Derivatives Implementation Group

Statement 133 Implementation Issue No. E6

QUESTION

When should an interest-bearing asset or liability be considered prepayable under the provisions of paragraph 68(d) of Statement 133? Specifically, do each of the illustrative debt instruments below contain terms and provisions that cause the instrument to be prepayable under paragraph 68(d)?

BACKGROUND

Paragraph 68 of Statement 133 describes the conditions that must be present in order for an entity to assume no ineffectiveness and thus be permitted to apply the shortcut method. The condition in paragraph 68(d) stipulates that the interest-bearing asset or liability is not prepayable, except in a hedge of an interest-bearing asset or liability that is prepayable due to an embedded call or put option provided that the hedging interest rate swap contains an embedded mirror-image call or put option. Paragraph 68(d) (as amended) lists several criteria that must be met in order for the call or put option embedded in the swap to be considered a mirror image of the call or put option embedded in the hedged item.

A debt instrument may contain various terms and provisions that permit either the debtor or the creditor to cause prepayment of the debt (that is, cause the payment of principal prior to the scheduled payment dates), including the terms in the following illustrative instruments:

Illustrative Debt Instrument 1

Some fixed-rate debt instruments include a typical call option that permits the debt instrument to be called for prepayment by the debtor at a fixed amount, for example, at par or at a specified premium over par. In some instruments, the prepayment amount varies based on when the call option is exercised.

Illustrative Debt Instrument 2

Some debt instruments include contingent acceleration clauses that permit the lender to accelerate the maturity of an outstanding note only if a specified event related to the debtor's credit deterioration or other change in the debtor's credit risk occurs (for example, the debtor's failure to make timely payment, thus making it delinquent; its failure to meet specific covenant ratios; its disposition of specific significant assets (such as a factory); a declaration of cross-default; or a restructuring by the debtor). A common example is a clause in a mortgage note secured by certain property that permits the lender to accelerate the maturity of the note if the borrower sells the property.

Illustrative Debt Instrument 3

Some fixed-rate debt instruments include a call option that permits the debtor to repurchase the debt instrument from the creditor at an amount equal to its then fair value.

Illustrative Debt Instrument 4

Some fixed-rate debt instruments, typically issued in private markets, include an option (frequently referred to as a "make-whole provision") that gives the debtor (that is, the issuer) the right to pay off the debt before maturity at a significant premium over the fair value of the debt at the date of settlement. A make-whole provision differs from a typical call option, which enables the issuer to benefit by prepaying the debt when market interest rates decline. In a declining interest rate market, the settlement amount of a typical call option is less than what the fair value of the debt would have been absent the call option. In contrast, a make-whole provision involves settlement at a variable amount typically determined by discounting the debt's remaining contractual cash flows at a specified small spread over the current Treasury rate. That calculation results in a settlement amount significantly above the debt's current fair value based on the issuer's current spread over the current Treasury rate. The make-whole provision contains a premium settlement amount to penalize the debtor for prepaying the debt and to compensate the investor (that is, to approximately make the investor whole) for its being forced to recognize a taxable gain on the settlement of the debt investment. In some debt instruments, the prepayment option under a make-whole provision will not be exercisable during an initial "lock-out" period.

• For example, Private Company A borrows from Insurance Company B under a 10-year loan with fixed periodic coupon payments. The spread over the Treasury rate for Company A at issuance of the debt is 275 basis points. The loan agreement contains a make-whole provision that if Company A prepays the debt, it will pay Insurance Company B an amount equal to all the future contractual cash flows discounted at the current Treasury rate plus 50 basis points.

Illustrative Debt Instrument 5

Some variable-rate debt instruments include a call option that permits the debtor to repurchase the debt instrument from the creditor at each interest reset date at an amount equal to par.

Illustrative Debt Instrument 6

Some fixed-rate debt instruments include both a call option as described in illustrative debt instrument 1 and a contingent acceleration clause as described in illustrative debt instrument 2.

