3.2 Legal Entities

ASC 810-10 — Glossary

Legal Entity

Any legal structure used to conduct activities or to hold assets. Some examples of such structures are corporations, partnerships, limited liability companies, grantor trusts, and other trusts.

The scope of the consolidation guidance in ASC 810-10 is limited to a reporting entity’s involvement with another legal entity. The Codification defines “legal entity” relatively broadly; therefore, almost any legal structure that is used to own assets, issue debt, or otherwise conduct activities would meet the definition of a legal entity. The particular legal form of the entity (e.g., a corporation, a partnership, a limited liability company, a grantor trust, or other trust) is not relevant to the determination of whether the entity is a legal entity. Divisions, departments, branches, and pools of assets are examples of entities that are typically not separate legal entities.

A collaborative arrangement that is not conducted via a separate entity is not in itself a legal entity. However, if a separate entity was formed to conduct the activities of a collaborative arrangement, that entity would typically represent a legal entity.

A reporting entity may consider the following factors when evaluating whether a legal entity exists, which will help it determine whether the structure has separate legal standing or identity:

Do third parties view the structure as a legal entity?
Does the structure invoice its customers under its own name?
Do the vendors invoice the structure under its own name?
Does the structure file a tax return or have a unique identification in any tax jurisdiction?
Does the structure have separate financial statements?
Does the structure have any regulatory filing requirements?
Does the structure have the ability to enter into contracts and agreements?
Is the structure able to open bank accounts?
Can the structure be sued or sue others?
Is the structure able to obtain financing?

Certain industries (such as the asset management industry) commonly use series trusts (referred to herein as a “series”) to permit (1) distinct sets of activities to be legally isolated and conducted separately from one another and (2) each series to benefit from the sharing of administrative and organizational costs. Although there is technically only one umbrella legal entity, each series fund issues its own share class(es) and has characteristics that are substantially the equivalent of operating as a separate entity. Other industries may also use a series or similar legal structure (e.g., segregated cell structures in the insurance industry).

Paragraph BC38 of ASU 2015-02 provides some insight into relevant considerations in the determination of whether an individual series fund is a legal entity. Although the example in the paragraph is specific to an individual series fund, it lists factors that are similar to those above. The FASB noted that it is reasonable to treat an individual series fund as a separate legal entity if the fund is required to comply with the requirements of the Investment Company Act of 1940 (the “1940 Act”) for registered mutual funds, which have the following characteristics:

Has its own investment objectives and policies.
Has its own custodial agreement.
Has its own shareholders separate from other series funds.
Has a unique tax identification.
Files separate tax returns with the Internal Revenue Service.
Has separate audited financial statements.
Is considered a separate investment company in virtually all circumstances for purposes of investor protection afforded by the Investment Company Act of 1940 by the Securities and Exchange Commission (SEC) staff’s Division of Investment Management (IM), in accordance with the June 2014 SEC IM staff’s Guidance Update No. 2014-06 titled “Series Investment Companies: Affiliated Transactions.”

The relative weight given to the above characteristics should be based on the relevant facts and circumstances. Reporting entities may need the assistance of legal counsel in determining whether a structure is a legal entity.

3.2.1 Evaluating Portions of Legal Entities or Aggregations of Assets Within a Legal Entity as Separate Legal Entities

ASC 810-10

15-15 Portions of legal entities or aggregations of assets within a legal entity shall not be treated as separate entities for purposes of applying the Variable Interest Entities Subsections unless the entire entity is a VIE. Some examples are divisions, departments, branches, and pools of assets subject to liabilities that give the creditor no recourse to other assets of the entity. Majority-owned subsidiaries are legal entities separate from their parents that are subject to the Variable Interest Entities Subsections and may be VIEs.

