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The company must be able to settle the embedded derivative feature in unregistered shares or equity classification is prohibited. As long as there has not been a failed registration that would prohibit issuance of unregistered shares, settling in unregistered shares is within the company’s control since issuance generally requires only the approval of its board of directors. A requirement to issue registered shares, on the other hand, is beyond the control of the company since approvals are generally required by both shareholders and regulatory entities (e.g., SEC, listing exchange, etc.). Obtaining such approvals is not assured. In this circumstance, ASC 815 assumes that the counterparty will force cash settlement if registered shares can not be delivered and there are no other share settlement alternatives provided for in the agreement.

The one exception to this assumption provided in ASC 815-40-25-16 is that if the embedded derivative feature requires only that the shares be registered as of inception of the instrument and there are no requirements for subsequent timely filings or registrations, then registered share settlement is considered to be within the control of the entity. In other words, if registered shares are available to satisfy settlement of the contract at inception, and if the embedded derivative feature does not impose any timely filing or other registration requirements on the entity, then delivery of registered shares is deemed to be within the control of the company.

If the contract provides for a penalty that is payable in the event that the company fails to deliver registered shares, such penalty may help mitigate the presumption of cash settlement.

A penalty should be evaluated in two different ways.

First, is the penalty in effect a cash settlement for failure to deliver registered shares? This can be disregarded if the contract provides for other settlement alternatives such that the “uneconomic” penalty can be avoided by using a different settlement alternative.

Second, is the penalty approximately equal to the difference in fair value between registered and unregistered shares? If so, the entity may presume settlement in unregistered shares and that payment of the penalty is to compensate the counterparty for the difference in fair value between registered and unregistered shares which is in effect a discount, not a penalty.

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