NOTE 18—DERIVATIVE AND OTHER FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS

Derivatives

Real Alloy may use forward contracts and options, as well as contractual price escalators, to reduce the risks associated with its metal, natural gas and certain currency exposures. Generally, Real Alloy enters into master netting arrangements with counterparties and offsets net derivative positions with the same counterparties against amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral under those arrangements in the consolidated balance sheets. For classification purposes, Real Alloy records the net fair value of each type of derivative position expected to settle in less than one year (by counterparty) as a net current asset or liability and each type of long-term position as a net noncurrent asset or liability.

Metal hedging

As metal is purchased to fill fixed-price customer sales orders at RAEU, London Metal Exchange (“LME”) future swaps or forward contracts may be sold. As sales orders are priced, LME future or forward contracts may be purchased, which contracts generally settle within six months. Real Alloy can also buy put option contracts for managing metal price exposures. Option contracts require the payment of a premium, which is recorded as a realized loss upon settlement or expiration of the option contract. Upon settlement of put option contracts, Real Alloy receives cash and recognizes a related gain if the LME closing price is less than the strike price of the put option. If the put option strike price is less than the LME closing price, no amount is paid and the option expires. Due to the RA Chapter 11 Case, Real Alloy had 10.7 thousand tonnes of offsetting metal buy and sell derivative contracts as of December 31, 2017.

Natural gas hedging

To manage the price exposure for natural gas purchases, Real Alloy may fix the future price of a portion of its natural gas requirements by entering into financial hedge agreements. Under these swap agreements, payments are made or received based on the differential between the monthly closing price on the New York Mercantile Exchange (“NYMEX”) and the contractual hedge price. Natural gas costs can also be managed through the use of cost escalators included in some long-term supply contracts with customers, which limits exposure to natural gas price risk. Due to the RA Chapter 11 Case, Real Alloy had 1.4 trillion of offsetting British thermal unit forward buy and sell derivative contracts as of December 31, 2017.

Currency exchange hedging

From time to time, Real Alloy may enter into currency forwards, futures, call options and similar derivative financial instruments to limit its exposure to fluctuations in currency exchange rates. As of December 31, 2017, no currency derivative contracts were outstanding.

Credit risk

Real Alloy is exposed to losses in the event of nonperformance by the counterparties to the derivative financial instruments discussed above; however, management does not anticipate any nonperformance by the counterparties. The counterparties are evaluated for creditworthiness and risk assessment prior to initiating trading activities with the brokers and periodically throughout each year while actively trading. As of December 31, 2017, no cash collateral was posted or held.

The table below presents gross amounts of recognized assets and liabilities, the amounts offset in the consolidated balance sheets and the net amounts of assets and liabilities presented as of December 31, 2017 and 2016. As of December 31, 2017 and 2016, there were no amounts subject to enforceable master netting arrangements or similar agreements that have not been offset in the consolidated balance sheets.


	December 31, 2017				December 31, 2016
(In millions)	Asset		Liability		Asset		Liability
Metal	$	—	$	—	$	—	$	(0.4)
Natural gas		—		—		0.6		—
Total		—		—		0.6		(0.4)
Effect of counterparty netting arrangements		—		—		—		—
Net derivative assets (liabilities) as classified in the consolidated balance sheets	$	—	$	—	$	0.6	$	(0.4)

The following table presents details of the fair value of Real Alloy’s derivative financial instruments as of December 31, 2017 and 2016, as recorded in the consolidated balance sheets:


		December 31,
(In millions)	Balance Sheet Classification	2017		2016
Derivative assets:
Natural Gas	Prepaid expenses, supplies and other current assets	$	—	$	0.6
Derivative liabilities:
Metal	Accrued liabilities	$	—	$	(0.4)

Common stock warrant liability

On June 11, 2010, warrants to purchase an aggregate of 1.5 million shares of Real Industry’s common stock were issued. The aggregate purchase price for the Warrants was $0.3 million, due in equal installments as the Warrants vested, 20% upon issuance and, thereafter, 20% annually on the anniversary of the issuance date and, as of June 30, 2015, the Warrants were 100% vested. The Warrants expire in June 2020 and had an original exercise price of $10.30 per share. The Warrants were issued without registration in reliance on the exemption set forth in Section 4(a)(2) of the Securities Act of 1933, as amended.

