Financial Instruments with Characteristics of Equity
The staff presented their papers which set out the general principles and decision rules for distinguishing between equity instruments and financial liabilities. The staff began discussions by focusing on one of the general principles, namely:
"An instrument shall be separated into a liability and equity components if the instrument has two separate or alternative outcomes, one of which would require equity classification if it were the only outcome and one of which would require liability classification if it were the only outcome."
Staff explained that as a consequence of this principle an equity instrument puttable at the option of the holder to the issuer would be bifurcated into an equity component and a liability component as the two outcomes were:
- equity (no exercise of put option) or
- liability (exercise of put option or the put option itself).
The staff then explained that under the proposed general principles that a convertible bond would not contain an equity component because both outcomes were liabilities (that is (1) if the conversion option was not exercised the outcome would be liability and (2) the conversion option is by default a liability under the principle. It was explained that the second outcome results in liability by virtue of the option meeting the definition of a derivative and the Board's previous decision (reflected in the decision rules) to treat all derivatives as liability instruments regardless of whether equity is delivered under them.
Board members began to question whether their previous decision to treat all derivatives as liabilities was appropriate. One Board member made the point that under this rule, forward contracts over equity would be treated as liabilities as would warrants. Some Board members felt that instruments that reduced leverage, such as equity forwards, should not be classified as liabilities. One Board member commented that treating derivatives as liabilities would at least result in the same accounting for both cash share appreciation rights and equity share appreciation rights. However, the Staff had earlier commented that the scope of the proposals had yet to be determined.
One Board member recommended that the Staff avoid a form-based model as this would be open to structuring opportunities. At least two Board members felt that the following decision rule included in the Staff paper would be open to structuring opportunities:
"An issuer would classify the following other instruments as equity: Instruments that the holder is required to own in order to do business with or otherwise actively engage in activities of the issuer and that are redeemable only if the holder dies, retires, resigns, or otherwise ceases to actively engage in the activities of the issuer. (This would include holdings the amount of which vary based on volume of business transacted by the holder)"
The Board went on to discuss some of the other outcomes of applying the proposed principles which were set out in the staff paper. Following this the Chairman asked the Board whether they agreed with the general principles and decision rules described in the Staff paper. A majority agreed for the staff to proceed to build on the current platform but felt that additional changes were needed to deal with undesirable outcomes of applying the proposed principles.