E.2 Collateralized Investment Vehicles

E.2.1 Consolidation Analysis

Collateralized investment vehicles (CIVs) are unique securitizations in that there is typically no transfer of assets from the sponsor to the securitization entity. Instead, the CIV purchases financial assets (e.g., senior syndicated loans) from the open market by using proceeds from a warehouse line (warehousing phase). Once the legal entity has accumulated loans of a quantity sufficient to permit securitization, it will issue beneficial interests and use the proceeds from the sale of its securities to pay off the warehouse line and purchase any remaining financial assets needed (securitization phase). Common examples of CIVs include CLOs and CDOs. A CIV is an example of a CFE, as defined in ASC 810.

A CIV employs a collateral manager (typically a bank or an investment manager that sponsors the CIV) that performs various functions for the CIV during its different stages. For example, during the initial warehousing phase, the collateral manager is responsible for acquiring the assets for the CIV and ensuring that the asset composition complies with the transaction documents. During the securitization phase, the collateral manager is responsible for determining the appropriate action to take in response to a default or other event as well as how to reinvest the principal proceeds received from the underlying loans.

Because a substantive contingent event may need to be resolved (e.g., market receptivity to the securitization or consent granted by all parties involved) before the CIV’s transition from the warehousing phase to the securitization phase, a separate consolidation analysis may need to be performed for each distinct phase. That is, because its securitization may be considered a fundamental redesign of the CIV, there may be different activities that most significantly affect the potential VIE’s economic performance during each phase.

Some CIVs use a co-issuer structure. For example, beneficial interests are co-issued to enhance marketability to U.S. insurers. It is common in the CLO market for the issuer to be domiciled outside the United States. In such a case, the offshore entity holds the assets and issues all the beneficial interests; the co-issuer is a domestic entity that co-issues certain of the beneficial interests. U.S. insurers may face statutory limits on foreign issued investments. Investments co-issued by a domestic issuer may not be subject to those limitations.

E.2.2 Determining Whether a CIV Is a VIE

A reporting entity is required to apply either the VIE model or the voting interest entity model in performing its consolidation assessment. To determine which model to use, the collateral manager must decide whether any of the following conditions apply:

The CIV has insufficient equity at risk to finance its activities.
The at-risk equity holders (as a group) lack any of the three characteristics of a controlling financial interest.
Members of the at-risk equity group have nonsubstantive voting rights.

If any of these conditions apply, the CIV should be evaluated under the VIE model.

Although a CIV may issue equity interests that provide credit support to the legal entity’s senior investors, the tranched capital structure of the CIV, as well as the multiple series of debt instruments typically issued by a CIV, will usually serve as qualitative evidence that the legal entity has insufficient equity at risk.

Even if a CIV has sufficient equity investment at risk, the equity interests do not typically have voting rights that give those investors power to direct the activities of the legal entity. Rather, the decision-making ability is typically granted to the collateral manager, and the ability to remove the collateral manager is often shared with holders of debt interests issued by the CIV. Unless a single equity holder with equity at risk has the unilateral ability to remove the collateral manager, or the collateral manager is acting as an agent on behalf of the at-risk equity group, through its equity investment at risk (i.e., the decision-making rights are not considered a variable interest), the CIV would be a VIE. See Chapter 5 for further discussion of whether a legal entity is a VIE.

E.2.3 Determining the Primary Beneficiary of a CIV

The chart below illustrates the steps a collateral manager would take in determining whether it is required to consolidate a CIV. The sections that follow the chart discuss the steps in detail.

E.2.3.1 Step 1: Does the Collateral Manager Have a Variable Interest in the CIV?

ASC 810-10

55-37 Fees paid to a legal entity’s decision maker(s) or service provider(s) are not variable interests if all of the following conditions are met:

The fees are compensation for services provided and are commensurate with the level of effort required to provide those services.
Subparagraph superseded by Accounting Standards Update No. 2015-02.
The decision maker or service provider does not hold other interests in the VIE that individually, or in the aggregate, would absorb more than an insignificant amount of the VIE’s expected losses or receive more than an insignificant amount of the VIE’s expected residual returns.
The service arrangement includes only terms, conditions, or amounts that are customarily present in arrangements for similar services negotiated at arm’s length.
Subparagraph superseded by Accounting Standards Update No. 2015-02.
Subparagraph superseded by Accounting Standards Update No. 2015-02.

