Goldman Sachs suggests proposed changes to CoCo convertible accounting rule be expanded

By Ronda Fears

Nashville, Sept. 28 - The Emerging Issues Task Force of the Financial Accounting Standards Board is set to meet Wednesday and Thursday to consider a proposed new accounting rule requiring issuers of convertibles with contingent conversion features to estimate potential dilution to reported earnings per share, as if the bonds were converted.

While sweeping, Goldman Sachs & Co. suggested that the proposed changes should be expanded.

The rule change proposed in Issue 04-8 prompted numerous responses from the convertible market, both buyside and sellside, along with several issuers and industry groups such as the U.S. Chamber of Commerce, Edison Electric Institute, New York State Bar Association and the National Association of Manufacturers.

In current practice there are three methods issuers use to include convertible bonds in diluted earnings per share - the if-converted method, the treasury stock method and the contingently issuable share guidance - all of which are in FASB Statement 128.

Most respondents to the task force proposal were against any change to the current methods of accounting for CoCo dilution unless the threshold stock price has been reached, although several of the investment banks suggested that if the discussions proceed it should be addressed in a broader accounting rule change.

In the case of Goldman's response, it was suggested that the proposed change does not go far enough to address accounting practices for convertibles, whether CoCo or not.

"We believe that a convertible bond, whether contingently convertible or not, should be included in diluted EPS in a manner that reflects its economic impact on the issuer's EPS," said Goldman managing director Timothy Bridges, who pointed out that Goldman has been an underwriter on more than 50 convertibles with CoCo features.

Goldman: Current methods inadequate

"In our opinion, neither the if-converted method, treasury stock method nor the contingently issuable share guidance, although well established and understood, completely reflects the economic impact of a convertible bond on the issuer's EPS," Bridges said in the response filed with FASB.

The if-converted method assumes conversion even at share price levels at which a rational investor would not convert and, conversely, Goldman said, the treasury stock method arguably understates the number of shares included in diluted EPS in some cases.

The CoCo method, as applied in current practice, does not include shares in diluted EPS when a convertible is out of the money and not likely to result in a conversion, Goldman said, but does include shares in diluted EPS when it is in the money and likely to result in the issuance of shares.

"Arguably this [current accounting method] is representative of the economics of a convertible bond," Bridges said in the response letter.

"However, there is a cliff effect to including the shares in diluted EPS such that when the share price is very close to the share price contingency there are no shares included in diluted EPS although given the time remaining for the conversion feature, it may be likely that the share price will go up such that the investor will convert. In addition, there may be a period when the CoCo bond is in the money but is not included in an issuer's diluted EPS because the share price is between the conversion price and the share price contingency."

Proposal viewed as stop gap measure

Furthermore, Goldman described the consensus reached by the task force on the new if-converted accounting method for CoCo convertibles as "a stop gap measure to address a much larger question, the accounting and EPS treatment of convertible bonds."

"Such stop gap measures tend to create more confusion and potentially misleading results than solutions," Goldman's Bridges stated in the firm's response letter. "We would encourage the board to leave current practice in place and address the accounting and EPS treatment of convertible bonds in a cohesive manner in Phase Two of the Liabilities and Equity Project."

The final consensus reached in Issue 04-8, whether to continue to permit the current practice of using the contingently issuable share guidance or not, should be applied consistently to all instruments that are contingently convertible into an issuer's shares, Goldman said, including contingently convertible stock, and contingently convertible options and warrants.

"If the guidance in Issue 04-8 is not applied consistently to similar instruments, it will lead to companies issuing instruments that are economically similar to a CoCo bond and achieving different EPS results," Goldman said.

Broader scope for convertibles needed

In the FASB Liabilities and Equity Project, Goldman pointed out that a July 16 staff proposal presented a list of possible principles or touchstones for distinguishing liabilities and assets from equity that could apply to convertibles.

Goldman said it was proposed that accounting and earnings per share for instruments with similar economic effects should be similar no matter the form of the contract and no matter the form of settlement, which Goldman agrees is a principle FASB should focus on while deliberating on its standards.

JPMorgan Chase agreed that the matter should be addressed in the Phase II Liabilities and Equity Standards discussions, noting that there are additional features found in contingently convertible debt that make them economically different from straight convertible debt such as contingent accretion, or contingent payment, features.

UBS, too, agreed that the matter should be addressed in the Phase II Liabilities and Equity Standards discussions.