Illustrative Debt Instrument 7

Some debt instruments contain an investor protection clause (which is standard in substantially all debt issued in Europe) that provides that, in the event of a change in tax law that would subject the investor to additional incremental taxation by tax jurisdictions other than those entitled to tax the investor at the time of debt issuance, the coupon interest rate of the debt increases so that the investor's yield, net of the incremental taxation effect, is equal to the investor's yield before the tax law change. The debt issuance also contains an issuer protection clause (which is standard in substantially all debt issued in Europe) that provides that, in the event of a tax law change that triggers an increase in the coupon interest rate, the issuer has the right to call the debt obligation at par. There would be no market for the debt were it not for the prepayment and interest rate adjustment clauses that protect the issuer and investors.

RESPONSE

An interest-bearing asset or liability should be considered prepayable under the provisions of paragraph 68(d) when one party to the contract has the right to cause the payment of principal prior to the scheduled payment dates unless (1) the debtor has the right to cause settlement of the entire contract before its stated maturity at an amount that is always greater than the then fair value of the contract absent that right or (2) the creditor has the right to cause settlement of the entire contract before its stated maturity at an amount that is always less than the then fair value of the contract absent that right. A right to cause a contract to be prepaid at its then fair value would not cause the interest-bearing asset or liability to be considered prepayable under paragraph 68(d) since that right would have a fair value of zero at all times and essentially would provide only liquidity to the holder. Notwithstanding the above, any term, clause, or other provision in a debt instrument that gives the debtor or creditor the right to cause prepayment of the debt contingent upon the occurrence of a specific event related to the debtor's credit deterioration or other change in the debtor's credit risk (for example, the debtor's failure to make timely payment, thus making it delinquent; its failure to meet specific covenant ratios; its disposition of specific significant assets (such as a factory); a declaration of cross-default; or a restructuring by the debtor) should not be considered a prepayment provision under the provisions of paragraph 68(d). Likewise, any term, clause, or other provision in a debt instrument that gives the debtor or creditor the right to cause prepayment of the debt contingent upon the occurrence of a specific event that (a) is not probable at the time of debt issuance, (b) is unrelated to changes in benchmark interest rates or any other market variable, and (c) is related either to the debtor's or creditor's death or to regulatory actions, legislative actions, or other similar events that are beyond the control of the debtor or creditor, should not be considered a prepayment provision under the provisions of paragraph 68(d). Application of this guidance to specific debt instruments is provided below.

Illustrative Debt Instrument 1

Yes. Fixed-rate debt instruments that provide the borrower with the option to prepay at a fixed amount are considered prepayable under paragraph 68(d) since those contracts permit settlement at an amount that is potentially below the contract's fair value (absent the effect of the call provision) as of the date of settlement. Such clauses can be exercised based on an economic advantage related to changes in the designated benchmark interest rate.

Illustrative Debt Instrument 2

No. Debt instruments that include contingent acceleration clauses that permit the lender to accelerate the maturity of an outstanding note only upon the occurrence of a specified event related to the debtor's credit deterioration or other changes in the debtor's credit risk are not considered prepayable under paragraph 68(d).

Illustrative Debt Instrument 3

No. Fixed-rate debt instruments that provide the debtor with the option to repurchase from the creditor the debt at an amount equal to the then fair value of the contract are not considered prepayable under paragraph 68(d) since that right would have a fair value of zero at all times. Such clauses, which provide the debtor with the discretionary opportunity to settle its obligation prior to maturity, are not exercised based on an economic advantage related to changes in the designated benchmark interest rate because the repurchases are done at fair value.

Illustrative Debt Instrument 4

No. Fixed-rate debt instruments that include a make-whole provision (as previously described) are not considered prepayable under paragraph 68(d) since it involves settlement of the entire contract by the debtor before its stated maturity at an amount greater than (rather than an amount less than) the then fair value of the contract.

