Derivatives Implementation Group

Statement 133 Implementation Issue No. K2

QUESTION

If a bond includes in its terms at issuance an option feature that is explicitly transferable independent of the bond and thus is potentially exercisable by a party other than either the issuer of the bond (the debtor) or the holder of the bond (the investor), should the option be considered under Statement 133 as an attached freestanding option or an embedded option by the writer and the holder of the option?

BACKGROUND

Certain structured transactions involving the issuance of a bond incorporate transferable options to call or put the bond. As such, those options are potentially exercisable by a party other than the debtor or the investor. For example, certain "put bond" structures involving three separate parties-the debtor, the investor, and an investment bank-may incorporate options that are ultimately held by the investment bank, giving that party the right to call the bond from the investor. Several put bond structures involving options that are exercisable by a party other than the debtor or investor are described in Statement 133 Implementation Issue No. B13, "Accounting for Remarketable Put Bonds."

RESPONSE

If a bond includes in its terms at issuance an option feature that is explicitly transferable independent of the bond and thus is potentially exercisable by a party other than either the issuer of the bond (the debtor) or the holder of the bond (the investor), that option should be considered under Statement 133 as an attached freestanding derivative instrument, rather than an embedded derivative, by both the writer and the holder of the option.

For example, a call option that is transferable either by the debtor to a third party and thus is potentially exercisable by a party other than the debtor or the original investor based on the legal agreements governing the debt issuance can result in the investor having different counterparties for the option and the original debt instrument. Accordingly, even when incorporated into the terms of the original debt agreement, such an option may not be considered an embedded derivative by either the debtor or the investor because it can be separated from the bond and effectively sold to a third party. The notion of an embedded derivative, as discussed in paragraph 12, does not contemplate features that may be sold or traded separately from the contract in which those rights and obligations are embedded. Assuming they meet Statement 133's definition of a derivative, such features must be considered attached freestanding derivatives rather than embedded derivatives by both the writer and the current holder.

In addition, Statement 133 Implementation Issue No. B3, "Investor's Accounting for a Put or Call Option Attached to a Debt Instrument Contemporaneously with or Subsequent to Its Issuance," requires that an option that is added or attached to an existing debt instrument by a third party also results in the investor having different counterparties for the option and the debt instrument and, thus, the option should not be considered an embedded derivative.

An attached freestanding derivative is not an embedded derivative subject to grandfathering under the transition provisions of Statement 133.

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.