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Contingent convertible bonds: a case study in using and accounting for a hybrid instrument.

In July 2013, the U.S. Federal Reserve Board approved a final rule implementing the Basel III regulatory capital reforms, which aimed to "strengthen the regulation, supervision and risk management of the banking sector" (http://www .bis.org/bcbs/basel3.htm). This is the third accord created by the Basel Committee on Banking Supervision (BCBS), under the auspices of the Bank of International Settlement.

According to Ben Bernanke, chairman of the Federal Reverse at that time--

This framework requires banking organizations to hold more and higher quality capital, which acts as a financial cushion to absorb losses, while reducing the incentive for firms to take excessive risks (Board of Governors of the Federal Reserve System, press release, Jul. 2, 2013).

To satisfy the Basel III capital cushion requirements in a way that is less demanding on their capital structure, European banks are already relying on a new type of hybrid debt instrument: contingent conversion (COCO) bonds.

Introduction to Convertible Bonds

Accounting Standards Codification (ASC) 470-20-25-10 defines convertible bonds as "debt securities which are convertible into common stock of the issuer or an affiliated company at a specified price at the option of the holder." It also states the following:

   The terms of such securities generally
   include (1) an interest rate which is
   lower than the issuer could establish
   for nonconvertible debt, and (2) an initial
   conversion price which is greater
   than the market value of the common
   stock at time of issuance.


Per ASC 470-20-25-12, no portion of the proceeds from the issuance of convertible bonds is attributable to the conversion feature; all of the proceeds are listed on the issuer's balance sheet as a liability. One exception to this is bifurcation--that is, when the proceeds for the option component are classified as a separate derivative asset or derivative liability, as explained below.

The following discussion will refer to Credit-Suisse's version of COCOs--buffer capital notes (BCN)--to help explain the issues that arise in determining the requirement for separate accounting for the embedded derivative conversion component. Credit-Suisse uses U.S. GAAP to prepare its consolidated financial statements. BCN's have several differences from normal convertible bonds:

* The interest rate paid is higher, not lower, than that of nonconvertible debt.

* The conversion price is not set at an amount that is necessarily greater than the market value of the common stock at time of issuance.

* Conversion of the debt into common shares is never effected at the option of the bondholder or bond issuer; rather, either of two events can cause the conversion of BCN debt into Credit-Suisse common shares: 1) if Credit-Suisse's Tier 1 capital ratio falls below 7% as reported in the quarterly financial statements, or 2) if the Swiss Financial Market Supervisory Authority (FINMA) considers Credit-Suisse at risk of insolvency and in need of an equity boost.

The BCNs' conversion price is the higher of a floor price of USD 20/CHF 20 per share (subject to customary adjustments) or the daily volume-weighted average sale price of ordinary shares over a five-day period preceding the notice of conversion ("Treasury, Risk, Balance Sheet and Off-Balance Sheet," Credit-Suisse, https://www.credit-suisse.com/pubhcations/ annualreporting/doc/2011/csg_ar11_treasury _risk_balance_en.pdf).

Derivative Basics

It is important for CPAs to be familiar with the concepts of hybrid instruments and derivatives. A hybrid is a financial instrument with two parts: a host contract and an embedded derivative. In the case of a BCN, the host is the bond and the embedded derivative is the conversion feature, which is essentially an inseparable call option on the issuer's stock. Per ASC 815-10-10-1, all derivative instruments should be measured at fair value. The accounting for changes in the fair value (that is, gains or losses) of a derivative depends upon whether it is part of a hedging relationship; the gain or loss on a derivative instrument not designated as a hedging instrument should be recognized currently in earnings (ASC 815-10-35-2).

Per ASC 815-10-15-83ff, a derivative is a financial instrument with three characteristics:

* Underlying--an objectively verifiable variable that determines the settlement of a derivative, such as a security or commodity price or index, or even the occurrence or nonoccurrence of a specified event

* 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 readily be settled net, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement. For example, typical interest rate swaps do not require that either party deliver interest-bearing assets with a principal amount equal to the notional amount of the contract, but only to the net amount due to the counterparty.

To illustrate these three criteria, consider a freestanding option that allows its owner to purchase 200 shares of stock at $50 per share:

* The underlying is the market price of a share; the notional amount is 200 shares.

* The initial net investment is less than the investment for the stock on which the option is based.

* Either party to the option can provide a net settlement for the contract by not having to actually deliver shares of stock or, if it does have to, the shares are easily converted into cash on an exchange.

