Box D(A) and Boxes D1, D2 and D3 — Evaluating embedded conversion options

The conversion feature in convertible debt should be evaluated for potential bifurcation under the criteria in ASC 815-15-25-1, which includes the considerations described in section 2.2.3. If the option meets the definition of a derivative, the analysis should also consider whether the conversion feature, if freestanding, would receive an exception from derivative accounting.

While issued less frequently, debt may also be exchanged into equity of another entity (referred to as exchangeable debt). The evaluation of an exchange feature for potential bifurcation should follow the guidance discussed in section 2.2.3 and this section. However, because the debt is not convertible into equity of the issuer, the exchange feature would generally be bifurcated. This section primarily focuses on the evaluation of conversion features. Refer to section 5.1 in Chapter 5 for further discussion of exchangeable debt.

2.2.4.1 Determining whether a conversion option is clearly and closely related to the debt host instrument

To be considered clearly and closely related to the debt host in convertible debt, the embedded feature’s underlying should relate to economic characteristics and risks that affect debt, such as interest rates, credit considerations or inflation.

Most commonly, the economic characteristics and risks of a conversion option embedded in a debt instrument are considered related to those of an equity instrument, because its value is influenced principally by the underlying equity security’s fair value (and the volatility in that fair value). Therefore, the economic characteristics and risks of an embedded conversion option in a debt instrument should not be considered clearly and closely related to the economic characteristics and risks of a debt host

contract, as stated in ASC 815-15-25-51.

2.2.4.2 Determining whether a conversion option meets the definition of a derivative

The criteria for the definition of a derivative should generally be applied to conversion features as follows:

• Underlying and notional amount — The underlying is the price (i.e., fair value) of the equity

instrument to be issued when the embedded conversion option is exercised, and the notional amount is the number of shares into which the debt instrument is convertible.

• No initial net investment — The implicit premium for the embedded conversion option at inception is considered the initial investment (not the initial investment in the convertible debt instrument), which should generally be less than the fair value of the underlying equity security.

• Net settlement — An embedded conversion option may require physical settlement (i.e., no possibility that the conversion option will settle in cash, such as ―classic convertible debt‖ described in section 2.1.2.1) such that, upon conversion, the issuer is required to deliver the underlying equity shares in settlement of the convertible debt. An embedded conversion option that requires physical settlement would meet the net settlement requirement only if the shares to be delivered upon conversion are

―readily convertible to cash‖ as described in ASC 815.

For example, a share of a publicly traded company is generally considered readily convertible to cash unless the market for the shares is not active and the number of shares to be exchanged (given the smallest increment available for conversion) is large relative to the daily trading volume of the underlying shares. However, if the underlying share is of a private company, the conversion option would generally not meet the net settlement criteria in a physical settlement unless there is sufficient active trading to result in a conclusion that a common share is readily convertible to cash.

In some cases, a convertible debt instrument may contractually require net settlement of the embedded conversion option. This net settlement of the conversion feature could be in shares or cash. For example, Instrument C provides that the conversion spread (i.e., the intrinsic value of the conversion option) is to be settled in net cash or net shares upon conversion. Instruments A, B and X also permit net settlement. In these cases, the embedded conversion option would meet the net settlement characteristic of a derivative even if the underlying shares were not readily convertible to cash.

2.2.4.3 Exceptions from derivative accounting

Notwithstanding that an embedded feature, if freestanding, may meet all the characteristics of a derivative, an embedded feature (including conversion options) should not be bifurcated if the feature is eligible for a scope exception from ASC 815. The most common exception for a conversion feature is provided by ASC 815-10-15-74(a), which states that contracts issued or held by that reporting entity that are both (1) indexed to its own stock and (2) classified in stockholders’ equity in its statement of financial position are not considered derivative instruments in the scope of ASC 815. That analysis draws on the indexation and classification guidance in ASC 815-40 related to contracts in an entity’s own stock.

If the embedded conversion option does not qualify for the scope exception in ASC 815-10-15-74(a), the issuer should determine whether the feature is eligible for other scope exceptions in ASC 815. While it is unlikely the instrument would qualify for any other exceptions, in the event convertible debt instruments are issued to nonemployees as compensation for goods or services, an exception may exist pursuant to ASC 815-10-15-74(b), which excludes contracts issued in a company’s own securities for stock-based compensation addressed in ASC 718, Compensation — Stock Compensation, or ASC 505-50, Equity Based Payments to Non-Employees. This exception applies only during the period prior to completion of performance, as clarified in ASC 815-10-55-49 through 55-53. Once performance has occurred, equity instruments granted to a nonemployee for goods or services become subject to the requirements of ASC 815.

