Speech by SEC Staff:
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Good Morning, it is a pleasure to once again speak at this conference. I am going to expand on a topic that Todd Hardiman spoke about last year. If you recall, last year Todd spoke about EITF 00-19. Todd gave a brief overview of how EITF 00-19 should be applied to compound and freestanding financial instruments, along with some key areas where the staff had been spending a lot of time working with various registrants.
This past year, EITF 00-19 and SFAS 133 have again been areas where the staff has spent a lot of time. Yesterday you heard my colleagues in the Office of the Chief Accountant speak about various SFAS 133 topics. Today, I will discuss one of the major areas the staff of the Division of Corporation Finance has been focusing on in EITF 00-19. While we have seen some progress since last year, it is still an area where improvements can be made. I think the FASB's issuance of proposed FSP 00-19-b on the accounting for registration payment arrangements will help matters in this area. I will discuss this proposed FSP a bit more towards the end of my presentation. In addition to the issuance of this proposed FSP, the FASB staff is also researching other ways to improve the operability of EITF 00-19.
My presentation today will principally focus on the application of paragraphs 14-18 of EITF 00-19. The general test in paragraphs 14-18 is whether the contract permits the registrant to settle in unregistered shares. Now, on its face, it seems like this would be a fairly easy, factually determinable question. However, in actuality the application of this test requires not only a good understanding of the terms of the contract you are analyzing, but also an understanding of the U.S. Securities Laws.
The basic premise of these paragraphs is that the events or actions necessary to deliver registered shares are not controlled by the issuer of the shares. If the contract permits the company to net-share settle or physically settle the contract only by delivering registered shares, EITF 00-19 presumes the company will be required to net-cash settle the contract. In such a case of course, the contract would have to be classified as a liability and marked to market each period through earnings.
Again, the basic premise doesn't sound like it would be that hard to comply with. However, it is often not easy to tell whether the company is required to deliver registered shares in satisfaction of the contract or whether there are further timely filing or registration requirements that are necessary in order to do so. Those determinations depend upon the operation of the U.S. Securities Laws. While not clearly indicated in paragraphs 14-18 of EITF 00-19, you must have knowledge of these laws in order to properly apply these paragraphs.
With that as an introduction, I will provide a very brief overview of the U.S. Securities Laws, and describe how these laws impact the application of these paragraphs. I will then describe how we think these paragraphs would apply to some common transactions.
Securities Law Overview
The Securities Act of 1933 addresses the process of offers and sales of securities. The basic statutory requirement is that all offers and sales of securities for value must be registered, unless the offer and sale associated with a particular transaction is "exempt." This requirement is set out in Section 5 of the statute, albeit not so simply stated.
There are two important points to note. First, the Securities Act is "transactional" in nature. Its provisions apply to the offers and sales of securities, not to the securities themselves. When we talk about registration under the Securities Act, we are not referring to the registration of shares, but rather the registration of the particular offers and sales. Secondly, the evaluation of whether an exemption is available for a transaction and a determination of when the exemption is needed must be made with respect to both the offers as well as to the sales.
Just briefly, I will discuss one of the most common exemptions that may be available to a company. It is important to note that there are numerous exemptions that might be available, and the conditions for establishing the availability of the exemptions vary and may be quite complex. The most relevant exemption for purposes of our EITF 00-19 discussion today is the Section 4(2) exemption.
Section 4(2) of the Securities Act
Section 4(2) of the Securities Act is available for any "offering by an issuer that does not involve a public offering" - the so called "private placement exemption." The conditions that need to be satisfied to determine whether this provision is available are quite complex, and if the offering process is in any way public, this exemption will not be available. It is probably easiest to discuss this exemption in the context of an example.
Example Illustration of the Private Offering Exemption
An example of how the private placement exemption applies to offers and sales of exercisable securities and to the underlying securities is as follows. An issuer may want to conduct an offering of shares of common stock and warrants for the purchase of additional shares of common stock. It will decide to conduct the offering as a registered transaction or under an exemption.
To conduct the non-registered transaction, the issuer may seek to offer "units" consisting of common stock and the common stock purchase warrants. In offering these units the issuer would be offering the units, the common stock in the units, the warrants in the units and assuming that the warrants are immediately exercisable or exercisable within a year, the shares of stock underlying the warrants.
It is important to note that the offering of these securities (shares, warrants and underlying shares) would commence as an unregistered offering at the same time. When the sale of the shares and warrants takes place, the investment decision with respect to those securities has been completed. The securities received are "restricted" because they were not issued in a public offering.
