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A convertible instrument may have embedded components other than the embedded conversion option. In addition, a reporting entity may execute agreements in connection with the issuance of a convertible instrument. In the following sections we describe some of the more common embedded components and agreements.
See FG 1.7 for information on registration rights and FG 1.6.1 for information on the evaluation of embedded put and call options in debt host instruments.

6.10.1A Contingent interest—before adoption of ASU 2020-06

A contingent interest feature requires additional interest to be paid only when certain conditions exist. Typically, contingent interest features are included for tax purposes to allow the reporting entity to deduct interest expense in excess of the cash coupon paid, although the extra deductions are subject to recapture. In addition, contingent interest can deter investors from exercising their put or conversion option.
A contingent interest provision in convertible debt typically requires the payment of additional interest if the instrument’s average trading price is at a specified level above or below par value. For example, a provision may call for contingent interest in the amount of 25 basis points multiplied by the instrument’s trading price to be paid if the average trading price is above $120. Many contingent interest features become effective only after a simultaneous put and call date.
A contingent interest feature that meets the definition of a derivative should be considered clearly and closely related to a debt host when indexed solely to interest rates and credit risk. However, the trading price of a convertible debt instrument is a function of more than just interest rates and credit risk due to the embedded conversion option. As a result, contingent interest features in convertible debt instruments that are indexed to the instrument’s trading price are generally not considered clearly and closely related to the debt host and should be separated and accounted for as a derivative.
The determination of the likelihood of paying contingent interest should be consistent for book and tax purposes. That is, if when determining the fair value of the bifurcated derivative for book purposes, a reporting entity determines the likelihood of payment is remote, then the same assertion should be used when determining if the interest is deductible for tax purposes. When determining the fair value of the bifurcated derivative, some reporting entities may conclude that such amount is not material because the likelihood of payment is remote. See TX 9.4.2 for information on the tax accounting considerations of contingent interest.

6.10.2A Greenshoe (overallotment option)—before adoption of ASU 2020-06

A greenshoe is a freestanding agreement between a reporting entity and an underwriter that allows the underwriter to call additional securities to “upsize” the amount of securities issued. These agreements are a mechanism enabling the underwriter to stabilize prices. If the convertible debt trades below the offering price, the underwriter can purchase the convertible debt for less than it was sold for, thereby decreasing supply and increasing the price. If the convertible debt trades above the offering price, the underwriter can exercise the greenshoe, thereby increasing supply and decreasing the price. For example, a 15% greenshoe on a $100 million convertible debt offering may allow an underwriter to require the reporting entity to issue an additional $15 million of debt at the original offering price. The term “greenshoe” comes from the name of the company (Green Shoe Manufacturing) that first used such an agreement with its underwriter.
Prior to the issuance of a convertible instrument, an underwriter will take orders from investors. The underwriter will then allocate the base amount plus any greenshoe amount to the investors. The amount allocated to investors in excess of the base amount is called an overallotment. The underwriter can fill an overallotment by exercising the greenshoe.
There are several types of greenshoes, the most common being an overallotment option. An overallotment option allows the underwriter to call additional securities from the reporting entity only to fill overallotments. The underwriter cannot exercise an overallotment option and hold or sell the securities for its own account. Other types of greenshoes allow the underwriter full discretion over the securities received by exercising their option.
A greenshoe on a publicly traded instrument generally will meet the definition of a derivative and, for issuances of convertible debt, will not meet the requirements for the scope exception for certain contracts involving a reporting entity’s own equity in ASC 815-10-15-74(a). As a result, a greenshoe on publicly traded debt is generally accounted for as a derivative under the guidance in ASC 815. The greenshoe is a written call option by the issuer on the convertible debt. As such, a portion of the proceeds received on the issuance of the convertible debt should be allocated to this written option based on its fair value. As a result, a discount (or a reduction of premium) will be created on the convertible debt. Since the written option meets the definition of a derivative, it should be subsequently measured at fair value, with changes in fair value recorded through earnings. Greenshoes are generally exercisable for a short period of time (typically less than 30 days) with an at-the-money strike price. As a result, greenshoes may have insignificant value.
A greenshoe on a privately placed instrument may not meet the definition of a derivative if the instrument is not readily convertible to cash. However, it is still a written call option and, as such, proceeds on the convertible debt issuance should be allocated to the greenshoe.

