Appendix D — Voting Interest Entity Model

D.2 The Effect of Noncontrolling Rights on Consolidation

ASC 810-10

25-2 Paragraph 810-10-15-10(a)(1)(iv) explains that, in some instances, the powers of a shareholder with a majority voting interest or limited partner with a majority of kick-out rights through voting interests to control the operations or assets of the investee are restricted in certain respects by approval or veto rights granted to the noncontrolling shareholder or limited partner (referred to as noncontrolling rights). That paragraph also explains that, in paragraphs 810-10-25-2 through 25-14, the term noncontrolling shareholder refers to one or more noncontrolling shareholders and the terms limited partner and general partner refer to one or more limited or general partners. Paragraph 810-10-15-10(a)(1)(iv) explains that those noncontrolling rights may have little or no impact on the ability of a shareholder with a majority voting interest or limited partner with a majority of kick-out rights through voting interests to control the investee’s operations or assets, or, alternatively, those rights may be so restrictive as to call into question whether control rests with the majority owner.

25-3 The guidance in paragraphs 810-10-25-1 through 25-14 shall be applied in assessing the impact on consolidation of noncontrolling shareholder or limited partner approval or veto rights in both of the following circumstances:

Investments in which the investor has a majority voting interest in investees that are corporations or analogous entities (such as limited liability companies that have governing provisions that are the functional equivalent of regular corporations), or investments in which a limited partner has a majority of kick-out rights through voting interests in a limited partnership
Other circumstances in which legal entities would be consolidated in accordance with generally accepted accounting principles (GAAP), absent the existence of certain approval or veto rights held by noncontrolling shareholders or limited partners.

25-4 The guidance in paragraphs 810-10-25-2 through 25-14 on noncontrolling rights does not apply in either of the following situations:

Entities that, in accordance with GAAP, carry substantially all of their assets, including investments in controlled entities, at fair value with changes in value reported in a statement of net income or financial performance
Investments in variable interest entities (VIEs) (see the Variable Interest Entities Subsection of Section 810-10-15).

25-5 The assessment of whether the rights of a noncontrolling shareholder or limited partner should overcome the presumption of consolidation by the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests in its investee is a matter of judgment that depends on facts and circumstances. The framework in which such facts and circumstances are judged shall be based on whether the noncontrolling rights, individually or in the aggregate, allow the noncontrolling shareholder or limited partner to effectively participate in certain significant financial and operating decisions of the investee that are made in the ordinary course of business. Effective participation means the ability to block significant decisions proposed by the investor who has a majority voting interest or the general partner. That is, control does not rest with the majority owner because the investor with the majority voting interest cannot cause the investee to take an action that is significant in the ordinary course of business if it has been vetoed by the noncontrolling shareholder. Similarly, for limited partnerships, control does not rest with the limited partner with the majority of kick-out rights through voting interests if the limited partner cannot cause the general partner to take an action that is significant in the ordinary course of business if it has been vetoed by other limited partners. This assessment of noncontrolling rights shall be made at the time a majority voting interest or a majority of kick-out rights through voting interests is obtained and shall be reassessed if there is a significant change to the terms or in the exercisability of the rights of the noncontrolling shareholder or limited partner.

25-6 All noncontrolling rights could be described as protective of the noncontrolling shareholder’s or limited partner’s investment in the investee, but some noncontrolling rights also allow the noncontrolling shareholder or limited partner to participate in determining certain significant financial and operating decisions of the investee that are made in the ordinary course of business (referred to as participating rights). Participation means the ability to block actions proposed by the investor that has a majority voting interest or the general partner. Thus, the investor with the majority voting interest or the general partner must have the agreement of the noncontrolling shareholder or limited partner to take certain actions. Participation does not mean the ability of the noncontrolling shareholder or limited partner to initiate actions.

25-7 Noncontrolling rights that are only protective in nature (referred to as protective rights) would not overcome the presumption that the owner of a majority voting interest or the limited partner with a majority of kick-out rights through voting interests shall consolidate its investee. Substantive noncontrolling rights that allow the noncontrolling shareholder or limited partner to effectively participate in certain significant financial and operating decisions of the investee that are made in the investee’s ordinary course of business, although also protective of the noncontrolling shareholder’s or limited partner’s investment, shall overcome the presumption that the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests shall consolidate its investee.

25-8 For purposes of this Subsection, decisions made in the ordinary course of business are defined as decisions about matters of a type consistent with those normally expected to be addressed in directing and carrying out the entity’s current business activities, regardless of whether the events or transactions that would necessitate such decisions are expected to occur in the near term. However, it must be at least reasonably possible that those events or transactions that would necessitate such decisions will occur. The ordinary course of business definition would not include self-dealing transactions with controlling shareholders or limited partners.

