Preference shares - PIK dividends

[hubertd]

Hi Everyone,

I'm very curious to find out what people are thinking here.

We're going to invest £20m in convertible irredeemable preference shares at a price of 20p per share (100m preference shares) which will convert into ordinary shares on 1:1 basis at our discretion at any time or mandatorily upon successful commissioning of the project. Dividends in kind (PIK dividends) are contractually accruing at SONIA+5% annually. So assuming SONIA is 5% the annual dividend would be 10% x £20m = £2m. These would mean we're granted £2m/£0.2 = 10 million preference shares. The number of additional preference shares the next year will ultimately depend on future SONIA.

How would these PIK dividends be looked at? Are my preference shares (both the intial I invest in and the additional ones) an equity instrument or a financial asset (debt) to be held at fair value through profit or loss?

[Leo]

I would go with financial asset classified as FVTPL and reclassified to Equity upon conversion. However, I would be interested if someone can quote the paragraph from IFRS 9 that mentions preference shares considered as a debt instrument instead of Equity instrument?

[DJP]

I believe hubertd's question is regarding the treatment from the investor's perspective (i.e. asset side).

It doesn't make any difference whether the instrument is classified as equity or a financial liability on the issuer's side. The payments under this asset fail the SPPI test and the financial asset is therefore accounted for at FVTPL. There is no requirement in IFRS to make a distinction between the nature of the financial assets other than categorising them as AC, FVOCI, or FVTPL instruments.

[hubertd]

I think the distinction is vital for a holder, not least for the ability to use FVOCI option which is only allowable by election for equity instruments. In my example, if the dividends were discretionary, the preference shares would be classified as equity. If these dividends were contractual and paid in cash it would be financial asset (debt) via FVTPL. My question is how the fact there are contractual PIK dividends impacts this assessment.

[DJP]

Yes, you are right in case you want to make the FVOCI election, but I just assumed you didn't want to given the only two options you suggested.

Going back to your question, this seems to be a contingent settlement. If the issuer does not have the ability to avoid delivering cash or another financial asset, then it is a financial liability. So what you need to understand is whether the "successful commissioning of the project" is an event under the control of the issuer. If it is, then it is equity, if not, it is a financial liability. Are the PIK dividends payable regardless of whether the project is commissioned or not? If they are, then the PIK are a financial liability.

[hubertd]

Thanks DJP. I don’t have any issue with the classification of the ‚successful commissioning’ of the project. This is a major project milestone and under the control of the issuer. Even if it was not I’m still receving fixed number of ordinary shares for fixed number of preference shares either upon commissioning or any time earlier at my discretion. It’s all clear up to this point. All I’m struggling with is the impact of pik dividend upon the classification. PIK dividends are accruing no matter the project status but they are not ‚payable’. I’m basically allocated additional preference shares equivalent to the monetary value of the dividends. Shall I treat the allocation of these additional preference shares as ‚delivery of another financial asset’ as far as ias 32 is concerned? One could argue these preference shares are equity instruments in which case I’m going a bit circular I think.

[DJP]

If the "successful commissioning of the project" is under the control of the issuer, they could prevent payment of the pref shares and of any subsequent PIK dividends, could they not?

[hubertd]

I don't think this is the right way of looking into this. The project is basically about successful commissioning of the plant. That's why the company was seeking finance and why we invested. Anyway, I can convert into ordinary shares at my discretion whenever I want. At this point some dividends would have been already accrued in the form of additional preference shares and I could convert both the original preference shares and the additional ones into the ordinary equity. As I said, I don't have any issue with the terms of 'successful commissioning' of the project. I'm interested in finding out if the contractual PIK dividends negate the equity classification of the shares and if so why.

[DJP]

The PIK dividends seem to be a financial liability because the issuer has a contractual obligation to deliver another financial asset (more pref shares).

The initial investment in pref shares seems to be equity because the issuer does not have a contractual obligation to pay cash or deliver another financial asset.

Therefore, in my opinion, this is a compound financial instrument that you will carry at FV in the investor's books.

[Leo]

without being able to opt for FVOCI option?

