4.4 Decision-Maker or Service-Provider Fees

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Subparagraph superseded by Accounting Standards Update No. 2015-02.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Subparagraph superseded by Accounting Standards Update No. 2015-02.
Subparagraph superseded by Accounting Standards Update No. 2015-02.

55-37B Facts and circumstances should be considered when assessing the conditions in paragraph 810-10-55-37. An arrangement that is designed in a manner such that the fee is inconsistent with the decision maker’s or service provider’s role or the type of service would not meet those conditions. To assess whether a fee meets those conditions, a reporting entity may need to analyze similar arrangements among parties outside the relationship being evaluated. However, a fee would not presumptively fail those conditions if similar service arrangements did not exist in the following circumstances:

The fee arrangement relates to a unique or new service.
The fee arrangement reflects a change in what is considered customary for the services.

In addition, the magnitude of a fee, in isolation, would not cause an arrangement to fail the conditions.

55-37C Fees or payments in connection with agreements that expose a reporting entity (the decision maker or the service provider) to risk of loss in the VIE would not be eligible for the evaluation in paragraph 810-10-55-37. Those fees include, but are not limited to, the following:

Those related to guarantees of the value of the assets or liabilities of a VIE
Obligations to fund operating losses
Payments associated with written put options on the assets of the VIE
Similar obligations, such as some liquidity commitments or agreements (explicit or implicit) that protect holders of other interests from suffering losses in the VIE.

Therefore, those fees should be considered for evaluating the characteristic in paragraph 810-10-25-38A(b). Examples of those variable interests are discussed in paragraphs 810-10-55-25 and 810-10-55-29.

55-37D For purposes of evaluating the conditions in paragraph 810-10-55-37, any variable interest in an entity that is held by a related party of the decision maker or service provider should be considered in the analysis. Specifically, a decision maker or service provider should include its direct variable interests in the entity and its indirect variable interests in the entity held through related parties, considered on a proportionate basis. For example, if a decision maker or service provider owns a 20 percent interest in a related party and that related party owns a 40 percent interest in the entity being evaluated, the decision maker’s or service provider’s interest would be considered equivalent to an 8 percent direct interest in the entity for the purposes of evaluating whether the fees paid to the decision maker(s) or the service provider(s) are not variable interests (assuming that they have no other relationships with the entity). The term related parties in this paragraph refers to all parties as defined in paragraph 810-10-25-43, with the following exceptions:

An employee of the decision maker or service provider (and its other related parties), except if the employee is used in an effort to circumvent the provisions of the Variable Interest Entities Subsections of this Subtopic
An employee benefit plan of the decision maker or service provider (and its other related parties), except if the employee benefit plan is used in an effort to circumvent the provisions of the Variable Interest Entities Subsections of this Subtopic.

For purposes of evaluating the conditions in paragraph 810-10-55-37, the quantitative approach described in the definitions of the terms expected losses, expected residual returns, and expected variability is not required and should not be the sole determinant as to whether a reporting entity meets such conditions.

55-38 Fees paid to decision makers or service providers that do not meet all of the conditions in paragraph 810-10-55-37 are variable interests.

The above guidance applies to both decision makers and service providers. The determination of whether a decision maker’s fee arrangement is a variable interest has a significant impact on the consolidation conclusion, because if it is determined that a decision maker’s fee arrangement is not a variable interest, the decision maker would be acting as a fiduciary for the legal entity. This determination could affect whether the legal entity is a VIE (see Section 5.3.1.1.3.1) and whether the decision maker is required to consolidate the VIE.

Fees paid to a decision maker or service provider do not represent a variable interest if all of the following are met:

The fees are “commensurate” under ASC 810-10-55-37(a). See Section 4.4.1.
The arrangement is “at market” under ASC 810-10-55-37(d). See Section 4.4.1.
The decision maker or service provider does not have any other interests (direct interests or indirect interests through its related parties) in the legal entity that absorb more than an insignificant amount of the potential VIE’s variability (ASC 810-10-55-37(c)). See Section 4.4.2.

In application of the criteria in ASC 810-10-55-37(c), a reporting entity should only include interests held by a decision maker’s or service provider’s related parties (or de facto agents), including those under common control, when the decision maker or service provider has a variable interest in the related party. If the decision maker or service provider has a variable interest in the related party, it would include its economic exposure to the legal entity through its related party on a proportionate basis. For example, if a decision maker or service provider owns a 20 percent interest in a related party, and that related party owns a 40 percent interest in the legal entity being evaluated, the decision maker’s or service provider’s interest would be considered equivalent to an 8 percent direct interest in the legal entity. However, if the decision maker or service provider did not hold the 20 percent interest in its related party, it would not include any of the related party’s interest in its evaluation (see Section 4.4.2.3.1).

4.4.1 “Commensurate” and “At-Market” Fees

As discussed above, three criteria must be met for a decision maker or service provider to conclude its fee does not represent a variable interest. Specifically, (1) the fees must be “commensurate,” (2) the fees must be “at market,” and (3) the decision maker or service provider must not have any other interests in the legal entity (either directly or indirectly through its related parties). However, if a decision maker or service provider’s fees are determined to represent a variable interest solely because they meet the third criterion, those fees are not included in the evaluation of the economics criterion (see Section 7.3). As a result, the determination of whether a decision maker’s or service provider’s fees are “commensurate” and “at market” is a critical step in both the assessment of whether such fees represent a variable interest and the evaluation of the economics criterion. “Commensurate” and “at market” can be described as follows:

Fees are “commensurate” (i.e., they are compensation for services provided and are commensurate with the level of effort required to provide those services).
A service arrangement is “at market” (i.e., it includes only terms, conditions, or amounts that are customarily present in arrangements for similar services negotiated at arm’s length).

The first step in the reporting entity’s assessment of whether its fee arrangement is commensurate and at market is to determine whether other benefits or elements are embedded in the fees. If the fees include compensation for assuming risk of loss in the potential VIE (see Section 4.4.1.1), the fee arrangement is a variable interest. However, other benefits or elements embedded in the fee arrangement that are not compensation for assuming risk of loss would not automatically cause the fee arrangement to be a variable interest and will need to be carefully evaluated.

If there are no other features embedded in the fee arrangement, the decision maker or service provider must consider whether the arrangement includes commensurate fees and at-market terms. At the 2015 AICPA Conference on Current SEC and PCAOB Developments, an SEC staff member, Professional Accounting Fellow Chris Semesky, stated the following:

I would also like to address the evaluation of whether a decision-maker’s fee arrangement is customary and commensurate. [Footnote omitted] This evaluation is done at inception of a service arrangement or upon a reconsideration event, such as the modification of any germane terms, conditions or amounts in the arrangement.

The determination of whether fees are commensurate with the level of service provided often may be determined through a qualitative evaluation of whether an arrangement was negotiated on an arm’s length basis when there are no obligations beyond the services provided to direct the activities of the entity being evaluated for consolidation. This analysis requires a careful consideration of the services to be provided by the decision-maker in relation to the fees.

