IFRS 9 Financial Instruments—Impact of symmetric ‘make whole’ and fair value prepayment options on the assessment of the SPPI condition - Agenda paper 7

Background

This was a new item. The query related to whether a debt instrument with a symmetric make whole prepayment option or a fair value prepayment option can meet the ‘solely payments of principal and interest on the principal amount’ (SPPI) criterion for measurement at amortised cost under IFRS 9.

• A symmetric make whole prepayment option allows the borrower to prepay the debt instrument at an amount that reflects the remaining contractual cash flows of the instrument discounted at a current market interest rate.
• A fair value prepayment option allows the borrower to prepay the debt instrument at its current fair value.

In both cases, the prepayment amount may be higher (if the current interest rate is lower than the EIR) or lower (if the current interest rate is higher than the EIR) than the unpaid amounts of principal and interest. Since the prepayment option is exercisable at the option of the borrower in the submitter’s fact pattern, if the borrower prepays at a lower amount, the submitter asks whether this would constitute ‘compensation for the early termination of the contract’ as envisaged in IFRS 9.B4.1.11. This is because it is the option holder, and not the other party, that appears to have gained in this case.

View 1: the instrument may meet the SPPI condition. Proponents of this view believe that the term ‘compensates’ should not been interpreted as requiring only the lender to be compensated as is the case if interest rates have decreased. If interest rates have increased, it is reasonable for the borrower to be compensated. Furthermore, the entire prepayment amount is determined using factors that reflect only the time value of money, which is typically one of the most significant elements of interest resulting in cash flows that would represent SPPI (IFRS 9.B4.1.7A).

View 2: the instrument does not meet the SPPI condition. Proponents of this view believes that IFRS 9.B4.1.11(b) envisages circumstances where the party that has the right to prepay (i.e. the option holder) may be required to compensate the other party, and not the other way round. In the present case, since it is the option holder that appears to be compensated upon prepayment, the instrument does not meet the SPPI condition.

Staff analysis and next step

The Staff supported view 2 for the reasons set out above.

The Staff intended to seek advice from the IC during this meeting on how to proceed with this query, and also to take the issue to the Board for deliberation.

Discussion

The IC had mixed views regarding whether the requirements of IFRS 9 were clear. Those who thought the requirements were clear agreed with the Staff’s analysis. They believed that the ordinary meaning of ‘compensation’ should be used to interpret the requirement, which would disallow negative compensation to be considered as meeting the SPPI requirement. In contrast, other IC members thought that IFRS 9 was unclear and that if the Standard allowed negative interest to be considered as meeting the SPPI criterion, then why should negative compensation be treated differently. A number of IC members also pointed out that the laws and/or regulations in certain jurisdictions required the inclusion of these types of prepayment options in financial instrument contracts, and any conclusions reached will have pervasive effects for entities in those jurisdictions. These members suggested that the Board need to understand the reason behind such regulations and take them into account when debating the issue. They also asked the Board to consider what is meant by ‘additional reasonable interest’.

A few IC members also noted that there were many similar fact patterns in the market and suggested that the Board analyse the issue with the broader picture in mind instead of focusing only on the specific fact pattern that had been submitted.

In concluding the discussion, the Chairman noted that the Board had on previous occasions discussed the role that regulations played in interpreting IFRS 9. On all those occasions, the Board rejected granting ‘an exception’ to the strict interpretation of SPPI on grounds of the clause being imposed by law/regulation as opposed to its being negotiated between the parties. In view of this black-and-white approach taken by the Board, the Chairman cautioned against the extent of the expectation that the IC should have on how far the Board would take the issue, as the latter had to be careful not to unpick the foundation of IFRS 9 relating to amortised cost.