17 and 18 of Statement 133 has a value of zero.

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.