Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

As we noted here, the SEC temporarily suspended the Tier 2 Regulation A+ offering of Med-X, Inc. The SEC stated it temporarily suspended the offering because Med-X has not filed its annual report on Form 1-K as required by Rule 257.

An administrative law judge has now vacated the suspension after determining the failure to file was inadvertent and based on erroneous advice of an experienced securities law practitioner.

The decision notes that investors were not significantly harmed and that a permanent suspension would not only adversely impact Med-X investors, but would unreasonably chill the use of Regulation A to raise capital. The decision notes “It is quite likely that companies would not use tier 2 for small offerings if accidental noncompliance with its reporting provisions results in permanent suspension and “bad actor” disqualification.”

In Davis et al v. EMSI Holding Co., the Delaware Court of Chancery held that officers and directors of an acquired company were entitled to advancement under the acquired Company’s by-laws for expenses incurred in defending an indemnification claim under the related stock purchase agreement.

As in many stock purchase agreements, the plaintiffs, as sellers, released claims against the acquired company, agreed to bear their own costs and expenses in the transaction, and also agreed that the indemnification provisions of the stock purchase agreement were the exclusive remedy for breaches of the stock purchase agreement. The defendant claimed that to grant the plaintiffs an advancement right would be an end run on these provisions.

The Court first rejected the defendant’s claim that the plaintiffs had waived their right to advancement. It noted that the exclusive remedy provision was irrelevant because that applied only to prosecuting a claim under the stock purchase agreement as opposed to asserting an extra-contractual right under the acquired company’s bylaws.

The Court found the provision which provided that each party to the stock purchase agreement was to bear their own costs and expenses in connection with the transaction was not controlling. The text of the provision provided that it was only applicable where it had not been otherwise agreed in the stock purchase agreement.  The Court opined that a carve out to the plaintiffs’ release of claims against the acquired company in the stock purchase agreement was “another agreement” which overrode the provision on bearing expenses.

The relevant provision of the stock purchase agreement included a broad release of the plaintiffs’ claims against the acquired entity. However, there was a carve out to the release which provided that the release did not apply to any right to indemnification the plaintiffs had as an officer or director under the relevant governing documents. The Court found the defendant’s argument that the carve out only applied to pre-existing third party claims and not to first party claims under the stock purchase agreement was illogical as the release applied to both first party and third party claims.

The Court also rejected the defendant’s argument that the carve out to the release only applied to “indemnification” and not to “advancement.” While Delaware law treats indemnification and advancement as separate rights, the acquired company’s bylaws used the term “indemnification” broadly.  More specifically, the company’s bylaws stated “the right to indemnification . . . shall include the right to be paid by the Corporation the expenses (including attorney’s fees) incurred in defending any such Proceeding in advance of its final disposition . . .”

Last, the defendants argued the plaintiffs were not entitled to advancement because they were not sued “by reason of” their status as officers and directors of the acquired company. The Court rejected the argument noting the allegations in the underlying action against the plaintiffs were that they misused their positions as officers and directors of the company in order to engage in a widespread fraud that involved the manipulation of the company’s business model and related financial reports for the purpose of facilitating a sale of the company at an exaggerated price. The allegations, couched as breaches of representations and warranties in the stock purchase agreement were not merely allegations that the plaintiffs breached specific contractual terms personal to them. Instead, the plaintiffs will be required to defend their actions as officers and directors of the company and their alleged intentional abuse of their corporate powers.

In EMSI Acquisition, Inc., v. Contrarian Funds, LLC et al, the Delaware Court of Chancery examined a fraud carve out from an indemnification cap and an action for confirmation of an auditors award on a purchase price adjustment.

The Plaintiff alleged the Company’s financial statements were manipulated. The Sellers were mostly non-management personnel that did not participate in the business. The Sellers and the Company clearly disclaimed making any other warranties other than those set forth in the Stock Purchase Agreement.  The SPA included a non-reliance clause where the Buyer represented that it was only relying on the promises and representations contained in the SPA.

