Chapter 5 — Determining Whether a Legal Entity Is a VIE

5.3 Equity Investors, as a Group, Lack the Characteristics of a Controlling Financial Interest

A reporting entity determines whether it holds a controlling financial interest in a legal entity differently under the VIE model than it does under the voting interest entity model. The voting interest entity model focuses on the voting rights conveyed by equity interests. Since the holder of an interest other than equity may control the legal entity, the voting interest entity model may not yield an appropriate consolidation conclusion if the equity interests at risk collectively do not possess the characteristics that are typical of equity interests. Accordingly, a legal entity is considered a VIE if the at-risk holders as a group, through their equity investment at risk, lack any of the following three qualities, which are the “typical” characteristics of an equity investment:

The power to direct the most significant activities of the legal entity (see Section 5.3.1).
The obligation to absorb the expected losses of the legal entity (see Section 5.3.2).
The right to receive the expected residual returns of the legal entity (see Section 5.3.3).

The rights of the equity investor group must be a characteristic of the equity investment at risk itself and not a characteristic of other interests held by the current holders of the equity investment at risk. For example, an interest outside the equity investment at risk may permit its holder to direct the most significant activities of the legal entity. If that substantively separate interest is held by a party that is also an owner of equity investment at risk, it should not be combined with the equity investment at risk in this analysis because by design, the rights and obligations do not inure to the equity interest itself. See Section 5.3.1.1.2.

Each individual equity investment at risk need not possess all three characteristics, but the total equity investment at risk must possess them all. By implication, as long as the group of equity investors possesses these three characteristics through their equity investment at risk, the failure of any one at-risk equity investor to possess the characteristics would not make the legal entity a VIE.

The following are situations (not all-inclusive) in which a legal entity is a VIE because the at-risk equity investors as a group lack one or more of the three characteristics:

Holders of variable interests other than equity investment at risk (e.g., debt holders, providers of guarantees, counterparties on derivative transactions that represent variable interests, providers under service contracts that represent variable interests) have sufficient voting rights or contractual rights to prevent the holders of the equity “at risk” from having the power to direct the activities of the entity that most significantly affect the legal entity’s economic performance.
Holders of variable interests other than equity investment at risk protect the equity investment at risk from expected losses or cap the return on the equity investment at risk.
Holders of equity that is not considered at risk have the power to direct the activities of the legal entity (or a single party and its related parties hold substantive participating rights over those decisions).

Example 5-22

The financing of Entity 1 consists of $100 million in equity investment at risk (two investors each hold $50 million of the at-risk equity) and $200 million in convertible debt held by a single unrelated investor. The convertible debt carries 66 percent of the voting rights on all matters subject to shareholder vote (including those activities that most significantly affect the entity’s economic performance). Because the convertible debt is not considered equity at risk, and the convertible debt holder can exercise power through voting on the activities that most significantly affect the entity’s economic performance, the holders of equity investment at risk, as a group, fail to possess the power-to-direct characteristic in ASC 810-10-15-14(b)(1) through their equity investment at risk (see the next section). Therefore, Entity 1 is a VIE.

5.3.1 The Power to Direct the Most Significant Activities of the Legal Entity

ASC 810-10

15-14 A legal entity shall be subject to consolidation under the guidance in the Variable Interest Entities Subsections if, by design, any of the following conditions exist. (The phrase by design refers to legal entities that meet the conditions in this paragraph because of the way they are structured. For example, a legal entity under the control of its equity investors that originally was not a VIE does not become one because of operating losses. The design of the legal entity is important in the application of these provisions.) . . .

b. As a group the holders of the equity investment at risk lack any one of the following three characteristics:

The power, through voting rights or similar rights, to direct the activities of a legal entity that most significantly impact the entity’s economic performance.
1. For legal entities other than limited partnerships, investors lack that power through voting rights or similar rights if no owners hold voting rights or similar rights (such as those of a common shareholder in a corporation). Legal entities that are not controlled by the holder of a majority voting interest because of noncontrolling shareholder veto rights (participating rights) as discussed in paragraphs 810-10-25-2 through 25-14 are not VIEs if the holders of the equity investment at risk as a group have the power to control the entity and the equity investment meets the other requirements of the Variable Interest Entities Subsections.
  
  01. If no owners hold voting rights or similar rights (such as those of a common shareholder in a corporation) over the activities of a legal entity that most significantly impact the entity’s economic performance, kick-out rights or participating rights (according to their VIE definitions) held by the holders of the equity investment at risk shall not prevent interests other than the equity investment from having this characteristic unless a single equity holder (including its related parties and de facto agents) has the unilateral ability to exercise such rights. Alternatively, interests other than the equity investment at risk that provide the holders of those interests with kick-out rights or participating rights shall not prevent the equity holders from having this characteristic unless a single reporting entity (including its related parties and de facto agents) has the unilateral ability to exercise those rights. A decision maker also shall not prevent the equity holders from having this characteristic unless the fees paid to the decision maker represent a variable interest based on paragraphs 810-10-55-37 through 55-38.
2. For limited partnerships, partners lack that power if neither (01) nor (02) below exists. The guidance in this subparagraph does not apply to entities in industries (see paragraphs 910-810-45-1 and 932-810-45-1) in which it is appropriate for a general partner to use the pro rata method of consolidation for its investment in a limited partnership (see paragraph 810-10-45-14).
  01. A simple majority or lower threshold of limited partners (including a single limited partner) with equity at risk is able to exercise substantive kick-out rights (according to their voting interest entity definition) through voting interests over the general partner(s).
  A. For purposes of evaluating the threshold in (01) above, a general partner’s kick-out rights held through voting interests shall not be included. Kick-out rights through voting interests held by entities under common control with the general partner or other parties acting on behalf of the general partner also shall not be included.
  02. Limited partners with equity at risk are able to exercise substantive participating rights (according to their voting interest entity definition) over the general partner(s).
  03. For purposes of (01) and (02) above, evaluation of the substantiveness of participating rights and kick-out rights shall be based on the guidance included in paragraphs 810-10-25-2 through 25-14C. . . .

If interests other than the equity investment at risk provide the holders of that investment with these characteristics or if interests other than the equity investment at risk prevent the equity holders from having these characteristics, the entity is a VIE. . . .

A legal entity can be structured to give a number of different involved parties the ability to make decisions related to the legal entity (e.g., the equity holders, the holders of interests other than equity such as debt, or a decision maker). For legal entities other than limited partnerships, a legal entity would be considered a VIE (regardless of the sufficiency of the equity investment at risk) if an interest or party outside the equity investment at risk is making the decisions that most significantly affect the legal entity’s economic performance. A limited partnership or similar entity would be considered a VIE unless the limited partners hold substantive kick-out or participating rights.

The legal form of a legal entity (e.g., corporation, partnership, LLC) can affect its governance and, accordingly, which party has the ability to make decisions. Generally, a legal entity structured as a limited partnership is required by applicable partnership law to have a general partner responsible for governing the limited partnership and has, by its nature, a decision maker. By contrast, other legal entities, such as corporations, have equity holders that generally make decisions, even if those decisions are delegated to another party. Accordingly, the determination of whether the equity holders, as a group, have the power to direct the most significant activities of a legal entity is based on the entity’s legal form. Possession of the “power to direct” characteristic is assessed differently depending on whether the legal entity is a limited partnership (or similar entity) or any other type of legal entity. See Section 5.3.1.2.1 for a discussion of what is meant by a “similar entity.”

As noted above, if participating rights are held by an interest or party outside the equity investment at risk, a legal entity would be considered a VIE. The legal form of the legal entity, however, governs which definition of participating rights (i.e., the VIE definition or the voting interest entity definition) is used in the determination of whether the legal entity is a VIE or voting interest entity. If the legal entity is an entity other than a limited partnership, the VIE definition is used. As discussed in Section 5.3.1.1.3.5, the analysis for a legal entity other than a limited partnership focuses on whether participating rights are related to the most significant activities, while the analysis for a limited partnership (or similar entity) focuses on whether the rights are related to decisions made in the ordinary course of business (see Section 5.3.1.2.7 for further discussion).

Note that for limited partnerships and entities other than limited partnerships, different definitions of participating rights are not used in the identification of the primary beneficiary of a VIE; rather, the VIE definition of participating rights applies to both types of legal entities. Accordingly, the primary-beneficiary analysis focuses on whether the participating rights are related to the activities that most significantly affect the VIE’s economic performance (see Section 7.2.11.4 for further discussion).

5.3.1.1 The Power to Direct the Most Significant Activities of an Entity Other Than a Limited Partnership (or Similar Entity)

ASC 810-10

b. As a group the holders of the equity investment at risk lack any one of the following three characteristics:

The power, through voting rights or similar rights, to direct the activities of a legal entity that most significantly impact the entity’s economic performance.
1. For legal entities other than limited partnerships, investors lack that power through voting rights or similar rights if no owners hold voting rights or similar rights (such as those of a common shareholder in a corporation). Legal entities that are not controlled by the holder of a majority voting interest because of noncontrolling shareholder veto rights (participating rights) as discussed in paragraphs 810-10-25-2 through 25-14 are not VIEs if the holders of the equity investment at risk as a group have the power to control the entity and the equity investment meets the other requirements of the Variable Interest Entities Subsections.
  01. If no owners hold voting rights or similar rights (such as those of a common shareholder in a corporation) over the activities of a legal entity that most significantly impact the entity’s economic performance, kick-out rights or participating rights (according to their VIE definitions) held by the holders of the equity investment at risk shall not prevent interests other than the equity investment from having this characteristic unless a single equity holder (including its related parties and de facto agents) has the unilateral ability to exercise such rights. Alternatively, interests other than the equity investment at risk that provide the holders of those interests with kick-out rights or participating rights shall not prevent the equity holders from having this characteristic unless a single reporting entity (including its related parties and de facto agents) has the unilateral ability to exercise those rights. A decision maker also shall not prevent the equity holders from having this characteristic unless the fees paid to the decision maker represent a variable interest based on paragraphs 810-10-55-37 through 55-38. . . .

