FASB Embedded Derivatives Investor Permitted, but Not Forced, to Settle Without Recovering Substantially All of the Initial Net Investment

FASB: Embedded Derivatives: Investor Permitted, but Not Forced, to Settle Without Recovering Substantially All of the Initial Net Investment

Derivatives Implementation Group

Statement 133 Implementation Issue No. B5

Title: Embedded Derivatives: Investor Permitted, but Not Forced, to Settle Without Recovering Substantially All of the Initial Net Investment
Paragraph references: 13(a), 61(a)
Date cleared by Board: July 28, 1999
Date latest revision posted to website: June 16, 2006
Affected by: FASB Statements No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities and No. 155, Accounting for Certain Hybrid Financial Instruments
(Revised June 16, 2006)

QUESTION

If 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, does the contract satisfy the condition in paragraph 13(a), thereby causing the embedded derivative to be considered not clearly and closely related to the host contract?

BACKGROUND

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:

  1. 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.

  2. 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. [Footnote omitted.]

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 being considered not 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.)

The following footnote was added at the end of subparagraph (a) by Statement 149: “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(a) as follows:

   ...the embedded derivative contains a provision that (1) permits any possibility whatsoever that the investor's (or creditor's) undiscounted net cash inflows over the life of the instrument would not recover substantially all of its initial recorded investment in the hybrid instrument under its contractual terms....

RESPONSE

No. The footnote to paragraph 13(a) added by Statement 149 clarifies that 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 recorded investment. Thus, if the investor in a 10-year note has the contingent option at the end of year 2 to put it back to the issuer at its then fair value (based on its original 10-year term), the condition in paragraph 13(a) would not be met even though the note’s fair value could have declined so much that, by exercising the option, the investor ends up not recovering substantially all of its initial recorded investment.

The condition in paragraph 13(a) was intended to apply only to those situations in which the investor (creditor) could be forced by the terms of a hybrid instrument to accept settlement at an amount that causes the investor not to recover substantially all of its initial recorded investment. For example, assume the investor purchased from a single-A-rated issuer for $10 million a structured note with a $10 million principal, a 9.5 percent interest coupon, and a term of 10 years at a time when the current market rate for 10-year single-A-rated debt is 7 percent. Assume further that the terms of the note require that, at the beginning of the third year of its term, the principal on the note is reduced to $7.1 million and the coupon interest rate is reduced to zero for the remaining term to maturity if interest rates for single-A-rated debt have increased to at least 8 percent by that date. That structured note would meet the condition in paragraph 13(a) for both the issuer and the investor because the investor could be forced to accept settlement that causes the investor not to recover substantially all of its initial recorded investment. That is, if increases in the interest rate for single-A-rated debt triggers the modification of terms, the investor would receive only $9 million, comprising $1.9 million in interest payments for the first 2 years and $7.1 million in principal repayment, thus not recovering substantially all of its $10 million initial net investment.

This guidance does not address the application of the condition in paragraph 13(b).

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.