Section 10.4(d) of the Stock Purchase Agreement provided a cap on indemnification claims by stating “[n]otwithstanding anything to the contrary in this Agreement”:

The Buyer Indemnified Parties shall only be entitled to indemnification (i) with respect to Losses in respect of the representations and warranties (other than the Excluded Representations and the Specific Indemnity Items) to the extent of, and exclusively from, any then remaining Escrow Funds . . .

The excusive remedies section of the SPA included the following carve out in Section 10.10(b):

Notwithstanding anything in this Agreement to the contrary (including . . . any limitations on remedies or recoveries . . .) nothing in this Agreement (or elsewhere) shall limit or restrict (i) any Indemnified Party’s rights or ability to maintain or recover any amounts in connection with any action or claim based upon fraud in connection with the transactions contemplated hereby . . .

On a motion to dismiss, the Court was faced with determining whether the two competing “Notwithstanding” sections were plain and unambiguous. The Court stated the Plaintiff did not seek to avoid the non-reliance clause by bringing a claim for fraud based on extracontractual representations.

Defendants claimed the Plaintiff had two choices: (1) suing contractually and going through the indemnification provisions or (2) suing for fraud. The Defendants believed the wording made clear that “[i]f the Company’s managers intentionally misrepresented facts to the Buyer without knowledge of falsity by the Seller, then the Buyer . . . must proceed with an Indemnity Claim subject to the Indemnity Fund’s liability cap.”

The Plaintiff argued that the SPA allowed the Buyer, without limitation or restriction, “to recover any amounts in connection with any action or claim ‘based upon fraud’ in connection with the contemplated transaction.” Plaintiff contended that, in this respect, the SPA deliberately “allocated to Sellers the risk that the Company was knowingly misrepresenting itself when it entered into the SPA” and that its claim was not subject to the limitations on recovery imposed by Section 10.4.  Plaintiff claimed this was true even if it has not pled and cannot prove that the Sellers acted with scienter in connection with their own representations and warranties or knew that the Company’s representations and warranties were false when made.

Referring to the dispute as resulting from “inelegant drafting,” the Court determined it could not grant the motion to dismiss because the Buyer’s interpretation was reasonable, and may or may not ultimately be the most reasonable after considering extrinsic evidence.

In accordance with the SPA, the parties had also initiated a so called “net working capital adjustment process” which required a determination by a “Settlement Auditor.” Defendants disputed certain adjustments made by the Settlement Auditor.  In the second count in the Complaint, the Plaintiff sought confirmation of the finding of the Settlement Auditor as an arbitration award pursuant to a Delaware statute.  The Court dismissed the claim because the SPA did not include a clear expression of intent to arbitrate.  The reason was the SPA stated the Settlement Auditor would resolve disputes “acting as an expert and not an arbitrator.”

The CFTC voted to seek public input on simplifying and modernizing the Commission’s rules. The action is part of an initiative which has been dubbed “Project KISS.”

The CFTC is seeking ideas from industry, other stakeholders and interested parties, and the broader public on where the CFTC rules can be simplified and made less costly to comply. CFTC Acting Chairman J. Christopher Giancarlo cautioned however, that this exercise is not about identifying existing rules for repeal or even rewrite. It is about taking CFTC’s existing rules as they are and applying them in ways that are simpler, less burdensome and less of a drag on the American economy.

The CFTC noted President Trump issued an executive order furthering his regulatory reform agenda to stimulate economic growth. The President’s executive order directed federal agencies to designate a Regulatory Reform Officer and establish a Regulatory Reform Task Force. While the CFTC is not directly covered by the President’s order, Mr. Giancarlo said the agency will review all CFTC rules with the ultimate goal to reduce regulatory burdens and costs for participants in the markets the agency oversees. Mr. Giancarlo designated Chief of Staff Michael Gill as CFTC’s Regulatory Reform Officer, who has been leading Project KISS and the work of the taskforce within the agency. Any rule change recommendations will be pursuant to the provisions in the Administrative Procedures Act.