The evaluation of whether the at-risk equity holders, as a group, have power to direct the most significant activities of a legal entity other than a limited partnership (or similar entity) focuses on whether the voting rights or similar rights of the at-risk holders’ equity investment at risk allow them to direct the activities that most significantly affect the legal entity’s economic performance. In making this determination, the reporting entity would:

Identify the group of equity investors that has equity investment at risk (see Section 5.2). If an equity investor has inconsequential equity (e.g., less than 1 percent of the outstanding equity) but has been granted decision-making rights, that investor would generally not be considered part of the group of equity investors at risk.
Identify the most significant activities that affect the economic performance of the legal entity (see Section 5.3.1.1.1).
Evaluate whether, as a group, the equity investors at risk unilaterally have the power over all of the most significant activities through their equity interest itself (i.e., not through a substantively separate management contract or other interest in the entity; see Section 4.3 for a discussion of various variable interests) (see Section 5.3.1.1.2).
If there is an outsourced decision maker (whether through a substantively separate arrangement with an equity investor or an unrelated third party), determine whether (1) the decision maker’s rights represent a variable interest, (2) a single equity investor at risk (including its related parties) holds a substantive kick-out right to remove the decision maker, or (3) a single equity investor at risk (including its related parties) or a single party outside the group of at-risk equity investors has the right to participate in the most significant activities of the entity (see Section 5.3.1.1.3).

The legal entity is a VIE if the above analysis demonstrates that a variable interest holder that does not hold equity investment at risk (or obtains its rights through a substantively separate contract) directs the most significant activities of the legal entity or a single party outside the group of at-risk equity investors substantively participates in the most significant activities (see Section 5.3.1.1.3.5).

5.3.1.1.1 Identifying the Most Significant Activities (Including Predetermined Activities)

The assessment of whether the reporting entity has the power to direct the most significant activities is consistent with the assessment performed later in the consolidation analysis to identify whether the reporting entity satisfies the primary-beneficiary power condition over a VIE (see Section 7.2). The reporting entity must carefully consider the design and purpose of the legal entity. In addition, unlike the analysis generally performed under the voting interest entity model, under the VIE analysis the reporting entity cannot assume that the operating, capital, and financing decisions or the hiring and firing of management or setting of management’s compensation are the legal entity’s most significant activities.

The reporting entity must identify the level at which the entity’s most significant decisions are made. For example, certain decisions may be made by the board of directors, while others may be made by another party (e.g., a decision maker through a contract that is substantively separate from the equity interests). If decisions about the most significant activities are made by the board of directors (which would be the case for most operating entities), a decision maker would effectively be acting as a service provider on behalf of the board of directors. See Section 7.2.5 for a discussion of the determination of whether the most significant activities are performed at the board level or at the manager level.

The reporting entity should also understand the purpose and design of the legal entity, including the risks that the legal entity was designed to create and pass through to the variable interest holders. Once the risks of the legal entity that affect its economic performance are identified, the reporting entity should evaluate the activities that are expected to have the most significant impact on the economic performance of the legal entity and the types of decisions that can be made regarding those activities, including significant decisions made in directing and carrying out the legal entity’s current business activities. Generally, activities related to managing the risks the legal entity was designed to pass along to the variable interest holders are the key activities that affect the economic performance. As part of this analysis, it is important for the reporting entity to distinguish between the ability (1) to make significant decisions that are expected to be made in the ordinary course of carrying out the legal entity’s current business activities and (2) to make decisions in exceptional circumstances or to veto or prevent certain fundamental changes in the legal entity’s design or activities. The latter are generally considered protective rights.

In limited situations, the ongoing activities performed throughout the life of a legal entity (e.g., administrative activities in certain resecuritization entities, such as Re-REMICs3) do not significantly affect the legal entity’s economic performance, though they may be necessary for the legal entity’s continued existence (see Section 7.2.3.2 for information about which party, if any, should consolidate a VIE with no ongoing activities). In such cases, the equity investment at risk would not possess the power to direct the most significant activities of the entity unless the holders of the equity investment at risk have (1) the unilateral ability to change the governing documents or contractual arrangements without the approval of other parties, such as lenders, and (2) the right to change the governing documents or contractual arrangements is integral to the design of the entity. If the equity holders have this unilateral ability, the right to change the governing documents or contractual arrangements is integral to the design of the entity, and these activities are the most significant activities, the equity holders would possess the power.

Example 5-23

A trust has been established to issue beneficial interests (including equity investment at risk) to investors. These interests are backed by a pool of mortgage-backed securities (MBS) that were identified and purchased at the trust’s inception. The holders of the trust’s beneficial interests are entitled to the cash flows from the underlying MBS if and when those cash flows are received by the trust. ServicerCo, the servicer of the trust, performs activities that are solely administrative (e.g., it collects cash flows from the securities and passes the cash flows to the holders of the beneficial interests); it neither actively manages the portfolio of MBS nor performs any risk-mitigation activities (e.g., activities related to credit defaults on the MBS). The trust is prohibited from disposing of or acquiring any securities, regardless of future events; and the MBS themselves do not provide their holder (i.e., the trust) with any decision-making (i.e., voting or other) rights. Neither ServicerCo nor the holders of the trust’s beneficial interests have the ability to change the governing documents of the trust.

All of the significant decisions related to the trust have been specified in the trust’s creation documents, which cannot be unilaterally altered by either ServicerCo or the holders of the trust’s beneficial interests. The ongoing activities performed throughout the life of the trust do not significantly affect the entity’s economic performance, though they may be necessary for the trust’s continued existence. Therefore, the group of holders of the trust’s equity investment at risk does not possess the ability to make decisions, and the trust is a VIE.

5.3.1.1.2 Determining Whether Decision-Making Rights Are Substantively Separate From an Equity Investment at Risk

In certain circumstances, an equity holder may own equity investment at risk and another substantively separate interest that gives that party the power to direct the most significant activities of the legal entity. If the power to direct the most significant activities is provided to the holder by embedding it in any variable interest of a legal entity other than the equity investment at risk, the legal entity is a VIE. However, if the power is through a decision-making contract that is determined not to be a variable interest, the legal entity is not a VIE under ASC 810-10-15-14(b)(1)(i).

Example 5-24

Assume that a legal entity is formed by the issuance of equity investment at risk and debt, both with voting rights proportional to the amount invested. Investor 1 contributes $20 in return for equity with a 20 percent vote. Investor 2 contributes $80 — $20 for equity with a 20 percent vote, and $60 for debt with a 60 percent vote. Decisions are based on a simple majority of all voting rights.

Although the holders of equity investment at risk have, as a group, the power to direct, the equity investment at risk does not convey the power to direct the activities of the legal entity that most significantly affect the legal entity’s economic performance. That conclusion is reached because 60 percent of the voting rights are attached to Investor 2’s debt instrument. The voting ability attached to the debt is so significant that it prevents the equity from possessing the power to direct. Therefore, the legal entity would be a VIE.

Alternatively, if Investor 2 contributes $80 — $60 for equity with a 60 percent vote, and $20 for debt with a 20 percent vote, the legal entity would not be a VIE under this criterion because the equity investment at risk conveys to the equity holders as a group the power (i.e., an 80 percent majority vote) to direct the activities of the legal entity that most significantly affect the legal entity’s economic performance.

Example 5-25

Assume that a legal entity is formed by two investors: Investors A and B. Investor A has equity investment at risk, but B does not. All of the most significant activities of the legal entity require the consent of both investors.

Although the equity investors, as a group, control the legal entity, B is not in the group of equity investors at risk. Therefore, the legal entity is a VIE because A, the only equity investor at risk, does not possess the power to direct the most significant activities.

It may be difficult to determine where power resides when an equity investor at risk separately holds decision-making rights over a legal entity through an interest other than equity. Although the discussion below is in the context of a management agreement, the concepts apply to any interests other than equity investment at risk that possess decision-making rights. The reporting entity must determine whether the decision-making rights that are derived from the separate management arrangement are substantively separate from the decision maker’s equity investment at risk.

The determination of whether a management agreement is substantively separate from an equity investment at risk should take into account all relevant facts and circumstances, including the form and substance of the pertinent arrangements. If the decision maker must maintain an equity investment at risk to retain its decision-making rights under the management agreement, the management agreement and the equity investment at risk would generally not be considered substantively separate. If, however, the decision maker is not required to maintain an equity investment at risk to retain its decision-making rights under the management agreement, the management agreement and the equity investment at risk would generally be considered substantively separate.