The evaluation of whether terms, conditions and amounts included in an arrangement are customarily present in arrangements for similar services may be accomplished in ways such as benchmarking the key characteristics of the subject arrangement against other market participants’ arrangements negotiated on an arm’s length basis, or in some instances against other arm’s length arrangements entered into by the decision-maker. There are no bright lines in evaluating whether an arrangement is customary, and reasonable judgment is required in such an evaluation. A decision-maker should carefully consider whether any terms, conditions, or amounts would substantively affect the decision-maker’s role as an agent or service provider to the other variable interest holders in an entity.

Therefore, we believe that the evaluation of whether the fees are commensurate should focus on whether the fee arrangements are negotiated at arm’s length (i.e., between unrelated parties) or have been implicitly accepted by market participants. Most decision-maker or service-provider fee arrangements are negotiated at arm’s length or have been implicitly accepted by market participants when a more than insignificant amount of the investor interests in the potential VIE is held by an unrelated party or parties (e.g., when an asset manager has marketed a fund to outside investors).2 In these situations, there is a presumption that the fees will be commensurate (even if the services are not provided by others in the marketplace — see Section 4.4.1.5). To support a conclusion that the arrangement is at market (i.e., customary) a reporting entity would, in addition to demonstrating that negotiations were at arm’s length or there was implicit acceptance by market participants, compare its fee arrangement with other arrangements it negotiated with third parties. Therefore, in these situations, it would typically not be necessary for a reporting entity to compare its fee arrangement to others in the marketplace to support its conclusion that the fee arrangement is commensurate and at market unless the reporting entity has no other internal benchmarks.

However, when fees are not negotiated at arm’s length, or there are other benefits or elements embedded in the fee arrangement, the reporting entity would generally need more evidence to determine whether the fee arrangement is designed in a manner that is inconsistent with the decision maker’s or service provider’s role and whether the fees would therefore not be commensurate or at market.

In this situation, the reporting entity should analyze whether the fee arrangement is similar to those entered into between the decision maker or service provider and unrelated parties, or among parties outside the arrangement being evaluated. As part of this assessment, the reporting entity should consider other interests that were entered into contemporaneously with the fee arrangement (e.g., if in addition to the fee arrangement, the decision maker received an equity interest with a preferential return). While the size of a fee would not, in isolation, prevent a compensation arrangement from meeting the commensurate or at market criterion, a significant discrepancy between the fee arrangement being analyzed and those entered into by third parties with relationships that are similar to the one between the potential VIE and the decision maker or service provider may indicate that the reporting entity’s fee is not commensurate or at market.

In certain circumstances, a decision maker or service provider may waive its fees, or a portion of its fees, for a specified period (e.g., during the startup of a fund). In such situations, the reporting entity should analyze whether the fee arrangement, including the effect of the fee waiver, is similar to an arrangement entered into between the decision maker or service provider and unrelated parties. A fee waiver itself does not preclude a decision maker from concluding that the fee arrangement is commensurate and at market. Rather, the decision maker should consider other fee arrangements the decision maker has entered into, whether it has a policy for waiving fees for similar funds, or whether fee waivers are common in its industry. The reporting entity should carefully consider the facts and circumstances in determining whether fee waivers meet the commensurate and at-market criteria.

Example 4-21

Entity A enters into an arrangement with an unrelated party to manage the operations of a potential VIE that was established to hold a single real estate asset for an annual fee of $100,000. The fees and terms of the arrangement are similar to other arrangements A has with other unrelated parties. Entity A and its related parties have no other interests in the potential VIE. Because the fee was negotiated at arm’s length with an unrelated party, is consistent with other arrangements with unrelated parties, and there are no other benefits or elements embedded in the fee arrangement, A would exclude its fees when assessing whether it has a variable interest or has satisfied the economics criterion in ASC 810-10-25-38A(b).

Example 4-22

Entity A enters into an arrangement with an investee (which is a related party) to manage the operations of a potential VIE that was established by the investee to hold a single real estate asset. Entity A and its related parties have no other interests in the potential VIE. Entity A will receive an annual fee of $100,000. The amount of the management fee is similar to those in arrangements entered into by A with other unrelated clients for similar arrangements in the nearby geographic area. Although the fee was negotiated with a related party, it is consistent with fees entered into by other parties with similar arrangements, and there are no other benefits or elements embedded in the fee arrangement. Entity A would therefore exclude its fees when assessing whether it has a variable interest or has satisfied the economics criterion in ASC 810-10-25-38A(b).

Example 4-23

Entity A manages an investment fund in exchange for a fixed annual fee equal to 50 basis points of assets under management and a variable fee equal to 20 percent of all returns in excess of a 5 percent internal rate of return (IRR). The investors in the investment fund are unrelated to A and have thus implicitly agreed to the terms and conditions of the fund, including A’s fee. The fee is also consistent with fee arrangements entered into by A with other unrelated parties. The management contract extends over the life of the investment fund and is cancelable only in the case of gross negligence, fraud, or other illegal acts by A. In this instance, A is significantly participating in the returns of the fund through its fee arrangement. However, since the fee arrangement was accepted by unrelated investors in the investment fund, and is consistent with other arrangements with unrelated parties, the fee arrangement is presumed to be commensurate and at market. Accordingly, as long as other benefits or elements are not embedded in the fee arrangement (e.g., see the example below), A would exclude its fee when assessing whether it has a variable interest or has satisfied the economics criterion in ASC 810-10-25-38A(b).

Example 4-24

Assume the same facts as in the previous example, except that because it received an amount significantly below fair market value for assets that it transferred at inception of the investment fund, Entity A receives for its management services a fixed annual fee equal to 50 basis points of assets under management and a variable fee equal to 80 percent of all returns in excess of a 5 percent IRR. In this instance, although the fee structure was accepted by unrelated parties that invested in the investment fund, the fees are not commensurate because there is another benefit or element embedded in the decision-maker contract. Entity A would therefore conclude that the fee arrangement is a variable interest and would include the entire fee in its assessment of whether it has satisfied the economics criterion in ASC 810-10-25-38A(b).

4.4.1.1 Compensation Received Related to Risk Exposure

If the fee arrangement is designed to expose a reporting entity to risk of loss in the potential VIE (e.g., a guarantee embedded in the fee arrangement), the fees will be considered a variable interest and included in the reporting entity’s evaluation under the economics criterion in ASC 810-10-25-38A(b). In paragraph BC43 of ASU 2015-02, the FASB explained that a fee arrangement that exposes a reporting entity to risk of loss in a potential VIE should never be eligible for exclusion from the evaluation of whether it (1) is a variable interest or (2) satisfies the economics criterion. This serves as a safeguard to ensure that if an arrangement is structured as a means to absorb risk of loss that the legal entity was designed to pass on to its variable interest holders, the arrangement will be included in the consolidation analysis. Therefore, even if such fees are otherwise commensurate and at market (see Section 4.4.1), they would not be eligible for (1) inclusion in the fee-arrangement evaluation under ASC 810-10-55-37 or (2) exclusion from the primary-beneficiary evaluation. A reporting entity’s expectation related to the magnitude of losses that it will incur from a fee arrangement that exposes the reporting entity to a risk of loss in a potential VIE does not factor into the evaluation. That is, a reporting entity cannot apply the guidance in ASC 810-10-55-37 on evaluating fee arrangements on the basis of its belief that the expected losses absorbed by the fee arrangement will be insignificant relative to the total expected losses of the potential VIE.