Proper identification of the legal entity being evaluated is critical since it affects all aspects of the consolidation analysis, including whether the legal entity is a VIE or voting interest entity and the nature and extent of any activities that will ultimately be consolidated. For example, before ASU 2015-02, a series was typically not considered a separate legal entity but rather a silo within the broader legal entity (i.e., the umbrella). In many instances, the umbrella would be considered a VIE, and a series (i.e., the silo2) would be consolidated by the asset manager during the period that the manager’s initial seed capital exceeds 50 percent of the economic interests in the series. The asset management industry initially expressed concerns that the ASU would require them to consolidate a series (the silo) at a lower threshold of economic interest (“potentially significant”). Conversely, if a series were to be considered its own legal entity that is evaluated for consolidation under the voting interest entity model, it would be possible for the asset manager to conclude that each series is a separate voting interest entity and that consolidation is required only to the extent that the asset manager has more than 50 percent of the voting interests.

Generally, a series should be considered its own legal entity under ASC 810-10 if the following three conditions are met:

Condition 1 — Essentially all the assets, liabilities, and equity of the larger legal structure reside in individual series, and essentially none of these items reside in the larger legal structure itself.
Condition 2 — The assets, liabilities, and equity of each series are legally isolated from the assets, liabilities, and equity of the other series.
Condition 3 — Each series presents itself, in all material respects, as a separate legal entity with respect to its dealings with its interest holders and third parties.

The third condition is consistent with the series fund structure discussed by the FASB in paragraphs BC38 and BC39 of ASU 2015-02 (see the introduction to Section 3.2).

Although the Board’s observations in paragraphs BC38 and BC39 are specific to series funds that are registered under the 1940 Act, the requirements under the 1940 Act for such funds (as articulated in paragraph BC38) provide a useful framework for evaluating whether the third condition is present in other structures (e.g., segregated cell companies, unregistered series funds, legal structures in other legal jurisdictions or industries). In many cases, the evaluation of international series structures may result in a different conclusion from series funds that are registered under the 1940 Act (i.e., that a separate international series should not be considered its own legal entity). A reporting entity should carefully evaluate the characteristics of international funds and use judgment in applying the above factors. For example, although an individual characteristic might not apply to another type of structure (e.g., the entity does not have a unique tax identification because it is located in a nontaxable jurisdiction), the reporting entity should evaluate the relevant factors in the framework in paragraph BC38 to determine whether the series, in substance, represents a separate legal entity.

3.2.1.1 SEC Staff Views on International Series Funds as Separate Legal Entities

The Asset Management Accounting Policy Committee of the Securities Industry and Financial Markets Association (SIFMA) and the Asset Management Industry Accounting Policy Group (AMIAPG) formally discussed international series funds with the SEC staff. After those discussions, SIFMA and AMIAPG sent a letter in January 2016 to the SEC staff to confirm the staff’s views on determining whether an international series fund would be considered a separate legal entity under the consolidation models. The letter stated, in part:

The SEC Staff would not object to the view that the considerations listed in ASU 2015-02, paragraph BC38, be considered indicators as to whether an individual series fund is a legal entity; rather than a prescribed list of criteria that must all be met.

The SEC Staff believes the determination as to whether an individual series fund is a separate legal entity for consolidation purposes requires the application of reasonable judgment and includes, but is not limited to, consideration of the following:

The definition of a legal entity as defined in the Master Glossary,
The considerations in paragraph BC38 in the Basis for Conclusions of ASU 2015-02,
The purpose, objective and strategy of each of the series funds within the umbrella,
The legal isolation of the assets, liabilities, and equity (i.e., segregation of assets and liabilities) of each of the individual series funds,
Whether the shareholders of an individual series fund have substantive decision-making rights related to the individual series fund; such rights include, but are not limited to, the ability to directly remove and replace the asset management company for the individual series fund or liquidate the individual series fund, approve the compensation of the asset management company for the individual series fund, and vote on changes to the fundamental investment strategy of the individual series fund, and
Other relevant jurisdictional characteristics.

The SEC Staff believes that legal isolation of the assets, liabilities and equity of each of the individual series funds and the existence of substantive shareholder decision-making rights at the series fund level can be viewed as relevant and significant considerations in the context of the asset management industry and, as a result, the SEC Staff would expect that in many series fund structures where these two considerations are present, the individual series fund would qualify as a separate legal entity for purposes of the consolidation analysis.