2.2.4.3.1 Meaning of “indexed to issuer’s own stock”

To determine whether a conversion feature is indexed to the issuer’s own stock, it should be analyzed pursuant to ASC 815-40-15-5 through 15-8, including the related implementation guidance. The examples in ASC 815-40-55-26 through 55-48 should, in particular, be considered. There are two steps for evaluating a feature. The first step evaluates any contingent exercise provisions. The second step requires an analysis of features that could change the instrument’s settlement amount.

In the first step, an exercise contingency (as defined in the indexation guidance) does not preclude an instrument (or embedded feature) from being considered indexed to an entity’s own stock provided that it is not based on either of the following:

• An observable market, other than the market for the issuer’s stock (if applicable)

• An observable index, other than an index calculated or measured solely by reference to the issuer’s own operations (e.g., sales revenue of the issuer, earnings before interest, taxes, depreciation and amortization of the issuer, net income of the issuer or total equity of the issuer)

In the second step, an instrument (or embedded feature) is considered indexed to an entity’s own stock if its settlement amount equals the difference between (1) the fair value of a fixed number of the entity’s equity shares and (2) a fixed monetary amount or a fixed amount of a debt instrument issued by the entity. While the second step appears to be a strict ―fixed-for-fixed‖ concept, an exception is provided so that if the feature’s strike price or the number of shares used to calculate the settlement amount is not fixed, the embedded feature could still be considered indexed to an entity’s own stock if the only variables that could affect the settlement amount would be inputs to a fair value valuation model for a fixed-for-fixed forward or option on equity shares.

Any feature that adjusts the embedded conversion option should be carefully analyzed. Those features could include antidilution provisions (e.g., adjustments for stock splits or dividends) as well as provisions that adjust the conversion price or rate to protect the investor from a loss of value due to events that were not expected to occur or events in the control of the issuer that could be detrimental to the holder (e.g., as merger, tender offer, nationalization, insolvency or delisting). Refer to section B3 in Appendix B for a comprehensive discussion of the indexation guidance.

If based on the indexation guidance the conversion option is not considered indexed to the issuer’s own stock, it would not qualify for the scope exception in ASC 815-10-15-74(a) and should be bifurcated.

2.2.4.3.2 Meaning of “classified in stockholders’ equity”

To determine whether an embedded conversion feature would be classified in stockholders’ equity if considered freestanding, ASC 815-40-25-1 through 25-43 should be considered, including the related implementation guidance (primarily codified in ASC 815-40-55-1 through 55-18). This guidance is referred to throughout this publication as ―the equity classification guidance.‖

The equity classification guidance generally indicates that an embedded conversion option on a

company’s own stock, if freestanding, would be considered to be classified in equity under either of the following types of settlement:

• Required physical settlement or net share settlement

• Issuer has a choice of net cash settlement or settlement in its own shares (physical settlement or net share settlement), regardless of the intent of the issuer

However, an embedded conversion option would not be considered classified in equity if either of the following provisions is present:

• Required net cash settlement (including a requirement to net cash settle if an event occurs that is outside the control of the issuer)

• Holder has choice of net cash settlement or settlement in shares (physical settlement or net share settlement)

ASC 815-40-25-7 through 25-38 include additional conditions that should be met for equity classification, including whether the issuer will have the ability, in all cases, to settle in shares. Those additional

conditions need not be met for conventional convertible debt (refer to section 2.2.4.10 for guidance on conventional convertible debt). If any condition (as summarized below) is not met for a debt instrument that is not conventional convertible debt, the embedded conversion option would not be considered classified in stockholders’ equity and should be bifurcated:

• Settlement is permitted in unregistered shares

• Entity has sufficient authorized and unissued shares

• Contract contains an explicit share limit

• No required cash payments if entity fails to timely file

• No cash-settled top-off or make-whole provisions

• No counterparty rights rank higher than shareholder rights

• No collateral requirements

Those criteria should be applied on a theoretically possible standard. Issuers should also evaluate the implementation guidance in ASC 815-40-55-2 through 55-6 that discusses circumstances where equity classification is appropriate despite the possibility of a cash settlement if holders of the same class of underlying shares also would receive cash in exchange for their shares.