But the offering of the shares underlying the warrants is not complete and will continue for the term of the warrant, or until the exercise of the warrant. That ongoing offer, as well as the associated sale of the underlying shares, needs to satisfy the basic Section 5 requirements throughout the offering period, just like any other transaction for value involving securities. So the offer of the shares underlying the warrants that continues after the warrants are issued, as well as the sale of the underlying shares, must be registered or an exemption has to be obtained.
In this fact pattern, the issuer would not be able to pursue the option of registering the offer and sale of the shares underlying the warrants because the issuer has already privately commenced the offer of the shares underlying the warrants. The registration route is not a possibility. Therefore the issuer of the privately placed warrant has to find an exemption with respect to the offering of the shares underlying the warrants. In all likelihood, the exemption the warrant issuer originally relied upon for the offering of the shares underlying the warrant will continue to be available. The issuer may also be able to identify some other exemption that would be applicable to the offers and sales of the underlying exercisable securities.
This is a very simplistic analysis of the application of the '33 Act registration provisions to warrant exercises. The thought to take away is that typically once an issuer commences a private (or unregistered) offering of shares underlying an exercisable security in reliance upon the private offering exemption, it will not be possible for the issuer to register the exercise of the warrants. The issuer is precluded from using a registration statement to offer and sell the underlying shares since the offering was commenced privately. In such a case, the shares delivered by the issuer would be restricted. However, the issuer can deliver shares that have been registered for resale. This is why it is very common to see the existence of a registration rights agreement related to the resale of the shares underlying the warrants that were issued in a private placement transaction. Absent a resale registration statement covering the shares received by the holder upon exercise of the warrants, the holder would have to establish an exemption from registration prior to selling those securities. For example, one exemption that could eventually be available to a holder is the Section 4(1) exemption through establishing that the criteria in Rule 144 are met.
Conversely, if an immediately exercisable warrant is sold in a public offering, or if a warrant exercisable within a year is sold in a public offering, not only will the warrant need to be registered for resale, but the associated offers and sales of the underlying shares will need to be registered. The inclusion within a registration statement of the underlying shares affixes a public character to the offering of the underlying shares. Since the offering process of the shares underlying the warrants was conducted publicly, it will not be possible for the issuer to later claim that it will be able to issue the underlying shares in reliance upon the 4(2) exemption (i.e. private placement exemption). The facts would be inconsistent with the requirement of that exemption that the transaction cannot involve a public offering.
These simple examples show why we can generally state that a transaction commenced in reliance upon a private offering exemption has to be completed in reliance upon an exemption, and conversely a transaction commenced in registered form must be completed in registered form.
Now let's analyze further what this means in the context of paragraphs 14-18 of EITF 00-19.
First, I want to provide a brief reminder of why an issuer may be within EITF 00-19 in the first place:
Let's start first with warrants. Warrants would first be analyzed to determine whether they are within the scope of SFAS 150. Assuming they are not, the warrants would be analyzed through EITF 00-19, regardless of whether the warrants meet the definition of a derivative under SFAS 133, to determine whether they should be classified as a liability or as equity.
Next let's take a forward contract. A forward contract would also be analyzed first through SFAS 150 to determine whether it is within the scope. Assuming it is not, similar to the warrants, the forward would be analyzed through EITF 00-19, regardless of whether it meets the definition of a derivative under SFAS 133, to determine whether it should be classified as a liability or as equity.
Next up is convertible debt. After determining the instrument is not within the scope of SFAS 150, registrants would then need to analyze whether the embedded conversion option in the debt host instrument should be bifurcated from the host instrument and accounted for separately as a derivative. After determining that the criteria for separation in paragraph 12 of SFAS 133 are met, we would then need to determine whether the scope exception in paragraph 11(a) of SFAS 133 is available. In order to do so, one of the criteria is whether the conversion option would qualify for equity classification under EITF 00-19. Assuming the conversion option is not "conventional" as discussed in paragraph 4 of EITF 00-19 and EITF 05-2, the conversion option would be analyzed under paragraphs 12-32 of EITF 00-19.