The legal entity’s formation documents may be silent about whether the decision maker is required to maintain an equity investment at risk to retain its decision-making rights under the management agreement. If so, the management agreement should be presumed to be substantively separate from the equity investment at risk unless other facts and circumstances provide persuasive evidence to the contrary. Other facts and circumstances that may be relevant include consent rights. For example, there may be sufficient evidence that the management agreement and equity investment at risk are not substantively separate if (1) the other equity investors at risk must provide their consent before the decision maker is allowed to transfer (dispose of) its equity interests while retaining its decision-making rights under the management agreement and (2) such a consent requirement is substantive.4

The evaluation of whether a management agreement is substantively separate from an equity investment at risk focuses on whether the existing decision maker is required to hold an equity investment at risk in the legal entity to retain its decision-making rights under the management agreement. A reporting entity should consider the following factors:

Whether the reporting entity with decision-making rights under the management agreement must maintain an equity investment at risk in the legal entity — In some cases, the contractual agreements pertaining to the legal entity may permit the reporting entity with decision-making rights to transfer its management agreement to a third party (or an existing equity investor in the legal entity) and still maintain its equity investment in the legal entity. This does not necessarily mean that the group of holders of equity investment at risk lacks the power to direct the activities that most significantly affect the economic performance of the legal entity. For example, if the contractual agreements permit the decision maker to transfer its management agreement only to a third party (or existing equity investor in the legal entity) that has an equity investment at risk in the legal entity, the group of equity investors at risk would have the power to direct the activities that most significantly affect the economic performance of the legal entity.
Whether the management agreement is considered a freestanding contract or embedded in the equity investment at risk under other applicable U.S. GAAP — While the objective of the evaluation under ASC 810-10-15-14(b)(1) is not to determine whether the management agreement is a freestanding contract under other applicable U.S. GAAP, performing this assessment may be helpful in the analysis of the form and substance of the arrangement. For example, if the decision maker can transfer the management agreement only to an equity investor at risk while still maintaining its equity investment in the legal entity, the management agreement would typically be considered a freestanding contract under other applicable U.S. GAAP.
However, since it must be determined whether the decision maker has the ability to transfer the management agreement to a third party that does not own an equity investment at risk in the legal entity, a conclusion that the management agreement is a freestanding contract under other applicable U.S. GAAP does not necessarily mean that the power to direct the activities that most significantly affect the economic performance of the legal entity does not reside with the equity investors at risk as a group.
Whether the legal entity has multiple classes of equity investment at risk — A legal entity may have more than one class of equity investment at risk. Since ASC 810-10-15-14(b)(1) focuses on the group of holders of equity investment at risk, it must be determined whether the decision maker is required to maintain an equity investment at risk (as opposed to a specific class of equity investment at risk) to retain the management agreement. For example, if the decision maker must maintain an equity investment at risk to retain its decision-making rights under the management agreement, but the class of equity investment at risk is not specified (or could change), the management agreement and equity investment at risk are still not considered substantively separate.
Whether the legal entity’s formation documents address whether a replacement decision maker is required to maintain an equity investment at risk — The terms and agreements of the legal entity may specify that any decision maker under a management agreement must also own an equity investment at risk in the legal entity. In these situations, the management agreement and equity investment at risk are unlikely to be considered substantively separate; therefore, the group of holders of equity investment at risk would not lack the power to direct the activities that most significantly affect the economic performance of the legal entity. In other situations, the terms and agreements of the legal entity may not specifically address whether a replacement decision maker is required to own an equity investment at risk. In these situations, the evaluation should focus on whether the current decision maker is required to maintain an equity investment at risk in the legal entity. However, a transfer of the management agreement to a party that does not hold equity investment at risk would represent a reconsideration event under ASC 810-10-35-4. This treatment is consistent with that of a situation in which the equity investors at risk choose not to require a replacement decision maker to own an equity investment at risk even though the legal entity’s formation documents specifically require any decision maker to own such an equity investment. In both situations, the change represents a reconsideration event under ASC 810-10-35-4.

5.3.1.1.3 Determining Whether the Equity Holders Have Power Over a Legal Entity When a Decision Maker Is Engaged

Assessing whether the equity holders, as a group, have the power to direct the most significant activities of a legal entity other than a limited partnership (or similar entity) can be difficult when the power over a legal entity is acquired through a management agreement. The flowchart below illustrates how to assess whether the equity investors at risk have power over a legal entity when a decision maker is engaged.

5.3.1.1.3.1 Does the Decision Maker Have a Variable Interest in the Legal Entity?

If it is determined that a decision maker exists, an evaluation of whether the decision maker has a variable interest in the legal entity must be performed. If there is no decision maker, the equity holders must perform step 1 in the flowchart above (and consider the general principles in Section 5.3.1.1) to determine whether the equity investors at risk have the collective power to direct the most significant activities of the legal entity through their equity investment at risk.

However, the mere existence of a decision maker in a legal entity does not mean that the holders of equity investment at risk as a group do not have the power to direct that legal entity’s most significant activities through their equity investment at risk. The equity holders may engage a decision maker to perform certain services on their behalf but retain ultimate responsibility for and power over decision making. In other words, when the decision maker is a fiduciary of the investors, it is presumed that the equity holders, as a group, have the power to direct the most significant activities of the legal entity.

If a decision maker’s fee arrangement does not constitute a variable interest, the decision maker’s power to direct the activities is effectively attributed to the investors. That is, the decision maker does not prevent the equity investors at risk, through their equity investment at risk, from possessing the power over the entity because the decision maker is deemed to be acting as a fiduciary (i.e., making decisions on behalf of others). In many cases, it will be easier to conclude that the decision maker’s fee is not a variable interest (and therefore that the power rests with the holders of equity investment at risk) than to perform the two-step evaluation outlined in the flowchart above. Accordingly, a reporting entity may be able to conclude that the legal entity meets the criterion in ASC 810-10-15-14(b)(1) simply because the decision maker’s fee arrangement is not a variable interest. See Section 4.4 for a discussion of whether decision-maker fees represent a variable interest.

5.3.1.1.3.2 Determine Whether the Equity Holders Have Power Through Their Equity Investment at Risk (Step 1)

If a decision maker has a variable interest in a legal entity, the reporting entity must next identify the level at which the legal entity’s most significant decisions are made. For example, certain decisions may be made by the board of directors, while others may be made by a decision maker through a contract that is substantively separate from the equity interests. If decisions about the most significant activities are made by the board of directors (which would be the case for most operating entities), the decision maker would effectively be acting as a service provider on behalf of the board of directors. See Section 7.2.5 for additional discussion of the determination of whether the most significant activities are performed at the board level or at the manager level. Paragraph BC35 of ASU 2015-02 discusses such circumstances:

This may be the case, for example, when the equity holders’ voting rights provide them with the power to elect the entity’s board of directors and the board is actively involved in making decisions about the activities that most significantly impact the entity’s economic performance. The equity holders may have power through voting rights in their equity-at-risk interests over the activities of a legal entity that most significantly impact the entity’s economic performance even if the entity has a decision maker.

If a reporting entity concludes that the most significant activities of the legal entity are directed by the decision maker (and not by the board of directors), the equity holders would not have the power to direct the most significant activities unless the equity holders as a group have the ability to remove and set the compensation of the decision maker. The example in ASC 810-10-55-8A though 55-8H indicates that “the activities that most significantly impact the economic performance of Fund A, which include making decisions on how to invest the assets of that fund, are carried out by the asset management company.” In that example, the most significant activities of the legal entity are directed by the decision maker and not conducted at the board-of-director level. However, the FASB concludes in the example that the entity’s shareholders are able to effectively direct those activities through their voting rights “because shareholders have the ability to directly remove and replace the asset management company, approve the compensation of the asset management company, and vote on the investment strategy of Fund A.”

Conversely, if decisions about the most significant activities are made by the board of directors, the decision maker would effectively be acting as a service provider on behalf of the board of directors. In addition, the board of directors is typically merely an extension of the legal entity’s equity holders established to act solely in a fiduciary capacity for the equity holders. However, this may not always be the case. For example, the board of directors may have been elected by the debt investors or parties other than the equity investors. If the board of directors is not considered to be acting on behalf of the holders of equity investment at risk, such holders do not have the power to direct the most significant activities of a legal entity. Rather, the party that elected the board of directors may have such rights.

5.3.1.1.3.3 Application to a Series Trust

ASC 810-10-55-8A through 55-8F provide the following example of the step 1 assessment:

ASC 810-10

55-8A An asset management company creates a series fund structure in which there are multiple mutual funds (Fund A, Fund B, and Fund C) within one (umbrella) trust. Each mutual fund, referred to as a series fund, represents a separate structure and legal entity. The asset management company sells shares in each series fund to external shareholders. Each series fund is required to comply with the requirements included in the Investment Company Act of 1940 for registered mutual funds.

55-8B The purpose, objective, and strategy of each series fund are established at formation and agreed upon by the shareholders in accordance with the operating agreements. Returns of each series fund are allocated only to that respective fund’s shareholders. There is no cross-collateralization among the individual series funds. Each series fund has its own fund management team, employed by the asset management company, which has the ability to carry out the investment strategy approved by the fund shareholders and manage the investments of the series fund. The Board of Trustees is established at the (umbrella) trust level.