The new lease accounting rules (Accounting Standards Update N0. 2016-02; Topic 842) will require the recognition of lease assets and lease liabilities for those leases classified as operating leases under existing GAAP. For public companies, the new standard is effective for fiscal years beginning after December 15, 2018.

While complexities can arise, the new standard defines a lease as a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment for a period of time in exchange for consideration.

Finance Leases versus Operating Leases

From a lessee’s perspective, there are two types of leases – finance leases and operating leases. Finance leases are treated in a manner similar to capital leases under existing GAAP.  The new standard requires a lessee to recognize lease assets and liabilities for both finance leases and operating leases.  One basic difference in treatment between finance leases and operating leases is that expense recognition is accelerated for finance leases while expense under an operating lease are generally recognized on a straight line basis.

A lease is classified as a finance lease if it meets any of the following criteria at lease commencement:

  • The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
  • The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
  • The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion is not used for purposes of classifying the lease.
  • The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments equals or exceeds substantially all of the fair value of the underlying asset.
  • The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

Lessees classify any lease that does not meet the criteria of a finance lease as an operating lease.

When determining lease classification, one reasonable approach to assessing the above criteria would be to conclude:

  • Seventy-five percent or more of the remaining economic life of the underlying asset is a major part of the remaining economic life of that underlying asset.
  • A commencement date that falls at or near the end of the economic life of the underlying asset refers to a commencement date that falls within the last 25 percent of the total economic life of the underlying asset.

Lease Term

The lease term is the non-cancellable period of the lease, together with all of the following:

  • Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option.
  • Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option.
  • Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor.

Lease Payments

At the commencement date, the lease payments include the following payments relating to the use of the underlying asset during the lease term:

  • Fixed payments, including in substance fixed payments, less any lease incentives paid or payable to the lessee.
  • Variable lease payments that depend on an index or a rate (such as the Consumer Price Index or a market interest rate), initially measured using the index or rate at the commencement date.
  • The exercise price of an option to purchase the underlying asset if the lessee is reasonably certain to exercise that option.
  • Payments for penalties for terminating the lease if the lease term reflects the lessee exercising an option to terminate the lease.
  • For a lessee only, amounts probable of being owed by the lessee under residual value guarantees.

Recognition

A lessee recognizes a right-of-use asset and a lease liability at the lease commencement date.

The lease liability is calculated using at the present value of the lease payments not yet paid, discounted using the discount rate for the lease at lease commencement. For a lessee, the discount rate for the lease is the rate implicit in the lease unless that rate cannot be readily determined. In that case, the lessee is required to use its incremental borrowing rate.

The cost of the initial right-of-use asset consists of the following:

  • The amount of the initial measurement of the lease liability.
  • Any lease payments made to the lessor at or before the commencement date, minus any lease incentives received.
  • Any initial direct costs incurred by the lessee.

After the commencement date, for an operating lease a lessee recognizes all of the following in profit or loss (impairments are not addressed here for simplicity):

  • A single lease cost, calculated so that the remaining cost of the lease is allocated over the remaining lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset.
  • Variable lease payments not included in the lease liability in the period in which the obligation for those payments is incurred.

After the commencement date, for an operating lease, a lessee measures both of the following:

  • The lease liability at the present value of the lease payments not yet paid discounted using the discount rate for the lease established at the commencement date.
  • The right-of-use asset at the amount of the lease liability, adjusted for the following:
    • Prepaid or accrued lease payments.
    • The remaining balance of any lease incentives received.
    • Unamortized initial direct costs.

Example

The following example demonstrates the application of the rules set forth above:

Lessee enters into a 10-year lease of an asset, with an option to extend for an additional 5 years. Lease payments are $50,000 per year during the initial term and $55,000 per year during the optional period, all payable at the beginning of each year. Lessee incurs initial direct costs of $15,000.

At the commencement date, Lessee concludes that it is not reasonably certain to exercise the option to extend the lease and, therefore, determines the lease term to be 10 years. Lessee also determines the lease is an operating lease.