A reporting entity should carefully consider the design of the potential VIE to determine whether the related exposure that the fee arrangement absorbs is a risk that the legal entity was designed to pass on to its variable interest holders. For example, the fee arrangement may be substantially a fee-for-service contract and have certain protections that are customary and standard, but it does not expose the decision maker or service provider to any of the primary risks of the potential VIE. In this case, the fees received are not designed as compensation for exposure to risk of loss in the potential VIE. While fees received as compensation for providing loss protection to the legal entity are typically easy to identify, reporting entities must carefully consider all the facts and circumstances associated with fee structures that are designed to reduce or eliminate losses that would otherwise accrue to the holders of the legal entity’s variable interests. In accordance with ASC 810-10-55-37C(d), a reporting entity should also consider obligations or arrangements that implicitly protect holders of other interests from suffering losses in a potential VIE.

Example 4-25

Although A’s fee is variable, the variability allows the service provider to participate in the profits of the fund but does not expose A to the risk of losses of the fund. Therefore, A would not have a variable interest because the fee arrangement does not expose A to the risk of loss in the potential VIE.

Example 4-26

Entity A enters into an arrangement with an unrelated party to manage the operations of a VIE with a single real estate asset for an annual fee of $120,000. However, the fee arrangement also contains a provision that requires A to pay $50,000 to the VIE for each month that the real estate asset is less than 70 percent occupied. Accordingly, if the real estate asset had occupancy of less than 70 percent for the full year, A would be required to pay the VIE $600,000. While the fee appears to have been negotiated at arm’s length with an unrelated party, A has effectively protected the holders of other interests in the VIE from suffering losses in the VIE. Therefore, A would have a variable interest, and the entire fee, as well as the maximum exposure to loss, must be included in A’s evaluation of whether it satisfies the economics criterion in ASC 810-10-25-38A(b) (see Section 7.3.4.3).

Example 4-27

Repurchase any loan as a result of identified origination defects, errors in servicing a loan, or other violations of standard representations and warranties.3
Advance principal, interest, taxes, and insurance to the investors of the trust. Entity A is permitted to collect any advance made through future cash flows from the assets of the trust. Further, A is only required to make an advance to the extent that it believes that the future cash flows will be sufficient to pay back the advances.

The investors of the trust have no recourse to A other than the above obligations. Although the obligations expose A to certain risks of loss, those risks are not the risks the trust was designed to pass on to its variable interest holders. Rather, the risks of the trust are the underlying credit of the financial assets transferred. The standard representations and warranties protect the investors from risks that the financial assets are not what they are purported to represent; the advances represent ongoing contractual obligations to service the financial assets and are only made if the servicer expects to collect on the advances (i.e., is not designed to absorb losses of the variable interest holders). Therefore, the fee arrangement is not compensation for exposure to the risk of loss in the potential VIE,4 and the reporting entity would be eligible to exclude the fees from its evaluation of whether (1) the fees represent a variable interest and (2) the economics criterion in ASC 810-10-25-38A has been satisfied.

Example 4-28

Entity A transfers loans into a securitization trust and retains the right to unilaterally perform the servicing function, which represents the activities that most significantly affect the economic performance of the trust. Entity A receives annually 50 basis points of the unpaid principal balance for performing the services, and this amount is determined to be commensurate and at market. The servicing agreement specifies that A has the option to repurchase any loan in the securitization trust that is modified to reduce the interest rate, reduce the principal amount, or extend the contractual term. The repurchase price is equal to the outstanding principal amount plus any accrued and unpaid interest and fees. Modifications to loans within the trust are allowed only in response to a deterioration in the borrower’s creditworthiness (i.e., to maximize expected cash flows on the loans). Assume that the securitization trust is a VIE that was designed to pass credit risk on to its variable interest holders.

Although A has an option, which represents an explicit right as opposed to an explicit obligation, to repurchase loans that are modified, through past practice A has established a history of always purchasing any modified loans even when the purchase price is in excess of the value of the loans. Investors in the securitization trust also have an expectation, on the basis of this history, that A will continue to repurchase modified loans. If A were to stop purchasing modified loans, its ability to execute future similar securitization trusts at favorable pricing would be negatively affected.

In this example, there is an implicit agreement that A will protect other variable interest holders from potential credit losses; therefore, the servicing arrangement is a variable interest. Entity A reaches this conclusion because (1) the repurchase price, by design, could expose it to losses since the fair value of modified loans would generally not be expected to equal or exceed the principal amount outstanding, plus accrued and unpaid interest and fees, and (2) on the basis of past practice and other available evidence, A expects to continue to absorb potential credit losses that would otherwise be absorbed by the third-party variable interest holders.

4.4.1.2 Fees in Excess of Adequate Compensation — Impact on Commensurate and At-Market Determinations

It is common for servicers in securitizations and other loan transfers to receive more than “adequate compensation” for their servicing of the financial assets. ASC 860-50-20 defines adequate compensation as follows:

The amount of benefits of servicing that would fairly compensate a substitute servicer should one be required, which includes the profit that would be demanded in the marketplace. It is the amount demanded by the marketplace to perform the specific type of servicing. Adequate compensation is determined by the marketplace; it does not vary according to the specific servicing costs of the servicer.

Under ASC 860-50, if a servicer is entitled to compensation that is in excess of adequate, a servicing asset must be recorded. The servicing asset represents the future expected value of performance under the servicing arrangement in excess of what the servicer would pay an unrelated party to perform the servicing on its behalf. Depending on the type of assets being serviced, the fees may be significantly higher than adequate compensation.

The recognition of a servicing asset is not an automatic indicator that the fees are not commensurate or at market. That is, although adequate compensation would be considered commensurate and at market because the fee is, by definition, consistent with “the amount demanded by the marketplace to perform the specific type of servicing,” since unrelated market participants determine the service-provider fee (e.g., servicers for government-sponsored entity trusts generally receive 25 basis points), an amount in excess of adequate compensation may still be considered commensurate and at market. The reporting entity should evaluate the arrangement, including whether (1) it was negotiated at arm’s length, (2) there are more than insignificant unrelated investors in the securitization, (3) the arrangement is consistent with other arrangements entered into with unrelated parties or other arrangements in the marketplace, and (4) there are other benefits or elements embedded in the fee arrangement unrelated to the services provided.

Conversely, if a servicer recognized a servicing liability at inception (i.e., the fees are below adequate compensation), those fees generally would not be commensurate or at market and, therefore, would be deemed a variable interest and included in the analysis of whether it has satisfied the economics criterion in ASC 810-10-25-38A(b).

Example 4-29

Entity A transfers loans into a securitization trust and retains the right to unilaterally perform the servicing function, which consists of performing the activities that most significantly affect the economic performance of the trust. The beneficial interests of the trust are held entirely by unrelated parties. Entity A receives annually 50 basis points of the unpaid principal balance each period for performing the services, which is consistent with the amount generally retained for servicing similar assets both internal to A for unrelated investors and other arrangements in the marketplace. Entity A determines that adequate compensation is 30 basis points and, therefore, recognizes a servicing asset upon transfer. However, A determines that there were more than insignificant unrelated investors in the trust and that there are no other benefits or elements embedded in the fee arrangement unrelated to the services provided. Therefore, despite recognizing a servicing asset, A would conclude that the fee arrangement is commensurate and at market.