55-8C The asset management company is compensated on the basis of an established percentage of assets under management in the respective series funds for directing the activities of each fund within its stated objectives. The fees paid to the asset management company are both of the following:

Compensation for services provided and commensurate with the level of effort required to provide the services
Part of service arrangements that include only terms, conditions, or amounts that are customarily present in arrangements for similar services negotiated at arm’s length.

55-8D The asset management company has sold 65 percent of the shares in Fund A to external shareholders and holds the remaining 35 percent of shares in Fund A.

55-8E The shareholders in each series fund have the ability through voting rights to do the following:

Remove and replace the Board of Trustees
Remove and replace the asset management company
Vote on the compensation of the asset management company
Vote on changes to the fundamental investment strategy of the fund
Approve the sale of substantially all of the assets of the fund
Approve a merger and/or reorganization of the fund
Approve the liquidation or dissolution of the fund
Approve charter and bylaw amendments
Increase the authorized number of shares.

55-8F For this series fund structure, the voting rights in paragraph 810-10-55-8E(a) are exercised at the (umbrella) trust level. That is, a simple majority vote of shareholders of all of the series funds (Fund A, Fund B, and Fund C) is required to exercise the voting right to remove and replace the Board of Trustees of the (umbrella) trust. However, the voting rights in paragraph 810-10-55-8E(b) through (i) are series fund-level rights. That is, only a simple majority vote of Series Fund A’s shareholders is required to exercise the voting rights in paragraph 810-10-55-8E(b) through (i) for Series Fund A.

In the example in ASC 810-10-55-8A through 55-8F, it is concluded that the equity investors (rather than the investment manager through its decision-making contract) have power through their voting rights because of their ability to constrain the decision maker’s authority. Accordingly, as long as the other conditions in ASC 810-10-15-14 are met, the entity would not be a VIE.

Further, the example indicates that the rights afforded to the equity investors of a series fund structure that operates in accordance with the 1940 Act would typically give the shareholders the ability to direct the activities that most significantly affect the fund’s economic performance through their equity interests. While these rights are often given to the investors of a fund structure that is regulated under the 1940 Act, they are less likely to be present in fund structures established in foreign jurisdictions (particularly those established in a structure similar to a series structure) or in domestic funds that do not operate in accordance with the requirements of the 1940 Act. See Section 3.2.1 for an additional discussion of series funds.

Although the example illustrates the evaluation for a legal entity that is regulated under the 1940 Act, it does not apply exclusively to such entities. The FASB clarifies in paragraph BC36 of ASU 2015-02 that “the Board does not intend for the two-step analysis described above to apply only to series mutual funds.”

Reporting entities will need to exercise considerable judgment in determining whether the equity investors at risk have power through their voting rights. Understanding the rights and responsibilities of each involved party, and the design of the legal entity itself, is critical in such a situation.

5.3.1.1.3.4 Determine Whether a Single Equity Owner Has a Substantive Kick-Out Right (Step 2)

If a reporting entity determines that the decision-making rights represent a variable interest and that the decision maker (rather than the equity investors) has power over the significant decisions (step 1), the reporting entity would then assess whether a single equity holder through its equity investment at risk (including its related parties and de facto agents — see Section 8.2) has the unilateral ability to remove the decision maker. ASC 810-10-20 provides the following VIE definition of kick-out rights:

The ability to remove the entity with the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance or to dissolve (liquidate) the VIE without cause.

If a single at-risk equity investor has the ability, through its equity investment at risk, to unilaterally remove the decision maker (or dissolve/liquidate the legal entity), then that single equity owner has the power to direct the activities and, accordingly, the equity group at risk would have the unilateral ability to direct the most significant activities. Said differently, in such a case, the decision maker is making decisions on behalf of the at-risk equity investors only temporarily at the discretion of the single at-risk equity investor with the kick-out rights. If such rights do not exist, the reporting entity would consider the effect of substantive participating rights held by a single equity investor (see Section 5.3.1.1.3.5).

In paragraph BC49 of ASU 2015-02, the FASB noted that liquidation rights “should be considered equivalent to kick-out rights [because they] provide the holders of such rights with the ability to dissolve the entity and, thus, effectively remove the decision maker’s authority.” See Section 5.3.1.2.5 for a discussion of when liquidation and withdrawal rights would be considered equivalent to kick-out rights.

5.3.1.1.3.5 Impact of a Single Equity Owner With Substantive Participating Rights (Step 2)

Since the FASB discusses participating rights in the same context as kick-out rights, the implication is that the two, though defined differently, should be treated similarly in the VIE analysis. We do not believe that the existence of a substantive participating right held by a single equity investor at risk should result in a conclusion that the legal entity is not a VIE. ASC 810-10-20 provides the following VIE definition of participating rights:

The ability to block or participate in the actions through which an entity exercises the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance. Participating rights do not require the holders of such rights to have the ability to initiate actions.

Further, ASC 810-10-15-14(b)(1)(i)(01) states, in part:

If no owners hold voting rights or similar rights (such as those of a common shareholder in a corporation) over the activities of a legal entity that most significantly impact the entity’s economic performance, kick-out rights or participating rights (according to their VIE definitions) held by the holders of the equity investment at risk shall not prevent interests other than the equity investment from having this characteristic unless a single equity holder (including its related parties and de facto agents) has the unilateral ability to exercise such rights. [Emphasis added]

The phrase emphasized above specifies that if substantive kick-out or participating rights are held by a single owner of equity investment, then the equity holder would not be prevented from having the power to direct the activities that most significantly affect the VIE’s economic performance. However, it does not indicate that the equity holder with such rights has that power. While an equity holder with a kick-out right may have the power to direct the most significant activities, a conclusion is less likely to be reached that an equity holder with participating rights has the power to direct the most significant activities. That is, if a single holder of equity investment at risk can substantively participate in decisions about a legal entity that are being made by the decision maker, that decision maker does not have the power to direct the most significant activities of the legal entity (i.e., the ability of the one equity investor to participate keeps the decision maker from having the unilateral ability to act but does not give the equity investor the unilateral ability). Thus, since the guidance above indicates that the decision maker does not have power but not that the equity investors, as a group, do have power, the next sentence in ASC 810-10-15-14(b)(1)(i)(01) would need to be considered, which states, in part:

Alternatively, interests other than the equity investment at risk that provide the holders of those interests with kick-out rights or participating rights shall not prevent the equity holders from having this characteristic unless a single reporting entity (including its related parties and de facto agents) has the unilateral ability to exercise those rights.

Accordingly, if a nonequity holder has the ability to direct the activities that most significantly affect the legal entity’s economic performance, and an equity holder has the ability to block the nonequity holder’s actions through a substantive participating right, the legal entity would still be a VIE because the equity holder would not have power over the entity. The VIE conclusion should be the same regardless of whether the equity investor at risk is initiating decisions (but could be blocked by a nonequity investor at risk) or another party is directing the most important economic activities (but could be blocked by the holder of equity investment at risk). In both instances, the legal entity would be a VIE. That is, a legal entity would be a VIE if power is distributed between (1) equity investment at risk and (2) equity investment not at risk or nonequity holders; for a legal entity to be a voting interest entity, only the holders of equity investment at risk may have power.

We therefore believe that it would be unusual for a substantive participating right held by a single at-risk equity investor alone to result in a conclusion that the equity investors as a group have the power to direct the most significant activities of a legal entity.

5.3.1.1.3.6 Franchise Agreements

A franchise agreement typically gives the franchisee equity investor(s) the right to use the franchisor’s brand name along with its associated operating policies and procedures for a period in exchange for a franchise fee. Generally, the franchisor has certain rights under the agreement to ensure that the integrity and quality of the brand is maintained. A reporting entity should therefore carefully analyze the rights granted to the franchisor to determine whether the franchisee is a VIE under ASC 810-10-15-14(b)(1). That is, the reporting entity must determine whether the rights held by the franchisor prevent the group of franchisee equity investors from having the power to direct the activities that most significantly affect the economic performance of the franchisee.

For example, a franchise agreement may specify that the franchisor has rights to participate in certain decisions related to:

The location and appearance of the franchisee.
Products sold by the franchisee.
Suppliers used by the franchisee.
Marketing by the franchisee.
Training of employees of the franchisee.
Days and hours of operation of the franchisee.
Sale of the franchisee.

Decisions related to the above items may be important to the franchisee’s economic performance; however, a franchisor’s right to participate in the decisions does not automatically cause the franchisee to be a VIE under ASC 810-10-15-14(b)(1). A reporting entity should assess whether the rights are protective in nature (i.e., intended to preserve the integrity and quality of the brand name) or prevent the franchisee equity investors at risk from holding the power to direct the activities that most significantly affect the economic performance of the franchisee.

Many of a franchisee’s activities are predetermined under the franchise agreement, which typically specifies that the franchisee equity investors have voluntarily agreed to operate the franchisee according to specified policies and procedures. Therefore, in assessing whether the franchisee equity investors at risk hold the power to direct the activities that most significantly affect the franchisee’s economic performance, the reporting entity must focus on whether the franchisee equity investors at risk control the activities that are not specified in the franchise agreement. Such activities include, but are not limited to, establishing and implementing capital and operating budgets; hiring, firing, and setting the compensation of franchisee employees; and establishing pricing for franchisee products and services.

