Derivatives Implementation Group

Statement 133 Implementation Issue No. A14

QUESTION

How should stock purchase warrants be evaluated under Statement 133 if those warrants restrict the sale or transfer of the shares received upon exercise of the warrant for a period of time from the exercise date?

BACKGROUND

Paragraph 9(c) of Statement 133 provides that a contract that requires delivery of the assets associated with the underlying has the characteristic of net settlement if those assets are readily convertible to cash. Footnote 5 to that paragraph makes explicit reference to the use of the phrase readily convertible to cash in paragraph 83(a) of FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises.

Paragraph 57(c)(3), as amended by Statement 149, states:

    Shares of stock in a publicly traded company to be received upon the exercise of a stock purchase warrant do not meet the characteristic of being readily convertible to cash if both of the following conditions exist: (a) the stock purchase warrant is issued by an entity for only its own stock (or stock of its consolidated subsidiaries) and (b) the sale or transfer of the issued shares is restricted (other than in connection with being pledged as collateral) for a period of 32 days or more from the date the stock purchase warrant is exercised. In contrast, restrictions imposed by a stock purchase warrant on the sale or transfer of shares of stock that are received from the exercise of that warrant issued by an entity for other than its own stock (whether those restrictions are for more or less than 32 days) do not affect the determination of whether those shares are readily convertible to cash. The accounting for restricted stock to be received upon exercise of a stock purchase warrant should not be analogized to any other type of contract.

Statement 133 Implementation Issue No. A10, "Assets That Are Readily Convertible to Cash," provides certain guidance that interprets the phrase readily convertible to cash. Implementation Issue A10 states the following:

   An asset (whether financial or nonfinancial) can be considered to be readily convertible to cash, as that phrase is used in paragraph 9(c), only if the net amount of cash that would be received from a sale of the asset in an active market is either equal to or not significantly less than the amount an entity would typically have received under a net settlement provision.

   ...an entity must evaluate, in part, the significance of the estimated costs of converting the asset to cash in determining whether those assets are readily convertible to cash. For purposes of assessing significance of such costs, an entity should consider those estimated conversion costs to be significant only if they are 10 percent or more of the gross sales proceeds (based on the spot price at the inception of the contract) that would be received from the sale of those assets in the closest or most economical active market.

Example
A company acquires a warrant to purchase shares of common stock in the publicly traded entity that issued the stock purchase warrant in exchange for cash, goods, services, or other consideration. The stock purchase warrant has no net settlement provision and there is no market mechanism to facilitate net settlement that would cause the warrant to meet the net settlement criteria as described in paragraphs 9(a) and 9(b) of Statement 133. The underlying common stock is publicly traded in an active market and the number of shares to be delivered under the stock purchase warrant is small relative to the daily transaction volume. Under the terms of the stock purchase warrant contract, the shares of common stock to be received upon exercise of the warrant are restricted from sale or transferability for a period of time that begins on the date of exercise, for example, from a one-day period to a several-month period. Once saleable or transferable, costs to deliver the shares to the active market and transaction costs are expected to be negligible.

RESPONSE

In accordance with paragraph 57(c)(3), as amended by Statement 149, newly outstanding shares of common stock in a publicly traded company to be received upon exercise of a stock purchase warrant cannot be considered readily convertible to cash, as that phrase is used in paragraph 9(c), if upon issuance of the shares, the sale or transfer of the shares is restricted (other than in connection with being pledged as collateral) for more than 31 days from the date the stock purchase warrant is exercised (not the date the warrant is issued) unless the holder has the power by contract or otherwise to cause the requirement to be met within 31 days of the date the stock purchase warrant is exercised. In contrast, if the sale of an actively traded security is restricted for 31 days or less from the date the stock purchase warrants are exercised, that limitation is not considered sufficiently significant to serve as an impediment to considering the shares to be received upon exercise of those stock purchase warrants as readily convertible to cash, as that phrase is used in paragraph 9(c). The guidance in this Implementation Issue that a restriction for more than 31 days prevents the shares from being considered readily convertible to cash applies only to stock purchase warrants issued by a company for its own shares of stock, in which case the shares being issued upon exercise are newly outstanding (including issuance of treasury shares) and are restricted with respect to their sale or transfer for a specified period of time beginning on the date the stock purchase warrant is exercised.

However, even if the sale or transfer of the shares is restricted for 31 days or less after the stock purchase warrant is exercised, an entity still must evaluate whether an active market can rapidly absorb the quantity of stock to be received upon exercise of the warrant without significantly affecting the price and whether the other estimated costs to convert the stock to cash are expected to be not significant. The assessment of the significance of those conversion costs should be performed only at inception of the contract. Thus, the guidance in Implementation Issue A10 must be applied to those stock purchase warrants with sale or transfer restrictions of 31 days or less on the shares of stock.

If the shares of an actively traded common stock to be received upon exercise of the stock purchase warrant can be reasonably expected to qualify for sale within 31 days of their receipt, such as may be the case under Rule 144 or similar rules of the SEC, any initial sales restriction is not an impediment to considering those shares as readily convertible to cash, as that phrase is used in paragraph 9(c). (However, a restriction on the sale or transfer of shares of stock that are received from an entity other than the issuer of that stock through the exercise of another option or the settlement of a forward contract is not an impediment to considering those shares readily convertible to cash, regardless of whether the restriction is for a period that is more or less than 32 days from the date of exercise or settlement.)

The consensus in EITF Issue No. 96-11, "Accounting for Forward Contracts and Purchased Options to Acquire Securities Covered by FASB Statement No. 115," would continue to apply to those warrants that are not derivatives subject to Statement 133 but involve the acquisition of securities that will be accounted for under FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities. However, such warrants are not eligible to be hedging instruments.

EFFECTIVE DATE

The revisions made on April 9, 2002, emphasize that the guidance regarding a 32-day-or-more restriction that prevents the shares that are delivered upon exercise from being considered readily convertible to cash applies only to stock purchase warrants issued by a company for its own shares of stock. The effective date of the April 9, 2002 revisions to the implementation guidance in this Issue for each reporting entity is the first day of its first fiscal quarter beginning after April 10, 2002, the date that the revised Board-cleared guidance was posted to the FASB website. The revision made on June 27, 2001, involved the deletion of the penultimate paragraph in the guidance that was cleared on December 6, 2000. The effective date of the June 27, 2001, revised implementation guidance in this Issue was August 1, 2001. That revised implementation guidance applied to all stock purchase warrants issued on or after August 1, 2001. Contracts entered into prior to August 1, 2001 are not subject to the revisions made on April 9, 2002 and June 27, 2001. Likewise, contracts entered into on or after August 1, 2001 are subject to the revisions made on both April 9, 2002 and June 27, 2001. The revisions made on March 26, 2003 do not affect the effective date.

The above response has been authored by the FASB staff and represents the staff’s views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.