The Warrants include customary terms that provide for certain adjustments of the exercise price and the number of shares of common stock to be issued upon the exercise of the Warrants in the event of stock splits, stock dividends, pro rata distributions and certain other fundamental transactions. Additionally, the Warrants are subject to pricing protection provisions. During the term of the Warrants, the pricing protection provisions provide that certain issuances of new shares of common stock at prices below the current exercise price of the Warrants automatically reduce the exercise price of the Warrants to the lowest per share purchase price of common stock issued. In February 2015, the Company issued shares of common stock in the Rights Offering at $5.64 per share, which is the exercise price of the 1,448,333 Warrants that remained outstanding as of December 31, 2017.

In April 2016, 20,000 Warrants were exercised on a cashless basis, resulting in the issuance of 7,552 shares of common stock; in May 2015, 15,000 Warrants were exercised, including 7,500 on a cashless basis, resulting in the issuance of 9,360 shares of common stock and gross proceeds of $0.1 million; and in September 2015, 16,667 Warrants were exercised on a cashless basis, resulting in the issuance of 6,969 shares of common stock. Upon exercise, the fair value of the Warrants exercised are reclassified to additional paid-in capital.

The common stock warrant liability is considered a derivative liability as a result of the anti-dilution and pricing protection provisions of the Warrants. The 2016 estimated fair value of the common stock warrant liability was based on a Monte Carlo simulation that utilized various assumptions, including estimated volatility of 47.1% volatility and an expected term of 3.4 years as of December 31, 2016, along with a 60% equity raise probability at a 15% discount to the 10-Day VWAP assumption in the periods following December 31, 2016. As a result of the Chapter 11 Cases, we adjusted our equity raise assumption to 0% as of December 31, 2017. Without the need to model the estimated effect of future equity raises, management is able to estimate the fair value of the common stock warrant liability using a Black-Scholes option model.

Significant decreases in the expected term or the equity raise probability and related assumptions would result in a decrease in the estimated fair value of the common stock warrant liability, while significant increases in the expected term or the equity raise probability and related assumptions would result in an increase in the estimated fair value of the common stock warrant liability. However, the most significant input in determining the fair value of the common stock warrant liability is the price of our common stock on the measurement date. A 10% increase or decrease in any or all of the unobservable inputs would not have a material impact on the estimated fair value of the common stock warrant liability.

The common stock warrant liability is the only asset or liability measured at fair value on a recurring basis using significant unobservable inputs (Level 3). The following table presents changes in the fair value of the common stock warrant liability during the years ended December 31, 2017, 2016 and 2015:


	Year Ended December 31,
(In millions)	2017		2016		2015
Balance, beginning of period	$	4.4	$	6.9	$	5.6
Warrants exercised		—		(0.1)		(0.2)
Change in fair value of common stock warrant liability		(4.4)		(2.4)		1.5
Balance, end of period	$	—	$	4.4	$	6.9

Fair values

Derivative contracts are recorded at fair value using quoted market prices and significant other observable inputs. The following tables set forth financial assets and liabilities and their level in the fair value hierarchy that are accounted for at fair value on a recurring basis as of December 31, 2017 and 2016:


	Fair Value	Estimated Fair Value as of December 31,
(In millions)	Hierarchy	2017		2016
Derivative assets	Level 2	$	—	$	0.6
Derivative liabilities	Level 2		—		(0.4)
Net derivative assets		$	—	$	0.2
Common stock warrant liability	Level 3	$	—	$	(4.4)

Both realized and unrealized gains and losses on derivative financial instruments are included within losses on derivative financial instruments in the consolidated statements of operations. The following table presents losses on derivative financial instruments during the years ended December 31, 2017, 2016 and 2015:


	Year Ended December 31,
(In millions)	2017		2016		2015
Realized losses:
Metal	$	1.8	$	0.6	$	2.9
Natural gas		0.1		0.6		0.5
Total realized losses		1.9		1.2		3.4
Unrealized losses (gains):
Metal		(0.4)		0.3		—
Natural gas		0.6		(1.3)		0.8
Total unrealized losses (gains)		0.2		(1.0)		0.8
Losses on derivative financial instruments, net	$	2.1	$	0.2	$	4.2