If a franchisor is taking on additional risk by providing financial support to the franchisee, the franchisor may need to be more involved in the decisions regarding the most significant activities of the franchisee. Accordingly, if a franchisor gives the franchisee financial support (e.g., through an equity investment or a loan), or the franchisee equity investors’ exposure to the economic performance of the franchisee is somehow limited, the reporting entity must carefully evaluate the franchisor’s decision-making rights to determine whether they are protective or give the franchisor control over the most significant activities of the franchisee. In such instances, the reporting entity must consider all relevant facts and circumstances to determine whether the franchisee is a VIE under ASC 810-10-15-14(b)(1). In addition, if a loan or a contract limits the equity investor’s exposure to the economic performance of the franchisee, the franchisee may be a VIE under ASC 810-10-15-14(a), ASC 810-10-15-14 (b)(2), or ASC 810-10-15-14(b)(3).

5.3.1.1.3.7 Contractual Arrangements That Are Designed to Transfer the Risks and Rewards of Ownership

There may be restrictions on a reporting entity’s legal ownership of a legal entity’s equity. In such a case, the reporting entity may enter into contractual arrangements that transfer all the legal entity’s risks and rewards from its equity owners to the reporting entity. The legal entity in these arrangements is a VIE because the owners of equity have effectively surrendered to the reporting entity both control and the right to participate in the legal entity’s economics.

Example 5-26

Entity A wishes to acquire Entity B, a corporation located in a foreign jurisdiction where the local regulations preclude foreign ownership of corporations in B’s industry. To effect the acquisition, A enters into a contractual arrangement with Shareholder C (the sole shareholder of B and unrelated to A), under which A acquires C’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. In addition, under the management services agreement, B must pay A 100 percent of its after-tax income in the form of a management fee. 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 can only be terminated by A. Alternatively, the management services agreement may give A the ability to unilaterally determine the amount of the fee payable in any given year. Because C, the sole equity investor of B, has surrendered control and cannot exercise power to direct the most significant activities of B, B is a VIE under ASC 810-10-15-14(b)(1)(i).

See Section D.3.4 for a discussion of the contract-controlled entity model under the voting interest entity model for legal entities that are not VIEs.

5.3.1.2 The Power to Direct the Most Significant Activities of a Limited Partnership (or Similar Entity)

ASC 810-10

b. As a group the holders of the equity investment at risk lack any one of the following three characteristics:

The power, through voting rights or similar rights, to direct the activities of a legal entity that most significantly impact the entity’s economic performance. . . .
ii. For limited partnerships, partners lack that power if neither (01) nor (02) below exists. The guidance in this subparagraph does not apply to entities in industries (see paragraphs 910-810-45-1 and 932-810-45-1) in which it is appropriate for a general partner to use the pro rata method of consolidation for its investment in a limited partnership (see paragraph 810-10-45-14).

01. A simple majority or lower threshold of limited partners (including a single limited partner) with equity at risk is able to exercise substantive kick-out rights (according to their voting interest entity definition) through voting interests over the general partner(s).

A. For purposes of evaluating the threshold in (01) above, a general partner’s kick-out rights held through voting interests shall not be included. Kick-out rights through voting interests held by entities under common control with the general partner or other parties acting on behalf of the general partner also shall not be included.

02. Limited partners with equity at risk are able to exercise substantive participating rights (according to their voting interest entity definition) over the general partner(s).

03. For purposes of (01) and (02) above, evaluation of the substantiveness of participating rights and kick-out rights shall be based on the guidance included in paragraphs 810-10-25-2 through 25-14C. . . .

A limited partnership would be considered a VIE regardless of whether it otherwise qualifies as a voting interest entity unless either of the following apply:

A simple majority or lower threshold (including a single limited partner) of the “unrelated” limited partners (i.e., parties other than the general partner, entities under common control with the general partner, and other parties acting on behalf of the general partner) with equity at risk have substantive kick-out rights (including liquidation rights — see Section 5.3.1.2.2).
The limited partners with equity at risk have substantive participating rights (see Section 5.3.1.2.7).

Accordingly, a limited partnership is considered a VIE unless limited partners hold substantive kick-out or participating rights. In addition to considering whether the limited partners have equity at risk, it is also necessary to consider whether the limited partner rights are possessed through the limited partner interest that is at risk rather than through a substantively separate contract (see Section 5.3.1.1.2 for a discussion of the determination of whether a separate contract should be considered part of the equity interest at risk).

While the FASB’s intent in creating an alternate approach for evaluating limited partnerships was based on their differing governance structures, the result is that if a general partner does not possess an interest in the limited partnership that is potentially significant, the general partner should not consolidate the limited partnership. Specifically, this requirement ensures that the general partner would only consolidate the limited partnership if it met the economics criterion of a controlling financial interest under the VIE model (see Section 7.3).

5.3.1.2.1 A Legal Entity That Is “Similar to a Limited Partnership”

The requirement to evaluate limited partnerships under the specific guidance on limited partnerships also applies to other legal entities that have governance structures similar to limited partnerships. Determining whether a legal entity is similar to a limited partnership is consequently an important step in the assessment of whether a legal entity is a VIE. ASC 810-10-05-3 states, in part:

Throughout this Subtopic, any reference to a limited partnership includes limited partnerships and similar legal entities. A similar legal entity is an entity (such as a limited liability company) that has governing provisions that are the functional equivalent of a limited partnership.

Accordingly, certain limited liability companies in which the managing member is the functional equivalent of a general partner, and in which the nonmanaging member or members are the functional equivalent of a limited partner, would be considered equivalent to limited partnerships and evaluated under the limited-partnership requirements. A conclusion cannot be reached that a legal entity is similar to a limited partnership merely on the basis of the existence of separate capital accounts. Any analysis of similarity should include the application of judgment and focus on the function of the legal entity, including the governance and the substance of the legal entity’s board of directors.

The specific guidance on limited partnerships does not apply to either general partnerships or limited liability companies that have multiple managing members since the governing provisions of such structures are not equivalent to those of limited partnerships.

Connecting the Dots

This scope guidance is one-directional (i.e., a legal entity that is not in the form of a limited partnership can be considered “similar to a limited partnership” for consolidation analysis purposes). However, we believe that in some circumstances, the governance of a legal-form limited partnership could be more similar to that of a corporation. For example, some limited partnerships may have irrevocably changed their governance structure to that of a board elected by the limited partners. We believe that in such instances, it is more appropriate for the variable interest holders to analyze the legal entity under the corporation consolidation guidance.

Example 5-27

Investor A (managing member) and Investor B (nonmanaging member) each own 50 percent of LLC, a limited liability company. As the managing member, A makes all the decisions related to activities that most significantly affect the economic performance of LLC. On the basis of LLC’s governing provisions, A is the functional equivalent of a general partner, and B is the functional equivalent of a limited partner. Therefore, LLC is considered equivalent to a limited partnership and should be evaluated under the limited-partnership VIE requirements.

Example 5-28

Assume the same facts as in the example above, except that LLC has a board of directors that is composed of four individuals (two are selected by Investor A, and two are selected by Investor B). The decisions related to the activities that most significantly affect the economic performance of LLC are made through a simple majority vote of the board of directors. As the managing member, A acts at the direction of the board, and its responsibilities are administrative. On the basis of LLC’s governing provisions, the decision-making ability held by the board of directors is substantive. Therefore, A is not the functional equivalent of a general partner, and LLC is not considered equivalent to a limited partnership. Consequently, LLC should not be evaluated under the limited-partnership VIE requirements.

Example 5-29

Investor A has a 40 percent equity interest in LLC and is the managing member. Investor B, Investor C, and Investor D each have a 20 percent equity interest in LLC and are nonmanaging members. As the managing member, A has the authority to act on behalf of LLC or bind LLC in any manner whatsoever, including, without limitation, entering into any agreement on behalf of LLC. Investor A is given this right through a separate management agreement because A is the only investor that has expertise in the industry that LLC operates.

In exchange for its services, A receives a fixed management fee and a performance fee. LLC also has a board of directors that is composed of four representatives (one each selected by Investor A, Investor B, Investor C, and Investor D). The decisions of the Board require unanimous consent; however, they are related to decisions made outside the ordinary course of business. As the managing member, A cannot transfer or sell its interest in the LLC without the consent of the nonmanaging members, but the nonmanaging members are not similarly constrained.

On the basis of the facts and circumstances, A is the functional equivalent of a general partner, and LLC is considered equivalent to a limited partnership. The decision-making rights held by the board of directors are deemed to be not substantive and to represent protective rights. In addition, A’s fee structure and its limitations on transferring its interest are also similar to those of a general partner given its expertise in LLC’s industry. Therefore, LLC should be evaluated under the limited-partnership VIE requirements.

5.3.1.2.2 Evaluating Kick-Out Rights

The evaluation of whether the limited partners with equity at risk can kick out the general partner focuses on whether a simple majority (or lower threshold) of the limited partner interests (excluding those held by the general partner, entities under common control with the general partner, and entities acting on behalf of the general partner) can remove the general partner. Accordingly, the kick-out rights would not be considered in the analysis unless (1) a simple majority (or lower threshold, including a single limited partner) of the limited partners can exercise the kick-out rights (or liquidation rights that are equivalent to kick-out rights, as discussed in Section 5.3.1.2.5); (2) the rights can be exercised by limited partner interests excluding those held by the general partner, entities under common control with the general partner, and entities acting on behalf of the general partner (see Section 5.3.1.2.3); and (3) the rights are substantive (see Section 5.3.1.2.4).