If the individual series fund is considered a legal entity for accounting purposes, the consolidation analysis is performed at the individual series fund level. The SEC Staff would also expect that in such situations, where the shareholders of the individual series fund have substantive decision-making rights, the individual series fund would generally meet the criteria to be classified as a voting interest entity, although such a conclusion would require analysis based on individual facts and circumstances.

It is our understanding that most international series funds are not designed with the substantive decision-making rights listed in the fifth bullet above. If the governance of an international series fund is amended to meet the definition of a separate legal entity, a reporting entity should determine whether substantive decision-making rights are at the series-fund level. We generally expect that a reporting entity’s conclusion that a separate legal entity exists would be based on the presence of all the substantive decision-making rights listed by the SEC staff. We believe all of these rights are required in substance but not necessarily in form. For example, if the shareholders could set compensation of the asset manager as low as zero, it may not be relevant that the shareholders do not have an explicit ability to remove and replace the asset manager since setting the compensation to zero may force the asset manager to resign. Therefore, in determining whether a separate legal entity exists, a reporting entity should carefully evaluate the facts and circumstances.

3.2.2 Multitiered Legal-Entity Structures

In a multitiered legal-entity structure, a reporting entity should generally begin its evaluation at the lowest-level entity. Each entity within the structure should then be evaluated on a consolidated basis. The attributes and variable interests of the underlying consolidated entities should generally become those of the parent company upon consolidation.

When a reporting entity applies the VIE model to a consolidated entity, it should analyze the design of the consolidated entity, including an analysis of the risks of the entity, why the entity was created (e.g., the primary activities of the entity), and the variability the entity was designed to create and pass along to its interest holders.

Note that there are situations in which a reporting entity may “look through” a holding company and therefore would not be required to examine the structure on a consolidated basis. For more information, see Section 3.2.3.

Example 3-1

Two investors each hold 50 percent of the ownership interests in Company H. Company H has 100 percent of the ownership interests in Entity X and consolidates X. Entity X is a business as defined in ASC 805 and represents substantially all of H’s consolidated activities and cash flows. Company H, on a stand-alone basis, does not meet the definition of a business in ASC 805. There are no other relationships or agreements between the investors, H, or X.

As noted above, the attributes of a consolidated entity become the attributes of the parent company. In this example, X’s attributes become those of H. When the investors are evaluating their ownership interests, they should consider H’s design on a consolidated basis. Because X meets ASC 805’s definition of a business, and its activities and cash flows represent substantially all of H’s consolidated activities and cash flows, H also meets ASC 805’s definition of a business. Therefore, the investors in H may be eligible for the business scope exception in ASC 810-10-15-17(d) (see Section 3.4.4). In determining whether any of the four conditions in ASC 810-10-15-17(d) are met, the investors in H should evaluate H’s consolidated activities and cash flows, inclusive of X.

Example 3-2

Two investors each hold 50 percent of the ownership interests in a holding company. The holding company has 100 percent of the ownership interests in Entity E and consolidates E. Entity E meets ASC 805’s definition of a business and represents substantially all of the holding company’s consolidated activities and cash flows. The holding company also consolidates Entity N, which does not meet ASC 805’s definition of a business. Other than its investments in E and N, the holding company has no assets, liabilities, or activities. There are no other relationships or agreements between the investors, the holding company, E, or N.

As in the example above, the attributes of the consolidated entities become those of the parent company. In this example, the attributes of E and N become those of the holding company.

When the investors are evaluating their ownership interests, they should consider the holding company’s design on a consolidated basis. Because substantially all of the holding company’s consolidated activities and cash flows are derived from E, the holding company meets ASC 805’s definition of a business. As in the example above, before applying the business scope exception, the investors must determine whether any of the four conditions in ASC 810-10-15-17(d) have been met regarding the holding company’s consolidated activities and cash flows. If so, the business scope exception cannot be applied (see Section 3.4.4).