Illustrative Debt Instrument 5

Although illustrative debt instrument 5, a variable-rate debt instrument, does have a fair value exposure between the date of a change in the benchmark interest rate and the reset date, a swap would not be an appropriate hedging instrument to hedge that fair value exposure. Thus, a fair value hedge of illustrative debt instrument 5 could not qualify for the shortcut method discussed in paragraph 68, which requires the hedging instrument to be an interest rate swap. In cash flow hedges, if the reset provisions always result in the instrument's par amount being equal to its fair value at a reset date, then an option for the debtor to prepay the variable-rate debt instrument at par at that reset date would not be considered prepayable under paragraph 68(d). However, if the reset provisions can result in the instrument's par amount not being equal to its fair value at those reset dates, then an option for the debtor to prepay the variable-rate debt instrument at par at a reset date would be considered prepayable under paragraph 68(d). (Because the reset provisions typically do not adjust the variable interest rate for changes in credit sector spreads and changes in the debtor's creditworthiness, the variable-rate debt instrument's par amount could seldom be expected to be equal to its fair value at each reset date.) Furthermore, in order to qualify for cash flow hedge accounting, the hedging relationship must meet the applicable conditions in Statement 133 and the entity designating the hedge (that is, the debtor or creditor) must conclude it is probable that future interest payments will be made during the term of the interest rate swap. If the creditor's counterparty (that is, the debtor) on a recognized variable-rate asset related to the hedged forecasted interest payments can cause that asset to be prepaid, then that creditor would likely be unable to conclude that all the forecasted interest payments on its recognized interest-bearing asset are probable and, thus, the cash flow hedging relationship would not qualify for the shortcut method. (Even though the creditor believes it could immediately obtain a replacement variable-rate asset if prepayment occurs and thus could conclude that the forecasted variable interest inflows are probable, the only hedged forecasted interest inflows that are eligible for application of the shortcut method are those related to a recognized interest-bearing asset at the inception of the hedge.) However, paragraph 68(d) indicates that its criterion that prohibits a prepayment option in the interest-bearing asset or liability does not apply to a hedging relationship if the hedging interest rate swap contains an embedded mirror-image option. In that latter case, if both the prepayment option and the mirror-image option in the swap were exercised, there would be no future hedged interest cash flows related to the recognized interest-bearing asset or liability and no future cash flows under the swap and, thus, the existence of the prepayment option would not preclude the use of the shortcut method.

Illustrative Debt Instrument 6

Yes. The same conclusions reached relative to illustrative debt instrument 1 also apply to illustrative debt instrument 6.

Illustrative Debt Instrument 7

No. Debt instruments that include contingent acceleration clauses that permit the debtor to accelerate the maturity of an outstanding note only upon the occurrence of a specified event that (a) is not probable at the time of debt issuance, (b) is unrelated to changes in benchmark interest rates or any other market variable, and (c) is related to regulatory actions, legislative actions, or other similar events are beyond the control of the debtor or creditor should not be considered a prepayment provision under the provisions of paragraph 68(d).

General Comments

An entity is not precluded from applying the shortcut method to a fair value hedging relationship of interest rate risk involving illustrative debt instruments 1 and 6 that are prepayable due to an embedded purchased call option provided that the hedging interest rate swap contains an embedded mirror-image written call option. In addition, an entity is not precluded from applying the shortcut method to a fair value hedging relationship of interest rate risk involving illustrative debt instruments 2, 3, 4, and 7 that are not considered prepayable provided that the hedging interest rate swap does not contain an embedded purchased or written call option related to changes in the designated benchmark interest rate. However, an entity would likely be precluded from applying the shortcut method to a cash flow hedging relationship of interest rate risk involving illustrative debt instrument 5 since the entity would likely be unable to conclude that all the forecasted interest payments on the recognized interest-bearing asset or liability are probable.

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.