Refer to section B4 in Appendix B for a comprehensive discussion of the equity classification guidance.

2.2.4.4 Contingently convertible debt

In a traditional convertible debt instrument, the holder may exercise its option to convert the notes into a number of underlying securities at any time. In contrast, contingently convertible (―CoCo‖) debt generally entitles the holder to convert only after certain contingencies have been satisfied. Contingently convertible debt often also allows conversion at the end of its life.

When exercise contingencies exist and the conversion feature meets the definition of a derivative, the issuer should evaluate each of those contingencies to determine whether they would preclude the conversion option from being considered indexed to its own stock. This evaluation should be made in the first step under the indexation guidance, which requires that the contingent exercise provisions not be based on an observable market (other than the market for the issuer’s stock) or an observable index (other than those calculated or measured solely by reference to the issuer’s own operations). Refer to section 2.2.4.3 and Appendix B for further discussion of these requirements.

The most common exercise contingencies in a CoCo are:

• Common stock trading price — A holder may convert the note if the last reported price of the stock for a specified period is more than some percentage of the conversion price. For example, a convertible debt instrument with a conversion price of $12 and a contingent conversion trigger of 130% may permit conversion only if the stock trades above $15.60 ($12 x 130%) for 20 out of the 30 days before the end of the quarter.

• Satisfaction of trading price condition or ―parity trigger‖ — A holder may convert during a specified period (often five business days) after any period in which the trading price per $1,000 principal amount of the debt for each day of that period was less than a percentage (e.g., 95%) of the parity value. For example, assume a convertible instrument with a conversion price of $12 and a

conversion ratio of 83.33 shares is convertible only when the debt is trading at less than 95% of its parity (as converted) value. In this example, if the trading price of the underlying stock is $15, the debt would be convertible only when it was trading at less than $1,187.50 (or 95% of $1,250, which is the parity value (83.33 shares x $15)).

• Notice of redemption — A holder may convert the note if the notes have been called for redemption by the issuer.

• Specified corporate transactions — A holder may convert the note upon the occurrence of specified corporate transactions. These corporate events may include ―fundamental change‖ triggers similar to those discussed in section 2.2.5.

Many common exercise contingencies pass the first step of the indexation guidance because they are contingent upon the trading price of the issuer’s equity shares or are not contingent on any observable market or index unrelated to the entity’s own stock or operations.

Parity trigger exercise contingencies are specifically addressed in ASC 815-40-55-45 through 55-46, which states in part:

The market price trigger and parity provision exercise contingencies are based on observable markets; however, those contingencies relate solely to the market prices of the entity’s own stock and its own convertible debt...therefore, Step 1 does not preclude the warrants from being considered indexed to the entity’s own stock.

Conversion exercise contingencies based on an observable market other than the market for the issuer’s stock or an observable index other than those referenced to the issuer’s own operations preclude the embedded conversion option from being considered indexed to the entity’s own stock. For example, if the embedded conversion option permits the holder to convert only if LIBOR increases or decreases by 200 basis points, the conversion feature would fail Step 1 of the evaluation under the indexation guidance, because LIBOR is an observable index that is not calculated or measured based on the market for the issuer’s own stock or measured solely by reference to the issuer’s own operations.

Refer to section 2.2.3.1 for how individual contingencies should be considered in evaluating embedded conversion features for bifurcation and section B3 in Appendix B for more information on the evaluation of exercise contingencies under the indexation guidance.

2.2.4.5 “Time value make-whole” features

Debt instruments may include some form of a make-whole provision, which provides that in the event of conversion by the investor under certain circumstances (e.g., change of control), the issuer is required to deliver to the holder additional consideration beyond the settlement of the conversion obligation. The additional consideration may be provided in cash or shares, usually at the issuer’s option. There are two frequent forms of the make-whole feature: an ―interest make-whole‖ and a ―time value make-whole.‖

Refer to section 2.2.6.2 for a discussion on interest make-whole features.

A time value make-whole feature is designed to compensate the investor for lost benefits of the investment (including the time value of the remaining term of the conversion option) upon conversion because of the occurrence of certain fundamental change events (refer to section 2.2.5) that result in early settlement of the instrument.