[hubertd]

Thanks DJP. This is the conclusion I've reached as well. It was good to speak.

[DJP]

You're welcome. I don't think you can use the FVOCI option for compound instruments.

[Leo]

"The PIK dividends seem to be a financial liability because the issuer has a contractual obligation to deliver another financial asset (more pref shares)."

HI DJP, I think "another financial assets" are defined as equity instrument of another entity?

[DJP]

Hi Leo,

What makes you think that? A financial asset is a financial asset as defined in IAS 32.

[Leo]

Sorry DJP, that was a question. In IAS 32, it says:

Financial asset: any asset that is:

cash,
an equity instrument of another entity
a contractual right [...]

SO, I'm wondering, if an entity delivers a financial asset that is settled in entity's own instrument, may look at this definition of a financial asset:

a contract that will or may be settled in the entity's own equity instruments and is:
a non-derivative for which the entity is or may be obliged to receive a variable number of the entity's own equity instruments a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity's own equity instruments. For this purpose the entity's own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the entity's own equity instruments puttable instruments classified as equity or certain liabilities arising on liquidation classified by IAS 32 as equity instruments

That's where the fixed for fixed criterion comes into play right?

[Leo]

So my point above is also that an entity delivers its own equity instrument is not a financial asset.

[DJP]

Hi Leo,

It is a financial asset because it is a non-derivative contract whereby the company will have to pay a variable number of pref shares depending on how SONIA evolves. See IAS 32 p11(d)(i)

[Leo]

Thanks DJP. One more question from the perspective of the issuer. If the prefs can be converted into a variable number of shares. Even though there is no mandatory payment in cash, can this still be considered as equity instrument?

[DJP]

Don't you mean "...still be considered as a financial liability"?

If the pref shares can be converted into a variable number of shares, it is a financial liability (IAS 32.11(b)(i))

[Leo]

And that's even that the issuer have an option to not pay cash or another financial asset right?

[DJP]

No, that's not correct. If the issuer has the option of avoiding paying cash or another financial asset, then it is equity.

[Leo]

even that the prefs can be converted into a variable number of ordinary shares (e.g., XX ordinary shares at maturity or anytime based on the fair value of the shares at that time)

To summarise:

The issuer can avoid to pay cash or deliver another financial asset. However, the preference shares can be converted into a variable number of ordinary shares.

For example, we see sometime that the issuer can choose either to redeem the prefs by cash or by delivering a variable number of ordinary shares (to be determined at the date of the redemption). So the issuer can choose to deliver a variable number of ordinary shares instead of cash.

I really have a doubt on this, because, that would be using the ordinary shares as a 'currency', which would be similar, economically speaking, to delivering cash right? Because the holder will get the shares and sell them and immediately get the same amount of cash.

I would say Liability

[DJP]

I think you are confusing things. The assessment depends on who has the option, and what that option is for.

If the issuer has the option of avoiding paying cash or another financial asset, it is equity.

If the holder has the option of converting the pref shares into a variable number of shares, it is a financial liability.

And to your last point, the issuer may have the option to either pay in cash or a variable number of ordinary shares, but it does not have the right to avoid paying one or the other. It is a financial liability.

[Leo]

"And to your last point, the issuer may have the option to either pay in cash or a variable number of ordinary shares, but it does not have the right to avoid paying one or the other. It is a financial liability." That's clear thanks DJP.

Sorry for being redundant, if the issuer can choose either to redeem the prefs by cash or by delivering a Fixed number of ordinary shares. That would be an equity right?

[DJP]

No. In my opinion, that would still be a financial liability.

[Leo]

On what basis please, I'm confused again

[DJP]

In the scenario you are hypothesising, arguably the issuer would only deliver a fixed number of shares if their value were lower than the amount of cash. Given that there is a possibility the settlement is made in cash -- which the issuer cannot avoid -- I think this meets the condition of financial liability.

[Leo]

But the issuer can avoid to settle it in cash, and deliver fixed number of shares instead. That looks like equity to me. Because they bear the risk of the change in the price of the shares, similar to a shareholder.

[Leo]

Or maybe an equity instrument with a derivative component, accounted separately? I've no idea