From time to time, we are required to measure other assets and liabilities at estimated fair value, typically from the application of specific accounting guidance under GAAP and are referred to as nonrecurring fair value measurements. These adjustments to fair value generally result from the application of lower of cost or market accounting or impairment charges of individual assets. The following table presents the Company’s assets measured at estimated fair value on a nonrecurring basis as of December 31, 2017 based on the fair value hierarchy:


		December 31,
(In millions)	Hierarchy	2017		2016
Goodwill - RANA	Level 3	$	—	$	33.6
Property, plant and equipment - RANA	Level 3		141.9		195.0
Identifiable intangible assets - RANA	Level 3		—		12.5
Identifiable intangible assets - Cosmedicine	Level 3		—		—
Inventories - Cosmedicine (Prepaid expenses, supplies and other current assets)	Level 3		—		0.1

The following table summarizes losses on assets recorded at fair value on a nonrecurring basis for the years ended December 31, 2017 and 2016:


	Year Ended December 31,
(In millions)	2017		2016
Goodwill impairment - RANA	$	33.6	$	61.8
Property, plant and equipment - RANA		40.5		—
Identifiable intangible assets impairment - RANA		10.1		—
Identifiable intangible assets impairment - Cosmedicine		—		0.1
Inventories impairment - Cosmedicine		0.1		0.7

Other Financial Instruments

The following tables present the fair value hierarchy, carrying values and fair value estimates of other financial instruments as of December 31, 2017 and 2016:


		December 31, 2017
(In millions)	Fair Value Hierarchy	Carrying Value		Estimated Fair Value
Assets
Cash and cash equivalents	Level 1	$	24.9	$	24.9
Restricted cash and restricted cash equivalents	Level 1		7.9		7.9
Financing receivable	Level 2		16.5		16.5
Loans receivable, net (other noncurrent assets)	Level 3		0.7		0.7
Liabilities
RA DIP Financing:
RA DIP ABL Facility	Level 2	$	66.7	$	67.9
New Money DIP Term Notes	Level 2		37.2		40.0
Liabilities subject to compromise:
Senior Secured Notes	Level 1		135.0		98.9
Roll Up DIP Term Notes	Level 1		170.0		124.5
Redeemable Preferred Stock	Level 3	$	28.5	$	13.1


		December 31, 2016
(In millions)	Fair Value Hierarchy	Carrying Value		Estimated Fair Value
Assets
Cash and cash equivalents	Level 1	$	27.2	$	27.2
Restricted cash and restricted cash equivalents	Level 1		5.5		5.5
Financing receivable	Level 2		28.4		28.4
Loans receivable, net (other noncurrent assets)	Level 3		0.8		0.8
Liabilities
Long-term debt:
Senior Secured Notes	Level 1	$	294.9	$	307.5
Revolving Credit Facilities	Level 2		55.5		57.0
Term loan	Level 2		1.5		1.5
Redeemable Preferred Stock	Level 3	$	24.9	$	26.8

We used the following methods and assumptions to estimate the fair value of each financial instrument as of December 31, 2017 and 2016:

Cash, cash equivalents, restricted cash and restricted cash equivalents

Cash, cash equivalents, restricted cash and restricted cash equivalents are recorded at historical cost. The carrying value is a reasonable estimate of fair value as these instruments have short-term maturities and market interest rates.

Financing receivable

Financing receivable represents the net amount due from the sale and transfer of trade accounts receivable under the Factoring Facility. The carrying value is a reasonable estimate of fair value as the financing receivable is generally outstanding for no more than thirty days and the counterparty is a large creditworthy financial institution.

Loans receivable, net

Loans receivable, net, consists of commercial real estate loans. The estimated fair value considers the collateral coverage of assets securing the loans and estimated credit losses, as well as variable interest rates, which approximate market interest rates.

RA DIP Financing

The RA DIP ABL Facility and New Money DIP Term Notes are senior-secured super-priority financing arrangements with market characteristics, including interest rates and maturity dates generally consistent with market terms.

Long-term debt or Liabilities subject to compromise – Senior Secured Notes and Roll Up DIP Term Notes

The estimated fair values of the Senior Secured Notes and Roll Up DIP Term Notes are based on observable market prices.