The number of additional shares to be provided to the investor is generally determined based on (1) the date on which the fundamental change occurs or becomes effective and (2) the price per share of the underlying equity security at that time, as set forth in the indenture.

In some cases, a make-whole provision may be triggered on any conversion, rather than certain contingent conversions. In those situations, the feature should be carefully evaluated to determine if it should be evaluated as part of the basic conversion option. Refer to the discussion of determining the unit of analysis in section 2.2.3.1 for further guidance.

Because time value make-whole provisions are not clearly and closely related to the debt host and would meet the definition of a derivative if considered freestanding, they should be evaluated under the indexation guidance to determine whether they would be afforded the scope exception pursuant to ASC 815-10-15-74(a). This evaluation is generally performed in conjunction with the analysis of the embedded conversion feature.

ASC 815-40-55-46 indicates that if the fair value of the shares into which the debt is convertible plus the make-whole shares would be expected to approximate the fair value of the convertible debt instrument at the settlement date (assuming no change in the pricing inputs — other than stock price and time — since the instrument’s inception), the time value make-whole feature would not violate the fixed-for-fixed concept in the indexation guidance because the number of make-whole shares is determined based on a table with axes of stock price and time, which would both be inputs in a fair value measurement of a fixed-for-fixed option on equity shares.

The following is an example of a typical time value make-whole table (except for the ―Amount‖ column, which has been added for reference) that could be included in an indenture. Based upon the stock price and the effective date, the number of additional shares per note can be determined.

Stock price Effective date

1 December 20X0 1 December 20X1 1 December 20X2 1 December 20X3 Shares Amount Shares Amount Shares Amount Shares Amount $ 15.00 5.00 $ 75.00 5.00 $ 75.00 5.00 $ 75.00 5.00 $ 75.00 $ 20.00 3.80 76.00 3.58 71.60 3.15 63.00 2.00 40.00 $ 25.00 2.50 62.50 2.15 53.75 1.60 40.00 1.05 26.25 $ 30.00 1.75 52.50 1.40 42.00 0.85 25.50 0.80 24.00 $ 35.00 1.25 43.75 0.95 33.25 0.35 12.25 0.25 8.75 $ 40.00 1.00 40.00 0.65 26.00 0.24 9.60 — — $ 45.00 0.75 33.75 0.50 22.50 0.15 6.75 — — $ 50.00 0.50 25.00 0.35 17.50 0.10 5.00 — — In evaluating whether the time value make-whole satisfies the criteria discussed in step 2 of the

indexation guidance, the terms of the indenture should provide that the stock price used to determine the make-whole payment should be the fair value of a share used as an input to an appropriate valuation model (e.g., Black-Scholes, lattice or other appropriate model that is based on the instrument’s terms and valuation theory) for a fixed-for-fixed option or forward. That is, if the stock price were determined based on a formula or other method that is designed to approximate fair value, but is not an actual fair value measurement, that variable affecting the settlement amount is not an input to a fair value model and thus the feature cannot be considered indexed to the issuer’s own shares.

To satisfy the indexation guidance, the make-whole amounts should represent compensation for the expected loss in the time value component at settlement (assuming no change in pricing inputs, other than stock price and time, since the instrument’s inception). Accordingly, the make-whole amount should fluctuate with the ―Stock Price‖ and the ―Effective Date‖ axes in a manner that is reasonably expected to compensate the investor for the value lost upon an early conversion.

For example, the time value of a conversion option typically decreases as the term to maturity shortens and decreases as the share price (fair value of the share) moves further away (higher or lower) from the contractual conversion price. In cases where the make-whole amount results in a fixed or predominantly fixed value for a number of different share prices on the same date, the make-whole provision may not be considered indexed to the entity’s own stock. Rather, it may be more akin to an interest make-whole feature. A feature expressed in such a table would likely require bifurcation (as discussed further in section 2.2.6.2).

If the time value make-whole feature and the base conversion option are considered indexed to the entity’s own equity, the exception in ASC 815-10-15-74(a) related to the feature being classified in equity if freestanding should also be considered, as discussed in section 2.2.4.3.2.

While ASC 815 does not explicitly address the unit of an embedded feature that should be evaluated,

While ASC 815 does not explicitly address the unit of an embedded feature that should be evaluated,