Example 3-3

An investor holds 50 percent of the ownership interests in a holding company. The holding company consolidates the following two entities, both of which meet ASC 805’s definition of a business:

Entity J, an operating entity.
Entity L, whose activities are primarily related to securitizations or other forms of asset-backed financings.

Entity L’s activities and cash flows represent substantially all of the holding company’s activities and cash flows. Other than its investments in J and L, the holding company has no assets, liabilities, or activities. There are no other relationships or agreements between the investor, the holding company, J, or L.

As in both examples above, the attributes of the consolidated entities become those of the parent company. In this example, the attributes of J and L become those of the holding company.

When the investor is evaluating its ownership interests, it should consider the holding company’s design on a consolidated basis. While J and L both meet ASC 805’s definition of a business, the investor would not be able to apply the business scope exception because the holding company is designed primarily to facilitate activities that are primarily related to securitizations or other forms of asset-backed financings, which is a scenario in which the business scope exception cannot be applied (see ASC 810-10-15-17(d)(4); also see Section 3.4.4).

Example 3-4

A group of investors establishes a holding company that is 100 percent funded by the equity of the investors. The design and purpose of the company is to hold all the equity of an operating company. The operating company is capitalized as follows: 3 percent by the equity investment from the holding company and 97 percent by non-investment-grade debt. Accordingly, assume that the operating company is a VIE due to insufficiency of equity investment at risk (see Section 5.2). In addition, assume that the holding company consolidates the operating company.

When the investors evaluate whether the holding company is a VIE, they should consider the holding company’s design on a consolidated basis. Because the sole purpose of the holding company was to aggregate investors to control the operating company, the holding company should be considered a VIE due to insufficiency of equity investment at risk (even if the operating company’s debt is nonrecourse to the holding company). That is, it would be inappropriate to ignore the substance of the significant debt at the operating company level and conclude that the holding company is a voting interest entity. The holding company is simply a pass-through for the investors to form the operating company.

Example 3-5

A group of investors establishes a collateralized manager vehicle (CMV) that is funded 100 percent by the equity of the investors. The CMV’s design and purpose is to sponsor, manage, and hold subordinated interests in various CLOs. The CLOs issue debt to third parties on a nonrecourse basis (i.e., the investors in the CLO only have recourse to the performance of the respective CLO). The CLOs are VIEs because they do not have sufficient equity investment at risk. The CMV consolidates the CLOs because the CMV has the power to direct the most significant activities and a potentially significant variable interest through the subordinated interests held.

When the investors are evaluating whether the CMV is a VIE, they should consider the CMV’s design on a consolidated basis. In contrast to the previous example, it would not be appropriate to consider the CLOs’ debt in the determination of whether the CMV has sufficient equity investment at risk. The CMV’s design and purpose was to sponsor and manage CLOs rather than to capitalize CLOs, and the CLOs’ debt is nonrecourse to the CMV. That is, despite the CMV’s consolidation of the CLOs (which are VIEs due to insufficient equity investment at risk), we do not believe that the debt issued at the subsidiary CLOs should affect whether the CMV has equity sufficient to finance its activities. Therefore, the equity that is needed to support the activities of the CMV is not at the same level as that needed to capitalize a financing vehicle.

3.2.3 “Looking Through” a Holding Company to the Underlying Legal Entity

Holding companies are frequently established (often for legal or tax purposes) to hold some or all of the ownership interests in a legal entity. In many cases, reporting entities have ownership interests in these holding companies for the sole purpose of investing in an underlying legal entity. Questions can arise about whether a reporting entity with an interest in a holding company can “look through” (i.e., ignore) a holding company and apply the provisions of the VIE model directly to the underlying legal entity as if the holding company does not exist. This is particularly relevant to the business scope exception discussed in Section 3.4.4.

For example, assume that an investor has a 40 percent ownership interest in HoldCo, a holding company that is not a joint venture. HoldCo was designed for the sole purpose of acquiring 100 percent of the ownership interests in Entity X, a preexisting single legal entity that is a business as defined in ASC 805. The investor was involved in the design of HoldCo but was not involved in the design or redesign of X. If the investor cannot look through HoldCo, it cannot apply the business scope exception because the investor was involved in the design of HoldCo (see ASC 810-10-15-17(d)(1)). If the investor can look through HoldCo, it can apply the business scope exception (provided that the investor, X, and HoldCo do not meet any of the other business scope exception conditions) because the investor was not involved in the design or redesign of X.