Reporting entities must evaluate rights that are granted by law or by contract that are retained by noncontrolling shareholders (or noncontrolling limited partners in a limited partnership) to assess whether such rights have an impact on the determination of whether the reporting entity has a controlling financial interest in a legal entity. Noncontrolling rights can be broadly categorized as either (1) protective rights or (2) participating rights. Only participating rights can preclude consolidation of a legal entity by an investor with a majority voting interest or a limited partner with a majority of kick-out rights.

D.2.1 Protective Rights

ASC 810-10

25-10 Noncontrolling rights (whether granted by contract or by law) that would allow the noncontrolling shareholder or limited partner to block corporate or partnership actions would be considered protective rights and would not overcome the presumption of consolidation by the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests in its investee. The following list is illustrative of the protective rights that often are provided to the noncontrolling shareholder or limited partner but is not all-inclusive:

Amendments to articles of incorporation or partnership agreements of the investee
Pricing on transactions between the owner of a majority voting interest or limited partner with a majority of kick-out rights through voting interests and the investee and related self-dealing transactions
Liquidation of the investee in the context of Topic 852 on reorganizations or a decision to cause the investee to enter bankruptcy or other receivership
Acquisitions and dispositions of assets that are not expected to be undertaken in the ordinary course of business (noncontrolling rights relating to acquisitions and dispositions of assets that are expected to be made in the ordinary course of business are participating rights; determining whether such rights are substantive requires judgment in light of the relevant facts and circumstances [see paragraphs 810-10-25-13 and 810-10-55-1])
Issuance or repurchase of equity interests.

ASC 810-10 — Glossary

Protective Rights (Voting Interest Entity Definition)

Rights that are only protective in nature and that do not allow the limited partners or noncontrolling shareholders to participate in significant financial and operating decisions of the limited partnership or corporation that are made in the ordinary course of business.

By definition, protective rights do not allow the noncontrolling shareholders or noncontrolling limited partners to participate in significant financial and operating decisions made in a corporation’s or limited partnership’s ordinary course of business. These types of rights do not overcome the presumption of consolidation of the corporation or limited partnership by the controlling financial interest holder. See Section D.2.3 for additional discussion of the evaluation of whether noncontrolling rights are substantive participating rights.

D.2.2 Participating Rights

ASC 810-10

25-11 Noncontrolling rights (whether granted by contract or by law) that would allow the noncontrolling shareholder or limited partner to effectively participate in either of the following corporate or partnership actions shall be considered substantive participating rights and would overcome the presumption that the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests shall consolidate its investee. The following list is illustrative of substantive participating rights, but is not necessarily all-inclusive:

Selecting, terminating, and setting the compensation of management responsible for implementing the investee’s policies and procedures
Establishing operating and capital decisions of the investee, including budgets, in the ordinary course of business.

25-12 The rights noted in paragraph 810-10-25-11 are participating rights because, in the aggregate, the rights allow the noncontrolling shareholder or limited partner to effectively participate in certain significant financial and operating decisions that occur as part of the ordinary course of the investee’s business and are significant factors in directing and carrying out the activities of the business. Individual rights, such as the right to veto the termination of management responsible for implementing the investee’s policies and procedures, should be assessed based on the facts and circumstances to determine if they are substantive participating rights in and of themselves. However, noncontrolling rights that appear to be participating rights but that by themselves are not substantive (see paragraphs 810-10-25-13 and 810-10-55-1) would not overcome the presumption of consolidation by the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests in its investee. The likelihood that the veto right will be exercised by the noncontrolling shareholder or limited partner should not be considered when assessing whether a noncontrolling right is a substantive participating right.

ASC 810-10 — Glossary

Participating Rights (Voting Interest Entity Definition)

Participating rights allow the limited partners or noncontrolling shareholders to block or participate in certain significant financial and operating decisions of the limited partnership or corporation that are made in the ordinary course of business. Participating rights do not require the holders of such rights to have the ability to initiate actions.

Participating rights allow the holder of such rights to participate in certain financial and operating decisions of an investee that occur “in the ordinary course of business” but do not require the holder to initiate actions. The retention of substantive participating rights by noncontrolling shareholders or noncontrolling limited partners would overcome the presumption that an investor with a majority voting interest should consolidate the investee. ASC 810-10-25-11 provides the following two examples of substantive participating rights that would preclude an investor with a majority voting interest from consolidating an investee: (1) selecting, terminating, and setting the compensation of management responsible for implementing the investee’s policies and procedures and (2) establishing operating and capital decisions of the investee (including budgets) in the ordinary course of business. See Table 1-1 in Section 1.4 for differences between the definition of participating rights under the voting interest entity model and the VIE model.

