Watch Out For Currency Mismatch!

PIPE issuers and their advisors have long tried to avoid having to treat securities they’ve issued as derivatives. The task of individually valuing securities, and even embedded features within the securities, every quarter is operationally challenging, time-consuming and expensive. In addition, “fair value accounting” can introduce undesirable levels of earnings volatility. The question is, how do you maneuver through this minefield? In the past, issuers have gone as far as renegotiating deals after execution so the “triggering” features could be removed due to the expense of complying with accounting rules governing derivatives in issued securities.

To add clarity to this complexity, the FASB issued ASC 815-40, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock (ASC 815-40) and ASC 815-40-15 Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock (ASC 815-40-15). We’ve seen renewed attention to this area as of late as activity among foreign issuers of PIPEs has increased.

The SEC has paid particular attention to securities issued by companies whose “functional currency” is not the US dollar (“USD”). This issue affects all foreign issuers of PIPE securities. The most common issuance is a convertible with warrants attached. Now this is where it gets tricky. If a settlement provision of a convertible security or warrant involves a currency other than the functional currency of the issuer, “derivative accounting” will likely come into play. As an issuer of convertible securities, does it matter what currency investors use when they convert your stock? You bet!

The following explanation can help you evaluate the difference between settlement currency and functional currency and why the difference is so important. It will address how structuring a PIPE deal can impact the issuer’s financial statements. Also, if you have already issued convertible securities but holders haven’t converted yet, evaluation of the currency implications of the settlement provision is essential.

Is it indexed or not?

When companies outside the US issue PIPE securities to US investors, they usually need to file US GAAP financial statements, or at least reconcile foreign statements to US GAAP. Under US GAAP, currency provisions should be evaluated according to the provisions of ASC 815-40-15, among other rules, to determine whether that provision is considered “indexed”.

Settlement provisions that are not considered “indexed” to the issuing company’s own stock are usually subject to ongoing fair value accounting requirements after issuance. The following section illustrates what happens when the settlement currency causes the securities to be considered “not indexed”, which often then triggers ongoing fair value accounting.

Technical Accounting

A convertible security “settles” when it converts. Settlement provisions take many shapes and sizes. One characteristic is the currency in which settlement occurs. Many foreign issuers of PIPE securities cater to investors with specific risk profiles with respect to currency exchange risk, so settlement currency is usually an integral part of the deal. Functional currency, on the other hand, is the currency that the issuer uses for its primary business operations.

In order to mitigate the potential requirement of ongoing fair value accounting implications after the deal, the settlement currency must be considered “indexed” to the company’s own stock. ASC 815-40-15 explicitly holds the view that settlement provisions in any currency other than the issuer’s functional currency are not considered indexed.

Paragraph 19 of ASC 815-40-15 says:

“The issuer of an equity-linked financial instrument incurs an exposure to changes in currency exchange rates if the instrument’s strike price is denominated in a currency other than the functional currency of the issuer. An equity-linked financial instrument (or embedded feature) would not be considered indexed to the entity’s own stock if the strike price is denominated in a currency other than the issuer’s functional currency (including a conversion option embedded in a convertible debt instrument that is denominated in a currency other than the issuer’s functional currency). The determination of whether an equity-linked financial instrument is indexed to an entity’s own stock is not affected by the currency (or currencies) in which the underlying shares trade.….”

When a settlement provision is not considered indexed, it can change the balance sheet classification of the instrument and require changes in the fair value of the instrument to be recorded in earnings at each reporting period. In other words, each security will need to be valued quarterly. Such valuations are made more complicated by the fact that private securities are illiquid in nature. Traditional valuation models like Black-Scholes are not well suited for valuing illiquid securities and can (1) overvalue the securities and (2) overstate the volatility of their values.

Functional Currency

Functional currency is a subjective accounting determination. It is generally based on the primary currency the company uses to conduct business, including how payables and receivables are settled, how revenues are collected and how expenses are paid. A company’s currency determination can often be surprising, with foreign companies adopting the USD and domestic companies adopting foreign currencies. The determination generally does not change once it is established because it is based on an analysis of the company’s business operations and objectives. There is much controversy over what factors should be given the most weight when making a functional currency determination. Auditors can hold differing views on the same set of facts and circumstances.

Consider a Chinese company that uses the Chinese Renminbi (“RMB”) to conducts all of its business operations in China. Its functional currency will likely be the RMB. But what about a US shell corporation with a Chinese subsidiary? In this case, the functional currency could very well be the US dollar if the primary currency used is deemed to be the USD.

Carefully structuring the settlement currency to match the issuer’s functional currency can mitigate the likelihood that the securities would fail to be considered indexed, if done properly. That may be easier said than done since different investors have specific appetites for currency risk. In any case, it is easier to change settlement currency than functional currency, since functional currency is based on fundamental business operations and settlement currency is based on the demands of investors.

If the securities have already been issued, but conversion has not yet taken place, it’s not too late to think about trying to change the deal.

Conclusion

Whether your settlement currency matches your functional currency or not, convertible securities need to be bifurcated at inception between the amounts attributable to the debt and the conversion option. But whenever there’s a mismatch, significant additional analysis may be required.