The rate implicit in the lease is not readily determinable. Lessee’s incremental borrowing rate is 5.87 percent, which reflects the fixed rate at which Lessee could borrow a similar amount in the same currency, for the same term, and with similar collateral as in the lease at the commencement date.

At the commencement date, Lessee makes the lease payment for the first year, incurs initial direct costs, and measures the lease liability at the present value of the remaining 9 payments of $50,000, discounted at the rate of 5.87 percent, which is $342,017. Lessee also measures a right-of-use asset of $407,017 (the initial measurement of the lease liability plus the initial direct costs and the lease payment for the first year).

Lessee determines the cost of the lease to be $515,000 (sum of the lease payments for the lease term and initial direct costs incurred by Lessee). The annual lease expense to be recognized is therefore $51,500 ($515,000 ÷ 10 years).

At the end of the first year of the lease, the carrying amount of Lessee’s lease liability is $362,093 ($342,017 + $20,076; the $20,076 represents accrued interest on the lease liability), and the carrying amount of the right-of-use asset is $375,593 (the carrying amount of the lease liability plus the remaining initial direct costs, which equal $13,500).

Short-Term Leases

As an accounting policy, a lessee may elect not to apply the recognition requirements of the new standard to short-term leases. Instead, a lessee may recognize the lease payments in profit or loss on a straight-line basis over the lease term and variable lease payments in the period in which the obligation for those payments is incurred. The accounting policy election for short-term leases is made by the class of underlying assets to which the right of use relates.

A short-term lease has a lease term of 12 months or less and does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise.

The CFTC is proposing to amend its regulations regarding certain duties of chief compliance officers, or CCOs, of swap dealers, major swap participants and futures commission merchants, which are referred to as registrants. The CFTC is also proposing to amend requirements for preparing and furnishing to the Commission an annual report containing an assessment of the registrant’s compliance activities.

Many of the proposed amendments are meant to harmonize the CFTC’s regulations with similar regulations adopted by the SEC.

The Commission proposes to add a definition of “senior officer” to § 3.1 of its rules to provide greater clarity regarding the CCO reporting line required by Commodity Exchange Act (“CEA”) section 4s(k)(2)(A) and § 3.3(a)(1) of the Commission’s regulations. The CFTC has not previously formally defined this term for purposes of the CCO rules. However, Commission staff has generally interpreted this term to refer to a registrant’s most senior officer, typically the chief executive officer or the equivalent. This interpretation is consistent with the SEC’s definition of “senior officer” in SEC rule 15Fk-1(e)(2). Accordingly, the Commission is proposing to define “senior officer” in new paragraph (j) to § 3.1 as “the chief executive officer or other equivalent officer of a registrant.”

This definition is in keeping with the CFTC’s continued belief that, as stated in the adopting release for the CCO rules, a “direct reporting line” from the CCO to the board of directors or highest executive officer ensures CCO independence. The “chief executive officer” is typically the highest executive level, but the definition includes the phrase “other equivalent officer” to acknowledge that a firm may have a different title for the highest executive officer.

The CFTC’s rules require the CCO to:

  • Establish and administer policies and procedures, including those related to ensuring compliance and remediating noncompliance issues;
  • Resolve any conflicts of interest; and
  • Prepare the CCO Annual Report.

Based on the practical experience gained from four years of implementation, the CFTC has determined that certain CCO rules could be revised to more accurately convey the Commission’s intent with respect to the scope of the CCO’s duties and to further harmonize with the SEC’s recently finalized CCO rules. In this regard, the proposed amendments are intended to maintain and clarify the underlying goal of the CCO’s active engagement in compliance monitoring while reducing regulatory burdens that provide limited corresponding benefit.

The CEA requires the CCO to annually prepare and sign the CCO Annual Report. CFTC rules § 3.3(e) and (f) implement this requirement. The Commission proposes to revise, reorganize, and clarify § 3.3(e) and (f) to further reduce burdens to registrants, incorporate the other proposed amendments, and further harmonize the provisions with the SEC’s parallel rules.