Example 4-30

Assume the same facts as in the example above, except that Entity A receives annually 200 basis points of the unpaid principal balance each period for performing the services, which is well in excess of what A charges in other securitization trusts. Entity A negotiated the higher servicing fee in return for lower proceeds on the transfer. In this case, although the fee arrangement was negotiated at arm’s length, and unrelated parties accepted the fee structure, A would determine that its fees are not commensurate and at market because additional returns have been embedded in the fee arrangement. Therefore, A would conclude that the fee arrangement is a variable interest and would include the entire fee in assessing whether it has satisfied the economics criterion in ASC 810-10-25-38A(b).

4.4.1.3 Fee Arrangements That Are Designed to Transfer the Residual Risks and Rewards of Ownership

A fee arrangement that is designed to transfer substantially all of the residual risks and rewards of ownership to the decision maker of a potential VIE would not be considered commensurate and at market. Case L in ASC 810-10-55-205Z through 55-205AI illustrates that this type of arrangement is a variable interest and would not be considered a fee that is excluded from the consideration under the economics criterion in ASC 810-10-25-38A(b). In Case L, the primary purpose of the legal entity was to bypass foreign investment restrictions and enable foreign investors to participate indirectly in restricted sectors through a series of contractual arrangements that gave the investor (Company A) all the net income of the legal entity.

We are aware of similar arrangements that transfer substantially all the risks and rewards of ownership to a reporting entity through contractual arrangements. Since substantially all the economics of the potential VIE, by design, are transferred to the reporting entity, the arrangement cannot be considered commensurate and at market, regardless of whether there are comparable arrangements in the marketplace. This conclusion would also apply to arrangements outside foreign jurisdictions, such as physician practice management entities in which an investor purchases the rights to operate and retain all or substantially all the residual risks and rewards of a legal entity.

These considerations are not limited to fee arrangements that absorb substantially all of a potential VIE’s economics. A distinguishing factor in many of these contractual arrangements is that they require the service provider/investor to make a significant investment to gain the rights to the future economics of the legal entity. Accordingly, reporting entities should carefully consider fee arrangements in which a significant amount of the economics of a legal entity are being redistributed to a reporting entity through a contract that requires a significant investment to gain those rights. Many of these arrangements have an obligation to fund losses and would not satisfy the condition in ASC 810-10-55-37C; therefore, the fees would automatically be variable interests and would not be evaluated to determine whether substantially all the risks and rewards of ownership are through a contractual arrangement. That is, since the fee arrangement includes an obligation to absorb losses, the fees are variable interests and no assessment of whether the fees are commensurate or at market is required.

Example 4-31

Entity A wishes to expand its presence into a foreign jurisdiction that precludes foreign ownership of companies in A’s industry. As a result, A enters into a contractual arrangement with the sole shareholder of Entity B, an unrelated party, under which A acquires the shareholder’s rights to all dividends paid from B in exchange for an up-front cash payment. Further, A enters into a management services agreement with B that gives A the ability to make all significant operating and capital decisions for B. The management services agreement has an initial five-year term, is unilaterally extendable by A for an unlimited amount of successive five-year terms, and requires that B pay to A 100 percent of its after-tax income in the form of a management fee. (Alternatively, the management services agreement may give A the ability to unilaterally determine the amount of the fee payable in any given year.) In this instance, B’s shareholder has effectively surrendered its control and right to participate in the risks and rewards of B to A, thus becoming a nominee shareholder. Entity A therefore has a variable interest and is required to include the fee in its evaluation of whether it has met the economics criterion in ASC 810-10-25-38A(b).

See Section D.3.4.1 for a discussion of the application of the contract-controlled entity model to arrangements other than physician practice management entities for those entities that are not VIEs.

4.4.1.4 Analyzing Decision-Making Rights Embedded in a General Partner Interest

A general partner’s ability to make decisions for a partnership is typically embedded in an equity interest. That is, the general partner typically invests a stated amount in the partnership in exchange for (1) an investment return on the stated amount (like the limited partners) and (2) additional returns designed to compensate it for its general partner services. An equity interest that gives the general partner decision-making rights is substantively a multiple-element arrangement with an equity component and an embedded fee component. Accordingly, the general partner should separate the stated investment and fee arrangement and determine whether the fee arrangement represents a variable interest under ASC 810-10-55-37.

Connecting the Dots

Before adoption of the FASB’s new revenue standard (ASC 606), general partner investors that did not have a controlling financial interest in the underlying partnership generally accounted for their general partner interest, excluding the disproportionate allocation of profits, by using the equity method of accounting in ASC 323. For the capital-allocation-based arrangement portion of their general partner investments, generally investors applied EITF Topic D-96, which specifies two acceptable approaches to accounting for the receipt of fees for performance-based fee arrangements. However, some investors may have determined that the capital-allocation-based arrangement portion of their general partner investments was within the scope of ASC 323.

As a result of the new revenue standard, questions have emerged regarding whether these capital-allocation-based arrangements are within the scope of ASC 606 or whether they should be accounted for under other GAAP (particularly ASC 323). In certain arrangements, a general partner may be able to demonstrate that its capital-allocation-based arrangements that involve an equity interest are financial instruments within the scope of other GAAP, particularly ASC 323. In such cases, these arrangements would qualify for the scope exception under ASC 606-10-15-2(c)(3).

However, we do not believe that a general partner’s conclusion regarding the accounting for its fee arrangement affects the analysis under ASC 810. That is, it remains appropriate to treat the stated investment and the fee arrangement separately in the determination of whether the general partner has a variable interest through the fee arrangement. We understand that this interpretation is consistent with the SEC staff’s view. For additional information about ASC 606, see Section 3.2.11 of Deloitte’s Roadmap Revenue Recognition.

This scenario is illustrated in Case J in ASC 810-10-55-205L through 55-205V, in which a fund manager with a general partner interest applied ASC 810-10-55-37 to analyze its general partner interests to determine whether its fees are a variable interest. Further, in our discussions with the FASB staff, the staff confirmed that fee components should be evaluated separately when they are embedded in a general partner equity interest. However, like other fee arrangements that are designed to compensate the decision maker or service provider for assuming risk of loss in the potential VIE (see Section 4.4.1.1), the embedded fee arrangement would automatically be considered a variable interest (i.e., would not be permitted to apply ASC 810-10-55-37) and would be included in the primary-beneficiary evaluation under ASC 810-10-25-38A if the embedded fee component provides loss protection to other interest holders.

In determining whether the general partner is using its decision-making rights in a fiduciary capacity (i.e., the decision-making rights are not considered a variable interest because they meet all the conditions in ASC 810-10-55-37), the general partner should consider the amount it invested for the equity component of its general partner interest and any other interests that it holds (e.g., limited partner interests or guarantees), including indirect interests held through its related parties, to assess its economic exposure to the partnership (ASC 810-10-55-37(c)) (see Section 4.4.2). The general partner should also analyze the fees to determine whether they are commensurate and at market (see Section 4.4.1).

If the general partner determines that it is acting in a fiduciary capacity, its fee arrangement would not satisfy the “power“ criterion in ASC 810-10-25-38A(a) and the general partner therefore would not consolidate the VIE. However, a substantive equity component will qualify as a variable interest (as would an equity interest held by the limited partners). Accordingly, even if the general partner concludes that it is not required to consolidate a partnership, the general partner would need to consider whether it should provide the VIE disclosures (see Section 11.2).