As ASC 810-10-55-37 indicates, the evaluation of whether fees paid to a collateral manager are a variable interest focuses on whether (1) the fees “are commensurate with the level of effort” (ASC 810-10-55-37(a)), (2) the collateral manager has any other direct or indirect interests (including indirect interests through its related parties) that absorb more than an insignificant amount of the CIV’s variability (ASC 810-10-55-37(c)), and (3) the arrangement’s terms are customary (ASC 810-10-55-37(d)).

When a collateral manager evaluates its economic exposure to a VIE under ASC 810-10-55-37(c), it should consider its direct interests in the CIV together with its indirect interests held through its related parties (or de facto agents) on a proportionate basis. For example, if a collateral manager owns a 20 percent interest in a related party, and that related party owns 40 percent of the residual tranche of the CIV being evaluated, the collateral manager’s interest would be considered equivalent to an 8 percent direct interest in the residual tranche of the CIV (20 percent of 40 percent). (In the assessment of whether the reporting entity meets the economics criterion in the primary-beneficiary determination, the guidance on entities under common control is consistent with the proportionate-basis guidance that applies to related parties. See Section 7.3.5.1 for additional information.) In situations in which the collateral manager does not hold an interest in the related party, the collateral manager would exclude the related party’s interest unless the interest was provided to the related party to circumvent the consolidation guidance (see Section 4.4.2.3.2).

As a general guideline, the evaluation of whether the collateral manager’s other variable interests absorb more than an insignificant amount of the CIV’s variability is based on whether the variability absorbed by the collateral manager through its other variable interests in the CIV exceeds, either individually or in the aggregate, 10 percent of the CIV’s expected variability. However, because of the subjective nature of the calculation of expected losses and expected residual returns, 10 percent is not a bright line or safe harbor.

The evaluation of a collateral manager’s economic exposure through its other interests should take into account the CIV’s purpose and design. In addition, all risks and associated variability that are absorbed by any of the CIV’s variable interest holders should be considered. The type of interest held by a collateral manager will affect its economic exposure to the CIV and, accordingly, the collateral manager’s conclusion about whether its decision-making arrangement is a variable interest. For example, a first-loss interest is more likely to expose the collateral manager to a significant amount of expected losses or the potential to receive significant expected residual returns than a senior interest. See Appendix C for more information about the quantitative concepts underlying these terms.

We expect that substantially all fees charged by collateral managers for services are commensurate with the level of effort required to provide those services and that their fee arrangements contain only customary terms and conditions. Therefore, as long as a collateral manager does not have other interests in the CIV (including indirect interests through its related parties) that would absorb more than an insignificant amount of the CIV’s variability, the collateral manager will not have a variable interest in the CIV and will not consolidate the CIV.

See Section 4.4 for further discussion of whether decision-maker or service-provider fees represent a variable interest.

E.2.3.2 Step 2: Does the Collateral Manager Have the Power to Direct the Activities That Most Significantly Affect the CIV?

When the collateral manager has other interests in the CIV (including interests through its related parties and certain interests held by its related parties under common control) that would absorb more than an insignificant amount of the CIV’s variability, the collateral manager would have a variable interest in the CIV and must determine whether it has power over the CIV’s most significant activities.

The economic performance of a CIV is generally most significantly affected by the underlying assets’ performance. Some of the factors that can affect the underlying assets’ performance may be beyond the direct control of any of the parties to the CIV (like voluntary prepayments) and, therefore, do not enter into the power analysis. The activities that most significantly affect the underlying assets’ performance in a CIV are typically related to the collateral manager’s selection, monitoring, and disposal of collateral assets.