D.2.3 Factors to Consider in Evaluating Whether Noncontrolling Rights Are Substantive Participating Rights

ASC 810-10

25-13 The following factors shall be considered in evaluating whether noncontrolling rights that appear to be participating are substantive rights, that is, whether these factors provide for effective participation in certain significant financial and operating decisions that are made in the investee’s ordinary course of business:

Consideration shall be given to situations in which a majority shareholder or limited partner with a majority of kick-out rights through voting interests owns such a significant portion of the investee that the noncontrolling shareholder or limited partner has a small economic interest. As the disparity between the ownership interest of majority and noncontrolling shareholders or between the limited partner with a majority of kick-out rights through voting interests and noncontrolling limited partners increases, the rights of the noncontrolling shareholder or limited partner are presumptively more likely to be protective rights and shall raise the level of skepticism about the substance of the right. Similarly, although a majority owner is presumed to control an investee, the level of skepticism about such ability shall increase as the investor’s or limited partner’s economic interest in the investee decreases.
The governing documents shall be considered to determine at what level decisions are made — at the shareholder or limited partner level or at the board level — and the rights at each level also shall be considered. In all situations, any matters that can be put to a vote of the shareholders or limited partners shall be considered to determine if other investors, individually or in the aggregate, have substantive participating rights by virtue of their ability to vote on matters submitted to a shareholder or limited partner vote.
Relationships between the majority and noncontrolling shareholders or partners (other than an investment in the common investee) that are of a related-party nature, as defined in Topic 850, shall be considered in determining whether the participating rights of the noncontrolling shareholder or limited partner are substantive. For example, if the noncontrolling shareholder or limited partner in an investee is a member of the immediate family of the majority shareholder, general partner, or limited partner with a majority of kick-out rights through voting interests of the investee, then the rights of the noncontrolling shareholder or limited partner likely would not overcome the presumption of consolidation by the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests in its investee.
Certain noncontrolling rights may deal with operating or capital decisions that are not significant to the ordinary course of business of the investee. Noncontrolling rights related to decisions that are not considered significant for directing and carrying out the activities of the investee’s business are not substantive participating rights and would not overcome the presumption of consolidation by the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests in its investee. Examples of such noncontrolling rights include all of the following:
1. Location of the investee’s headquarters
2. Name of the investee
3. Selection of auditors
4. Selection of accounting principles for purposes of separate reporting of the investee’s operations.
Certain noncontrolling rights may provide for the noncontrolling shareholder or limited partner to participate in certain significant financial and operating decisions that are made in the investee’s ordinary course of business; however, the existence of such noncontrolling rights shall not overcome the presumption that the majority owner shall consolidate, if it is remote that the event or transaction that requires noncontrolling shareholder or limited partner approval will occur. Remote is defined in Topic 450 as the chance of the future event or events occurring being slight.
An owner of a majority voting interest or limited partner with a majority of kick-out rights through voting interests who has a contractual right to buy out the interest of the noncontrolling shareholder or limited partner in the investee for fair value or less shall consider the feasibility of exercising that contractual right when determining if the participating rights of the noncontrolling shareholder or limited partner are substantive. If such a buyout is prudent, feasible, and substantially within the control of the majority owner, the contractual right to buy out the noncontrolling owner or limited partner demonstrates that the participating right of the noncontrolling shareholder or limited partner is not a substantive right. The existence of such call options, for purposes of the General Subsections, negates the participating rights of the noncontrolling shareholder or limited partner to veto an action of the majority shareholder or general partner, rather than create an additional ownership interest for that majority shareholder. It would not be prudent, feasible, and substantially within the control of the majority owner to buy out the noncontrolling shareholder or limited partner if, for example, either of the following conditions exists:
1. The noncontrolling shareholder or limited partner controls technology that is critical to the investee.
2. The noncontrolling shareholder or limited partner is the principal source of funding for the investee.

Paragraph 810-10-55-1 provides additional guidance on assessing substantive participating rights.

25-14 An entity that is not controlled by the holder of a majority voting interest or holder of a majority of kick-out rights through voting interests because of noncontrolling shareholder or limited partner veto rights described in paragraphs 810-10-25-2 through 25-13 and 810-10-55-1 is not a VIE if the shareholders or partners as a group (the holders of the equity investment at risk) have the power to control the entity and the equity investment meets the other requirements of paragraphs 810-10-15-14 and 810-10-25-45 through 25-47, as applicable.