Example 4-32

Entity A is the general partner of Limited Partnership B (which is a VIE because its limited partners do not have kick-out or participating rights over the general partner). Entity A has a 5 percent general partner interest in B that provides it with (1) risks and rewards that are similar to those of the limited partners and (2) the right to receive a performance-based fee. The performance fee is compensation for A’s management of B’s operations and is commensurate and at market. Further, the 5 percent general partner interest (exclusive of the fee component) does not receive any benefits or risks that are disproportionate to those of the other investors. In its capacity as the general partner, A makes all significant decisions that affect the economic performance of B. Entity A has also provided a separate guarantee to the partnership related to a remote event. Accordingly, while it is not expected that the guarantee will absorb more than an insignificant amount of the VIE’s expected losses (ASC 810-10-55-37(c)), the guarantee could potentially be significant to the VIE (ASC 810-10-25-38A(b)) (without taking probability into account).

The embedded fee arrangement would meet all three criteria in ASC 810-10-55-37 and would therefore not be considered a variable interest (A would conclude that it is acting as a fiduciary). As a result, A’s performance-based fee arrangement would not satisfy the power criterion in ASC 810-10-25-38A(a) because A would not have a variable interest that gives it power. Accordingly, A would not meet the primary-beneficiary criteria and would not consolidate the VIE. Specifically, in evaluating its economic exposure as part of its assessment of whether the embedded fee arrangement is a variable interest, A has determined that its 5 percent general partner equity interest and guarantee do not collectively absorb more than an insignificant amount of B’s expected variability. However, the general partner equity interest and guarantee would be considered variable interests, and A must provide the required VIE disclosures. On the other hand, if A had a general partner equity interest of 15 percent (which absorbs more than an insignificant amount of B’s expected variability), A’s fee arrangement would be a variable interest because it would not satisfy the criterion in ASC 810-10-55-37(c). As a result of that variable interest, A would also meet both of the primary-beneficiary criteria in ASC 810-10-25-38A.

4.4.1.5 Absence of Similar Arrangements

At times, no comparable fee arrangements will be available (internally or in the marketplace) for a reporting entity to use in assessing whether its fee arrangement is commensurate and at market. As stated in ASC 810-10-55-37B, a fee would not presumptively fail to be commensurate and at market in the absence of similar service arrangements if either of the following apply:

“The fee arrangement relates to a unique or new service.”
“The fee arrangement reflects a change in what is considered customary for the services.”

In such situations, the determination of whether a fee arrangement is commensurate and at market will be based on the reporting entity’s facts and circumstances. Questions to consider include, but are not limited to, the following:

Was the service arrangement negotiated at arm’s length, or have the terms been implicitly accepted by unrelated market participants (i.e., a more than insignificant amount of the investor interests in the potential VIE is held by an unrelated party or parties)?
Are there other benefits or elements embedded in the fee arrangement?
If the services are unique because they are incremental (or reductive) to other internal arrangements with unrelated third parties or marketplace arrangements, does the increase (or decrease) in fees adjust appropriately for the incremental (or reductive) services?
How was the pricing determined by the service provider (e.g., does it take into account the expected cost plus a reasonable profit margin for the risk of providing the services)?

4.4.2 Analyzing Other Interests of the Decision Maker or Service Provider

The FASB retained the requirement for reporting entities to consider whether a decision maker or service provider has any other interests (direct, implicit, or indirect interests through its related parties) in the legal entity that absorb more than an insignificant amount of the potential VIE’s variability. The FASB reasoned that if such interests are held by the decision maker or service provider (or certain of its related parties), the decision maker or service provider may be acting, at least in part, as a principal rather than a fiduciary in providing its services. In performing this analysis, the decision maker and service provider should therefore consider the design of the legal entity and all contractual or noncontractual provisions.

4.4.2.1 Meaning of “Insignificant” in the Analysis of Fees Paid to a Decision Maker or Service Provider

ASC 810-10 does not define the term “insignificant” as used in ASC 810-10-55-37(c). However, as a general guideline, if the expected losses absorbed or expected residual returns received through variable interests (other than the fee arrangement) in the potential VIE exceed, either individually or in the aggregate, 10 percent or more of the expected losses or expected residual returns of the potential VIE, the condition in ASC 810-10-55-37(c) is not met, and the decision-maker or service-provider fee would be considered a variable interest. However, because of the subjective nature of the calculation of expected losses and expected residual returns, in some fact patterns (e.g., when the variable interest holders do not share in losses and returns on a proportional basis), 10 percent should not be viewed as a bright-line threshold or safe harbor. In light of these considerations, the reporting entity will need to apply professional judgment and assess the nature of its involvement with the potential VIE. See Section 7.3.3 and Example 4-32 for further discussion of insignificant interests.

The analysis under ASC 810-10-55-37(c) deals with the expected outcome of the potential VIE. Therefore, when analyzing a decision-maker or service-provider fee under this criterion, a reporting entity would identify and weigh the probability of the various possible outcomes in determining the expected losses and expected residual returns of the potential VIE. However, the reporting entity may not be required to prepare a detailed quantitative analysis (that is, an analysis consistent with the quantitative concepts described in Appendix C) to reach a conclusion under ASC 810-10-55-37(c). For example, if a decision maker holds 100 percent of the residual interest in a legal entity (and the residual interest is substantive), a reporting entity may qualitatively conclude that holding all of a substantive residual interest would represent more than an insignificant amount of the legal entity’s expected losses or expected residual returns. Conversely, if a decision maker holds less than 10 percent of the residual interest in a legal entity, the reporting entity may qualitatively conclude that holding less than 10 percent of the residual interest would not represent more than an insignificant amount of the legal entity’s expected losses or expected residual returns.

Although the consideration of the probabilities of various outcomes is important in the determination of whether a decision-maker or service-provider fee is a variable interest under ASC 810-10-55-37(c), such probabilities generally may not be considered in the determination of whether the reporting entity meets the economics criterion under ASC 810-10-25-38A(b). That is, while the “significant“ threshold is used in both assessments, the evaluation of a decision maker’s economic exposure under ASC 810-10-25-38A(b) focuses on whether the reporting entity’s economic exposure could be more than insignificant. Therefore, if the condition in ASC 810-10-55-37(c) is not met as a result of a direct or indirect interest held by the decision maker, it would be unusual for the decision maker to not meet the economics criterion in ASC 810-10-25-38A(b). See Section 7.3.2 for more information about the economics criterion.

4.4.2.2 Performance-Based Fee Arrangements

Certain fee arrangements may allow asset managers to receive performance-based fees (i.e., calculated on the basis of the performance of the underlying assets being managed). The fee arrangements may be complex as a result of high-water marks or performance hurdles, and external factors such as a market index may be used to evaluate the performance of the underlying assets. A performance fee may also be subject to (1) lock-up provisions, under which the fees will only be paid to the investment manager once the underlying investments have been sold, or (2) clawback provisions, under which the manager is required to return the fee for underperformance in future periods.

To align the interests of an asset manager with those of investors, asset managers typically structure their fee arrangements to include participation in the legal entity’s profits (along with the equity investors). Such fee arrangements should be assessed under ASC 810-10-55-37 to ascertain whether they represent variable interests rather than evaluated as equity instruments. In addition, lock-up provisions that affect the timing of when the asset manager will receive these fees do not cause the fees to be considered equity interests in the legal entity being evaluated.