These criteria raise an important question: does a BCN's embedded conversion option fit the definition of a derivative?

Analysis of a Derivative Underlying

Statement of Financial Accounting Standards (SFAS) 133, Accounting for Derivative Instruments and Hedging Activities, explains more about derivative underlyings in Appendix C:

   Derivative instruments typically permit
   the parties to participate in some or all
   of the effects of changes in a referenced
   price, rate, or other variable, which
   is referred to as the underlying, for
   example, an interest rate or equity index
   or the price of a specific security, commodity,
   or currency ... the price or rate
   of the associated asset or liability, which
   is used to determine the settlement
   amount of the derivative instrument, is
   the underlying.


The underlying for a BCN is either Credit-Suisse's Tier 1 ratio or the occurrence of a FINMA decision that a conversion into equity is needed for Credit-Suisse's financial health. The Tier 1 ratio does not represent an effect that is shareable by an investor; it is simply a financial statistic describing one aspect of the company's situation.

Unlike share prices, Tier 1 ratio changes result in no gain or loss. This dissimilarity calls into question whether the conversion option of a BCN is truly a derivative, even though it has an underlying variable (Tier 1 ratio) and specified event (FINMA decision). Should this decision be made based on what is "typical" for derivatives and disqualify a BCN's conversion feature from being a derivative, or is the existence of a variable and a specified event sufficient?

Another consideration is whether the BCN's 7% capital ratio conversion trigger qualifies as an underlying. The Tier 1 ratio information for Credit-Suisse is based on management-issued quarterly reports and is not issued by a third party, unlike the examples of underlyings in ASC 815-10-15-88. Is information truly objectively verifiable when its source is management? Perhaps an auditor's unqualified opinion on the accuracy of financial statements would qualify this information as objectively verifiable.

Another concern is that the Tier 1 ratio is derived from BCBS calculations that are "not straightforward" ("Consultative Document: Application of Own Credit Risk Adjustments to Derivatives," Basel Committee on Banking Supervision, Dec. 21, 2011). Can an underlying based on calculations that are not straightforward and might be open to multiple interpretations qualify as objectively verifiable?

The other cause of conversion, FINMA's determination of Credit-Suisse being on the brink of insolvency, would presumably qualify as an underlying event, similar to a scheduled payment or climatic condition, because it is produced and reported by a third party.

Analysis of Initial Net Investment

ASC 815-10-15-83(b) explains initial net investment as follows:

   The contract requires no initial net
   investment or an initial 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.


In this case, the question is whether the price paid for the derivative embedded in a BCN is less than the stock into which the BCN might be converted. This depends upon the answer to another question: when the embedded derivative is separated from its host contract (as discussed later in the section on bifurcation), how are a BCN's issuance proceeds allocated between the resulting debt and derivative? ASC 815-15-30-2 and SFAS 133 Implementation Issue B6 provide that the fair value of the embedded derivative should be determined first, and then that value should be deducted from the basis of the hybrid. The resulting amount is the value assigned to the debt host.

But a characteristic differentiating BCN's from normal convertible bonds is that the price for a BCN is lower, not higher, than the price of a plain vanilla bond from the same issuer. In other words, a BCN pays a higher interest rate than a plain vanilla bond, whereas a normal convertible pays a lower interest rate than a plain vanilla bond. Unless the embedded derivative is accorded a negative value, the sum of the derivative and debt-only portion will not accurately reflect the BCN's sub-plain vanilla debt pricing. Because the derivative has a negative value, the amount paid for it is less than the stock into which it would convert; therefore, the characteristic of initial net investment is satisfied

Application of Net Settlement

ASC 815-10-15-99 gives the following explanation of a contract that is net settled: "Net settlement by delivery of derivative instrument or asset readily convertible to cash." SFAS 133 (ASC 815-10-15-122) explains the reasoning behind this requirement:

   Net settlement is an important characteristic
   that distinguishes a derivative from
   a nonderivative because it permits a contract
   to be settled without either party's
   accepting the risks and costs customarily
   associated with owning and delivering the
   asset associated with the underlying (for
   example, storage, maintenance, and
   resale). However, if the assets to be
   exchanged or delivered are themselves
   readily convertible to cash, those risks are
   minimal or nonexistent. Thus, the parties
   generally should be indifferent as to
   whether they exchange cash or the assets
   associated with the underlying.