Kick-Out Rights

25-14A For limited partnerships, the determination of whether kick-out rights are substantive shall be based on a consideration of all relevant facts and circumstances. For kick-out rights to be considered substantive, the limited partners holding the kick-out rights must have the ability to exercise those rights if they choose to do so; that is, there are no significant barriers to the exercise of the rights. Barriers include, but are not limited to, the following:

Kick-out rights subject to conditions that make it unlikely they will be exercisable, for example, conditions that narrowly limit the timing of the exercise
Financial penalties or operational barriers associated with dissolving (liquidating) the limited partnership or replacing the general partners that would act as a significant disincentive for dissolution (liquidation) or removal
The absence of an adequate number of qualified replacement general partners or the lack of adequate compensation to attract a qualified replacement
The absence of an explicit, reasonable mechanism in the limited partnership’s governing documents or in the applicable laws or regulations, by which the limited partners holding the rights can call for and conduct a vote to exercise those rights
The inability of the limited partners holding the rights to obtain the information necessary to exercise them.

25-14B The limited partners’ unilateral right to withdraw from the partnership in whole or in part (withdrawal right) that does not require dissolution or liquidation of the entire limited partnership would not be deemed a kick-out right. The requirement to dissolve or liquidate the entire limited partnership upon the withdrawal of a limited partner or partners shall not be required to be contractual for a withdrawal right to be considered as a potential kick-out right.

25-14C Rights held by the limited partners to remove the general partners from the partnership shall be evaluated as kick-out rights pursuant to paragraph 810-10-25-14A. Rights of the limited partners to participate in the termination of management (for example, management is outsourced to a party other than the general partner) or the individual members of management of the limited partnership may be substantive participating rights. Paragraphs 810-10-55-4N through 55-4W provide additional guidance on assessing kick-out rights.

55-1 Examples of how to assess individual noncontrolling rights facilitate the understanding of how to assess whether the rights of the noncontrolling shareholder or limited partner should be considered protective or participating and, if participating, whether the rights are substantive. An assessment is relevant for determining whether noncontrolling rights overcome the presumption of control by the majority shareholder or limited partner with a majority of kick-out rights through voting interests in an entity under the General Subsections of this Subtopic. Although the following examples illustrate the assessment of participating rights or protective rights, the evaluation should consider all of the factors identified in paragraph 810-10-25-13 to determine whether the noncontrolling rights, individually or in the aggregate, provide for the holders of those rights to effectively participate in certain significant financial and operating decisions that are made in the ordinary course of business:

The rights of the noncontrolling shareholder or limited partner relating to the approval of acquisitions and dispositions of assets that are expected to be undertaken in the ordinary course of business may be substantive participating rights. Rights related only to acquisitions that are not expected to be undertaken in the ordinary course of the investee’s existing business usually are protective and would not overcome the presumption of consolidation by the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests in its investee. Whether a right to approve the acquisition or disposition of assets is in the ordinary course of business should be based on an evaluation of the relevant facts and circumstances. In addition, if approval by the shareholder or limited partner is necessary to incur additional indebtedness to finance an acquisition that is not in the investee’s ordinary course of business, then the approval by the noncontrolling shareholder or limited partner would be considered a protective right.
Existing facts and circumstances should be considered in assessing whether the rights of the noncontrolling shareholder or limited partner relating to an investee’s incurring additional indebtedness are protective or participating rights. For example, if it is reasonably possible or probable that the investee will need to incur the level of borrowings that requires noncontrolling shareholder or limited partner approval in its ordinary course of business, the rights of the noncontrolling shareholder or limited partner would be viewed as substantive participating rights.
The rights of the noncontrolling shareholder or limited partner relating to dividends or other distributions may be protective or participating and should be assessed in light of the available facts and circumstances. For example, rights to block customary or expected dividends or other distributions may be substantive participating rights, while rights to block extraordinary distributions would be protective rights.
The rights of the noncontrolling shareholder or limited partner relating to an investee’s specific action (for example, to lease property) in an existing business may be protective or participating and should be assessed in light of the available facts and circumstances. For example, if the investee had the ability to purchase, rather than lease, the property without requiring approval of the noncontrolling shareholder or limited partner, then the rights of the noncontrolling shareholder or limited partner to block the investee from entering into a lease would not be substantive.
The rights of the noncontrolling shareholder or limited partner relating to an investee’s negotiation of collective bargaining agreements with unions may be protective or participating and should be assessed in light of the available facts and circumstances. For example, if an investee does not have a collective bargaining agreement with a union or if the union does not represent a substantial portion of the investee’s work force, then the rights of the noncontrolling shareholder or limited partner to approve or veto a new or broader collective bargaining agreement are not substantive.
Provisions that govern what will occur if the noncontrolling shareholder or limited partner blocks the action of an owner of a majority voting interest or general partner need to be considered to determine whether the right of the noncontrolling shareholder or limited partner to block the action has substance. For example, if the shareholder or partnership agreement provides that if the noncontrolling shareholder or limited partner blocks the approval of an operating budget, then the budget simply defaults to last year’s budget adjusted for inflation, and if the investee is a mature business for which year-to-year operating budgets would not be expected to vary significantly, then the rights of the noncontrolling shareholder or limited partner to block the approval of the operating budget do not allow the noncontrolling shareholder or limited partner to effectively participate and are not substantive.
Noncontrolling rights relating to the initiation or resolution of a lawsuit may be considered protective or participating depending on the available facts and circumstances. For example, if lawsuits are a part of the entity’s ordinary course of business, as is the case for some patent-holding companies and other entities, then the noncontrolling rights may be considered substantive participating rights.
A noncontrolling shareholder or limited partner has the right to veto the annual operating budget for the first X years of the relationship. Based on the facts and circumstances, during the first X years of the relationship this right may be a substantive participating right. However, following Year X there is a significant change in the exercisability of the noncontrolling right (for example, the veto right terminates). As of the beginning of the period following Year X, that right would no longer be a substantive participating right and would not overcome the presumption of consolidation by the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests in its investee.