While lock-up provisions may affect the timing or receipt of fees received under the arrangement, they do not change the nature of the fee arrangement to that of an equity investment. That is, although the amount allocated to the asset manager is subject to future reversal if performance of the legal entity declines, a performance-based fee subject to a lock-up provision should still be regarded as a fee arrangement. The FASB’s intention in amending the guidance on fee arrangements was to distinguish between fee arrangements that allow the recipient to participate in the variability in the economic performance of the legal entity and those that expose the recipient to a risk of loss. As explained in paragraph BC42 of ASU 2015-02, the FASB determined that a fee arrangement that can result in the nonreceipt of fees exposes the recipient to an opportunity cost but not to a risk of loss (i.e., the recipient will never have to “write a check”). A lock-up provision exposes the recipient to such an opportunity cost but not to a risk of loss; accordingly, the presence of a lock-up provision does not affect the ability of a service provider or decision maker to assess the fee arrangement under the requirements in ASC 810-10-55-37.

Further, a performance-based fee that has been distributed to the asset manager but is subject to future clawback would also not be treated as an “other interest“ (e.g., equity interest or a guarantee). That is, although the asset manager may be required to refund the legal entity for the amount received, the purpose and design of the arrangement is no different from other performance-based fee arrangements. In other words, over the life of the legal entity, the fee arrangement only exposes the asset manager to opportunity cost (i.e., not earning the performance-based fee), not to losses of the legal entity. However, a requirement that the asset manager refund an amount to the legal entity that is in excess of the performance fees received would expose the asset manager to the risk of losses of the legal entity and therefore would be considered a guarantee.

Once the fee crystalizes (e.g., because the profits on the underlying investments have been realized), there may be a period before which the asset manager is entitled to withdraw its fees. In such circumstances, that portion of the arrangement would no longer be treated as a fee arrangement but rather like all other liabilities of the legal entity. However, the liability would typically not subject the asset manager to a more than insignificant amount of the legal entity’s variability because the amounts payable are short term, fixed in amount, and not subordinate to other liabilities of the legal entity, and the probability of a credit-related event that would prevent their payment is often remote.

However, if the asset manager receives its performance-based fee in the form of additional equity interests, or invests the performance-based fees it received back into the legal entity as an additional equity investment, its investment would represent an other interest that would need to be included in the evaluation of whether (1) the fees paid to the asset manager represent a variable interest in the legal entity (a reconsideration event), (2) the reporting entity is the primary beneficiary of the VIE, and (3) the reporting entity is required to provide the VIE-related disclosures (see Section 11.2).

4.4.2.3 Impact of Related-Party Relationships on Identification of Variable Interests for a Decision Maker or Service Provider

In its evaluation of the conditions in ASC 810-10-55-37(c), a decision maker or service provider must consider (in addition to its direct other interests) interests held by certain of its related parties. An exception is provided for any interests held by an employee or employee benefit plan of the decision maker or service provider unless the employee or employee benefit plan is used in an effort to circumvent the provisions of the VIE model in ASC 810-10 (see Sections 4.4.2.3.5 and 4.4.2.3.6).

4.4.2.3.1 Interests Held by Related Parties

Interests held by a decision maker’s or service provider’s related parties (or de facto agents) would only be included in the evaluation of whether the decision maker’s or service provider’s fee arrangement is a variable interest when the decision maker or service provider has a variable interest in the related party. If the decision maker or service provider has a variable interest in the related party, it would include its economic exposure to the legal entity through its related party on a proportionate basis.

Example 4-33

A collateral manager owns a 20 percent interest in a related party, and the related party owns 40 percent of the residual tranche of the CFE being evaluated. In this case, the collateral manager’s interest would be considered equivalent to an 8 percent direct interest in the residual tranche of the CFE. Therefore, in addition to considering its own direct interest (if any), the collateral manager should include its 8 percent indirect interest when assessing whether its fee arrangement is a variable interest in the CFE and, if so, whether the collateral manager is the primary beneficiary of the CFE. However, if the collateral manager did not hold the 20 percent interest in its related party, it would not include any of the related party’s interest in either evaluation.

4.4.2.3.2 Interests Held by Related Parties That Are Under Common Control

In a manner consistent with the guidance discussed in Section 4.4.2.3.1, a decision maker or service provider is generally required to include interests held by related parties on a proportionate basis when it has a variable interest in the related party in its evaluation of whether a fee arrangement is a variable interest, regardless of whether the related parties are under common control. This topic was addressed by SEC staff member Chris Semesky at the 2015 AICPA Conference on Current SEC and PCAOB Developments:

For purposes of illustration consider an entity that has four unrelated investors with equal ownership interests, and a manager that is under common control with one of the investors. The manager has no direct or indirect interests in the entity other than through its management fee, and has the power to direct the activities of the entity that most significantly impact its economic performance.

In this simple example, if the manager’s fee would otherwise not meet the criteria to be considered a variable interest, the fact that an investor under common control with the manager has a variable interest that would absorb more than an insignificant amount of variability would not by itself cause the manager’s fee to be considered a variable interest. The guidance to consider interests held by related parties when evaluating whether a fee is a variable interest specifically refers to instances where a decision-maker has an indirect economic interest in the entity being evaluated for consolidation. [Footnote omitted] However, in the instance where a controlling party in a common control group designs an entity in a way to separate power from economics for the purpose of avoiding consolidation in the separate company financial statements of a decision-maker, OCA has viewed such separation to be non-substantive.

In my example, if the manager determines that its fee is not a variable interest the amendments in ASU 2015-02 are not intended to subject the manager to potential consolidation of the entity. In other words, a decision-maker would not be required to consolidate through application of the related party tiebreakers once it determines that it does not have a variable interest in the entity.

Although the remarks were within the context of ASU 2015-02, we believe that the SEC staff’s conclusion that a party’s design of an entity to circumvent consolidation by separating power from economics would be considered nonsubstantive continues to be relevant for entities that have adopted ASU 2018-17. A reporting entity might be able to conclude that an interest held by its related party under common control was not provided to the related party in an effort to circumvent consolidation of the legal entity when, for example, (1) a founder and CEO of an asset manager invests his or her own money in a potential VIE directly or through personal family trusts or (2) a parent entity with a consolidated asset manager and a separate consolidated subsidiary actively trades in and out of funds but does not, by design, hold seed capital or long-term interests in a fund. The legal entity’s design would rarely be used in either of these circumstances to circumvent the consolidation provisions. However, the same conclusion could not be reached by a regulated financial institution that transfers its beneficial interests in a securitization structure that it sponsors to an entity under common control to avoid consolidation of the securitization entity in its stand-alone financial statements. Accordingly, facts and circumstances should always be carefully considered.

Example 4-34

Subsidiary A and Subsidiary B are under common control but do not have ownership interests in each other. Subsidiary A is the general partner (decision maker) for Partnership C, but does not have any other interests in C. Subsidiary B owns 30 percent of C’s limited partner interests. The partnership is considered a VIE.

