FASB Embedded Derivatives Application of Paragraph 13(b) to Call Options That Are Exercisable Only by the Debtor
Derivatives Implementation Group
Statement 133 Implementation Issue No. B39
|Title:||Embedded Derivatives: Application of Paragraph 13(b) to Call Options That Are Exercisable Only by the Debtor|
|Paragraph references:||13, 61(a), 61(d)|
|Date cleared by Board:||June 29, 2005|
|Date latest revision posted to website:||January 17, 2007|
|Affected by:||FASB Statement No. 155, Accounting for Certain Hybrid Financial Instruments
Statement 133 Implementation Issue No. B40, “Application of Paragraph 13(b) to Securitized Interests in Prepayable Financial Assets”
(Revised December 20, 2006)
Are there circumstances in which an embedded call option (including a prepayment option) that can accelerate the settlement of a hybrid instrument containing a debt host contract would not be subject to the conditions in paragraph 13(b) of Statement 133?
Paragraph 13 of Statement 133 states:
For purposes of applying the provisions of paragraph 12, an embedded derivative instrument in which the underlying is an interest rate or interest rate index that alters net interest payments that otherwise would be paid or received on an interest-bearing host contract is considered to be clearly and closely related to the host contract unless either of the following conditions exist:
- The hybrid instrument can contractually be settled in such a way that the investor (holder) would not recover substantially all of its initial recorded investment.*
- The embedded derivative meets both of the following conditions:
(1) There is a possible future interest rate scenario (even though it may be remote) under which the embedded derivative would at least double the investor’s initial rate of return on the host contract.
(2) For each of the possible interest rate scenarios under which the investor’s initial rate of return on the host contract would be doubled (as discussed under paragraph 13(b)(1)), the embedded derivative would at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return (under each of those future interest rate scenarios) for a contract that has the same terms as the host contract and that involves a debtor with a credit quality similar to the issuer’s credit quality at inception.
Even though the above conditions focus on the investor’s rate of return and the investor’s recovery of its investment, the existence of either of those conditions would result in the embedded derivative instrument not being considered clearly and closely related to the host contract by both parties to the hybrid instrument. (Note that Statement 155 was issued in February 2006 and allows for a fair value election for hybrid financial instruments that otherwise would require bifurcation. Hybrid financial instruments that are elected to be accounted for in their entirety at fair value cannot be used as a hedging instrument in a Statement 133 hedging relationship.) Because the existence of those conditions is assessed at the date that the hybrid instrument is acquired (or incurred) by the reporting entity, the acquirer of a hybrid instrument in the secondary market could potentially reach a different conclusion than could the issuer of the hybrid instrument due to applying the conditions in this paragraph at different points in time. [Footnote 6 omitted.]
* The condition in paragraph 13(a) does not apply to a situation in which the terms of a hybrid instrument permit, but do not require, the investor to settle the hybrid instrument in a manner that causes it not to recover substantially all of its initial recorded investment, provided that the issuer does not have the contractual right to demand a settlement that causes the investor not to recover substantially all of its initial net investment.
Paragraph 61(a) elaborates on the condition in paragraph 13(b) as follows:
An embedded derivative in which the underlying is an interest rate or interest rate index and a host contract that is considered a debt instrument are considered to be clearly and closely related unless, as discussed in paragraph 13, the embedded derivative contains a provision that…could under any possibility whatsoever at least double the investor’s initial rate of return on the host contract and at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return for a contract that has the same terms as the host contract and that involves a debtor with a similar credit quality.
Paragraph 61(d) of Statement 133 elaborates on the applicability of paragraph 13 to embedded calls and puts in debt instruments as follows:
Call options (or put options) that can accelerate the repayment of principal on a debt instrument are considered to be clearly and closely related to a debt instrument that requires principal repayments unless both (1) the debt involves a substantial premium or discount (which is common with zero-coupon bonds) and (2) the put or call option is only contingently exercisable, provided the call options (or put options) are also considered to be clearly and closely related to the debt host contract under paragraph 13.