In the analysis of which party has the power to direct those activities, questions that should be answered include the following:

Does the collateral manager hold the power unilaterally?
Alternatively, do other parties also have relevant rights and responsibilities? For example:
- Is there another party or other parties that direct other important activities of the CIV? If so, which activities are the most important?
- Is there another party that has to consent to every important decision?
- Is there another party that can direct the collateral manager to take certain actions?
- Is there another party that can replace the collateral manager without cause?
- Is there another party or other parties that direct the same activities as the collateral manager but for a different portion of the CIV’s assets?
Is the collateral manager’s right to exercise power currently available or contingent on the occurrence of some other event(s)?

E.2.3.2.1 Circumstances in Which a Collateral Manager Might Not Have Power

The collateral manager might not have power in the following situations:

The collateral manager can be replaced without cause by a single unrelated party (see Section E.2.3.2.2).
All important decisions require the consent of one or more unrelated parties (see Section E.2.3.2.3).
The collateral manager manages less than a majority of the assets in the VIE (see Section E.2.3.2.4).

See Section 7.2 for further discussion of evaluating the power criterion.

E.2.3.2.2 Kick-Out Rights

Although not common for CIVs, substantive kick-out rights (i.e., those that can be exercised at will and not upon a contingent event) held by a single party (including its related parties and de facto agents) that are unrelated to the collateral manager prevent the collateral manager from having power because the collateral manager could be removed. Such rights would generally be considered substantive if there are no significant financial or operational barriers to their exercise.

E.2.3.2.3 Shared Power and Participating Rights

The right of an unrelated party to veto all the important decisions made by the collateral manager would, if substantive, prevent the collateral manager from satisfying the power condition since power would be shared. The requirement to obtain consent is considered a participating right when the consent is required for the activities that most significantly affect the legal entity’s economic performance. However, when the consent is related only to activities that are unimportant or only to certain of the significant activities, power would not be considered shared. In addition, a reporting entity would need to closely analyze the legal entity’s governance provisions to understand whether the consent requirements are substantive (e.g., the consequences if consent is not given).

However, if power is considered shared (e.g., the collateral manager is required to obtain approval from the residual holder for all significant decisions), the collateral manager will need to determine whether the other party (residual holder) is a related party (or de facto agent). If power is considered shared within a related-party group, and the group as a whole has the characteristics of a controlling financial interest, the collateral manager must perform the related-party tiebreaker test to determine which party in the group must consolidate the CIV. ASC 810-10-25-44 notes that an entity must use judgment in determining “which party within the related party group is most closely associated with the VIE” and should consider all relevant facts and circumstances. The guidance provides the following four indicators, which are the same as those under prior GAAP, for consideration in this assessment:

“The existence of a principal-agency relationship between parties within the related party group.”
“The relationship and significance of the activities of the [legal entity] to the various parties within the related party group.”
“A party’s exposure to the variability associated with the anticipated economic performance of the [legal entity].”
“The design of the [legal entity].”

Example E-1

A collateralized loan entity is formed to acquire commercial loans, drawing down on a line of credit as it identifies new loans. Once the CLO has accumulated sufficient loans to permit securitization, the entity will issue beneficial interests and use the proceeds from the sale of its securities to pay off the warehouse line and purchase any remaining assets needed. The CLO is sponsored by the investment manager.

During the warehousing stage, the investment manager invests $1 million for 20 percent equity ownership in the entity, and other investors provide $4 million for the remaining equity interests in addition to $95 million provided by the bank in the form of a line of credit. The investment manager cannot (1) make any decisions (e.g., loan purchases or issuances of beneficial interests) without approval from the bank or (2) transfer its equity interest in the CLO (the bank is not similarly constrained). Further, the entity is unable to transition from the warehousing phase to the securitization phase without the agreement of all the equity investors and the bank.

The investment manager has determined that the arrangement should be evaluated as a multiphase entity because of the significant uncertainty about the CLO’s ability to transition from the warehousing phase to the securitization phase. In addition, the investment manager has determined that the CLO is a VIE during the warehousing phase since the bank (a nonequity holder) has the ability to participate in the entity’s most significant decisions during this phase. This determination will need to be reevaluated when the CLO proceeds to the securitization phase and issues beneficial interests in the securitization entity (redesign of the CLO).