Example 5-30

A limited partnership is formed to acquire a real estate property. The partnership has a general partner that holds a 20 percent limited partner interest in the partnership, and eight unrelated limited partners equally hold the remaining equity interests. Profit and losses of the partnership (after payment of general partner fees, which represent a variable interest in the entity) are distributed in accordance with the partners’ ownership interests. There are no other arrangements between the partnership and the general partners/limited partners.

The general partner is the property manager and has full discretion to buy and sell properties, manage the properties, and obtain financing. In addition, the general partner can be removed without cause by a simple majority of all of the limited partners (including the limited partner interests held by the general partner). The removal rights are held by all the partners in proportion to their partnership interests.

In this example, the limited partner interests held by the general partner are permitted to vote on the removal of the general partner. The general partner, through its limited partner interests, will therefore vote 20 percent of the overall interests voting on the removal. The unrelated limited partner interests only hold 80 percent of the interests voting on removal. Since the unrelated limited partners are unable to remove the general partner unless more than a simple majority of the limited partner interests vote on the removal (i.e., the general partner’s presumed no vote on removal will require 75 percent of the unrelated limited partner interests — six of the eight unrelated limited partners — to remove the general partner), the kick-out rights would not be substantive, and the limited partnership would be considered a VIE.

Note that some partnership agreements are structured so that the general partners and their “related” parties are unable to exercise the rights associated with any limited partner interests they hold. In these situations, a simple majority of the “unrelated” limited partners with equity at risk may have the ability to exercise substantive kick-out rights over the general partner, regardless of whether the general partner holds any other interests.

In the determination of whether there are simple majority kick-out rights, certain factors will be known. For example, the contractual terms will provide the mechanism for removing the general partner, and the total number of limited partner interests will be apparent. However, variables such as who the qualifying limited partners are, what makes a kick-out right substantive, and what a substantive participating right is, will need to be determined.

EITF 04-5 introduced the concept of analyzing whether a simple majority of limited partners can remove the general partner. The purpose of the analysis was to identify the smallest possible combination of limited partnership interests that is at least a simple majority. If, on the basis of the governance provisions of the limited partnership and ownership interests held by the limited partners, the number of eligible partner interests required to remove the general partner is less than this amount, then the simple-majority requirement is met. ASC 810-10-55-4N contains examples (originally from EITF 04-5) of the application of this requirement. The examples below, which are adapted from ASC 810-10-55-4N, are intended to demonstrate its application in certain more complex structures. Note that the examples focus on the amount of limited partnership interests needed to remove the general partner, not a simple count of the number of limited partners (i.e., it would be expected that a limited partner with more ownership interests would get a weighted vote — see Examples 5-35 and 5-36, in which the limited partners have unequal partnership interests).

Example 5-31

A limited partnership agreement includes a requirement that a simple majority of the limited partner voting interests is needed to remove the general partner. Assume that the limited partnership has three limited partners, none of which have any relationship to the general partner, and that each holds an equal amount of the limited partner voting interests (33.33 percent). Under the simple-majority requirement in the partnership agreement, a vote of no more than two of the three limited partners would be needed to remove the general partners. Accordingly, a provision that entitles any individual limited partner to remove the general partner, or a provision under which a vote of two of the limited partners is needed to remove the general partner, would meet the substantive kick-out right requirements. However, if a vote of all three limited partners is needed to remove the general partner, the right would not meet the requirements for a substantive kick-out right because the necessary vote is greater than a simple majority of the limited partner voting interests.

Example 5-32

Assume the same facts as in the example above, except that there are two limited partners that each hold an equal interest. In this case, a vote of both limited partners would be required for a simple majority of the limited partner voting interests, so a provision entitling any individual limited partner to remove the general partner, or a provision under which a vote of both limited partners is needed to remove the general partner, would meet the requirements for a substantive kick-out right.

Example 5-33

Assume the same facts as in Example 5-31, except that there are 100 limited partners, and each holds an equal interest. In this case, a vote of 51 limited partners would be required for a simple majority of the limited partner voting interests, so a provision under which a vote of less than 52 limited partners is needed to remove the general partner would meet the requirements for a substantive kick-out right. However, if a vote of 52 or more limited partners is needed to remove the general partner, that provision would not meet the requirements for a substantive kick-out right because the necessary vote is greater than a simple majority of the limited partner voting interests.

Example 5-34

A limited partnership agreement includes a requirement that a vote of 66.6 percent of the limited partner voting interests is needed to remove the general partner. There are three independent limited partners that each hold an equal percentage (33.33 percent) of the limited partner voting interest. A vote of two of the three limited partners represents 66.7 percent of the limited partner voting interests, which also represents the smallest possible combination of voting interests that is at least a simple majority of the limited partner voting interests. As long as there are no barriers to the exercise of the kick-out rights, those rights in this scenario meet the simple majority requirement and therefore represent substantive kick-out rights that overcome the presumption of control by the general partner. That is, although there is a 66.6 percent requirement in the governance of the limited partnership agreement, because there are only three limited partners with equity interest, the substance of the arrangement is a simple majority (i.e., there is no substantive difference between a stated 50.1 percent or 66.6 percent requirement, because in both instances, two of the three limited partners are needed).

Example 5-35

A limited partnership agreement includes a requirement that a vote of 66.6 percent of the limited partner voting interests is needed to remove the general partners. There are three independent limited partners that hold 45 percent (LP1), 25 percent (LP2), and 30 percent (LP3) of the limited partner voting interests, respectively. To determine whether kick-out rights are substantive in such a scenario, the reporting entity should identify the smallest possible combination of limited partner interests that constitutes a simple majority. To remove the general partners, a vote of LP1 in combination with either LP2 or LP3 would be a simple majority of the limited partners and would satisfy the 66.6 percent contractual requirement. By contrast, a vote to exercise the kick-out rights by LP2 and LP3 also would represent a simple majority vote of the limited partners. However, their voting interests (55 percent) would not meet the required threshold of 66.6 percent for removal of the general partners. Accordingly, these kick-out rights would be assessed as nonsubstantive because LP2 and LP3, which represent at least a simple majority of the limited partner voting interests, cannot remove the general partners.

The above conclusion applies even though a vote of LP1 in combination with either LP2 or LP3 would be a simple majority of the limited partners and would satisfy the 66.6 percent contractual requirement. This is because the analysis is premised on whether the smallest possible combination of limited partner interests that constitutes a simple majority that would be able to remove the general partners, not on whether any possible combination of limited partner interests that is a simple majority would be able to remove the general partners.

Example 5-36

A provision in a limited partnership agreement states that the general partner may be removed if the following two conditions are met: (1) four out of the six limited partners vote to remove the general partner and (2) the limited partnership interest of the four limited partners that vote for removal must exceed 50 percent of the limited partnership’s voting interest. The six independent limited partners hold 22 percent (LP1), 22 percent (LP2), 22 percent (LP3), 13 percent (LP4), 10.5 percent (LP5), and 10.5 percent (LP6) of the limited partnership interest, respectively. To determine whether kick-out rights are substantive in such a scenario, the reporting entity should identify the smallest possible combination of limited partner voting interests that constitute a simple majority. In this example, LP1, LP2, and LP3 are the smallest combination of limited partners whose combined limited partnership voting interest is in excess of a simple majority of the limited partnership voting interest. Because the limited partnership agreement requires at least four limited partners to remove the general partner, LP1, LP2, and LP3 would not be able to remove the general partner if they acted in concert and their kick-out rights would be viewed as nonsubstantive.

The above conclusion applies even though a simple majority of any combination of the number of limited partners results in the ability to remove the general partner. LP3, LP4, LP5, and LP6 have, on a combined basis, the lowest voting ownership interest represented by at least a majority of the number of limited partners. If those limited partners voted together, the general partner would be removed. However, that combination of a simple majority of the number of limited partners is not the smallest combination of limited partners whose limited partnership voting interest is in excess of a simple majority of the limited partnership voting interest.

5.3.1.2.3 Whether Limited Partners Are “Acting on Behalf of the General Partner”

In the evaluation of whether a simple majority of the limited partners can remove the general partner, interests held by the general partner, entities under common control with the general partner, and parties acting on behalf of the general partner should not be considered in the identification of the number of limited partner interests needed to remove the general partner. If the general partner owns limited partnership interests, it is not reasonable to expect the general partner to tender a vote to remove itself. Accordingly, if in theory the general partner owns 45 percent of the limited partnership units, and a 51 percent vote is required to remove the general partner, it can be assumed that the 45 percent of limited partner interests owned by the general partner will vote no. Therefore, the relevant percentage required to remove the general partner is much higher than 51 percent: all but 4 percent of the total limited partner units must vote yes.

Thus, interests should be identified that are attributable to the general partner, or that, because of relationships, would otherwise vote along with the general partner. Identifying interests owned by the general partner is relatively straightforward. In addition, paragraph BC69 of ASU 2015-02 notes, in part, that:

Current GAAP uses the term common control in multiple contexts, and the term is not defined in the Master Glossary. Therefore, for purposes of evaluating the criteria in paragraphs 810-10-25-42, 810-10-25-44A, and 810-10-55-37D, the Board’s intent was for the term to include subsidiaries controlled (directly or indirectly) by a common parent, or a subsidiary and its parent.

