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If the embedded feature can only be settled under its terms by net cash settlement (i.e., one party pays the other party the net cash or loss realized from the contract), then asset or liability classification is required.  And, logically, equity classification is precluded.

If the embedded feature provides for physical settlement or net share settlement, or the choice between either cash settlement or share settlement, then the answer to this question is ‘no’.

This question should be answered ‘yes’ only if 1) net cash settlement is REQUIRED or 2) net cash settlement is REQUIRED upon occurrence of an event(s) and that event(s) is outside the control of the entity. In the case of #2, even if there are other settlement alternatives, the presence of this requirement taints the instrument since net cash settlement is not provided as an alternative. It should also be pointed out here that the probability of the event occurring is not relevant. Even if the probability is considered highly remote, the taint of equity classification is still present.

The determination of whether an event is outside the control of the entity can get tricky. Events that are clearly unrelated to the entity such as weather events, geological events and governmental approvals are obvious. The entity cannot control those outcomes. The entity may be able to influence a government decision, but that is far from having control. The tricky part arises when the event is controlled by shareholders or the board of directors, which is typically elected by the shareholders.

So where do you draw the line at defining ‘entity’? This can quickly become a legal question. State law is the ultimate determinant of what control can be exercised by shareholders, what rights reside with the board of directors, where board responsibility falls with respect to shareholders, and so on. All states are different in their statutes and in their case law.

If you have a net cash settlement requirement upon a change of control, you really need to consult with an attorney to understand which party really controls a change of control. Shareholders often have the right to approve a sale without management and/or board consent. Shareholders are not necessarily the ‘entity’. Particular attention should be paid the the control exercised by the counterparty to the embedded feature through percentage ownership of shares and board positions allowed to be appointed.

There is one possible exception to this result. The question here is whether the entity could be forced to net cash settle the contract, regardless of how remote. This issue of shareholder control is made moot if, under the terms of the contract or by means of the entity’s governing documents, or both, the shareholders would also receive net cash settlement of their stock. In other words, if the contract requires net cash settlement upon occurrence of the event and shareholders would also receive cash upon occurrence of the event, then equity classification is not precluded. Clear as mud? Sorry, this one is hard to explain. The basic premise is that if the counterparty to the contract and the holders of the shares underlying the contract are effectively treated the same upon occurrence of the event, then this net cash settlement requirement does not by itself taint the instrument’s equity classification.

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