Under the VIE model, the restrictions imposed on the investment manager’s ability to transfer or encumber its equity interest create a de facto agency relationship between the investment manager and the bank. Therefore, although the decisions that most significantly affect the entity during the warehousing phase require the consent of both parties, because the investment manager shares power with the bank, the investment manager cannot conclude that there is no primary beneficiary of the CLO. Rather, because the related-party group (including de facto agents) meets both criteria in ASC 810-10-25-38A, the investment manager would apply the related-party tiebreaker test in ASC 810-10-25-44 to determine whether it should consolidate the CLO. Note that a different consolidation conclusion may be reached after the CLO’s transition from the warehousing to securitization phase.

E.2.3.2.4 Multiple Parties With Power

The concept of multiple parties with power can manifest itself in two ways:

Multiple parties performing different activities — It is possible that in certain CIVs, one service provider is engaged to manage investments and another is engaged to manage funding. In such situations, the reporting entity must use judgment and analyze all the facts and circumstances to determine the activity that most significantly affects the economic performance of the legal entity.
Multiple parties performing the same activities — If the joint consent of multiple unrelated parties is required for decisions regarding directing the relevant activities of a legal entity, power is shared, and no party would consolidate. However, when multiple parties individually perform the same activities over separate pools of similar assets, and consent is not required, the party that has unilateral decision making over a majority of the assets would have power over the CIV.

E.2.3.3 Step 3: Does the Collateral Manager Have a Potentially Significant Interest?

If a collateral manager determines that its decision-making arrangement is a variable interest as a result of any direct or indirect interests through its related parties, its interests will usually represent an obligation to absorb losses of the VIE or a right to receive benefits from the VIE that could potentially be significant to the VIE. That is, if a collateral manager’s fee is a variable interest because the collateral manager has other direct interests (or indirect interests through its related party) in the CIV that represent a more than insignificant economic interest in the CIV, it would meet the “economics” criterion (ASC 810-10-25-38A(b)) in the primary-beneficiary analysis.

However, if the collateral manager’s fee is a variable interest solely because (1) the fee arrangement is not customary or at market but the collateral manager does not have any direct interests (including the fee) or indirect interests through its related parties that meet the economics criterion or (2) the collateral manager’s related party under common control holds an interest in the CIV in an effort to circumvent the consolidation guidance, the collateral manager may not meet this requirement. The collateral manager would only include interests held by its related parties under common control in the primary-beneficiary analysis if it has a direct interest in those related parties. Accordingly, if the collateral manager’s fee arrangement is a variable interest solely for one of these two reasons, and the collateral manager does not have an interest in those related parties, the collateral manager individually would not have both of the characteristics of a controlling financial interest. However, the collateral manager would still need to assess whether it should consolidate the CIV under the related-party tiebreaker test (step 4).

E.2.3.4 Step 4: Is the Collateral Manager Required to Perform the Related-Party Tiebreaker Test to Determine Whether It Has a Controlling Financial Interest?

E.2.3.4.1 Related Parties Under Common Control

A collateral manager and its related parties must individually determine which party should consolidate a CIV. Each member of a related-party group with a variable interest in the CIV may determine that it individually does not possess both characteristics of a controlling financial interest but that the related-party group as a whole possesses both characteristics. A reporting entity would perform the related-party tiebreaker test in this situation only if both characteristics of a controlling financial interest reside within a related-party group that is under common control.

We expect that the related-party tiebreaker guidance will apply in extremely limited circumstances to a collateral manager and its related parties under common control. A determination that the collateral manager meets the power criterion through a fee arrangement is most likely to have been made if the collateral manager has a direct or indirect economic interest in the CIV that absorbs more than an insignificant amount of the CIV’s variability (see Section 4.4.2). In addition, when performing the economics-criterion assessment, the collateral manager is required to consider its indirect economic interests in a VIE held through related parties under common control on a proportionate basis (see Section 7.3.5.1). Therefore, the related-party tiebreaker guidance would apply to the collateral manager and its related parties under common control only if either (1) the collateral manager fees were not commensurate or at market but the collateral manager did not have any direct interests (including the fee) or indirect interests through its related parties that met the economics criterion or (2) it was determined that the collateral manager’s decision-making arrangement was a variable interest because a CIV was designed in an effort to circumvent consolidation in the stand-alone financial statements of the collateral manager or related party under common control (see Section 4.4.2.3.2).

