Check the Redemption Provisions of Your Securities
Certain Redeemable Preferred Stock Not Permanent Equity on the Balance Sheet
The Rule -- Preferred securities that are redeemable for cash or other assets are to be classified outside of permanent equity if they are redeemable:
- at a fixed or determinable price on a fixed or determinable date;
- at the option of the holder; or
- upon the occurrence of an event that is not solely within the control of the issuer. 1
The SEC staff believes that this analysis applies to other equity instruments as well, including common stock, stock options and warrants, where redemption of these securities is outside the control of the issuer.
Determining whether an equity security is redeemable upon the occurrence of an event that is not solely within the control of the issuer might be the most difficult of the three redemption scenarios to evaluate. Each event that could trigger redemption should be evaluated separately, and the possibility that any triggering event that is not solely within the control of the issuer could occur — no matter how remote — would require the security to be classified outside of permanent equity.
Ordinary liquidation events that involve the redemption and liquidation of all equity securities, such as the payment of cash upon final liquidation, should not result in a security being classified outside of permanent equity. However, deemed liquidation events that require one or more particular class or type of equity security to be redeemed could cause those securities to be classified outside of permanent equity.
Practical Implications
The SEC now is enforcing more strictly this long-standing rule. Issuers, with the help of counsel and independent auditors, should examine the redemption provisions of all securities classified on their balance sheets as permanent equity to see if they are properly classified. Moving a redeemable security outside of permanent equity on the balance sheet would reduce the issuer’s shareholders’ equity. This would affect any relevant stock market listing or contractual compliance test based on an equity standard. For example, a company that plans to maintain its Nasdaq listing status by meeting the new $10 million equity requirement (effective as of November 1, 2001) must examine the redemption provisions of any security classified on its balance sheet as permanent equity to ensure that the security is properly classified and the equity threshold is properly met.
Loan agreements often contain financial covenants based on financial ratios that refer to shareholders’ equity. Companies with outstanding loan agreements that are planning an equity financing should be sure to draft redemption provisions such that the balance sheet classification of the new equity being offered in the financing will not violate the financial ratio covenants. Alternatively, issuers may amend loan agreements, as necessary, so that any required shifting of a redeemable security to a position on the balance sheet outside of permanent equity does not violate a financial covenant.
Illustrations
The SEC has provided the following illustrations for guidance: 2
Securities to be classified outside of permanent equity
- The SEC believes that where a preferred security may be redeemed by the issuer upon an affirmative vote by the majority of its board of directors, if the preferred security holders control a majority of the votes of the board, the preferred security is redeemable at the option of the holder and it must be classified outside of permanent equity. The SEC acknowledges that simply because a redemption provision requires approval by the board of directors, it does not necessarily mean that redemption is controlled by the issuer.
- In the SEC’s view, a security that becomes redeemable after a merger or consolidation resulting in the stockholders of the issuer holding less than a majority (or other specified percentage) of the voting power of the outstanding stock of the surviving corporation should be classified outside of permanent equity. This is because a purchaser could acquire the specified percentage of the voting power of the outstanding stock, without company approval, triggering redemption.
- Securities redeemable upon the occurrence of any of the following events should be classified outside of permanent equity, as they are not solely within the issuer’s control:
- inability to convert the security into common stock (e.g., where the issuer does not have enough common shares authorized to convert) and shareholder approval is required to authorize additional common shares
- failure to have a registration statement declared effective by a certain date
- failure to maintain compliance with debt covenants
- failure to achieve specified earnings targets
- reduction in the issuer’s credit rating.
Securities to be classified as permanent equity
- A preferred security that is redeemable when an issuer decides to sell all or substantially all of its assets and distribute the proceeds would be appropriately classified as permanent equity. The decision to sell all or substantially all of the issuer’s assets and to distribute the proceeds to common stockholders is solely within the issuer’s control. The outcome would be different if the preferred stockholders could trigger or otherwise require, without the issuer’s approval, the sale of the assets and the distribution through representation on the board of directors, or through other rights.
- Preferred stock that is redeemable if the issuer company is merged with or consolidated into another company, where approval of the transaction by the issuer’s board of directors is required, would be appropriately classified as permanent equity. The decision to merge or consolidate is within the control of the issuer. This assumes that the preferred stockholders cannot control the vote of the board through direct representation or through other rights, in which case the decision that would trigger the redemption would not be within the control of the issuer.
- Where redemption of an equity security is required upon the death or disability of a stockholder, and this redemption will be funded from the proceeds of an insurance policy that is currently in force, and which the company has the intent and ability to maintain in force, the security is properly classified as permanent equity.
Endnotes
1 Rule 5-02.28 of Regulation S-X adopted in Accounting Series Release No. 268, Presentation in Financial Statements of "Redeemable Preferred Stocks."
2 July 19, 2001 SEC Staff Announcement, Topic D-98; Speech given December 4, 2000 by Dominick J. Ragone III, Professional Accounting Fellow, Office of the Chief Accountant, U.S. Securities and Exchange Commission.
The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts.
Robert Friedel and Russell D. Paul