D.2.3.1 Evaluating Whether Participating Rights Are Substantive

ASC 810-10-25-13 and ASC 810-10-55-1 provide factors and examples to help reporting entities determine whether noncontrolling rights represent substantive participating rights. The premise of this guidance is that even if rights granted to a noncontrolling shareholder (or limited partner) appear to be substantive, there may be other factors that limit the effect of those rights. Generally, rights to participate in decisions that are not expected to be made in the ordinary course of business (i.e., those related to matters whose likelihood of occurrence is remote or that apply only in exceptional circumstances) are considered protective rights. Rights to participate in decisions related to matters whose occurrence is at least reasonably possible in the ordinary course of business are participating rights. Reporting entities must use judgment to determine whether participating rights are substantive participating rights. The likelihood that an entity will exercise its rights is not considered in the assessment. Rather, if an entity has the right to participate in decisions, it is assumed that those rights will be exercised.

For example, the noncontrolling shareholder may have a right to veto the operating and capital decisions of the investee in the ordinary course of business, but its economic interest may be small, and the majority owner may have a call option on the noncontrolling shares whose exercise would be prudent, feasible, and substantially within the control of the majority owner. In such a scenario, the right to participate in the operating and capital decisions may not overcome control by the majority owner.

A variation of the above example might involve a situation in which the majority shareholder and the noncontrolling shareholder each have buy-sell rights. As discussed in Section D.1.6.2, a buy-sell term in a contractual agreement can take various forms, including one in which each investor has the ability to offer to buy out the entire equity interest of another investor (the “offeree”) upon giving notice to the offeree. The investor making the offer (the “offeror”) names a price for the offeree’s interest at its discretion, or it may offer the interest at fair value. After receiving the offer, the offeree typically is contractually required to either (1) sell its entire interest in the entity to the offeror at the named price or (2) buy the offeror’s interest at the named price.

The evaluation of a buy-sell right in the context of determining whether a participating right held by a noncontrolling interest holder is substantive was discussed at the 2020 AICPA Conference on Current SEC and PCAOB Developments. In prepared remarks, SEC Professional Accounting Fellow Jeffrey Nick discussed the assessment of substantive participating rights in situations in which the majority shareholder has an option to acquire the noncontrolling shareholder’s shares at fair value in the event of a disagreement (and, similarly, the noncontrolling shareholder holds the same rights). Mr. Nick stated the following:

Consider a fact pattern presented to OCA staff relating to the consolidation analysis for a voting interest entity. This legal entity, a limited liability corporation with governing provisions that are the functional equivalent of a regular corporation, had its equity ownership divided between two investors, of which the reporting entity was one. These investors had a long-standing relationship, where one, the reporting entity, historically provided funding for investments, and the other provided know-how relating to identifying the investment opportunity and managing the investment on an ongoing basis. The shares in the legal entity conveyed economic rights in varying degrees at varying times, initially providing the registrant with the bulk of the economics of the legal entity until a stated rate of return was achieved, at which point the economics shifted to more equally distribute earnings among the parties. While the registrant held a majority voting interest through its share ownership, the other investor’s consent was required to effect certain significant decisions, including approving or modifying operating and capital budgets. In the event of a disagreement in these circumstances requiring the other investor’s consent, the arrangement included a buy/sell clause by which three outcomes could occur: either party could acquire the other party’s shares at fair value, or consent could be provided on the decision subject to disagreement. The registrant concluded that the buy/sell clause provided the registrant with the ability to break a deadlock unilaterally, believing that the other investor would not disagree with the registrant and risk its own removal from the venture. For [these reasons] the registrant concluded that the other investor did not have substantive participating rights, and thus that the registrant should consolidate the investee.

