FASB Fair Value Hedges Firm Commitments-Statutory Remedies for Default Constituting a Disincentive for Nonperformance

FASB: Fair Value Hedges: Firm Commitments-Statutory Remedies for Default Constituting a Disincentive for Nonperformance

Derivatives Implementation Group

Statement 133 Implementation Issue No. F3

Title: Fair Value Hedges: Firm Commitments-
Statutory Remedies for Default Constituting a Disincentive for Nonperformance
Paragraph references: 440-442
Date cleared by Board: November 23, 1999

QUESTION

Would the requirement that a firm commitment "includes a disincentive for nonperformance that is sufficiently large to make performance probable" be met if the agreement includes no explicit monetary penalty for nonperformance, but the legal jurisdiction that governs the agreement provides remedies for default equivalent to the damages suffered in the event of nonperformance?

BACKGROUND

Statement 133, paragraph 540, defines a firm commitment as follows:

An agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics:
  1. The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity's functional currency or of a foreign currency. It may also be expressed as a specified interest rate or specified effective yield.

  2. The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable.

At issue is whether the disincentive for nonperformance that is sufficiently large to make performance probable can exist outside the agreement.

For example, Company A enters into an agreement to purchase 4,000 barrels of a common solvent from a chemical company at $200 per barrel on June 1, 2000. The provisions of the agreement do not include a specific disincentive for nonperformance that is sufficiently large to make performance probable. However, the laws of the legal jurisdiction to which the agreement is subject provide a disincentive for nonperformance if Company A does not take delivery of the barrels pursuant to the agreement. The solvent is not readily convertible to cash.

RESPONSE

Yes. In the legal jurisdiction that governs the agreement, the existence of statutory rights to pursue remedies for default equivalent to the damages suffered by the nondefaulting party, in and of itself, represents a sufficiently large disincentive for nonperformance to make performance probable for purposes of applying the definition of a firm commitment. The binding provisions of an agreement are regarded to include those legal rights and obligations codified in the laws to which such an agreement is subject.

Therefore, because the governing legal jurisdiction provides statutory rights to pursue remedies for default equivalent to the damages suffered, the example agreement described above includes a disincentive for nonperformance that is sufficiently large to make performance probable for purposes of applying the definition of a firm commitment.

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.