UK Puttable Warrants

[aj_uk]

Hi All,

Would be grateful on feedback on the following question which is bugging me. I'm using IFRS.

A lender lends say $100m to a company/borrower at an interest rate of LIBOR + 5%. As a sweetener to the deal, the lender gets puttable warrants in the borrower (strike price say 20% above current share price).

However there is a value cap on the Put (which is relatively low), which means if the company just does reasonably well and the shares free-market value rises moderately, the borrower would be better off selling any shares as a result of the warrant exercise in the free market, rather than utilising the Put. So the Put would only be used in the case basically of poor / below-average free-market share performance of the company.

My question is should this puttable warrant be a liability or equity, or a combination?

IAS 32 indicates puttable instruments should generally be liabilities but eg in the case of exceptional company performance it seems odd to have what could be a huge liability growing on the balance sheet (as it is marked to market) when any potential monetary settlement has a far lower cap.

Would the liquidity of the underlying shares (eg if the underlying co. was private vs public) change anything?

Thanks very much in advance.

AJ

 

[mike99]

(Assuming puttable instruments as per IAS 32:16A-D don't apply.)

Although it might at first seem odd, IAS 32:23 is very clear: If an entity writes a put option over its own equity instruments, it must record a liability. It will then debit equity on the date it records the liability. Any changes in the fair value of the liability will be recorded in profit/loss, and not equity, as equity is never remeasured to fair value, if you're within the scope of IAS 32 (.22).

This issue has been debated for a long time, and IAS 32 was revised to include the provision. The reason taken by the Board is that the entity, upon signing the contract, has a contractual obligation to deliver a financial asset (e.g. cash) in exchange for its equity shares. The obligation exists and the entity cannot avoid paying it, i.e. it is beyond the control of the entity to prevent settling it. The option holder can do what they want; whether they decide to act economically and not exercise it if the share price rises, or whether they decide to act uneconomically and exercise it even whilst recording a loss, this is beyond the entity's control.

The estimate of likelihood would come into the valuation of the option. If it was very likely that the holder would not exercise it by selling shares back to the issuer (e.g. very likely the market price of the entity would rise), then the option would have a value close to zero (and zero if exercise is less than strike).

However, the issue of whether a liability should be recognised or not should be separated from the issue determining the fair value of the option.

[Edit: No, the liquidity of the underlying shares would not impact whether a liability should be recognised or not. It could impact in your measurement of the option, I suppose, depending on your option pricing model.]