6.10.3A Call option overlay—before adoption of ASU 2020-06

A call option overlay (call spread, capped call) is a transaction executed between a reporting entity issuing a convertible debt instrument and an investment bank. In a call option overlay, the reporting entity buys a call option from the investment bank that mirrors the conversion option embedded in the convertible debt instrument, effectively “hedging” or canceling the economic effect of the embedded conversion option. The reporting entity pays a premium to the investment bank to buy this option. The reporting entity then sells a call option to the investment bank, almost always at a higher strike price than the embedded conversion option and purchased call option, effectively raising the strike price of the convertible debt instrument transaction. If the strike price of the sold call option is higher than the strike price of the purchased call option, the reporting entity will receive a lower premium from the investment bank for selling this option.
The primary reasons a reporting entity may execute a call option overlay transaction are (1) to receive additional tax benefits and (2) to synthetically raise the strike price on the convertible debt instrument.
A call option overlay may be executed as two separate call option transactions—referred to as a call spread—or it can be executed as a single integrated transaction—referred to as a capped call. A call spread and a capped call are accounted for separately from the convertible debt instrument with which they are issued or associated. A call spread is accounted for as two transactions (1) a purchased call option on the reporting entity’s own stock and (2) a written call option on the reporting entity’s own stock at a higher strike price, whereas a capped call is accounted for as a single transaction. See FG 5.6A for information on the analysis of freestanding equity-linked instruments.
A call option overlay is included in diluted EPS based on the form of the transaction. A capped call generally is not included in diluted EPS because it is anti-dilutive. In a call spread, however, the purchased call is not included in diluted EPS because it is anti-dilutive, but the sold call is included in diluted EPS when dilutive. This can create so called “double dilution” from the convertible debt instrument and the sold call, if the reporting entity’s stock price increases to a level above the strike price on the sold call.

6.10.4A Share-lending arrangements—before adoption of ASU 2020-06

Less commonly, a reporting entity issuing a convertible debt instrument may enter into a share-lending agreement with an investment bank. A share-lending agreement is intended to facilitate the ability of investors, primarily hedge funds, to borrow shares to hedge the conversion option in the convertible debt instrument. Typically, they are executed in situations where the issuing reporting entity’s stock is difficult or expensive to borrow in the conventional stock borrow market.
The terms of a share-lending arrangement typically require the reporting entity to issue (loan) shares to the investment bank in exchange for a small fee, generally equal to the par value of the common stock. Upon conversion or maturity of the convertible debt, the investment bank is required to return the loaned shares to the reporting entity. The shares issued are legally outstanding, entitled to vote, and entitled to dividends, although under the terms of the arrangement the investment bank may agree to reimburse the issuer for dividends received and may agree not to vote on any matters submitted to a vote of the reporting entity’s shareholders.
ASC 470-20-25-20A and ASC 470-20-35-11A provide guidance on the accounting for a share-lending arrangement.

ASC 470-20-25-20A

At the date of issuance, a share-lending arrangement entered into on an entity’s own shares in contemplation of a convertible debt offering or other financing shall be measured at fair value (in accordance with Topic 820) and recognized as an issuance cost, with an offset to additional paid-in capital in the financial statements of the entity.

ASC 470-20-35-11A

If it becomes probable that the counterparty to a share-lending arrangement will default, the issuer of the share-lending arrangement shall recognize an expense equal to the then fair value of the unreturned shares, net of the fair value of probable recoveries, with an offset to additional paid-in capital. The issuer of the share-lending arrangement shall remeasure the fair value of the unreturned shares each reporting period through earnings until the arrangement consideration payable by the counterparty becomes fixed. Subsequent changes in the amount of the probable recoveries should also be recognized in earnings.

Amortization of the discount created by the fair value of the share lending agreement which is treated as a debt issuance cost will increase the overall implied cost of the convertible debt. See FG 1.2.3 for information on the amortization of debt issuance costs.
See FSP for information on the earnings per share treatment of share lending arrangements.

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