Note that in instances in which the collateral manager does not have a variable interest through the fee arrangement in a VIE but the related parties under common control collectively would, if aggregated, have met the power and economics criteria collectively, the parent of the related parties under common control would consolidate the VIE. That is, although the CIV may not be consolidated by either of the subsidiaries in their stand-alone financial statements, the parent must assess the VIE on the basis of its aggregate direct and indirect interests. See Section 7.4.2.3 for further discussion of diversity in practice as a result of a determination that a decision maker with contractual power does not have a variable interest but a related party under common control meets the economics criterion.

E.2.3.4.2 Related Parties Not Under Common Control

If neither the collateral manager nor a related party under common control is required to consolidate a CIV, but the related-party group (including de facto agents) possesses the characteristics of a controlling financial interest, and substantially all of the CIV’s activities are conducted on behalf of a single entity in the related-party group, that single entity would be the primary beneficiary of the CIV.

Interests held by the reporting entity’s de facto agents (typically as a result of a one-way transfer restriction) would not be included in the consolidation analysis on an indirect basis unless the reporting entity has economic exposure to the VIE through its de facto agents. Accordingly, these restrictions are less likely to result in consolidation.

E.2.4 Reconsideration of the Primary-Beneficiary Conclusion

The VIE guidance in ASC 810 requires a reporting entity to continually reconsider its conclusion regarding which interest holder is the CIV’s primary beneficiary. The collateral manager’s conclusion could change as a result of any of the following:

A change in the legal entity’s design (e.g., a change in its governance structure, management, activities, purpose, or in the primary risks it was designed to create and pass through to variable interest holders).
The addition of terms to the variable interests, or the modification or retirement of terms.
A change in the holders of a legal entity’s variable interests (e.g., a reporting entity acquires or disposes of variable interests in a VIE), causing the reporting entity to have (or no longer have), in conjunction with its other involvement with the legal entity, a variable interest in the CIV.
A significant change in the anticipated economic performance of a legal entity (e.g., as a result of losses significantly in excess of those originally expected) or other events (including the legal entity’s commencement of new activities) that cause a change in the reporting entity’s responsibilities such that it now has the power to direct the activities that most significantly affect the legal entity’s economic performance.
Two or more variable interest holders become (or are no longer) related parties.
A contingent event that transfers, from one reporting entity to another reporting entity, the power to direct the activities of the legal entity that most significantly affect the legal entity’s economic performance.

Because continual reconsideration is required, the collateral manager will need to determine when, during the reporting period, the change in primary beneficiary occurred. If the collateral manager determines that it is no longer the primary beneficiary of a CIV, it would need to deconsolidate the CIV as of the date the circumstances changed and recognize a gain or loss. See Section 7.1.5 for a discussion of reassessing the primary beneficiary.

E.2.5 Accounting for Interests in Unconsolidated CIVs

If a collateral manager is not required to consolidate a CIV, it must determine the appropriate accounting for any interests it holds in the CIV. Most interests in CIVs will meet the definition of a “debt security” and are therefore accounted for in accordance with ASC 320. If the investment is a debt security, the collateral manager must first decide whether to elect the “fair value option” and subsequently record its interests at fair value, with fair value changes reported in earnings. The collateral manager can make the election on an item-by-item basis (e.g., for the residual but not the senior interests held in a CIV); however, the election must be made when each investment is first recognized, and it is irrevocable once made.

If the collateral manager decides not to elect the fair value option, it must elect to classify debt securities as trading, available for sale (AFS), or held to maturity (HTM). While this initial classification generally cannot be changed if the holder retains the security, transfers from the AFS category to the HTM category are permitted in limited circumstances. To classify a security as HTM, the holder must have the positive intent and the ability to hold the security until its maturity. However, if the interest can be prepaid or otherwise settled so that the collateral manager would not recover substantially all of its recorded investment, the instrument cannot be classified as HTM. Given the restrictions on HTM classification, collateral managers typically classify their interests in a CIV as either AFS or trading.