Lastly, let's talk about convertible preferred stock. This analysis is really the same as convertible debt, except for the fact that you need to consider the host instrument more carefully to determine whether it is more akin to debt or equity. This analysis is important, since it would impact whether the criteria for separation under paragraph 12 of SFAS 133 would be met. The only guidance existing in the literature that addresses this issue is paragraph 61(l) of SFAS 133, which basically just gives the two extreme examples to highlight an instrument that is more akin to debt, and one that is more akin to equity, which doesn't provide a lot of insight into how the analysis should be performed. However, some of the things the staff considers as part of this analysis are: whether there are any redemption provisions in the instrument, the nature of the returns (stated rate or participating), whether the returns are mandatory or discretionary, whether there are any voting rights, whether there are any collateral requirements, whether the preferred stockholders participate in the residual, whether they have a preference in liquidation, and whether the preferred stockholders have creditor rights (i.e. the right to force bankruptcy). The staff does not believe any of these factors alone are determinative, and understands that judgment in this area is required. If the host is more akin to debt, the same analysis under convertible debt would be performed. If the host is considered to be more akin to equity, the conversion option would not be bifurcated from the host instrument since it would be considered clearly and closely related to the host instrument. Other GAAP literature would then need to be considered in the appropriate accounting for the convertible preferred stock instrument.
Now lets move on to the staff's actual experience with Paragraphs 14-18 of EITF 00-19
Remember, the basic premise of paragraphs 14-18 is that the events or actions necessary to deliver registered shares are not controlled by the issuer of the shares. Therefore, except in the fact pattern where the contract involves the delivery of shares at settlement that are registered as of the inception of the derivative transaction and there are no further timely filing requirements, if the contract permits the company to net-share settle or physically settle the contract only by delivering registered shares, it is assumed the company will be required to net-cash settle the contract.
In just a moment, I am going to illustrate the application of the basic premise with the following three common examples:
Before I discuss the examples in detail, it is important to note that we have seen numerous situations where registrants have tried to assert that the contract permits settlement in unregistered shares. This assertion appears to stem from the fact that oftentimes the contract itself does not specifically state that the company must settle in registered shares. However, U.S. Securities Laws may implicitly require settlement in registered shares because the company will not be able to find an exemption from registration and therefore settling in unregistered (or restricted) shares would be a violation of U.S. Securities laws.
A perfect example of this would be in a transaction where warrants were sold in a registered offering - typically along with shares of common stock in a type of unit offering. As noted earlier, the shares underlying the warrants must also be offered on a registered basis. The staff has seen the structure quite a bit recently with the Special Purpose Acquisition Companies or SPAC transactions, but these unit offerings are not limited to those deals.
As mentioned earlier, in a typical registered unit offering transaction, the issuer will register the offer and sale of the shares underlying the warrants. During the term of the warrants, the issuer will have to deliver a "current prospectus" to the warrant holders in connection with any exercises by them. These further registration requirements stem from the fact that the holder of the warrant has to make a separate investment decision at the time of the exercise of the warrant and therefore a current prospectus must be delivered to the holder. Initially the issuer will be able to use the prospectus that was declared effective with respect to the unit offering when it sells shares to exercising warrant holders. However, as time passes, the prospectus will be required to be updated to disclose additional information or provide updated financial information.
ince the company is either explicitly or implicitly obligated to deliver registered shares upon exercise and settlement of the warrant, the warrants would not qualify for equity classification under EITF 00-19 because there are further registration and prospectus delivery requirements that are outside of the control of the company.
It is important to note that the terms of the warrant contract need to be carefully evaluated to determine whether liability classification is required. In many circumstances, the warrant agreement may indicate that the warrants will not be exercisable unless at the time of exercise a prospectus relating to common shares issuable upon exercise of the warrants is current and the common shares have been registered under the Securities Act or qualified or deemed to be exempt under the Securities Laws. In these cases, typically the warrant agreement will indicate that the company must use their best efforts to maintain a current prospectus.
As mentioned earlier, if the warrants were sold in a registered offering, there will likely not be an exemption available to the company for the sale of the shares underlying the warrants. If there is not a current prospectus, the company will not be able to deliver registered shares upon exercise of the warrants. Pursuant to paragraph 17 of EITF 00-19, the staff believes that if the warrant agreement requires delivery of registered shares, does not specify how the contract would be settled in the event the company is unable to deliver registered shares, and does not specify any circumstances under which net cash settlement would be permitted or required, net cash settlement must be assumed since it is unlikely that noncompliance is an acceptable alternative. However, the staff has seen circumstances, particularly related to the aforementioned SPAC registered unit offering transactions, whereby the warrant agreement clearly indicates, in either the original agreement or by clarifying amendment, that in the event the company does not have an effective registration statement, there is no circumstance that would require the registrant to net cash settle the warrants. In such a case, the staff would not object to the company's conclusion that the warrants would not be required to be classified as liabilities.