"Changing the accounting treatment will not change the reality that it is economically irrational for investors to ever convert into common stock if the stock price is below the conversion price," said Richard Ng-Yow, UBS head of U.S. equity-linked origination, and John Gallagher, executive director of accounting policy and support, in the bank's comment letter.

There are other incentives for the CoCo converts, UBS pointed out, such as efficiency in dilution management, tax advantages and the price impact on conversion.

GM: Task force overstepped authority

By far, issuers such as General Motors Corp., which has $8 billion of CoCo convertibles outstanding, were the biggest group responding to the proposed accounting rule change. Not surprising, perhaps, issuers were unilaterally opposed to the changes and some suggested the task force had overstepped its authority.

"We have learned time and again that markets do not always react rationally and it is important not to destroy shareholder value unless economic events warrant such an action," said Peter Bible, chief accounting officer at GM, in the company's response filed at the FASB.

A large number of issuers have accessed the contingently convertible debt market over the last few years, GM noted, pointing out; however, the impact of the changes is more pronounced for GM.

"GM believes that there are real economic differences between convertible debt and contingently convertible debt to both the issuer and the investor that would not be recognized by the tentative consensus," GM's response letter stated.

"Our second concern is that, in reaching its tentative consensus on Issue No. 04-8, we believe that the EITF exceeded its authority."

GM asserted the proposal would be a fundamental change to FASB Statement 128 and would require a more official involvement from FASB staff.

BDO Seidman LLP, an accounting and consultant firm based in Chicago, agreed that the proposed change exceeds the authority of the task force.

General Mills: Rule must note call options

General Mills Inc. suggested the proposed change be expanded to include the effect of call options used by issuers to limit the dilution impact of convertibles.

"We would also urge the Task Force to modify its tentative consensus to address those situations where an issuer of contingently convertible debt has also purchased call options that effectively offset the contingent issuance of common stock," said Kenneth Thome, senior vice president of financial operations, in General Mills' response letter.

"It seems particularly incongruous to require the dilutive effect of the contingent shares "regardless of whether the market price trigger (or other contingent feature) has been met," as proposed by the tentative consensus, when no provisions exist in GAAP that would recognize the offsetting affect of the call option. Such accounting would represent a drastic and misleading departure from the economics of the transactions.

Sallie Mae prefers treasury stock method

SLM Corp., better-known as Sallie Mae, asserted no change in accounting for CoCo convertibles is needed, stressing the impact of the proposed changes would be drastic, but if a singular accounting method for diluted earnings per share is the goal, then it prefers the treasury stock method.

As an illustration to the impact of the proposed change, Sallie Mae said in reference to its $2 billion convertible floater, the impact of the new rule would be 10 cents per share to its expected 2004 EPS.

"The current approach appears to be a hasty, and perhaps reckless, rush to judgment without the normal deliberative processes that FASB utilizes in the development of sound accounting principles," said Robert Crawford, controller at SLM, in the company's response letter.

"We also believe that the proposal will not improve or enhance, but instead confuse and complicate, the users' accurate understanding of an entity's financial statements."

Moreover, Sallie Mae said there is no need for a change, but if the accounting is changed to include CoCos in diluted EPS upon issuance, then the treasury stock method is more representative than the if-converted method in assessing potential dilution.

Buyside warns of loophole

Jeffrey Landry, an analyst for two hedge funds with about $2 billion in capital under management, told the FASB task force in a comment letter that he supports portions of the proposed accounting changes to CoCo convertibles, but he warned that the treasury stock method must be addressed to close a loophole issuers could use to disguise EPS dilution from convertibles.

"First, due to the call features and parity provisions within CoCo convertible bond indentures, I agree with the draft abstract consensus stating that shares issuable under CoCos should be included in EPS calculations when the stock price exceeds the conversion price regardless of whether contingent market price triggers have been met or not," Landry said in the letter.

But, he added that the task force should amend their proposals to "also address CoCo issuers who intend to evade including potentially issuable shares in EPS calculations by stating that they intend to pay cash for the principal value of the convertible (i.e., the treasury stock method)."

Landry noted that GM and other CoCo convertible issuers have already aired intentions to pursue the "cash intent" tact if the new CoCo accounting proposal as drafted is ratified.

"It does not make financial sense for companies to pay cash to settle obligations that have appreciated from higher stock prices," Landry said.

"If a company is faced with a cash payment for an appreciated CoCo bond there is almost 100% certainty they will issue equity to raise the cash due. This will dilute shareholders as much as if they had issued shares due under the conversion terms of the bonds. If you do not close this technical loophole CoCo issuers will continue to obfuscate their true equity obligations and will render your decision ineffective."

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