E.2.6 Accounting for Consolidated CIVs

When collateral managers initially consolidate a CIV, they are required to measure the CIV’s assets and liabilities at fair value. While some collateral managers subsequently account under ASC 320 for the financial assets of a consolidated CFE as trading, AFS, or HTM, many elect the fair value option and subsequently account for both the financial assets and financial liabilities at fair value. CIVs are CFEs; therefore, a reporting entity that measures both the financial assets and financial liabilities of a consolidated CIV at fair value may use a measurement alternative to determine the fair value of its financial assets and financial liabilities if certain criteria are met.

See Sections 10.1.3 and 10.2.2 for further discussion of the use of a measurement alternative for the initial and subsequent measurement of CFEs.

E.2.7 Risk Retention Rules

On October 22, 2014, the SEC and five other federal agencies2 adopted a final rule that requires sponsors of securitizations, under certain conditions, to retain a portion of the credit risk associated with the assets collateralizing an asset-backed security (ABS).3

Under the final rule, sponsors of securitizations are:

Required to retain no less than 5 percent of the credit risk of assets in an ABS offering (unless they qualify for certain exemptions).
Prohibited from financing (other than on a full recourse basis), hedging, or transferring the credit risk they are required to retain for most of the life of the retained security.

Under the risk retention requirements, a sponsor is prohibited from hedging or transferring any interest it is required to retain under the rule to any person other than a majority-owned affiliate. Of particular interest to constituents is whether a collateral manager could comply with the risk retention rule by transferring the retained interest to a consolidated affiliate (i.e., the sponsor either owns a majority [51 percent] stake or a controlling financial interest of a VIE) whose third-party investors own the other interests in the consolidated affiliate. If so, the sponsor’s exposure could be effectively decreased (below 5 percent) when a portion of the risk is absorbed by the third-party investors of the consolidated affiliate. Companies should not only consider the accounting implications of establishing these types of structures but also consult with their legal and regulatory advisers to ensure that they will not be viewed as hedging the credit risk they are required to retain.

The final rule permits sponsors of securitizations to select the form of risk retention obligation, which could be:

An eligible vertical interest (a proportionate 5 percent interest in every tranche of a securitization).
An eligible horizontal residual interest (an interest in the first loss tranche of a securitization with a market value equal to at least 5 percent of the market value of all the securities issued).
A combination of both or an “L-shaped” interest (the combined interest is no less than 5 percent of the market value of all securities issued).

The type of interest retained by the sponsor (i.e., vertical, horizontal, or L-shaped) will affect the sponsor’s economic exposure to the securitization structure and, accordingly, the sponsor’s consolidation conclusion. If a sponsor holds the subordinate horizontal tranche of a securitization structure, it would be more likely to consolidate the structure than if it holds a vertical interest (or a combination of interests).

At the 2015 AICPA Conference on Current SEC and PCAOB Developments, an SEC staff member, Professional Accounting Fellow Chris Rickli, provided the following example:

In 2014, several federal agencies adopted final rules to implement the Dodd-Frank credit risk retention requirements for asset-backed securities. [Footnote omitted] Over the past several months, OCA has received accounting consultations related to the application of Topic 810 [footnote omitted] to a registrant’s involvement with a so-called collateralized manager vehicle, or CMV. CMVs are designed to sponsor various types of securitization transactions.

In one particular fact pattern, the CMV itself was required to hold an ownership interest in the underlying securitization to which it acted as a sponsor. The registrant made an initial equity contribution to the CMV, and obtained one of three seats on the CMV’s board of directors. The remaining equity capital was funded by third party investors, several of which were individually significant.

The registrant also entered into a services agreement to provide certain support functions to the CMV, including middle and back office operations, investment research, and other administrative activities.