In limited circumstances, it may be necessary or appropriate for an investor to look through a holding company and apply the VIE model directly to a single underlying legal entity. The investor can only do this when (1) the holding company is a nonsubstantive entity because it does not have any substantive identity separate from that of the underlying legal entity and (2) the economics of the arrangement do not change as a result of the holding company’s insertion between the investors and the underlying legal entity.

A holding company is considered to have no substantive identity separate from its investment in the legal entity when all variable interests in the holding company represent indirect variable interests of the reporting entity in the underlying legal entity because they are virtually indistinguishable from direct variable interests of the holding company in the underlying legal entity (i.e., the reporting entity’s variable interests in the holding company are essentially “back-to-back” with the holding company’s variable interests in the underlying legal entity, and the holding company represents a pass-through entity). When looking through a holding company is deemed to be appropriate, in general, the conclusions reached under a VIE evaluation (regarding (1) whether a legal entity is a VIE and (2) who consolidates the legal entity as its primary beneficiary) with respect to looking through a holding company should be the same conclusions that would be reached if the analysis were performed separately for the holding company and the underlying legal entity. All facts and circumstances should be considered, including (1) the design of both the holding company and the underlying legal entity and (2) the nature of the relationships with the variable interest holders and their related parties.

Satisfaction of all the following conditions may indicate that a reporting entity can look through a holding company to a single underlying legal entity when applying the VIE model:

Other than its ownership interests in the single underlying legal entity, the holding company is restricted by its governing documents from holding any assets, issuing debt, or engaging in any operating activities on its own behalf.
The governing documents of the holding company and the underlying legal entity are substantively the same.
The governing documents associated with the holding company and the underlying legal entity require that both entities have the same individuals on the board of directors or other bodies that determine the financial and operating policies of the entity.
Other than tax implications of the holding company, the risks and rewards of the interest holders (including their interests in profits and losses and in liquidation) would be identical if their interests were directly in the underlying legal entity instead of in the holding company.

Example 3-6

An investor holds 40 percent of the ownership interests in a holding company. The holding company has 100 percent of the ownership interests in a single legal entity and consolidates that legal entity. The legal entity is a business as defined in ASC 805. Other than its ownership interests in the legal entity, the holding company has no assets, liabilities, or activities. There are no other relationships or agreements between the investor, the holding company, and the legal entity. Assume that the four conditions described above have been met in this arrangement.

The investor can look through the holding company and apply the VIE model directly to the underlying legal entity because the holding company is a nonsubstantive entity under the VIE subsections. To apply the business scope exception, the investor must determine whether any of the four conditions in ASC 810-10-15-17(d) have been met for either the investor or the single underlying legal entity. If any of the conditions have been met, the business scope exception cannot be applied.

Example 3-7

Assume the same facts as in the example above except that the holding company takes out a loan from a third-party bank. In this scenario, the investor would not be able to look through the holding company to the underlying legal entity because the holding company’s loan precludes the investor from doing so since it has not satisfied the first condition described above (i.e., the holding company is not restricted by its governing documents from holding any assets, issuing debt, or engaging in any operating activities on its own behalf).

Example 3-8

An investor has 40 percent of the ownership interests in a holding company, which holds 100 percent of the ownership interests in a legal entity. The legal entity takes out a loan from a third-party bank. The investor has guaranteed repayment of the loan in the event of default. There are no other relationships or agreements between the investor, the holding company, and the legal entity. Assume that the four conditions described above have been met in this arrangement.

Although not required to do so, the investor would be able to look through the holding company since the investor’s guarantee represents a direct variable interest in the legal entity (i.e., the guarantee has no impact on the holding company).

Footnotes

See Chapter 6 for a discussion of silos.

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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.