This explanation does not specifically refer to the assessment of whether a limited partnership is a VIE. Nonetheless, it is reasonable to conclude that the application of the common control definition should be consistent throughout the consolidation analysis.

However, considerable judgment is required in the determination of whether a limited partner is acting on behalf of the general partner. Although now superseded, ASC 810-20-25-8(a) indicated that all “relevant facts and circumstances shall be considered in assessing whether other parties, including, but not limited to, those defined as related parties in Topic 850, may be acting on behalf of the general partners in exercising their voting rights as limited partners.”

The following are examples of relevant facts and circumstances to be considered in the evaluation of whether a limited partner is acting on behalf of the general partner:

The design of the partnership, including:
- The risks that the partnership was designed to pass on to its variable interest holders.
- The reason the limited partner holds its interest in the partnership.
The nature of the relationship(s) between the general partner and the limited partner, including:
- The degree of influence the general partner has over the limited partner.
- Any investment the limited partner has in the general partner. For example, if the limited partner has a material investment in a general partner, and removal of the general partner would adversely affect its investment, the limited partner might be acting on behalf of the general partner.
- Any dependencies the limited partner has on the general partner.
- Other operating or financial arrangements between the parties.
The existence of any call options between the general partner and limited partner, including:
- The terms of the option, the exercise price, and exercise period. For example, if the limited partner’s interest can be purchased at fair value or less, the limited partner may be acting on behalf of the general partner.
- The existence of any barriers to exercising the option. For example, the general partner controls technology that is critical to the limited partnership, or the general partner is the principal source of funding for the limited partnership.
Whether the limited partner’s exercise of its right to vote to remove the general partner would trigger significant financial penalties or other operating barriers.
Any incentives or disincentives that may affect the likelihood that the limited partner would act in accordance with the general partner.
Any regulatory, contractual, or other requirements that may affect the limited partner’s ability to vote to remove the general partner. For example, a related-party limited partner’s charter or organizational documents may require an independent person (or committee of independent persons) to exercise any right to vote to retain or remove the general partner.

5.3.1.2.4 “Substantive” Kick-Out Rights

For a kick-out right to be substantive, the right must be exercisable “without cause” (as opposed to a right that is triggered upon a contingent event, such as default by the general partner). Although a limited partnership’s organizational documents may give the limited partners the ability to remove the general partner, that stated right may not always have substance. ASC 810-10-25-14A defines substantive kick-out rights that are specific to limited partnerships as follows:

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

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

Although this guidance is specific to limited partnerships, reporting entities may analogize to it when evaluating kick-out rights related to entities other than limited partnerships.

Note that when a reporting entity holds a call option, it should evaluate its forward starting rights and potential kickout rights. See Section 7.2.10.1 for a detailed discussion of forward starting rights in a primary-beneficiary assessment.

5.3.1.2.5 Evaluation of Liquidation and Withdrawal Rights as Kick-Out Rights

ASC 810-10-20 provides the following voting interest entity definition of kick-out rights:

The rights underlying the limited partner’s or partners’ ability to dissolve (liquidate) the limited partnership or otherwise remove the general partners without cause.

As discussed in Section 7.2.11.3, paragraph BC49 of ASU 2015-02 notes the FASB’s view that liquidation rights “should be considered equivalent to kick-out rights [because they] provide the holders of such rights with the ability to dissolve the entity and, thus, effectively remove the decision maker’s authority.” Accordingly, any liquidation right should be considered a kick-out right as long as the right (1) is substantive6 and (2) gives a simple majority (or lower threshold)7 of limited partners with equity investment at risk the ability to liquidate a limited partnership without cause. As described in Sections 7.2.11 and D.1.6, if the substantive kick-out right is held by a single limited partner, it may result in that limited partner’s consolidation of the limited partnership (under both the VIE and voting interest entity models).

Liquidation rights must be distinguished from withdrawal rights since ASC 810-10-25-14B indicates that a limited partner’s unilateral right to withdraw from an entity that does not require dissolution or liquidation of the entire entity “would not be deemed a kick-out right.” Therefore, a reporting entity should carefully analyze withdrawal rights to determine whether, on the basis of the specific facts and circumstances, they represent liquidation rights. In a manner similar to liquidation rights, when the exercise of a withdrawal right does require the dissolution or liquidation of the entire limited partnership, the right should be considered a kick-out right only if it (1) is substantive, (2) gives a simple majority (or lower threshold) of limited partners the ability to withdraw without cause, and (3) results in the liquidation of the limited partnership.8

Note also that special consideration is necessary when a liquidation right (or a withdrawal right that represents a liquidation right) is exercisable in the future as opposed to currently exercisable. Generally, the right would be ignored until exercisable unless there are no significant decisions to be made before the right becomes exercisable. See Section 7.2.10.1 for a more detailed discussion of future potential voting rights.

5.3.1.2.6 Evaluation of Buy-Sell Clauses as a Liquidation Right

A buy-sell term in a contractual agreement can take various forms. However, in an arrangement in which two investors each own 50 percent of an entity, a buy-sell clause generally gives the investors the ability to offer to buy out the entire equity interest of another investor (the “offeree”) upon giving notice to the offeree. The investor making the offer (the “offeror”) typically names a price for the offeree’s interest at its discretion. After receiving the offer from the offeror, the offeree typically is contractually required to either (1) sell its entire interest in the entity to the offeror at the named price or (2) buy the offeror’s interest at the named price. Buy-sell agreements are not typically considered liquidation rights. See Section 7.2.10.1 for a discussion of forward starting rights in a primary-beneficiary assessment.

Example 5-37

Investor A (the managing member) and Investor B (the nonmanaging member) each own 50 percent of LLC, a limited liability company. As the managing member, A makes all of the most significant decisions regarding LLC. Both investors have the right to initiate a buy-sell clause that, once initiated, will result in ownership by one of the investors in 100 percent of LLC and may result in the liquidation of LLC. We do not believe that this scenario is akin to a liquidation right that would be deemed a kick-out right. Although B can initiate the buy-sell, it can only offer to buy A’s interest. However, A has the first right to buy B’s interest instead. Said differently, a buy-sell clause does not operate like a unilateral liquidation right, because A has the option to retain control over LLC’s assets.

5.3.1.2.7 Substantive Participating Rights

A limited partnership would also not be considered a VIE if the limited partners with equity at risk have substantive participating rights (provided the other criteria to not qualify as a VIE are met). Note that the definition of participating rights in the evaluation of whether a limited partnership is a VIE is the same definition as that applied in the voting interest entity model (see Section D.2 for a detailed discussion of the determination of whether noncontrolling rights are substantive participating rights or protective). Accordingly, the analysis focuses on whether the limited partners can participate in the significant financial and operating decisions of the limited partnership (i.e., the voting interest entity definition that focuses on decisions made in the ordinary course of business, such as selecting and terminating management and setting its compensation or making operating and capital decisions) rather than in the most significant activities of the entity (i.e., the VIE model definition).

ASC 810-10-25-13 provides guidance on evaluating whether participating rights are substantive. Factors that must be considered include the percentage ownership interest of the parties with the participating rights, the relationship between the parties with the rights and others involved with the partnership, and the activities in which the parties can participate.

5.3.1.2.8 Reassessing Whether Kick-Out or Participating Rights Exist

In the evaluation of kick-out or participating rights, it is sometimes necessary to reconsider those rights. A scenario may exist in which, upon formation, a limited partnership is a VIE because the general partner, along with entities under common control or parties acting on its behalf, has sufficient interests to prevent a simple majority of the limited partners from exercising kick-out rights. After the limited partnership’s formation, its governing documents are amended to permit a simple majority of the limited partners, excluding the general partner (and entities under common control or parties acting on its behalf), to exercise the kick-out rights that accrue to those interest holders irrespective of the holdings of the general partner.

ASC 810-10-35-4(e) indicates when the initial determination of VIE status should be reconsidered, noting that such reconsideration should take place if “[c]hanges in facts and circumstances occur such that the holders of the equity investment at risk, as a group, lose the power from voting rights or similar rights of those investments to direct the activities of the entity that most significantly impact the entity’s economic performance.”

In the scenario above, the holders of the equity investment at risk effectively gain power as a result of the general partner’s disposal of its kick-out rights as opposed to losing the power to direct activities (as would be the case if the general partner obtained additional kick-out rights). However, the right to exercise power over the significant activities of an entity is fundamental to the determination of whether an entity is a VIE and, if so, whether the holder of a variable interest in the VIE is the primary beneficiary. Accordingly, either a gain or a loss of power to direct the activities of a limited partnership that most significantly affect its economic performance should be deemed a reconsideration event in the context of evaluating whether a substantive kick-out or participating right exists. As a result, if such a reconsideration event occurs, the partners would need to reconsider all the requirements of ASC 810-10-15-14 in determining whether the limited partnership is a VIE.

5.3.1.2.9 Partnerships in the Extractive and Construction Industries

As stated in ASC 810-10-15-14(b)(1)(ii), partnerships in the extractive and construction industries that are accounted for under the pro rata method of consolidation would not be considered VIEs solely because the limited partners do not have substantive simple majority kick-out or participating rights.

5.3.2 The Obligation to Absorb the Expected Losses of the Legal Entity

ASC 810-10

b. As a group the holders of the equity investment at risk lack any one of the following three characteristics: . . .