OCA staff objected to the registrant’s conclusion that it should consolidate the legal entity under the voting interest entity model.

We would not view a buy-sell provision in which the majority investor has the ability to purchase a noncontrolling interest holder’s interest at fair value (and a noncontrolling interest holder possesses the same right for the majority shareholder) as a situation that would prevent a noncontrolling interest holder from having an ability to exercise substantive participating rights should such an investor possess those rights.

For more information about the evaluation of call options and other forward starting rights in connection with the voting interest entity model, see Section D.1.4. For further discussion of buy-sell rights, see Section D.1.6.2.1.

Likewise, a noncontrolling shareholder (or limited partner) may have a right to consent to the operating and capital decisions of the investee in the ordinary course of business, but the contractual agreement may specify that such consent “shall not be unreasonably withheld or delayed.” If an agreement includes such language related to the participating rights granted to the noncontrolling shareholder (or limited partner), the reporting entity should not presume that the participating rights are not substantive. While the ability of the noncontrolling shareholder (or limited partner) to exercise its rights may be constrained on the basis of that language, its presence in an agreement would not automatically result in a conclusion that the participating rights are not substantive. Rather, a reporting entity should assess why the agreement contains the language and obtain a detailed understanding of the consent process.

When determining whether consent rights are truly substantive, the reporting entity should also carefully assess whether the rights allow the noncontrolling shareholder to participate in decisions that are made in the ordinary course of business. The reporting entity must use significant judgment and consider all relevant facts and circumstances in making this determination. It may be helpful to consider what would happen if the noncontrolling shareholder tried to exercise a consent right related to an activity to which such language applied. There may be significant uncertainty related to whether the action of withholding or delaying consent is, in fact, reasonable (and an arbitrator or court proceeding might be needed to make that determination). Such uncertainty might call into question whether the majority interest holder actually has control over the decision. Further, a reporting entity should generally not analogize to situations in which the contractual language (e.g., “unreasonably withheld”) might apply to a more narrow set of decisions (e.g., transfer restrictions as described in Sections 5.3.1.1.2 and 8.2.3.4).

In addition, since ASC 810-10-25-14A defines substantive kick-out rights that are specific to limited partnerships, a reporting entity may analogize to that guidance when evaluating (1) kick-out rights related to legal entities other than limited partnerships or (2) approval or veto rights granted to a noncontrolling interest holder.

Example D-9

Assume that Entity A and Entity B contributed certain assets to Entity C and that A and B own 60 percent and 40 percent, respectively, of the voting common shares of C. Assume that C is not a VIE. The operations of C are controlled by five managers, three of whom are appointed by A and two by B. Managers can be replaced only by the party that elected them. The following actions require the unanimous consent of all five managers:

Borrowing money on behalf of C in an amount in excess of $500,000.
Renewing, extending, modifying, rearranging, or refinancing borrowings by C in excess of $500,000.
Acquiring, leasing, holding, or selling any or all real or personal property of C (or any interest therein) involving amounts or values in excess of $500,000.
Paying or incurring any expense, debt, or obligation of C in excess of $500,000.
Approving any long-term (more than one year) supply contract or other contract involving amounts in excess of $500,000.

The $500,000 approval limit represents less than 1 percent of C’s estimated fair value upon formation. If the managers cannot reach unanimous agreement about an action, the action will be decided through an independent binding arbitration process.

In this scenario, A should not consolidate C. The rights granted in connection with the actions outlined above are expected to allow B to effectively participate in significant decisions that would be made in C’s ordinary course of business. They therefore qualify as participating rights under ASC 810-10-25-11. Because A does not control C, A should account for its investment in C under the equity method.

Consider, however, a scenario in which the $500,000 approval limit represented 40 percent of C’s estimated fair value upon formation. In such a case, because of the high approval threshold relative to the entity’s estimated fair value, B is unable to effectively participate in significant decisions that would be made in C’s ordinary course of business. Therefore, the rights granted to B would be considered protective, and A would consolidate C.

Example D-10

Entity A has a majority voting interest in Entity C, a voting interest entity; however, Entity B has the right to consent to decisions related to the following:

Operating expenses in a fiscal year that exceed 135 percent of the aggregate amount of operating expenses for the immediately preceding fiscal year.
Capital expenditures in any fiscal year that exceed an aggregate amount equal to 200 percent of the capital expenditures for the immediately preceding fiscal year.