Let's take another example - consisting of debt and a forward contract. We have seen these transactions sometimes referred to as "equity security units" which typically consist of a stock purchase contract and an ownership percentage in a senior note, say 2.5% ownership in a $1,000 senior note. The forward contract requires the holder to purchase shares of common stock on a preset date in the future. The number of shares required to be purchased depends on the trading price of the company's common stock during a period preceding that date.
If a company conducted a registered offering of "equity security units" the company would implicitly and sometimes explicitly, have an obligation to deliver registered shares upon settlement of the stock purchase contract. However, in this fact pattern, the company would not be required to classify the stock purchase contract as a liability due to paragraph 18 of EITF 00-19. Paragraph 18 indicates that if the contract involves the delivery of shares that have been registered as of the inception of the transaction, and there are no further timely filing or registration requirements, the requirement that share delivery be within the control of the company is met. The conclusion that there are not further timely filing or registration requirements stems from the fact that the investment decision (to purchase common stock in the future under the stock purchase contract) has been made at inception and there is no further investment decision to be made. In effect, there really is just a delayed delivery of the shares underlying the stock purchase contract.
Let's take a final example related to either registered convertible debentures or registered convertible preferred stock that could be immediately converted into shares of common stock of the registrant. In this case, the issuer would register the convertible debt or convertible preferred stock, plus the common shares underlying the convertible debt or convertible preferred stock, since the issuer is really transacting a sale of both the convertible security and an offer of the underlying common shares. There will typically be an exemption available to the company for the issuance of common shares upon conversion. This exemption is under Section 3(a)(9) of the Securities Act, and pertains to the exchange of one class of securities of an issuer for a different class of securities of the same issuer, in which no consideration or commissions are being paid. This is important, and different from my earlier general statement that once you start an offering publicly, you must complete it publicly. In this case, the Section 3(a)(9) exemption is typically available even if the offering of the convertible security takes place in a registered format. In general, the conditions of Section 3(a)(9) will be met at the time of conversion of the publicly held debt or convertible preferred stock. However, registrants should ensure they have discussed with their legal counsel the availability of the Section 3(a)(9) exemption to their fact pattern, particularly in unusual circumstances such as when it is uncertain if the securities are convertible into those of the same issuer, arrangements which may involve the payment of remuneration for soliciting the exchange, or arrangements where the convertible securities are not potentially immediately convertible into shares of common stock of the registrant and the issuer has not registered all of the shares which could be issued upon conversion at inception along with the convertible debt. However, assuming Section 3(a)(9) is available, which is generally the case, the offering of securities that underlie the convertible debentures that commenced in the registration process can be completed without the availability of a current prospectus. The shares delivered by the company will be freely tradeable since the transaction and the shares underlying the conversion option were registered upfront. As a result, even if the convertible debt or convertible preferred stock offering was conducted publicly, the registrant would not be required to conclude the embedded conversion option fails equity classification under paragraphs 14-18 of EITF 00-19. Of course, this assumes that the settlement alternatives are equivalent and that the remaining criteria for equity classification must also be met before the final analysis is completed.
Finally, I wanted to close my presentation by discussing FSP 00-19-b in more detail and the implications of this proposed FSP on the accounting for registration rights agreements on a go forward basis. Again, remember that registration rights agreements will only be present in transactions that were issued through an exemption from registration and relate to the resale of securities that are issuable upon exercise or conversion of financial instruments. The proposed FSP requires a company to recognize and measure the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement under SFAS 5 and Interpretation 14. The financial instruments themselves, that is the warrants, convertible debt instruments, etc., would be recognized and measured in accordance with other applicable GAAP, without regard to the contingent obligation to transfer consideration to the registration payment arrangement. Currently, registrants would have likely selected one of the four different views outlined in the Issue Summary for EITF 05-4 for their accounting policy, and as such, the adoption of this proposed FSP could significantly change their accounting for these contracts. Until the final FSP is issued and adopted by the registrant, the staff would expect registrants to continue to use their existing policy consistently among all of their contracts, along with clear disclosure regarding the policy selected. Upon the final issuance of the FSP, which for calendar year companies is expected to go into effect beginning with the first quarter of 2007, with early adoption permitted, the registrant would apply the transition guidance in the FSP. The proposed FSP has an appendix of implementation guidance containing several examples of how the transition to the new standard should be accounted for.
That concludes my prepared marks. Thank you for your time.
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