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

I had a lengthy conversation with a client’s securities lawyer a while back. The topic was a detachable stock purchase warrant that was subject to a registration rights agreement (RRA). Under the terms of the warrant agreement the company is required to file a registration statement covering resale of common shares issued to settle exercise of the warrant.

One of the (many) tests for equity classification in ASC 815 starts at ASC 815-40-25-11 and basically says that if the company is required to settle the derivative (in this case, exercise of the warrant) in registered shares and there are no provisions in the agreement for any other settlement alternative, then it is assumed that share settlement is not within the control of the company and, therefore, the company has not met the criteria for classifying the warrant in equity. This results in a liability that must be measured at fair value. A very bad result if you are trying to avoid fair value accounting of the warrant.

However, the securities attorney pointed out that a registration statement covering RESALE is required only when the shares issued upon settlement are not already registered. His position is that the company has no choice but to settle the warrant exercise in unregistered shares as a matter a law. The registration statement does NOT register the shares; rather, the registration statement permits RESALE of the shares once the unregistered shares have been issued to the warrant holder. Thus, the warrant can ONLY be settled in unregistered shares and the criteria for equity classification in ASC 815 is met (assuming all of the other conditions for equity classification have been met, of course), in his opinion. Failure to file the registration statement, or failure to maintain its effectiveness, has NO EFFECT on the settlement of the warrant is always settled in unregistered shares, with or without registration.

Typically, a RRA will incorporate liquidated damages payable should the company not meets its registration obligation. This is generally the only remedy available to the warrant holder and is evaluated as a contingent liability, not net cash settlement of the warrant.

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