Because C operates in a mature business for which year-to-year budgeted operating expenses would not be expected to vary significantly, A determines that its inability to unilaterally increase the budgeted operating expenses in a fiscal year by more than 135 percent of the expenses from the immediately preceding fiscal year does not prevent A from unilaterally making all of the necessary financial and operating decisions in the ordinary course of C’s business.

Further, because C is not a capital-intensive business, A determines that its inability to increase the budgeted capital expenditures by more than 200 percent of the expenditures from the immediately preceding fiscal year does not prevent A from unilaterally making all of the necessary financial (including capital) and operating decisions in the ordinary course of C’s business.

On the basis of these specific facts and circumstances, A may determine that B’s consent rights (individually and in the aggregate) do not represent substantive participating rights and that A therefore has a controlling financial interest in C.

Example D-11

Entity A and Entity B form Entity C, a voting interest entity, and have 70 percent and 30 percent, respectively, of the ownership interests in C. Entity C was formed to own, develop, and operate a single commercial real estate property that is not subject to any lien or other form of indebtedness.

Entity A, as the manager, executes the day-to-day operations of C, for which A receives a separate management fee. However, the following major decisions related to the governance of C require unanimous approval of both A and B:

Any decision to effect or undertake a material alteration in excess of $20 million, which represents 5 percent of C’s estimated fair value upon formation.
Acquisition by C of any real property or other material asset apart from the single commercial real estate property.
Extension of credit or the undertaking or modification of loans outside of the approved budget.

Since C was formed to manage a single commercial real estate property that was not expected to be altered after its development, A concludes that a material alteration is considered outside the normal course of business. In addition, because C was designed to hold the single commercial real estate property and not to acquire and manage other properties, A concludes that acquisition of additional properties is outside the normal course of business. Further, since the single commercial real estate property is not subject to any lien or other form of indebtedness, A concludes that the extension of credit or the undertaking or modification of loans is outside the ordinary course of business.

On the basis of these facts and circumstances, A may determine that B’s consent rights (individually and in the aggregate) do not represent substantive participating rights and that A therefore has a controlling financial interest in C.

Example D-12

Assume the same facts as in the previous example except that Entities A and B must unanimously approve the business plan, which includes the operating budget and capital budget for the single commercial real estate property.

If A and B approve the annual business plan, A, as the manager, is afforded the discretion to increase spending by no more than 10 percent or $1 million of the approved business plan for each line item as long as the total spending does not exceed the total budgeted spending by more than 5 percent.

As the manager, A concludes that its decision-making authority is constrained by the business plan because it is expected to operate Entity C within the confines of the operating and capital budgets, which must be approved by B. However, as a result of failure to reach agreement on the proposed business plan (i.e., failure to obtain B’s approval), the operating budget automatically reverts to the prior-year budget (or the most recent unanimously approved budget).

Although the prospect of defaulting to the prior-year budget (or most recent unanimously approved budget) could potentially suggest that B’s participating right is not substantive, the specific facts and circumstances regarding C’s underlying property would also need to be considered. For example, if the capital expenditures for the underlying commercial real estate property that were expected to be required in the ordinary course of business over the life of the entity were greater than those in the original approved budget, the fact that B must approve a budget increase may indicate that B has a substantive participating right.

Further, A and B must unanimously approve any execution, modification, or termination of a lease of the single commercial real estate property. Under ASC 810-10-25-13, a participating right is substantive if the holder has the ability to prevent a majority owner from making certain significant ordinary-course financial or operating decisions related to the entity. Therefore, B may have a substantive participating right since it has the right and the ability to block A from making the leasing decisions regarding the commercial real estate property (in the near term).

If the single commercial real estate property were under a long-term lease arrangement (and a substantive lease term remained) before A and B entered into the limited partnership, it may be unlikely that B would be able to exercise any substantive participating rights related to the leasing activities. However, if the property were vacant upon the formation of the limited partnership or if it were under a short-term lease, the facts and circumstances may lead to a conclusion that B has a substantive participating right.

However, the specific facts and circumstances should be carefully considered in the analysis of whether the above rights represent (individually or in the aggregate) substantive participating rights.

D.2.3.2 Noncontrolling Approval or Veto Rights Qualified by the Phrase “Other Than in the Ordinary Course of Business”

Situations have arisen in which a noncontrolling interest holder was granted substantive approval or veto rights and the terms of those rights were qualified by the phrase “other than in the ordinary course of business.” In situations in which that phrase was used to qualify a noncontrolling interest holder’s approval or veto rights and was vaguely defined, the SEC objected to consolidation by the majority owner. Accordingly, the contractual inclusion of undefined phrases such as “except in the normal course of business” or “other than in the ordinary course of business” is not considered sufficient to preclude a noncontrolling right, that would otherwise be considered a substantive participating right, from being treated as a substantive participating right. Rather, the reporting entity should evaluate the substance of the noncontrolling rights to determine whether the rights are substantive participating rights. Such an evaluation may include consideration of the following factors (not all-inclusive):

