Derivatives Implementation Group

Statement 133 Implementation Issue No. A7

QUESTION

Does the existence of a contractual requirement that one party obtain the other's permission to assign rights or obligations to a third party under a contract, in and of itself, preclude a contract from meeting the definition of a derivative because it would not possess the net settlement characteristic described in paragraph 9(b) of Statement 133 as a market mechanism?

For the purposes of this question, assume that if the contract did not contain an assignment clause, an established market mechanism that facilitates net settlement outside the contract exists.

BACKGROUND

Some commodity contracts contain a provision that allows one or both parties to a contract to assign its rights or obligations to a third party only after obtaining permission from the counterparty. Under the assignment clause addressed in this issue, permission shall not be unreasonably withheld. The primary purpose of an assignment clause is to ensure that the non-assigning counterparty is not unduly exposed to credit or performance risk if the assigning counterparty is relieved of all of its rights and obligations under the contract. Accordingly, a counterparty could withhold consent only in limited circumstances, such as when the contract would be assigned to a third party assignee that has a history of defaulting on its obligations or has a lower credit rating than the assignor.

Paragraph 9(b) of Statement 133 indicates that the net settlement characteristic of the definition of a derivative may be satisfied if "One of the parties is required to deliver an asset of the type described in paragraph 9(a), but there is a market mechanism that facilitates net settlement, for example, an exchange that offers a ready opportunity to sell the contract or to enter into an offsetting contract." Paragraph 57(c) of Statement 133, as amended, elaborates on that notion. It states:

    A contract that meets any one of the following criteria has the characteristic described as net settlement [in paragraph 9(b)]….(2) There is an established market mechanism that facilitates net settlement outside the contract. The term market mechanism is to be interpreted broadly. Any institutional arrangement or other agreement that enables either party to be relieved of all rights and obligations under the contract and to liquidate its net position without incurring a significant transaction cost is considered net settlement. The evaluation of whether a market mechanism exists and whether items to be delivered under a contract are readily convertible to cash must be performed at inception and on an ongoing basis throughout a contract’s life.

RESPONSE

No. The existence of an assignment clause does not, in and of itself, preclude the contract from possessing the net settlement characteristic described in paragraph 9(b) as a market mechanism. Once the determination is made that a market mechanism that facilitates net settlement outside of the contract exists, then an assessment of the substance of the assignment clause is required in order to determine whether that assignment clause precludes a party from being relieved of all rights and obligations under the contract through that existing market mechanism. Although permission to assign the contract shall not be unreasonably withheld by the counterparty in accordance with the terms of the contract, the assignment feature cannot be viewed simply as a formality because it may be invoked at any time to prevent the non-assigning party from being exposed to unacceptable credit or performance risk. Accordingly, the existence of the assignment clause may or may not permit a party from being relieved of its rights and obligations under the contract.

If it is remote that the counterparty will withhold permission to assign the contract, the mere existence of the clause should not preclude the contract from possessing the net settlement characteristic described in paragraph 9(b) as a market mechanism. Such a determination requires assessing whether a sufficient number of acceptable potential assignees exist in the marketplace such that assignment of the contract would not result in imposing unacceptable credit risk or performance risk on the non-assigning party. Consideration should be given to past counterparty and industry practices regarding whether permission to be relieved of all rights and obligations under similar contracts has previously been withheld. However, if it is reasonably possible or probable that the counterparty will withhold permission to assign the contract, the contract is precluded from possessing the net settlement characteristic described in paragraph 9(b) as a market mechanism. If the contract meets the definition of a derivative, each party to the contract needs to determine whether the normal purchases and normal sales exception under paragraph 10(b) applies to the contract.

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.