GAO released an analysis of a generalizable sample of conflict minerals disclosures filed with SEC in 2015. The analysis found that an estimated 49 percent of companies in 2015 reported having determined whether the conflict minerals in their products came from covered countries, compared with 30 percent in 2014—an increase of 19 percentage points. As a result of due diligence, a majority of companies reported in 2015 that they were unable to determine the country of origin of the conflict minerals in their products and whether such minerals benefited or financed armed groups in the covered countries. However, companies reported a range of actions they had taken, or planned to take, to build on or improve their due diligence efforts, such as shifting operations or encouraging those in their supply chain to shift from current suppliers to suppliers who are certified as conflict free.

GAO analyzed a random sample of 100 reports from a population of 1,281 to create estimates generalizable to the population of all companies that filed specialized disclosure reports and conflict minerals reports with SEC. GAO spoke with company representatives to obtain additional perspectives. GAO representatives also traveled to China, Malaysia, and Singapore for field work and visited conflict minerals processing facilities to observe conflict minerals processing and due diligence processes.

The report also notes that as of July 2016, the Department of Commerce (Commerce) had not submitted to Congress a report that includes an assessment of the accuracy of Independent Private Sector Audits (IPSA) and other due diligence efforts as well as recommendations for IPSA processes, as the Dodd-Frank Act requires, and had not developed a plan for doing so. Commerce officials told GAO in July 2016 that they had not yet assessed the accuracy of the four IPSAs filed in 2014 or the six IPSAs filed in 2015. Commerce officials said they established a team to manage Commerce’s responsibilities related to IPSAs in March 2016, but the officials noted that they did not have the internal knowledge or skills to review IPSAs or establish best practices.

 

The new revenue recognition standards under GAAP (Accounting Standards Update 2014-09; Topic 606) will be applicable to public companies for annual reporting periods beginning after December 15, 2017. While much time and effort is being put into adoption of the new standard, consideration should also be given to how contracts can be drafted to facilitate revenue recognition under the new standard. While it is impossible to summarize every nuance that should be considered when preparing contracts, high level thoughts can be set forth on each of the five steps outlined in the new standard.

Identify the Contract(s)

The first step under the new standard it so identify the applicable contract. In general, the new standard provides that a contract is an agreement between two or more parties that creates enforceable rights and obligations.  Lawyers should be aware an entity must combine two or more contracts entered into at or near the same time with the same customer (or related parties of the customer) and account for the contracts as a single contract if one or more of the following criteria are met:

  • The contracts are negotiated as a package with a single commercial objective.
  • The amount of consideration to be paid in one contract depends on the price or performance of the other contract.
  • The goods or services promised in the contracts (or some goods or services promised in each of the contracts) are a single performance obligation.

Identify the Performance Obligations

The next step is to identify the performance obligations in the contract. A performance obligation is a promise in a contract with a customer to transfer to the customer either:

  • A good or service (or a bundle of goods or services) that is distinct.
  • A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.

A good or service that is promised to a customer is distinct if both of the following criteria are met:

  • The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct).
  • The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the good or service is distinct within the context of the contract).

A good or service that is not distinct should be combined with other promised goods or services until the entity identifies a bundle of goods or services that is distinct.

The step is important because revenue is ultimately recognized when or as performance obligations are satisfied. Thus contract drafting principles should include clearly identifying the performance obligations to determine when revenue is recognized.  The following example drives the point home:

An entity, a contractor, enters into a contract to build a hospital for a customer. The entity is responsible for the overall management of the project and identifies various goods and services to be provided, including engineering, site clearance, foundation, procurement, construction of the structure, piping and wiring, installation of equipment, and finishing.

The promised goods and services are capable of being distinct. The customer could benefit from the goods and services either on their own or together with other readily available resources. This is evidenced by the fact that the entity, or competitors of the entity, regularly sells many of these goods and services separately to other customers. In addition, the customer could generate economic benefit from the individual goods and services by using, consuming, selling, or holding those goods or services.

