In May, 2003, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 150 - Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments which have characteristics of both liabilities and equity. It requires certain instruments to be classified as liabilities where previously such instruments were classified either as equity, or between the liabilities and equity sections (sometimes referred to as the "mezzanine" section) of the issuer's financial statements. SFAS 150 requires issuers to disclose the nature and terms of the financial instruments and the rights and obligations embodied in them.
SFAS 150 is a response to the accounting community's concerns surrounding the classification of financial instruments which have characteristics of both equity and debt. It is a part of a larger project by which the FASB will address accounting for other types of hybrid financial instruments such as convertible bonds and puttable stock.
Financial Instrument Affected
SFAS 150 requires an issuer to classify the following instruments as liabilities (or assets in some circumstances):
Mandatorily redeemable stock, i.e., stock which by its terms unconditionally requires redemption by the issuer for cash at a specified date or upon an event that is certain to occur. Stock redeemable only at liquidation or dissolution of an issuer is not considered mandatorily redeemable;
Forward purchase contracts, written put options, and other financial instruments not in the form of shares that obligate (or may obligate) the issuer to settle its obligations for cash or other assets (but not issuer securities);
Certain financial instruments that include an obligation that the issuer must (or may) settle by issuing an undetermined number of equity shares and has a monetary value at inception that (i) is fixed, (ii) is tied to a market index or other benchmark (but not the fair value of the issuer's equity shares), or (ii) varies inversely with the fair value of the equity shares (for example, a written put option);
Certain financial instruments which are conditionally redeemable may be classified as equity. However, when the condition is resolved, (i.e. when the redemption becomes certain,) it must be reclassified as a liability. For example, minority shares in a corporation which become redeemable upon the sale of majority shares to a third-party would be required to be classified as a liability only upon the actual sale of the majority shares. Prior to the sale, the shares must be classified as equity.
Application Of SFAS 150
SFAS 150 applies to: issuers' classification and measurement of financial instruments, including those that comprise more than one option or forward contract. However, the Statement does not apply to features that are embedded in a financial instrument that is not entirely a derivative. For example, the Statement does not change the accounting treatment of conversion features, conditional redemption features or other features embedded in non-derivative financial instruments. It does not affect the classification of conditionally redeemable stock and convertible bonds. Lastly, the Statement does not address certain financial instruments indexed partly to the issuer's equity shares, and partly, but not predominantly, to something else.
SFAS also does not apply to: the timing of recognition of financial instruments that are issued in connection with a business transaction; or employee compensation arrangements such as stock options, warrants and shares owned by an issuer's ESOP.
Most financial instruments subject to the Statement are measured at fair value, unless required to be measured differently under GAAP. Forward contracts to repurchase equity shares of an issuer that require physical settlement in exchange for cash are initially measured at the fair value of the shares at inception, adjusted for any consideration or unstated rights or privileges, which would be the same amount as if the settlement occurred immediately. Such contracts and mandatorily redeemable financial instruments are subsequently measured (i) at the present value to be paid at settlement if the amount of cash at the settlement date is fixed, or (ii) at the amount that would be paid under the conditions specified in the contract if settlement occurred at the reporting date, if such aspects are not fixed.
Effect Of SFAS 150
The most dramatic impact of SFAS 150 will be felt by privately held companies. Many private companies have buy-sell agreements in place which require the issuer to repurchase shares of equity securities held by shareholders. Buy-sell agreements are used by many private companies to establish the level of each shareholder's interest and to ensure continuation of the business after the death, disability or retirement of a shareholder. The repurchase obligations in buy-sell agreements are triggered upon the retirement, death or disability of a shareholder.
Under SFAS 150, shares subject to such agreements would be considered to be mandatorily redeemable because it is certain that at some point the company's repurchase obligation will be triggered. Accordingly, the securities must be classified as debt by the issuer. Such securities must be classified as such regardless of whether the issuer has purchased life insurance to fund the repurchase obligation. Cross-purchase agreements pursuant to which shareholders (and not the issuer) are required to purchase shares of a deceased or disabled shareholder would not result in the shares being classified as debt.
In cases where all of an issuer's equity securities are subject to repurchase, there may be little or no equity on the issuer's financial statements. Some issuer's financial statements could even show negative equity if the issuer is required to repurchase shares at fair value and the fair value of the shares exceeds book value.
Another problem exists because of the reduction of the net worth many companies will experience as a result of the application of SFAS 150. Many bank loan agreements require companies to maintain a specified net worth or face acceleration of the loan. By increasing liabilities, application of SFAS may result in the breach of these covenants even though the actual financial position of the borrower has not been affected.
Other public companies may also be affected by SFAS 150. Many bank holding companies utilize mandatorily redeemable preferred stock and other instruments (such as trust preferred securities). Previously, these companies had classified these securities at the "mezzanine" level. These companies will now be required to reclassify these securities as debt and increase their liabilities by the amount of the redemption obligation. This will in turn negatively affect a financial institution's capital ratios. It is unclear how bank regulatory authorities will deal with these new rules, although it is unlikely that regulators will reduce regulatory capital requirements.
SFAS went into effect for financial instruments entered into or modified after May 31, 2003. However, some aspects of the Statement have been delayed until December 15, 2004, and some have been delayed indefinitely.
For entities that are not registered with the Securities and Exchange Commission, the application of SFAS 150 has been delayed (i) until December 15, 2004 for financial instruments mandatorily redeemable for either a fixed amount or for an amount determined by reference to an external index, and (ii) indefinitely, with respect to all other mandatorily redeemable financial instruments.
During that time, the FASB has stated that they intend to reconsider certain implementation issues. We hope these issues will include those problematic issues described above.
Michael T. Rave is Counsel in the Transactions Practice Group, and is located in the Morristown office of Pitney Hardin.