Although much attention is being given to the treatment for the sophisticated new financial instruments created by the financial industry's rocket-scientists, the "ordinary" term loan has undergone some changes which bear consideration. As part of their marketing strategy, banks and financial institutions have created loans which at first appear to be ordinary term loans, but which give the lender certain call options which create questions about the true nature of the debt. At issue is the balance sheet classification of these loans.

The Issues

One might think that with all of the authoritative guidance issued about debt classification the issue should be an easy one. However, a review of existing literature indicates that there are still substantial unresolved issues which exist--as a result, the specific language used in a loan agreement will probably be the prime determinant of how the debt should be classified. The central question is whether the call language in the loan agreement constitutes a "subjective acceleration clause" or a "demand call." How this question is answered will affect whether all or only a portion of the loan will be classified as a current liability in the balance sheet of the obligor. As discussed below, if it is considered a subjective acceleration clause the entire loan would be required to be classified as current only under certain specified limited conditions, while if it is considered a demand clause, the entire loan must be classified as a current liability.

Authoritative Literature

The concept of subjective acceleration clauses is first addressed in FASB Statement No. 6, "Classification of Short-Term Obligations Expected to Be Refinanced," where it is stated that a short-term obligation which is being refinanced on a long-term basis does not qualify for long-term treatment if the new agreement contains acceleration clauses which are not objectively determinable. Although the term "subjective acceleration clause" is not specifically used, such non-objective or subjective clauses are explained in a footnote.

In Technical Bulletin 79-3 the FASB staff stated its view that subjective acceleration clauses in long-term debt agreements (as opposed to short-term debt being refinanced) would only cause such debt to be classified as a current liability in situations involving recurring losses or liquidity problems where it is considered probable that the clause will be invoked. The Bulletin states that neither reclassification to current nor any disclosure would be required if the likelihood of acceleration of the due date were remote based on the lender's history of calling such loans and the financial condition of the borrower.

In FASB Statement No.78, "Classification of Obligations That are Callable By the Creditor," the 1979 Technical Bulletin is discussed in Paragraphs 10 and 11 and the Technical Bulletin is left unmodified. Paragraph 11 states that "The Board believes that creditors and debtors perceive a substantive difference between the rights that a creditor has under such a subjective acceleration clause and the rights that a creditor has under either (a) an obligation that is due on demand or (b) an obligation that is callable because of a violation of an objectively determinable provision."

In issue 86-5, "Classification of Demand Debt with Long-Term Repayment Schedules," the Emerging Issues Task Force (EITF) addressed the question of whether clauses in loan agreements with scheduled payments which allow the creditor to demand payment at any time constitute subjective acceleration clauses. In its consensus, the EITF stated that such provisions are not subjective acceleration clauses and that the debt should be classified as a current liability.

What's the Difference?

Based on the foregoing the issue remains, how does one differentiate between a subjective acceleration clause and a demand clause?

In footnote 4 to Paragraph No. 11(b) of FASB Statement No. 6, the phrases "material adverse change" and "failure to maintain satisfactory operations" are given as examples of nonobjective clauses.

In Footnote 3 to Paragraph 10 of FASB Statement No. 78, a subjective acceleration clause is defined as "a provision in a debt agreement that states that the creditor may accelerate the scheduled maturities of the obligation under conditions that are not objectively determinable;" it then repeats the above phrases as examples. In their discussion and analysis of the debt classification issue, the authors of Warren Gorham & Lamont's "GAAP Practice Manual" add the following phrases as example of subjective acceleration clauses," if the debtor does not maintain satisfactory operations," "if the borrower experiences recurring losses or liquidity problems" and "if the creditor feels uncomfortable about the loan for any reason." Based on the foregoing, it would appear that if the creditor must first make some sort of adverse determination about the borrower before it can exercise the option, the clause should be considered a subjective acceleration clause. However, if the creditor has retained an unrestricted right to call the loan without regard to the debtor's financial standing, such right should be considered the equivalent of a call provision.

Conclusion

Since installment loans with demand provisions are typically marketed as long-term installment debt, the debtor may believe there is little practical difference between loans which contain subjective acceleration clauses and loans where the lender has an unrestricted demand option. However, there is a perceived difference in the authoritative literature, one which affects the balance sheet classification of the debt. Therefore, draft loan agreements should be carefully reviewed to make sure they clearly exhibit the parties' intent. Lenders are not always familiar with the implications of the EITF consensus and may be willing to redraft the loan document to clearly evidence the borrower's belief that he is entering into a long-term arrangement.