However, the way the contract is drafted, the goods and services are not distinct. The entity’s promise to transfer individual goods and services in the contract are not separately identifiable from other promises in the contract. This is evidenced by the fact that the entity provides a significant service of integrating the goods and services (the inputs) into the hospital (the combined output) for which the customer has contracted.

If business needs so dictated, the contract could have been drafted to arrive at a different result.

Determine the Transaction Price

The transaction price is the amount of consideration (for example, payment) to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties. While ultimately there are other factors to consider, such as the existence of a financing component or non-cash consideration, generally an entity will have to consider the effects of:

  • Variable consideration—If the amount of consideration in a contract is variable, an entity should determine the amount to include in the transaction price by estimating either the expected value (that is, probability-weighted amount) or the most likely amount, depending on which method the entity expects to better predict the amount of consideration to which the entity will be entitled.
  • Constraining estimates of variable consideration—An entity should include in the transaction price some or all of an estimate of variable consideration only to the extent it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

The amount of consideration can vary because of discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties, or other similar items. The promised consideration also can vary if an entity’s entitlement to the consideration is contingent on the occurrence or nonoccurrence of a future event. For example, an amount of consideration would be variable if either a product was sold with a right of return or a fixed amount is promised as a performance bonus on achievement of a specified milestone.

Consider the following example:

An entity enters into a contract with a customer to build a customized asset. The promise to transfer the asset is a performance obligation that is satisfied over time. The promised consideration is $2.5 million, but that amount will be reduced or increased depending on the timing of completion of the asset. Specifically, for each day after March 31, 20X7 that the asset is incomplete, the promised consideration is reduced by $10,000. For each day before March 31, 20X7 that the asset is complete, the promised consideration increases by $10,000.

In addition, upon completion of the asset, a third party will inspect the asset and assign a rating based on metrics that are defined in the contract. If the asset receives a specified rating, the entity will be entitled to an incentive bonus of $150,000.

In determining the transaction price, the entity prepares a separate estimate for each element of variable consideration to which the entity will be entitled:

The entity decides to use the expected value method to estimate the variable consideration associated with the daily penalty or incentive (that is, $2.5 million, plus or minus $10,000 per day). This is because it is the method that the entity expects to better predict the amount of consideration to which it will be entitled.

The entity decides to use the most likely amount to estimate the variable consideration associated with the incentive bonus. This is because there are only 2 possible outcomes ($150,000 or $0) and it is the method that the entity expects to better predict the amount of consideration to which it will be entitled.

To complicate things further, the entity must also consider factors surrounding constraining estimates of variable consideration – the entity can only include the variable consideration to the extent it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

Lawyers should recognize that when significant components of variable consideration are included in contracts it may be more difficult to estimate and recognize revenue. While ultimately variable consideration may be desired or unavoidable, its importance from an accounting perspective should be considered in the approach to negotiation and documentation.  Downside can perhaps be controlled by including floors on the amount the consideration can be decreased.  The upside can be enhanced by removing contingencies as to when the amount is determinable and drafting clarity on the related conditions.

Allocate the Transaction Price to the Performance Obligations in the Contract

For a contract that has more than one performance obligation, the fourth step requires an entity to allocate the transaction price to each performance obligation in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for satisfying each performance obligation.

The objective when allocating the transaction price is for an entity to allocate the transaction price to each performance obligation (or distinct good or service) in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for transferring the promised goods or services to the customer.

To meet the allocation objective, an entity should generally allocate the transaction price to each performance obligation identified in the contract on a relative standalone selling price basis. The standalone selling price is the price at which an entity would sell a promised good or service separately to a customer.  If a standalone selling price is not directly observable, an entity should estimate the standalone selling price at an amount that would result in the allocation of the transaction price meeting the allocation objective discussed above.