In this example, on the basis of an analysis of the specific facts and circumstances, A would conclude that its fee arrangement is not a variable interest as long as C has not been designed to circumvent consolidation by A or B. Subsidiary A itself does not have a significant interest in the partnership. In addition, although B is under common control with A and owns 30 percent of the equity of C, A would not consider B’s 30 percent interest when it evaluates whether A meets the condition in ASC 810-10-55-37(c). Accordingly, if the fees are commensurate and at market, the fee arrangement would not be a variable interest.

4.4.2.3.3 What Is Meant by “Common Control”

Entities under common control are limited to subsidiaries of a common parent as well as a subsidiary and its parent, as indicated in paragraph BC69 of ASU 2015-02. The diagram in the example below illustrates this relationship.

Example 4-35

Entity R has a wholly owned, consolidated asset management subsidiary, Subsidiary A. Subsidiary A is the 1 percent general partner of the Fund. Subsidiary A’s general partner interest gives A decision-making rights over the Fund, and in exchange for performing its services, A is entitled to receive a base management fee and a performance-based fee (or carried interest) equal to 20 percent of all returns in excess of a specified threshold. These fees are commensurate and at market (see Section 4.4.1). Entity R also has a 1 percent general partner interest in Co-Investment Fund E. Entity R has the power through its general partner interest to direct all the significant activities of E and cannot be removed without cause. However, R does not have an obligation to absorb losses of E or a right to receive benefits from E that could potentially be significant to E. Therefore, R does not consolidate E. Because R does not consolidate E, a parent-subsidiary relationship does not exist between R and E, and thus E and A are not considered related parties under common control.

4.4.2.3.4 Entities Under Common Control of an Individual

In the determination of common control, an individual can be considered a parent. The parent does not need to be a separate legal entity for a parent/subsidiary relationship to exist. That is, an individual that possesses a controlling financial interest may be identified as a parent. The ASC master glossary defines “parent,” in part, as an “entity that has a controlling financial interest in one or more subsidiaries.” In addition, given the FASB’s objectives, as described in paragraph BC69 of ASU 2015-02, regarding identification of related parties under common control in ASC 810-10-25-42, ASC 810-10-25-44A, and ASC 810-10-55-37D, the definition of a parent should include any interest holder that has a controlling financial interest in a subsidiary.

In some instances, two or more reporting entities may have a high degree of common ownership, which would not typically result in a conclusion that the reporting entities are under common control. See Example 8-4 in Section 8.2.2.

4.4.2.3.5 Employees and Employee Benefit Plans

ASC 810-10 generally requires indirect economic interests to be included in a reporting entity’s assessment on a proportionate basis. However, ASC 810-10-55-37D specifies certain situations in which holdings of employees or employee benefit plans may be excluded from a reporting entity’s analysis of its involvement with a potential VIE under ASC 810-10-55-37(c) unless the interests are being used to circumvent the provisions of the VIE model.

Note that this exception is limited to the evaluation of the fee arrangement under ASC 810-10-55-37. A reporting entity’s economic exposure through an interest held by an employee or an employee benefit plan are included (either entirely or on a proportionate basis) in a reporting entity’s assessment of whether it is the primary beneficiary of a VIE (see Section 7.3).

Although this exclusion is limited to the application of ASC 810-10-55-37, its practical effect is to reduce instances in which a reporting entity may be identified as the primary beneficiary of a VIE. This is because in the absence of other direct or indirect holdings in a VIE, a fee paid to a decision maker would typically not be identified as a variable interest in a VIE unless the fee is not commensurate and at market (see Section 4.4.1). As a result of excluding these interests in the application of ASC 810-10-55-37, there will be fewer instances in which a fee paid to a decision maker is identified as a variable interest. Accordingly, in these instances, the fee recipient is considered to be acting in a fiduciary capacity and therefore lacks the power criterion in ASC 810-10-25-38A(a) of a primary beneficiary.

Example 4-36

Entity A establishes an investment fund, which it offers to third-party investors. Entity A may only be removed as the manager by a two-thirds vote of the fund’s shareholders. In exchange for providing its services, A receives a base fee equal to 2 percent of assets under management plus an incentive fee equal to 20 percent of all returns in excess of a specified IRR. This fee is commensurate and at market. Entity A also maintains a defined benefit pension plan (the “Plan”) for its employees. The Plan currently holds a 15 percent interest in the investment fund. The Plan maintains a diversified investment portfolio that includes a combination of investment funds that are managed by A and third parties. Further, the Plan’s portfolio is adequately designed to meet the Plan’s obligations. Entity A holds no other direct or indirect interests in the fund, and the fund is a VIE.

Although A, as the Plan’s sponsor, has an obligation to fund the Plan to ensure that it can meet its obligations, given the Plan’s design and the diversified nature of its portfolio, it does not appear that A is using the Plan to circumvent the provisions of the VIE model. Accordingly, in applying ASC 810-10-55-37, A excludes the holdings of the Plan and concludes that it is performing its services in a fiduciary capacity because (1) its fee is commensurate and at market and (2) it has no other interest in the investment fund.

However, if A were to conclude that it has a variable interest in the fund (e.g., because A’s fee arrangement is not commensurate or at market), it would need to consider all of its interests, including its exposure through its employees (employee benefit plans) in determining whether it is the primary beneficiary of the fund.

4.4.2.3.6 Employer Financed Plans

A decision maker may provide nonrecourse financing (or guarantee third-party financing) to allow its employees to purchase interests in a legal entity that it manages. Even though the decision maker may have economic exposure to the potential VIE through its employees, it would exclude any exposure that it has through these arrangements when evaluating whether its fee arrangement represents a variable interest unless those interests are used in an effort to circumvent the provisions of the VIE model. For example, if the financing was provided to the employee as part of the design of a specific fund as a means to increase the decision maker’s exposure to the fund, it is likely that the reporting entity would conclude that the purpose of providing the financing was to circumvent these provisions. Conversely, if the decision maker offers nonrecourse financing to its employees to invest in a fund that it manages as an employee benefit, it is unlikely that the reporting entity would conclude that the financing was used to circumvent this guidance.

However, if the decision maker determines that its fee arrangement is a variable interest, the decision maker would include its indirect exposure to the VIE through its employees in the primary-beneficiary evaluation. Finally, if the decision maker determines that it does not have a variable interest through its fee arrangement as a result of excluding its exposure through financing its employee’s interests, the decision maker should consider whether it is required to disclose its indirect interests in the legal entity through its financing arrangement as part of its VIE disclosures.

4.4.2.3.7 Fee Arrangements Through a Related Party

In the determination of whether fees paid to decision makers or service providers represent variable interests, ASC 810-10-55-37(c) requires the decision maker to analyze whether it holds other interests, directly or indirectly through its related parties, that absorb more than an insignificant amount of the expected losses or the expected residual returns of the legal entity being analyzed. When evaluating whether a decision maker absorbs any economic exposure to a legal entity through its related parties, the decision maker would not include fee arrangements that it has with its related party in determining its indirect exposure to the legal entity being analyzed, unless the fee arrangement is a variable interest. That is, as long as the decision maker does not have any variable interests in the related party, the decision maker would not include any of its related party’s interests in its evaluation.

However, if the decision maker holds a variable interest in its related party, it would include its indirect exposure through those interests in its related parties in its evaluation.