Does the description of being an "asset readily convertible to cash" apply to a BCN? The conversion of a BCN may occur when FINMA decides that its issuer is in danger of insolvency; in such a scenario, would Credit-Suisse stock be considered to have an active market? (If the case of Lehman Brothers is any guide, the answer is yes: the average daily volume of Lehman shares traded one week before its bankruptcy was over 400 million.)

Yet, as the above guidance points out, "the parties should generally be indifferent as to whether they exchange cash or the assets associated with the underlying." It is questionable whether the holder of a BCN would be indifferent to receiving common shares of a company threatened by bankruptcy. In that case, the BCNs may not be considered readily convertible to cash and the embedded option would not qualify as net settled and, therefore, would not be a derivative.

Insurance Exception

ASC 815-10-15-13 lists financial contracts that are not considered derivatives, including "certain insurance contracts." ASC 815-10-15-52 explains the insurance exception in more detail and describes a contract concerning "an identifiable insurance event (other than change in price)"; ASC 815-10-15-53 adds to that "an identifiable insurable event (for example, theft or fire) instead of changes in a variable."

A BCN's conversion is caused by a change in a variable (Tier 1 ratio) other than price. Accordingly, the embedded derivative of a BCN might fall under this exception and not qualify as a derivative. Moreover, what is the definition of an identifiable insurance event? MetLife provides an illustrative example; it offers wedding insurance, with one of the covered insurance events being a bridal dress shop that goes out of business (http://www.mike .metlife.com/Wedding-Insurance. 10.htm). This event seems similar to FINMA deeming that Credit-Suisse needs an equity boost to avoid going out of business. If so, a BCN's embedded conversion option might fall under the insurance exception and, therefore, be disqualified from the derivative classification.

Equity Exception

According to ASC 815-10-15-74(a), a contract is not be considered a derivative asset or liability by a reporting entity if it satisfies both of the following criteria:

* It is indexed to the reporting entity's own stock.

* It is classified in the reporting entity's stockholders' equity section in its balance sheet.

It is important to note the phrase "reporting entity" and the difference that it makes in applying the equity exception. Convertible bonds typically convert into the bond issuer's stock, so the above conditions would only apply to the bond issuer. This means that the bondholder would typically never apply this exception; however, a bond issuer could do so and, as a result, not classify convertible bonds' embedded conversion options as derivatives.

The first criterion--indexed to the reporting entity's own stock--has two tests that must be passed, per ASC 815-40-15-5 through 815-40-15-8. The first test is to evaluate the instrument's conversion conditions. If the conversion component is based on either 1) the market for the issuer's stock, or 2) an observable index related to the reporting entity's own operations, then it would be considered indexed to the issuer's own stock.

A BCN has two causes of conversion. The first one passes this test because it is based on the bond issuer's operations, specifically its Tier 1 ratio. The second cause also passes this test because it is based on FTNMA's determination regarding Credit-Suisse's need of capital to prevent insolvency. If a BCN conversion option also passes the second test--settlement terms under ASC 815-40-15-7(c)--it will be considered indexed to the underlying stock. In a nutshell, if the settlement involves a fixed number of shares for a fixed amount of debt it would be considered indexed to an entity's own stock--for example, if the conversion feature of a $1 million BCN would specify that the bond converts into 1,000 Credit-Suisse shares.

As mentioned above, for BCNs, "the conversion price will be the higher of a floor price of USD 20/CHF 20 per share (subject to customary adjustments) or the daily weighted average sale price of ... ordinary shares over a trading period preceding the notice of conversion" (http://www.lse.ac.uk/ fmg/events/conferences/past-conferences/ 2011/DBWorkshop_14Mar2011/8-CreditSuissePressRelease.pdf). This conversion settlement does not involve a fixed amount of shares to be exchanged for a fixed amount of debt; however, the rules [ASC 81540-15-7(d) and (e)] further state that the instrument or embedded feature would still be considered indexed to an entity's own stock if the only variables that could affect the settlement amount are variables typically used to determine the fair value of a fixed-for-fixed forward or option on equity shares--for example, the entity's stock price. Because the settlement of shares for a fixed amount of debt is calculated using the share price, the BCNs would pass this test.

By passing both tests, the BCNs would be considered indexed to the issuer's stock. If the BCNs also satisfy the next criterion, they would qualify for the equity exception and would not be considered derivative assets or liabilities for purposes of the issuer's reporting.