Long-term debt – Revolving Credit Facilities and term loan

The estimated fair values of the Revolving Credit Facilities and the term loan is based on market characteristics, including interest rates and maturity dates generally consistent with market terms.

Redeemable Preferred Stock

Due to the bankruptcy, the Redeemable Preferred Stock is carried at its liquidation preference as of December 31, 2017. The 2017 estimated fair value of the Redeemable Preferred Stock is based on the estimated fair value of the consideration the holder will receive in the RI Plan for its interest in the Redeemable Preferred Stock.

In 2016, the carrying value of Redeemable Preferred Stock is based on the estimated fair value of the instrument at issuance, calculated using a discounted cash flow analysis using the Hull & White model, with an original term of sixty-six months, assuming either the holder will put or the issuer will call at the redemption date. The cash dividend yield and the Redeemable Preferred Stock, including the payment-in-kind Redeemable Preferred Stock, were discounted at the spot rate plus a 17.5% credit spread adjustment to a zero coupon yield curve, which was being accreted to redemption value over the period preceding the holder’s right to mandatorily redeem the instrument, or sixty-six months from issuance, using the effective interest method. An increase in the discount rate would result in a decrease in the estimated fair value of the Redeemable Preferred Stock, while a decrease in the discount rate would result in an increase in the estimated fair value of the Redeemable Preferred Stock. The 2016 estimated fair value of the Redeemable Preferred Stock was determined using a discounted cash flow using a 15% credit spread and a 44 month redemption period, assuming that the Redeemable Preferred Stock would be redeemed by either the Company or the holder on the redemption date.

The Company’s Level 3 assets and liabilities are determined using valuation techniques that incorporate unobservable inputs that require significant judgment or estimation. The following tables present quantitative information about the valuation techniques and unobservable inputs applied to Level 3 fair value measurements as of December 31, 2017 and 2016:


	December 31, 2017
(In millions)	Estimated Fair Value		Valuation Technique	Unobservable Input	Input Value
Common stock warrant liability	$	—	Black-Scholes	Volatility		107.6	%
				Expected term		2.4 years
				Equity raise probability		—	%
				Issue price discount to fair value		—	%
Redeemable Preferred Stock	$	13.1	RI Plan	Percentage ownership exchange		31	%
				Percentage ownership of the RI Plan sponsor		49	%


	December 31, 2016
(In millions)	Estimated Fair Value		Valuation Technique	Unobservable Input	Input Value
Common stock warrant liability	$	4.4	Monte Carlo Simulation	Volatility		47.1	%
				Expected term		3.4 years
				Equity raise probability		60	%
				Issue price discount to fair value		25	%
Redeemable Preferred Stock	$	26.8	Discounted cash flow	Credit spread		15	%
				Redemption period		44 months

Significant unobservable inputs used in the fair value measurement of the common stock warrant liability include volatility, expected term, the probability of an equity raise, and the offering price discount to fair value, presuming the equity raise is a rights offering. The estimated fair values were determined using a Black-Scholes option model in 2017 and a Monte Carlo simulation in 2016. Management determined that the results from using a Black-Scholes option model versus the results of using a Monte Carlo simulation with a 0% equity raise assumption would yield the same estimated fair value. Significant decreases in volatility, expected term or the equity raise probability would result in a decrease in the estimated fair value of the common stock warrant liability, while significant increases in volatility, expected term or the equity raise probability would result in an increase in the estimated fair value of the common stock warrant liability. The primary drivers in the estimated fair value of the common stock warrant liability is the measurement date common stock price and the equity raise assumption.

Significant unobservable inputs used in the fair value measurement of the Redeemable Preferred Stock include the estimated credit spread and redemption period. The Company used these unobservable inputs in a discounted cash flow analysis using the Hull & White model to estimate the fair values presented for 2016. Decreases in the redemption period and credit spread would result in an increase in the estimated fair value of the Redeemable Preferred Stock, while increases in the redemption period and credit spread would result in a decrease in the estimated fair value of the Redeemable Preferred Stock. The estimated fair value of the Redeemable Preferred Stock as of December 31, 2017 was determined based on the terms of the current RI Plan as proposed. A material change in the proposed terms of the RI Plan or the failure to have the RI Plan confirmed by the Bankruptcy Court or effectuate the confirmed RI Plan could result in a decrease in the estimated fair value of the Redeemable Preferred Stock.