Example 4-37

The asset manager, as general partner, is responsible for all of the investment decisions of the master fund. The asset manager cannot be removed and, therefore, in accordance with ASC 810-10-15-14(b)(1)(ii), the master fund is considered a VIE. The asset manager, through a service arrangement, is also responsible for making all the investment decisions for the feeder fund.

In return for its services, the asset manager receives a base management fee and a performance fee from the feeder fund that are commensurate and at market. In addition, the asset manager has determined that the feeder fund is a voting interest entity. The remaining investors of the master fund are other feeder funds managed by the asset manager. The asset manager receives a similar fee arrangement from those feeder funds. Therefore, the asset manager does not receive an additional fee for its service to the master fund; however, the overall fee structure is considered commensurate and at market.

The asset manager is required to analyze whether its general partner interest in the master fund is a variable interest in accordance with ASC 810-10-55-37 (see Section 4.4.1.4). When performing this evaluation, the asset manager is required to consider both its direct and its indirect exposure to the master fund through its related party (feeder fund). In this case, although the fee received from the feeder fund represents a variable interest in the feeder fund (as a result of the other interests held by the asset manager), the asset manager would only be required to include its 25 percent interest in the feeder fund when evaluating its exposure on an indirect basis. That is, in this example, the asset manager would include its 7.5 percent indirect interest in the master fund (its share on a proportionate basis — 25 percent of 30 percent) through the feeder fund in both its evaluation of whether the fee represents a variable interest under ASC 810-10-55-37 and its economics-criterion evaluation under ASC 810-10-25-38A(b) (see Section 7.3). However, if the asset manager did not have a direct investment in the feeder fund, it would not include any of the feeder fund’s investment when evaluating its economic exposure to the master fund.

4.4.3 Reassessment of Whether a Decision Maker’s or Service Provider’s Fee Is a Variable Interest

ASC 810-10-55-37 provides three criteria that, if met, would result in the determination that a decision maker’s or service provider’s fee arrangement is not a variable interest and that therefore the decision maker or service provider is acting as a fiduciary of the legal entity’s variable interest holders. Changes in a legal entity’s facts and circumstances associated with these three criteria will need to be carefully evaluated in the assessment of whether a fee arrangement becomes (or is no longer) a variable interest.

4.4.3.1 Reassessment of Commensurate and At-Market Criteria

The decision maker or service provider is not required to reconsider its previous conclusions about whether a fee arrangement is commensurate and at market (see Section 4.4.1) unless (1) the fee arrangement itself was significantly modified or (2) the responsibility of the decision maker or service provider significantly changes (e.g., the legal entity undertakes additional activities or acquires additional assets that were not anticipated as of the date of the previous determination). That is, it would not be appropriate to reconsider the commensurate and at-market criteria if a reconsideration event unrelated to the fee arrangement occurs or the responsibility of the decision maker or service provider does not change.

Example 4-38

Entity A manages an investment fund in exchange for a fixed annual fee equal to 50 basis points of assets under management and a variable fee equal to 20 percent of all returns in excess of an 8 percent IRR. Entity A determined that the fees are commensurate and at market. Subsequently, A purchases 5 percent of the outstanding interests in the investment fund from an unrelated third party. At the time of the purchase, the fee arrangement is no longer commensurate because the market now offers only 10 percent of all returns in excess of an 8 percent IRR. It would be inappropriate to reconsider the commensurate and at-market criteria because the fee arrangement was not modified and the investment fund did not undertake additional activities or acquire additional assets. However, as discussed below, other interests must be reconsidered.

4.4.3.2 Reassessment of the Other-Interests Criterion

A reporting entity is required to reconsider whether a fee meets the criterion in ASC 810-10-55-37(c) regarding other interests when there has been (1) a change in the design of the legal entity, (2) an acquisition or disposal of other variable interests in the legal entity by the decision maker or service provider (including an interest held through a related party), (3) a change in a related-party relationship, or (4) a significant change in the economic performance of the legal entity and that change is expected to continue throughout the life of the legal entity.

The reconsideration events in ASC 810-10-35-4(a)–(d) (see Chapter 9) focus on changes in the legal entity’s design. Therefore, if one of those events occurs, a decision maker or service provider would need to reassess, concurrently with its reconsideration of the legal entity’s status as a VIE, and on the basis of facts and circumstances that exist as of the date of the reconsideration event, whether its fee meets the condition in ASC 810-10-55-37(c).

ASC 810-10-35-4 indicates that a “legal entity that previously was not subject to the Variable Interest Entities Subsections shall not become subject to them simply because of losses in excess of its expected losses that reduce the equity investment.” Therefore, a reporting entity would typically not be required to reassess whether its fee meets the other interests condition as a result of changes in general market conditions or changes in the economic performance of the legal entity. However, if a significant change occurs in the economic performance of the legal entity, and the change is expected to continue throughout the life of the legal entity, the decision maker or service provider may no longer be serving in a fiduciary capacity (or as a principal).

Example 4-39

An investment manager creates a CLO and retains a 12 percent residual interest in the entity. 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.

The investment manager initially has the power to direct the activities that most significantly affect the CLO’s economic performance. In addition, the residual interest owned by the investment manager absorbs more than an insignificant amount of the CLO’s variability; therefore, the investment manager would consolidate the CLO. Subsequently, as a result of the economic performance of the underlying securities in the CLO, the residual interest holders will not receive any future cash flows from the legal entity. Accordingly, the investment manager would reassess whether its fee is a variable interest under ASC 810-10-55-37 and whether it continues to be the primary beneficiary.

Example 4-40

Company R establishes a real estate partnership (a VIE), provides 1 percent of the partnership’s capital investments, and manages its activities under a separate management contract. For its role as manager, R receives remuneration that is customary and commensurate with services performed. In addition, R separately has guaranteed the performance of the real estate properties for the first three years after the partnership’s formation and, as a result, will absorb more than an insignificant amount of the partnership’s expected losses.

During the three-year guarantee period, R has a variable interest in the partnership through its management fee and its performance guarantee. Company R has the power to direct the activities that most significantly affect the partnership’s economic performance. In addition, R’s guarantee absorbs more than an insignificant amount of the partnership’s variability; therefore, R would consolidate the partnership. After the three-year guarantee period, since there is no possible scenario in which R will have to perform under the guarantee in the future, R would reassess whether its fee is a variable interest under ASC 810-10-55-37 and whether it continues to be the primary beneficiary.

Footnotes

In some cases, a legal entity may not have direct outside investors; rather, the investors invest through another legal entity that was formed in conjunction with the legal entity (e.g., a master-feeder structure). In these circumstances, the lack of outside investors would not be an indication that the fees paid (or lack thereof) to the legal entity’s decision maker are not commensurate and at market.

Standard representations and warranties include those asserting that the financial asset being transferred is what it is purported to be on the transfer date. Examples include representations and warranties about (1) the characteristics, nature, and quality of the underlying financial asset, including characteristics of the underlying borrower and the type and nature of the collateral securing the underlying financial asset; (2) the quality, accuracy, and delivery of documentation related to the transfer and the underlying financial asset; and (3) the accuracy of the transferor’s representations relative to the underlying financial asset.

This conclusion is also consistent with permitted recourse in the evaluation of whether the transfer of a portion of a financial asset meets the definition of a participating interest in ASC 860-10-40-6A(c)(4).

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.