Classified in stockholders' equity. ASC 815-15-55-217 offers implementation guidance for a normal convertible bond. The embedded option is considered to be indexed to the issuer's own stock and would be classified as equity in the issuer's balance sheet because the issuer is required to deliver its own shares upon conversion. A BCN is no different from a normal convertible bond in this aspect and, therefore, its conversion option would also be classified as equity from the point of view of the issuer.

In addition, a BCN would be subject to the conditions of ASC 815-10-15-78 because it does not convert into a fixed amount of shares because the amount is based on a formula. The main point is to ensure that a BCN can only be converted into shares and not net settled in cash, because a net cash settled contract is not considered equity, except in limited circumstances (ASC 815-40-15-7).

Because a BCN conversion option qualifies for the equity exception for the issuer, it would not be classified as a derivative. The bondholder would classify the conversion option as a derivative, however, because the conversion option would not be considered equity on its balance sheet, because it converts into the issuer's stock, not its own.

Bifurcation

If one decides that a BCN's conversion component should be classified as a derivative from the point of view of the bondholder, the next step in COCO accounting is separating the BCN debt from its embedded derivative and accounting for each separately (i.e., bifurcation). SFAS 133 explains the rationale behind not treating a host and its embedded derivative as one entity:

   The Board considers it important that an
   entity not be able to avoid the recognition
   and measurement requirements of
   this Statement merely by embedding a
   derivative instrument in a nonderivative
   financial instrument or other contract.
   Therefore, certain embedded
   derivatives are included in the scope of
   this Statement if they would be subject
   to the Statement on a freestanding basis.


Because a derivative must be measured at fair value, with changes in its fair value recognized in earnings, one significant result of bifurcation is that this recognition of gain or loss may be different than if the embedded conversion option were accounted for under the rules governing its debt host.

Under ASC 815-15-25-1, three criteria must be satisfied to require bifurcation. One of them is especially relevant to this discussion: "The economic characteristics and risks of the embedded derivative instrument are not clearly and closely related to the economic characteristics and risks of the host contract."

In the case of a normal convertible bond, this criterion is met because the embedded conversion option's value is related to the price of the issuer's stock, whereas the host contract's value is related to interest rates; equity is not clearly and closely related to interest rates. Similarly, a BCN's conversion option is related to the issuer's Tier 1 ratio, which is not closely related to interest rates.

Fair value simplification election. Even if a hybrid, such as a BCN, must be split apart (in this case, by the bond investor only), FASB allows an election to irrevocably account for it as one unit at fair value, with changes in fair value recognized in earnings (ASC 8-15-15 25-4). Furthermore, if an entity cannot reliably identify and measure an embedded derivative that must be separated from the host contract, the entire contract should be measured at fair value, with the gain or loss recognized in earnings (ASC 815-15-25-53).

Proposed changes to Topic 825-10. Under the proposed Accounting Standards Update (ASU), Financial Instruments, Topic 825, bondholders would no longer split convertible bonds into their component parts because this type of accounting would no longer apply to assets; instead, hybrid contracts that are assets would be measured at fair value in their entirety, with changes in fair value recognized in income. Liabilities would continue to be subject to bifurcation.

Additional Insight

In this example, BCNs begin life as debt but may be converted into common stock to fortify the company's (Credit-Suisse's) capital structure. The following characteristics differentiate a BCN from a normal convertible bond:

* The conversion of debt into common shares is not executed per the whim of the bondholder or issuer, but only by either Credit-Suisse's Tier 1 ratio falling below 7% or FINMA considering Credit-Suisse at risk of insolvency.

* The interest rate paid by a BCN is higher than that of plain vanilla debt issued by the same entity.

The following questions remain to be resolved about BCNs:

* Is a BCN's conversion option considered insurance, and therefore precluded from being classified as a derivative?

* Is information provided by a bond issuer considered objectively verifiable?

* Are BCN investors indifferent to having their bonds converted into the equity of a company threatened by insolvency?

If U.S. banking rules would allow BCN-like bonds to qualify as Tier 1 capital, large U.S. banks might also consider them a productive use of their capital, while simultaneously satisfying Basel III requirements.

Allen Schulman is a graduate student at Fairleigh Dickinson University, Lakewood, N.J., and an associate at Kawaller & Co. risk management, Brooklyn, N.Y.
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Title Annotation:Finance: corporate finance
Author:Schulman, Allen
Publication:The CPA Journal
Article Type:Case study
Date:Jun 1, 2014
Words:3439
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