The long awaited salvation from the havoc of the Securities and Exchange Commission's (SEC) treatment of liquidated damages and other cash settlement provisions may at last be on the horizon.
For almost two years now, the SEC has held up registration statements, and in many cases has required issuers to restate financial statements, on account of perceived excessive liquidated damages and other cash settlement provisions in capital raising transactions. In implementing EITF Issue No. 00-19, 'Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock,' the SEC Staff has haphazardly imposed constraints on financing transactions containing these types of provisions.Failure to comply with these constraints has had dreadful effects, including delayed effectiveness of registration statements and restatements of financial statements.The capital markets community has been struggling to navigate through the fleeting whims of the Staff, which itself has conceded its own quandary on how exactly to implement this EITF in the absence of guidance from The Financial Accounting Standards Board (FASB).
The FASB recently issued for comment a proposed FASB Staff Position (FSP EITF 00-19-b) addressing how companies should account for liquidated damages provisions in their registration rights agreements. The FSP provides that liquidated damages penalties in a registration rights agreement that are triggered when an issuer fails to file and have declared effective the related resale registration statement, or fails to maintain its effectiveness as required by the agreement, generally should be accounted for under FASB Statement No. 5, Accounting for Contingencies, and should not cause the related warrant, convertible security or other financial instrument to be accounted for as a derivative liability under EITF 00-19.
What this means for issuers and investors in PIPEs transactions: This FSP is significant because, despite the uncertainty regarding the proper accounting for such liquidated damages provisions, the Staff of the SEC has been requiring companies that issue a warrant or convertible instrument in conjunction with an agreement to register the financial instrument or the equity shares underlying it to account for the instrument under EITF 00-19 as a liability if the registration rights agreement requires the issuer to pay liquidated damages in cash to the holder of the instrument in the event of a registration default.The only way to avoid the recognition of a liability as a result of a cash payment liquidated damages provision in this context has been to cap the aggregate amount of liquidated damages payable under the registration rights agreement in the event of a registration default. Initially, the SEC Staff accepted a 10% cap, and then began and currently continues to allow caps in the 18% to 24% range.
Although the proposed FSP is subject to final approval by the FASB, it strongly suggests that the SEC's current position on this issue is not appropriate. Ultimately, the adoption of this FSP should require the SEC to reverse its application of EITF 00-19 in this context.Final approval of the FSP would (i) allow issuers to not have to book any liability relating to such cash liquidated damages provisions unless the payment of damages becomes probable and can be reasonably estimated, (ii) allow issuers who have previously accounted for warrants and convertible instruments under EITF 00-19 to make adjustments to their financial statements to conform to the new FSP and (iii) obviate the need for a cap on liquidated damages provisions in registration rights agreements in order to avoid application of EITF 00-19. It is important to note, however, that the registration arrangements described in the FSP do not specifically address liquidated damages paid solely for an issuer's failure to file a registration statement, only for the failure to have a registration statement declared effective or to maintain its effectiveness.Until the broader application is confirmed, parties would be well advised to continue to include a cap on those provisions for now.
Scope of the Staff Position : The FSP would apply to the issuer of any contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement. For purposes of the FSP, a 'registration payment arrangement' is an arrangement with both of the following characteristics:
• The arrangement specifies that the issuer will endeavor (1) to file a registration statement for the resale of specified financial instruments and/or the resale of equity shares that are issuable upon exercise or conversion of specified financial instruments and for that registration statement to be declared effective by the SEC (or other applicable securities regulator if the registration statement will be filed in a foreign jurisdiction) within a specified grace period, and/or (2) to maintain the effectiveness of the registration statement for a specified period of time (or in perpetuity), and
• The arrangement requires the issuer to transfer consideration to the counterparty if the registration statement for the resale of the financial instrument(s) subject to the arrangement is not declared effective or if effectiveness of the registration statement is not maintained.
The FSP would apply regardless of whether the consideration is payable in a lump sum or periodically, and the form of consideration may vary. The FSP also would apply to any arrangement that requires an issuer to obtain and/or maintain a listing on a stock exchange, instead of obtaining and/or maintaining an effective registration statement, if the arrangement otherwise has the characteristics of a registration payment arrangement.
The FSP would not apply:
• To contingent obligations under other commercial arrangements;
• If the liquidated damages are to be determined by reference to the price of a commodity; or
• To arrangements in which the financial instrument(s) subject to the arrangement are settled when the consideration is transferred, such as where a warrant is contingently puttable if the corresponding resale registration statement is not declared effective within a specified grace period.
Moreover, the FSP would not otherwise affect the applicability of EITF 00-19, and issuers would still need to analyze the other provisions of their warrants and convertible instruments to determine the proper classification of such financial instruments as equity or liabilities.
Proposed accounting treatment : Assuming the FSP is approved in its current form, liquidated damages provisions in registration rights agreements and other contingent obligations to make future payments or otherwise transfer consideration under a registration payment arrangement would be recognized and measured separately in accordance with the well known Statement 5 and FASB Interpretation No. 14, Reasonable Estimation of the Amount of a Loss.An issuer would separately account for the financial instrument(s) subject to the registration payment arrangement in accordance with other applicable generally accepted accounting principles without regard to the liquidated damages provision or other similar contingent obligation to transfer consideration pursuant to the registration payment arrangement.
While subjective, the familiar principles of Statement 5 - probability of payment and ability to reasonably estimate its amount - are a welcome change to the present situation. As a result, when a company privately places securities and concurrently agrees to register either the securities or the stock issuable upon the conversion or exercise of the securities, the company would need to make a determination at that time as to whether the payment of liquidated damages or other transfer of consideration is probable and can be reasonably estimated. If a payment is probable and its amount can be reasonably estimated, the liquidated damages or other contingent liability under the registration payment arrangement would be included in the allocation of proceeds from the related financing transaction using the measurement guidance in Statement 5. The remaining proceeds would be allocated to the financial instrument(s) issued in conjunction with the registration payment arrangement based on the provisions of other applicable generally accepted accounting principles. An issuer would need to reassess the accounting for the liquidated damages provision or other similar contingent obligation in the event that the payment of liquidated damages or a similar contingent obligation subsequently becomes probable and can be reasonably estimated or if the measurement of a previously recognized contingent liability increases or decreases in a subsequent period.
The FSP also contains transitional accounting rules that would permit issuers who previously have accounted for outstanding warrants or convertible instruments under EITF 00-19 as a result of the existence of a liquidated damages provision in a resale registration statement to make adjustments to their financial statements on a prospective basis.
Effective date : The FSP is subject to comment until December 4, 2006.The FASB currently expects the FSP to be finalized during the first quarter of 2007. Assuming that the FASB approves the FSP, the FSP currently would be expected to become effective immediately for registration payment arrangements and the financial instruments subject to those arrangements that are entered into or modified after the date of issuance of the FSP.For registration payment arrangements and related financial instruments that are entered into prior to the issuance of the FSP, the FSP currently would be expected to become effective for financial statements issued for fiscal years beginning after December 15, 2006, and interim periods within those fiscal years. Early adoption is permitted as of the beginning of the interim period of adoption. It remains to be seen whether the SEC Staff will follow the guidance of the FSP prior to its final approval.
Steven E. Siesser is Chairman of the Specialty Finance Group of Lowenstein Sandler PC, New York, New York. His practice includes the representation of investment banks and investment funds, including equity, mezzanine and hedge funds. He can be reached at (212) 204-8688. Paul W. Hartzel is Counsel to the firm's Corporate Department and a member of the Specialty Finance Group. He can be reached at (973) 597-6224.