The likelihood that the activity associated with the approval or veto rights will occur on the basis of the purpose and design of the entity, and the expected frequency of such occurrence(s).
What could “trigger” the approval or veto rights held by the noncontrolling interest holder. In other words, the point at which the majority voting interest holder is no longer able to unilaterally direct the operating and capital decisions of the entity under the provision qualified by the phrase “except in the ordinary course of business” provision (i.e., whether frequency, size, or a combination of both triggers the approval or veto rights).
Whether the majority voting interest holder has alternative means by which to complete the activity that would eliminate the need to consider or invoke the provision qualified by the phrase “except in the ordinary course of business” (e.g., approval of the operating and capital budget or other mechanisms).
Other rights held by the noncontrolling interest holder, or the lack thereof, to participate in other activities of the legal entity.

Reporting entities may need the assistance of legal counsel in determining the substance of the noncontrolling interest holder’s rights.

This guidance also applies to non-SEC registrants.

Example D-13

Entity A and Entity B each hold 50 percent of Entity C, which leases high-value construction equipment to its customers. Assume that C is not a VIE. The entities have an agreement under which A has the ability to appoint three members of C’s five-member board of directors, and B can appoint the two remaining members. The agreement also specifies that for several significant decisions, unanimous approval of the board must be obtained “other than in the normal course of business,” which the agreement does not define. Specifically, the applicable provision states, in part, that “the directors have no authority or power to take the following action without unanimous approval: purchase, take, receive, lease or otherwise acquire, own, hold, improve, sell, dispose, use, or otherwise deal in or with real or personal property or any interest in real or personal property, wherever situated, having a value greater than $100,000, other than in the normal course of business.” Making purchases or acquisitions of this nature is considered an action that will take place as part of directing and carrying out C’s current business activities.

In this example, the use of the phrase “other than in the normal course of business” does not preclude the unanimous-approval requirement from being a participating right because the meaning of that phrase is not defined and is not a “safe harbor” in which such a right is simply a protective right. Accordingly, to determine whether the right is participating or protective, the reporting entity must perform additional analysis of the relevant facts and circumstances (e.g., the purpose and design of the legal entity, legal counsel’s interpretation of the substance of the unanimous approval requirement), including how and when the right would be subject to approval with respect to directing and carrying out C’s business activities.

D.2.3.3 Noncontrolling Rights to Block Acquisitions and Dispositions of Assets

Under ASC 810-10-25-10, noncontrolling rights to block acquisitions and dispositions of assets that are not expected to be undertaken in the ordinary course of business are protective rights and would not overcome the presumption of consolidation by the investor with a majority voting interest or a limited partner with a majority of kick-out rights in its investee. Under previous guidance in EITF 96-16, there was a presumption that a noncontrolling interest holder’s right to block “[a]cquisitions and dispositions of assets greater than 20 percent of the fair value of the investee’s total assets” would be indicative of a protective right, whereas a noncontrolling interest holder’s right to block “[a]cquisitions and dispositions of 20 percent or less do not necessarily lead to the conclusion that it is a substantive participating right.” However, the FASB removed this 20 percent presumption when issuing EITF 04-5 and, instead, revised the language to focus on acquisitions and dispositions in the ordinary course of business. Therefore, a reporting entity must use judgment in determining whether, on the basis of the facts and circumstances, noncontrolling rights are participating or protective in nature.

Example D-14

Entity A and Entity B restructured a 50-50 (respective voting and economic ownership) corporate joint venture agreement involving Entity C. Under the agreement, A has 90 percent of the voting and economic interest in C, and control of the board. Entity A appoints all management of C and thus has management control of C’s operations. Assume that C is not a VIE. The stated purpose of the restructuring was to transfer control of C to A. The restructuring allows B to obtain liquidity for its investment in C and to extricate itself in part from C’s operations but also allows B to retain its financial interest in certain royalties and fixed payments through its remaining 10 percent economic ownership interest in C. However, one specific provision of the restructured operating agreement is that A cannot agree to make any transfer, in any transaction or series of transactions, of any asset or assets of C, the absence of which, singly or in the aggregate, would materially diminish or impair C’s primary business activities or C’s ability to conduct its primary business activities.

In this example, the rights granted to B do not allow B to participate in the management or in the financial and operating decisions of C but rather protect its financial interest in the event that A decides to substantially change the nature, purpose, and design of C’s primary business. The purpose of the provision is to ensure that A cannot eviscerate C’s operations to the detriment of B. Therefore, the rights granted to B would not be sufficient to preclude A from consolidating C.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.