Should Warrants Be Considered Derivatives? | BBD, LLP

Posted by admin on Jul 26, 2012 3:12:00 PM

Current financial markets provide various incentives for entities interested in raising capital for their developing enterprises to offer potential investors. One example of an incentive used is a warrant issued along with a debt instrument. The warrants could theoretically be exercised at a future date for a common stock interest in the company, once the capital raised from the debt issuance begins to bear fruit and the enterprise value increases. For mutual and hedge funds investing in these developing companies, the financial statement disclosure requirements have drastically increased due to the Statement on Financial Accounting Standard No. 161, Disclosures about Derivative Instruments and Hedging Activities (the “Statement or FAS 161”). The Statement has been included in the FASB Codification (the “Code”) under 815-10 Derivatives and Hedging. FAS 161 was effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged.

From the FASB:

The Statement changes the disclosure requirements for derivative instruments and hedging activities. Entities are required to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under Statement 133 and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows.

For most instruments, such as forward currency contracts or future contracts, the applicability of FAS 161 is clear. However, for other instruments, more specifically warrants, the appropriateness of the FAS 161 disclosure requirements remains less clear. A popular website defines a warrant as, “A derivative security that gives the holder the right to purchase securities (usually equity) from the issuer at a specific price within a certain time frame.” In order to determine if an instrument is considered a derivative, the Code offers the guidance below:

  • Definition of Derivative Instrument
    • A financial instrument or other contract with all of the following characteristics:
      • Underlying, notional amount, payment provision. The contract has both of the following terms, which determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required:
        • One or more underlyings
        • One or more notional amounts or payment provisions or both
    • Initial net investment. The contract requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
    • Net settlement. The contract can be settled net by any of the following means:
      • Its terms implicitly or explicitly require or permit net settlement
      • It can readily be settled net by a means outside the contract
      • It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement

By using the above definition, a warrant would seem to fit most of the above. The underlying would be the common stock of the company, whose notional amount and payment provisions are defined in the terms of the warrant contract. Typically, the warrant contracts include expiration dates well into the future and an exercise price set above the current fair value of the common stock. With the expiration date set into the future, the warrant’s value is impacted by the time value of money. Both this factor and the fluctuation in the underlying stock’s price impact the value of the warrant, thereby causing the holder to consider this investment as a derivative.

However, if the warrants are issued along with a debt security, and the warrants can be considered detachable, that is exercised separately without sacrificing the debt security, a certain portion of the purchase price of the debt should be allocated to the warrant. This would seem to exclude a warrant from consideration as a derivative through the second bullet mentioned above. The holder of the investment should consider the fair value of this detachable warrant at the time of purchase to conclude how much of the total purchase cost should be allocated to the warrants. Presumably, as described above, the warrants would have no fair value at the time of purchase, thereby rendering the cost allocable to the warrants as zero.

The last characteristic mentioned above regarding the net settlement requires further consideration. With net settlement several criteria could be met to satisfy this provision; net settlement under contract terms, through market mechanism, or by delivery of derivative instrument or asset readily convertible to cash. It is this first criterion which will be considered in relation to a warrant. The settlement under the terms of the contracts can be satisfied by any of the following:

  1. Net share settlement
  2. Net settlement in the event of nonperformance or default
  3. Structured settlement as net settlement
  4. Net settlement of a debt instrument through exercise of an embedded put option or call option.

Section 815-10-15 of the Code defines Net Share Settlement, “as the party with a loss delivers to the party with a gain shares with a current fair value equal to the gain.” Section 815 states that, “if either counterparty could net share settle a contract, then it would be considered to have the net settlement characteristic of a derivative instrument regardless of whether the net shares received were readily convertible to cash.” The conversion of a warrant to a common stock security would seem to fit this concept of net share settlement.

Careful consideration should be taken when determining the classification of a warrant as a derivative for a fund. Circumstances surrounding the warrant will dictate the appropriate treatment under ASC 815 (FAS 161). The Investment Company Institute (“ICI”) issued a White Paper in February of 2009 regarding the implementation of FAS 161. Warrants are not mentioned in this document, which could lead a reader to one of two conclusions; 1) the ICI does not consider warrants a derivative and therefore FAS 161 does not apply, or 2) conditions surrounding warrants are too unique that the ICI was hesitant to provide guidance. Terms and conditions surrounding different warrants held by the same fund could differ on the appropriateness of Section 815 consideration.

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