Posted by & filed under Derivatives, Equity-Linked Transactions.

This one has bugged me for some time. There are, as we are well aware of at this point, three elements to the accounting definition of a derivative: 1) and underlying and either i) a notional, ii) a payment, or iii) both; 2) little or no initial investment and 3) net settlement. I want to focus on net settlement.

Net settlement can happen in one of three ways (yes, another list): 1) by the terms of the contract, 2) by way of a market mechanism and 3) by delivering, in physical settlement, an item that is readily convertible to cash or is itself a derivative. If the subject of the analysis is an embedded equity-linked provision, such as a stock conversion right in convertible debt, and if the company is publicly traded with enough volume to absorb the converted shares, we immediately conclude that the net settlement condition is met. The problem I see is that we do this regardless of whether the shares actually deliverable are eligible for resale. Just because the company is listed and its shares trade doe NOT mean that the shares in a particular contract can be traded.

Take, for example, a convertible instrument that is subject to a registration rights agreement in which the issuer has agreed to use commercially reasonable best efforts to registered the underlying shares. Until the registration statement becomes effective, if it ever becomes effective, the shares can not be sold UNLESS the one-year Rule 144 holding period has expired. Seems to me that until the registration statement is declared effective or the one-year holding period expires, the shares are not readily convertible to cash.

I have searched all over the web to find any discussion of this and have found nothing. It is not addressed in the many whitepapers published on this area of accounting. I have asked audit firms who as a group respond that it is a matter of firm policy to conclude that net settlement exists if the company is listed, regardless of whether the shares in question can be sold.

I’d love to hear some thoughts on this.

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