The conditions in paragraph 13(b) do not apply to an embedded call option in a hybrid instrument containing a debt host contract if the right to accelerate the settlement of the debt can be exercised only by the debtor (issuer/borrower). This guidance does not affect the application of the condition in paragraph 13(a) or the application of the provisions of paragraph 61(d) as interpreted by Statement 133 Implementation Issue No. B16, "Calls and Puts in Debt Instruments." In addition, this guidance does not apply to other embedded derivative features that may be present in the same hybrid instrument.
The conditions in paragraph 13(b) were intended to apply only to situations that meet the two conditions specified in paragraphs 13(b)(1) and 13(b)(2) and for which the investor has the unilateral ability to obtain the right to receive the high rate of return specified in those paragraphs. When the embedded derivative is an option rather than a forward contract, it is important to analyze whether the investor is the holder of that option. For an embedded call option, the issuer or borrower (and not the investor) is the holder, and thus only the issuer (borrower) can exercise the option. Consequently, the investor does not have the unilateral ability to obtain the right to receive the high rate of return, which is contingent upon the issuer’s exercise of the embedded call option.
Application of this guidance to specific debt instruments is provided below.
|1. An unsecured commercial loan that includes a prepayment option that permits the loan to be prepaid by the borrower at a fixed amount at any time at a specified premium over the initial principal amount of the loan.||No.||The commercial loan is prepayable only at the option of the borrower.|
|2. A fixed-rate debt instrument issued at a discount that is callable at par value at any time during its 10-year term.||No.||The fixed-rate debt instrument is callable at par value only by the issuer.|
|3. A fixed-rate 10-year bond that contains a call option that permits the issuer to prepay the bond at any time after issuance by paying the investor an amount equal to all the future contractual cash flows discounted at the then-current Treasury rate plus 45 basis points. The spread over the Treasury rate for the borrower at the issuance of the bond was 300 basis points.||No.||The fixed-rate 10-year bond is callable only at the option of the issuer.|
|4. A 5-year debt instrument issued at par that has a quarterly coupon equal to 15 percent minus 3 times 3-month LIBOR and that includes a call provision that allows the issuer to call the debt at any time at a specified premium over par.||No.||The instrument is callable only by the issuer, so the embedded call option feature will not be subject to the conditions in paragraph 13(b). However, the conditions in paragraph 13(b) are still applicable to the levered index feature of the debt.|
|5. A fixed rate debt instrument is issued at par and is callable at any time during its 10-year term. If the debt is called, the investor receives the greater of the par value of the debt or the market value of 100,000 shares of XYZ common stock (an unrelated company).||No.||The instrument is callable only by the issuer, so the embedded call option feature will not be subject to the conditions in paragraph 13(b). However, the embedded call option is not considered clearly and closely related to the debt host contract because the payoff is based on an equity price.|
|6. A mortgage-backed security (MBS) is issued, whereby cash flows associated with principal payments (including full or partial prepayments and related penalties) received on the related mortgage loans are passed through to the MBS investors.||Not applicable (see comments).||Although the related mortgage loans are prepayable, and thus each contain a separate embedded call option, the MBS itself does not contain an embedded call option. While the MBS investor is subject to prepayment risk, the MBS issuer has the obligation (not the option) to pass through cash flows from the related mortgage loans to the MBS investors. Therefore, MBS are not within the scope of this Issue. Issue B40 addresses the application of paragraph 13(b) to securitized interests in prepayable financial assets.|
EFFECTIVE DATE AND TRANSITION
The effective date of the implementation guidance in this Issue is the first day of the first fiscal quarter beginning after December 15, 2005. Earlier application as of the beginning of a fiscal quarter is permitted provided that early application as of the same date is elected for Statement 133 Implementation Issue No. B38, "Evaluation of Net Settlement with Respect to the Settlement of a Debt Instrument through Exercise of an Embedded Put Option or Call Option." If an entity had bifurcated an embedded derivative but is no longer required to do so under the guidance in this Issue, the entity should account for the effects of initially complying with the implementation guidance prospectively for all existing financial instruments. The carrying amount of the related hybrid instrument at the guidance's effective date should be the sum of the carrying amount of the host contract and the fair value of the previously bifurcated embedded derivative.
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.