2.7 Protective Rights

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2.7 Protective Rights

ASC 810-10 — Glossary

Protective Rights (VIE Definition)

Rights designed to protect the interests of the party holding those rights without giving that party a controlling financial interest in the entity to which they relate. For example, they include any of the following:

Approval or veto rights granted to other parties that do not affect the activities that most significantly impact the entity’s economic performance. Protective rights often apply to fundamental changes in the activities of an entity or apply only in exceptional circumstances. Examples include both of the following:
1. A lender might have rights that protect the lender from the risk that the entity will change its activities to the detriment of the lender, such as selling important assets or undertaking activities that change the credit risk of the entity.
2. Other interests might have the right to approve a capital expenditure greater than a particular amount or the right to approve the issuance of equity or debt instruments.
The ability to remove the reporting entity that has a controlling financial interest in the entity in circumstances such as bankruptcy or on breach of contract by that reporting entity.
Limitations on the operating activities of an entity. For example, a franchise agreement for which the entity is the franchisee might restrict certain activities of the entity but may not give the franchisor a controlling financial interest in the franchisee. Such rights may only protect the brand of the franchisor.

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.

While protective rights protect the interests of the holder, they do not allow the holder to participate in the significant financial and operating decisions made in a voting interest entity’s ordinary course of business or to participate in the most significant activities of a VIE. Unlike participating rights, protective rights do not preclude another entity from having the power to direct the most significant activities of a legal entity.

Both protective rights and participating rights are approval or veto rights. The key to differentiating between the two types of rights is the underlying activity or action to which the rights relate. Protective rights often apply to fundamental changes in the activities of a legal entity or apply only in extraordinary circumstances. Participating rights involve the ability to approve or veto the significant financial and operating decisions for a voting interest entity and the activities that most significantly affect a legal entity’s economic performance for a VIE, and would generally be expected to occur in an entity’s normal course of business.

ASC 810-10-25-10 lists protective rights (not all-inclusive) that are often provided to the noncontrolling shareholder or limited partner of a voting interest entity. The rights pertain to the following:

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.

Determining whether rights are protective or participating may require significant judgment. Depending on the facts and circumstances, rights that are protective in one instance may be participating in another.

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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.