An aspect of the registrant’s consolidation analysis related to whether the CMV was a voting interest entity under Topic 810. The analysis focused heavily on the ownership of the CMV and the role of the CMV’s board of directors. The equity holders of the CMV, as represented by the board of directors, had power over the most significant activities of the CMV, including the development of the investment strategy, the hiring and firing of service providers, and the appointment of individuals to the CMV’s investment committee. Based on these factors, we did not object to the conclusion that the CMV was a voting interest entity under Topic 810.

We understand that many variations of this type of entity exist in the marketplace. Therefore, it is possible that several of the most significant factors to the analysis may vary greatly from CMV to CMV, and therefore may result in different accounting conclusions. As a result, it would not be appropriate to analogize our conclusions to other fact patterns that involve a CMV.

I would also like to note that our conclusions did not extend beyond the registrant’s GAAP accounting analysis. A critical part of the registrant’s legal analysis would likely include whether the CMV would qualify as a legal sponsor. This is a legal question and was not addressed as part of the accounting consultation. To the extent there is uncertainty related to legal questions, entities should consult with their primary regulator. [Emphasis added]

Example E-2

An investment manager sponsors a CLO and retains a 5 percent vertical interest (i.e., an interest in each class of ABS interests issued as part of the CLO). The investment manager designed the vertical tranche to be compliant with the risk retention rules. For its role as collateral manager, the investment manager receives remuneration that is customary and commensurate with services performed, including a senior management fee that is paid senior to the notes, a subordinate management fee that is paid senior to the CLO’s preferred shares, and an incentive fee.

Further, the investment manager is the reporting entity that has the contractual right to make decisions related to the activities that most significantly affect the CLO’s economic performance. The vertical interest owned by the investment manager does not absorb more than an insignificant amount of the CLO’s variability (since it owns only 5 percent of all tranches).

The fees received by the investment manager are customary and commensurate with remuneration for services performed (i.e., negotiated at arm’s length). In addition, the fees received by the investment manager do not expose it to the risk of loss described in ASC 810-10-55-37C. Further, because the investment manager’s vertical interest would never absorb more than 5 percent of the CLO’s economic performance, once the investment manager appropriately excludes the fees from its variable interest assessment, it would never possess the right to receive benefits or the obligation to absorb losses that are more than insignificant to the CLO (under ASC 810-10-55-37(c)). Therefore, the investment manager’s decision-making agreement would not represent a variable interest. Although the investment manager’s 5 percent vertical interest is an other direct interest in the CLO, it does not represent an interest that gives the investment manager the right to receive benefits or the obligation to absorb losses that are more than insignificant to the expected residual returns of the CLO. Therefore, because the decision-making arrangement is not a variable interest, the investment manager would not be required to consolidate the CLO.

In this example, it is assumed that the other investors are not related parties or de facto agents of the investment manager; if they were, the consolidation conclusion could be affected.

Connecting the Dots

In February 2018, the U.S. Court of Appeals for the District of Columbia in Loan Syndications & Trading Ass’n v. SEC (882 F.3d 220, D.C. Cir. 2018) held that the final risk retention rule does not apply to “open-market CLO” managers. Accordingly, the court reversed the district court’s ruling and instructed it to “grant summary judgment to the [Loan Syndications and Trading Association] on whether application of the rule to CLO managers is valid under [Section] 941, to vacate summary judgment on the issue of how to calculate the 5 percent risk retention, and to vacate the rule insofar as it applies to open-market CLO managers.” The period in which to appeal the circuit court’s decision has lapsed. Preparers are encouraged to consult with their legal advisers regarding the application of the credit risk retention rules to their particular facts and circumstances.

While Example E-2 focuses on a CLO manager, we believe that it continues to be relevant since it can be applied generally to the consolidation analysis for securitization structures irrespective of whether the risk retention requirements apply.

Footnotes

A collateral manager must also assess whether it would be required to perform the related-party tiebreaker test (see step 4 for additional details).

The other federal agencies are the Office of the Comptroller of the Currency in the Department of the Treasury, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, and the Department of Housing and Urban Development.

The final rule was issued in response to a mandate of Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which added new credit risk retention requirements to Section 15G of the Securities Exchange Act of 1934.

Confidential and Proprietary — for Use Solely by Authorized Personnel

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.