LOWENSTEIN SANDLER PC CLIENT ALERT SPECIALTY FINANCE PROPOSED FASB STAFF POSITION CLARIFIES THE ACCOUNTING FOR LIQUIDATED DAMAGES PENALTIES IN REGISTRATION RIGHTS AGREEMENTS By Steven E. Siesser, Esq. and Paul W. Hartzel, Esq. October 2006 The long awaited salvation Financial Accounting Standards instrument in conjunction with an from the havoc of the Securities Board (FASB). agreement to register the financial and Exchange Commission’s instrument or the equity shares The FASB recently issued for comment (SEC) treatment of liquidated underlying it to account for the a proposed FASB Staff Position (FSP damages and other cash settle- instrument under EITF 00-19 as EITF 00-19-b) addressing how compa- ment provisions may at last be a liability if the registration rights nies should account for liquidated on the horizon. agreement requires the issuer to pay damages provisions in their registra- liquidated damages in cash to the tion rights agreements. The FSP For almost two years now, the SEC has holder of the instrument in the event provides that liquidated damages held up registration statements, and in of a registration default. The only way penalties in a registration rights agree- many cases has required issuers to to avoid the recognition of a liability as ment that are triggered when an restate financial statements, on a result of a cash payment liquidated account of perceived excessive liqui- issuer fails to file and have declared damages provision in this context has dated damages and other cash effective the related resale registration been to cap the aggregate amount settlement provisions in capital raising statement or to maintain its effective- of liquidated damages payable under transactions. In implementing EITF ness as required by the agreement the registration rights agreement in Issue No. 00-19, “Accounting for generally should be accounted for the event of a registration default. Derivative Financial Instruments under FASB Statement No. 5, Initially, the SEC Staff accepted a 10% Indexed to, and Potentially Settled in, Accounting for Contingencies, and cap, and then began and currently a Company’s Own Stock,” the SEC should not cause the warrant, convert- continues to allow caps in the 18% to Staff has haphazardly imposed ible security or other financial 24% range. constraints on financing transactions instrument to be accounted for as a containing these types of provisions. derivative liability under EITF 00-19. Although the proposed FSP is subject Failure to comply with these con- to final approval by the FASB, it What this means for straints has had dreadful effects, strongly suggests that the SEC’s including delayed effectiveness of reg- issuers and investors in current position on this issue is not istration statements and restatements PIPEs transactions: of financial statements. The capital This FSP is significant because, despite markets community has been strug- the uncertainty regarding the proper gling to navigate through the fleeting accounting for such liquidated whims of the Staff, which itself has damages provisions, the Staff of the conceded its own quandary on how SEC has been requiring companies exactly to implement this EITF in the absence of guidance from The that issue a warrant or convertible
LOWENSTEIN SANDLER PC CLIENT ALERT Specialty Finance appropriate. Ultimately, we believe instrument or other agreement. For statement, if the arrangement other- that this FSP will require the SEC to purposes of the FSP , a “registration wise has the characteristics of a reverse its application of EITF 00-19 in payment arrangement” is an arrange- registration payment arrangement. this context. Final approval of the FSP ment with both of the following The FSP would not apply: would (i) allow issuers to not have to characteristics: book any liability relating to such cash • To contingent obligations under • The arrangement specifies that liquidated damages provisions unless other commercial arrangements; the issuer will endeavor (1) to file a the payment of damages becomes registration statement for the resale • If the liquidated damages are to be probable and can be reasonably esti- of specified financial instruments determined by reference to the mated, (ii) allow issuers who have and/or the resale of equity shares price of a commodity; or previously accounted for warrants and that are issuable upon exercise or convertible instruments under EITF • To arrangements in which the conversion of specified financial 00-19 to make adjustments to their financial instrument(s) subject to instruments and for that registration financial statements to conform to the arrangement are settled when statement to be declared effective the new FSP and (iii) obviate the need the consideration is transferred, by the SEC (or other applicable for a cap on liquidated damages pro- such as where a warrant is contin- securities regulator if the registra- visions in registration rights gently puttable if the corresponding tion statement will be filed in agreements in order to avoid applica- resale registration statement is not a foreign jurisdiction) within a tion of EITF 00-19. It is important to declared effective within a specified specified grace period, and/or (2) note, however, that the registration grace period. to maintain the effectiveness of arrangements described in the FSP the registration statement for a Moreover, the FSP would not other- do not specifically address liquidated specified period of time (or in wise affect the applicability of EITF damages paid solely for an issuer’s perpetuity), and 00-19, and issuers would still need to failure to file a registration statement, analyze the other provisions of their only for the failure to have a registra- • The arrangement requires the issuer warrants and convertible instruments tion statement declared effective or to transfer consideration to the to determine the proper classification to maintain its effectiveness. Until we counterparty if the registration of such financial instruments as equity are able to determine whether the statement for the resale of the or liabilities. In addition, the FSP position statement would apply to financial instrument(s) subject to would not apply to liquidated late-filing damages, our advice is to the arrangement is not declared damages payments arising from the continue to include a cap on those effective or if effectiveness of the failure to maintain listing of securities provisions for now. registration statement is not on a stock exchange. maintained. Scope of the Proposed Accounting The FSP would apply regardless Staff Position: Treatment: whether the consideration is payable The FSP would apply to the issuer of in a lump sum or periodically, and the Assuming the FSP is approved in its any contingent obligation to make form of consideration may vary. The current form, liquidated damages future payments or otherwise transfer FSP also would apply to any arrange- provisions in registration rights consideration under a registration ment that requires an issuer to obtain agreements and other contingent payment arrangement, whether and/or maintain a listing on a stock obligations to make future payments issued as a separate agreement or exchange, instead or obtaining and/or or otherwise transfer consideration included as a provision of a financial maintaining an effective registration under a registration payment arrange-
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