An entity should allocate a variable amount (and subsequent changes to that amount) entirely to a performance obligation or to a distinct good or service that forms part of a single performance obligation if both of the following criteria are met:

  • The terms of a variable payment relate specifically to the entity’s efforts to satisfy the performance obligation or transfer the distinct good or service (or to a specific outcome from satisfying the performance obligation or transferring the distinct good or service).
  • Allocating the variable amount of consideration entirely to the performance obligation or the distinct good or service is consistent with the allocation objective discussed above when considering all of the performance obligations and payment terms in the contract.

The following example is instructive:

An entity enters into a contract with a customer for two intellectual property licenses (Licenses X and Y), which the entity determines to represent two performance obligations each satisfied at a point in time. The standalone selling prices of Licenses X and Y are $800 and $1,000, respectively. According to the contract, the entity transfers License Y at inception of the contract and transfers License X three months later.

The price stated in the contract for License X is a fixed amount of $300, and for License Y the consideration is 5 percent of the customer’s future sales of products that use License Y. The entity’s estimate of the sales-based royalties (that is, the variable consideration) is $1,500.

The entity concludes that even though the variable payments relate specifically to an outcome from the performance obligation to transfer License Y (that is, the customer’s subsequent sales of products that use License Y), allocating the variable consideration entirely to License Y would be inconsistent with the principle for allocating the transaction price since it does not reflect the standalone price.

When License Y is transferred at the inception of the contract, the entity recognizes $167 of the $300 of the stated price of License X as revenue ($1,000 ÷ $1,800 × $300). When License X is transferred three months later, the entity recognizes $133 of the stated price of License X as revenue $133 ($800 ÷ $1,800 × $300).

Stated prices in contracts may vary from standalone selling prices to satisfy one of the party’s needs. However, the stated prices are not necessarily recognized under the new revenue pronouncement.  Lawyers should have an understanding as to how the stated prices were determined, and then obtain input from all of the client’s constituencies.  The sales team may be able to make a sale based on given prices, but the accounting team could find the results unpalatable, or management may be surprised at the result.  In the foregoing example, the result may have been avoided by drafting two separate contracts if License X and License Y had two different commercial objectives and were otherwise unrelated.

Recognize Revenue When (or As) the Entity Satisfies a Performance Obligation

The final step provides an entity should recognize revenue when (or as) it satisfies a performance obligation by transferring a promised good or service to a customer. A good or service is transferred when (or as) the customer obtains control of that good or service.

For each performance obligation, an entity should determine whether the entity satisfies the performance obligation over time by transferring control of a good or service over time. If an entity does not satisfy a performance obligation over time, the performance obligation is satisfied at a point in time.

An entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognizes revenue over time if one of the following criteria is met:

  • The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.
  • The entity’s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced.
  • The entity’s performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date.

If a performance obligation is not satisfied over time, an entity satisfies the performance obligation at a point in time. To determine the point in time at which a customer obtains control of a promised asset and an entity satisfies a performance obligation, the entity would consider indicators of the transfer of control, which include the following:

  • The entity has a present right to payment for the asset.
  • The customer has legal title to the asset.
  • The entity has transferred physical possession of the asset.
  • The customer has the significant risks and rewards of ownership of the asset.
  • The customer has accepted the asset.

The following example is straightforward and fairly intuitive demonstration of recognizing revenue over time because the customer simultaneously receives and consumes the benefits provided by the entity’s performance:

An entity enters into a contract to provide monthly payroll processing services to a customer for one year.

The promised payroll processing services are accounted for as a single performance obligation. The performance obligation is satisfied over time because the customer simultaneously receives and consumes the benefits of the entity’s performance in processing each payroll transaction as and when each transaction is processed. The fact that another entity would not need to re-perform payroll processing services for the service that the entity has provided to date also demonstrates that the customer simultaneously receives and consumes the benefits of the entity’s performance as the entity performs.

Note that in this example timing of payments is irrelevant and the entity recognizes revenue over time by measuring its progress toward complete satisfaction of that performance obligation.

The following example arrives at a different result where the amount and timing of the payments are relevant to revenue recognition:

An entity enters into a contract with a customer to build an item of equipment. The payment schedule in the contract specifies that the customer must make an advance payment at contract inception of 10 percent of the contract price, regular payments throughout the construction period (amounting to 50 percent of the contract price), and a final payment of 40 percent of the contract price after construction is completed and the equipment has passed the prescribed performance tests. The payments are nonrefundable unless the entity fails to perform as promised. If the customer terminates the contract, the entity is entitled only to retain any progress payments received from the customer. The entity has no further rights to compensation from the customer.

When determining whether its performance obligation to build the equipment is a performance obligation satisfied over time, the entity considers whether it has an enforceable right to payment for performance completed to date if the customer were to terminate the contract for reasons other than the entity’s failure to perform as promised. Even though the payments made by the customer are nonrefundable, the cumulative amount of those payments is not expected, at all times throughout the contract, to at least correspond to the amount that would be necessary to compensate the entity for performance completed to date. This is because at various times during construction the cumulative amount of consideration paid by the customer might be less than the selling price of the partially completed item of equipment at that time. Consequently, the entity does not have a right to payment for performance completed to date.

Lawyers should realize that revenue recognition may not solely depend on the timing of payments. Recognition of revenue over time relates in part to consumption of benefits, customer control over the asset or being assured of adequate payment.  While the foregoing are not exclusively related to legal concepts, contract drafting can be used to bolster the necessary indicia to recognize revenue.  Appropriate drafting will be dependent on the facts and circumstances. The facts and circumstances can likely be identified by asking the client “How are we going to recognize revenue and what facts will help make that determination?”

Recognizing revenue at a point in time is more exclusively related to legal concepts, such as a right to payment, legal title, physical possession and customer acceptance. Where these concepts are the lynch pin to recognizing revenue they should be clearly drafted into the contract.

The Board of Governors of the Federal Reserve System has assessed its first penalty for violation of the Volcker Rule against Deutsche Bank AG.

The Volker Rule required Deutsche Bank’s Chief Executive Officer to annually attest to the Board of Governors in writing that the bank had in place processes to establish, maintain, enforce, review, test, and modify required compliance programs. In March 2016, Deutsche Bank’s Co-CEO executed and delivered the required attestation which identified the existence of weaknesses in the bank’s Volcker Rule compliance program, including governance, design, and operational deficiencies across key compliance pillars and the design of reporting mechanisms.

The Board of Governors then determined that Deutsche Bank failed to establish a compliance program reasonably designed to ensure and monitor compliance with Volcker Rule requirements and assessed a civil money penalty in the amount of $19.71 million. Deutsche Bank agreed to the penalty and also agreed to take corrective actions.

A shareholder of Intel Corporation has filed a complaint in the United States District Court for the Southern District of New York. The shareholder seeks a preliminary and permanent injunction and any other appropriate relief with respect to a stockholder vote to approve the amendment and restatement of Intel’s 2006 equity incentive plan to add 33 million shares to the plan and extend its term.

According to the complaint, Intel’s proxy statement does not include the information required by Item 10(a)(1) of Schedule 14A. That Item specifically requires that “[i]f action is to be taken with respect to any plan pursuant to which cash or noncash compensation may be paid or distributed,” the proxy statement soliciting this vote must “[d]escribe briefly the material features of the plan being acted upon, identify each class of persons who will be eligible to participate therein, indicate the approximate number of persons in each such class, and state the basis of such participation.”

The complaint states Intel’s disclosure falls short because it only states “Intel has a long-standing practice of granting equity awards not only to its executives and directors but also broadly among its employees. In 2016, approximately 84% of Intel’s employees received an equity award.” It also has a table that reports, “Eligible participants: All of our full-time and part-time employees, where legally eligible to participate, and our non-employee directors.”

In a hearing on April 25, 2017, the plaintiff withdrew its request for a preliminary injunction.