2. The obligation to absorb the expected losses of the legal entity. The investor or investors do not have that obligation if they are directly or indirectly protected from the expected losses or are guaranteed a return by the legal entity itself or by other parties involved with the legal entity. See paragraphs 810-10-25-55 through 25-56 and Example 1 (see paragraph 810-10-55-42) for a discussion of expected losses. . . .

A legal entity is a VIE if the holders of equity investment at risk do not have the obligation to absorb the expected losses. Equity interests are expected to be the most residual interests in a legal entity. If the equity interests do not absorb the expected losses of the legal entity, the party protecting the equity interests from losses may be the party that has a controlling financial interest. Further, such structuring suggests that the legal entity is different from a typical legal entity and that, therefore, application of the voting interest entity model may not yield meaningful results.

The relevance of the guidance in ASC 810-10-15-14(b)(2) was clearer when it was part of FIN 46(R), and consolidation of a VIE depended primarily upon which party was exposed to a majority of the expected losses. The linkage is now less apparent between the root cause of a determination that a legal entity is a VIE (e.g., a guarantor protecting equity investors from certain expected losses) and the party that ultimately consolidates (see Chapter 7). Nonetheless, the FASB retained this guidance, presumably because it still believes that any legal entity that has variable interests that protect the equity investors from expected losses requires additional scrutiny as a VIE.

Determining whether the equity investors lack the obligation to absorb expected losses requires the application of judgment. Logically, equity investors do not have the obligation to absorb the expected losses of a legal entity if another interest protects them from absorbing those losses, either in part or in full. Equity investments typically absorb first-dollar loss in a legal entity; to the extent that an agreement or instrument protects the equity investors from absorbing that first-dollar loss, the condition in ASC 810-10-15-14(b)(2) is met (and the legal entity would be a VIE). A quantitative analysis of expected losses is generally not required. In the performance of a qualitative analysis, judgment should be applied that takes into account the totality of the legal entity’s capital structure and the associated rights.

To qualitatively assess whether the equity at risk has the obligation to absorb a legal entity’s expected losses, a reporting entity should consider the contractual arrangements that it and other interest holders have with each other and with the potential VIE that may protect one or more holders of equity investment at risk from the expected losses or guarantee them a return (e.g., a guarantee of the residual value of the majority of the fair value of the potential VIE’s assets, or a contractual arrangement that guarantees a specific return).

In addition, a reporting entity should consider the contractual allocation of cash flows in determining whether the equity investment at risk absorbs the first risk of loss of a potential VIE to the extent of its equity invested. If a qualitative analysis indicates that no interests (1) are subordinate to the equity investment at risk, (2) protect the equity investors at risk, or (3) guarantee the equity investors a return, the analysis is generally sufficient for the assessment of whether the equity investment at risk has the obligation to absorb the expected losses of the legal entity.

A variety of agreements and instruments protect the equity investors and therefore can be indicative of a VIE. The following are potential examples of these agreements and interests:

Total return swaps (financial instruments that transfer an investor’s exposure to a legal entity, in full, for a return in something else).
Guaranteed returns (terms in an agreement that promise an investor in the legal entity a certain return on its investment in a legal entity).
Certain supply arrangements (contracts under which a purchaser acquires output and pays for the cost of a legal entity’s production).
Residual value guarantees (agreements under which a lessee pledges to a lessor that a subject asset will have a certain value after the passage of a certain amount of time).
Certain guarantees of the legal entity’s indebtedness, to the extent that the financial instrument would prevent losses from being absorbed by the equity investors.
Certain puts with a fixed exercise price, to the extent that the financial instrument transfers the first-dollar risk of loss to a counterparty.
Agreements with certain counterparties to reimburse the losses of an equity investor.

In each of the above examples, exposure to first-dollar loss is transferred away from the group of equity investors. Interests that a legal entity acquires in the ordinary course of its business — like certain insurance policies, certain indemnification agreements, and equivalent agreements — do not share that design and accordingly would not result in the identification of a legal entity as a VIE (see Example 5-42). Likewise, arrangements among equity holders to share losses in a proportion other than that suggested by relative equity ownership does not result in the identification of a legal entity as a VIE.

There is no direct linkage between a conclusion about the sufficiency of equity investment at risk (as discussed in Section 5.2) and a conclusion about the obligation to absorb expected losses among the equity investors at risk as a group. Although the variable interest holders of a legal entity may determine that the total equity investment at risk exceeds expected losses, the analysis focuses on whether the holders of the equity investment at risk are actually the sole group exposed to those expected losses before other parties involved with the legal entity. If the holders of the equity investment at risk are protected (e.g., because another party has provided a limited guarantee on assets that comprise more than half the total fair value of the legal entity’s assets) or are guaranteed a return, the legal entity is a VIE. Note that the guidance in Section 4.3.11 on interests in specified assets must be considered. If the protection from losses relates to an interest in a specified asset (rather than in the legal entity as a whole), it would not cause the legal entity to be a VIE under this criterion.

Example 5-38

Assume that Enterprises A and B form a joint venture (Entity C) that does not qualify for any of the scope exceptions to the VIE model. The joint venture consists mostly of three assets (all real estate assets), each with a fair value representing 33 percent of C’s total assets. The real estate assets have been guaranteed by different third parties, each unrelated to A and B. Each guarantor is required to absorb decreases in the value of the real estate asset specific to the guarantor’s respective guarantee up to a stipulated amount. The guarantor’s loss absorption occurs before any absorption by the equity holders.

In this example, the guarantees do not prevent the equity holders (A and B), as a group, from absorbing the expected losses of the legal entity, because each of the guarantors is considered to hold a variable interest in a specific asset under ASC 810-10-25-55 and 25-56 rather than a variable interest in the legal entity as a whole. ASC 810-10-25-56 states, in part, “Expected losses related to variable interests in specified assets are not considered part of the expected losses of the legal entity for purposes of . . . identifying the primary beneficiary unless the specified assets constitute a majority of the assets of the legal entity” (emphasis added). Therefore, since the guarantees are not considered variable interests in C (the legal entity), C is not a VIE under this condition.

Note that the third-party guarantors need to consider the “silo” guidance discussed in Chapter 6.

Example 5-39

Assume the same facts as in the example above except that the guarantor guaranteed two or three of the real estate assets. The guarantor must aggregate its interests in determining whether it has a variable interest in the legal entity. The variable interest in specific assets represents a majority of the fair value of the entity’s total assets; therefore, the expected losses of the assets, excluding the guarantee, would be considered part of the expected losses of the legal entity. Because the equity holders as a group would be protected from such expected losses by the guarantee variable interest, they would lack the obligation to absorb the expected losses of the legal entity.

Note that if this example were changed so that the equity holders absorbed the first risk of loss up to the amount of their equity investments before the performance under the guarantee, the equity interests would not lack the obligation to absorb the expected losses of the legal entity in accordance with ASC 810-10-15-14(b)(2).

Example 5-40

Assume the same facts as in Example 5-38 except that the guarantors of the real estate assets are related parties. As in Example 5-39, the guarantees must be aggregated, which represents a majority of the fair value of the legal entity’s total assets; thus, the guarantors would hold variable interests in the legal entity (rather than specified assets), and the equity interests lack the obligation to absorb the expected losses of the legal entity.

Example 5-41

Assume the same facts as in Example 5-38 except that one of the joint venture’s real estate assets constitutes the majority of the fair value of Entity C’s total assets. As in Examples 5-39 and 5-40, the guarantee is related to a majority of C’s total assets; thus, the guarantor would hold a variable interest in the legal entity (rather than specified assets), and the equity interests lack the obligation to absorb C’s expected losses.

Example 5-42

Legal Entity A owns and operates several manufacturing plants. It purchases property and casualty insurance to cover against various potential natural disasters (e.g., fire) and business interruption.

In this example, A’s purchase of insurance to protect against certain potential losses would not, by itself, result in a conclusion that A is a VIE.

ASC 810-10-15-14(b)(2) is applied to identify entities that, by design, have variable interests that protect the equity investors from expected losses that the legal entity was designed to create and distribute to its equity interest holders. Though the purchase of insurance does protect A’s equity interest holders from certain risks of loss, these are not losses that A was designed to create and distribute to them.

Note that in evaluating ASC 810-10-15-14(b)(2), a reporting entity must use judgment to determine which risk(s) the legal entity was designed to create and distribute to its equity interest holders.

5.3.2.1 Put Option on an Equity Interest

The right of equity holders (individually or as a group) in a legal entity to put their equity interest to another party not otherwise involved with the legal entity at a fixed price would generally not prevent the equity investors at risk from having the obligation to absorb the expected losses of the legal entity. Although the fixed-price put (whether physically or cash settled) protects the individual equity holder(s) from the expected losses of the legal entity, the put is with a party not otherwise involved with the legal entity. That is, the holder or holders of equity investment at risk purchase the put from an unrelated third party outside the legal entity. Therefore, the put option does not cause the legal entity to be a VIE under ASC 810-10-15-14(b)(2) because the counterparty to the put, if the put is exercised, will become a holder of equity investment at risk and will be exposed to the expected losses and residual returns of the entity. However, a reporting entity should always consider the substance of the put option as well as the design of the legal entity in determining whether a legal entity is a VIE under ASC 810-10-15-14(b)(2). If a fixed-price put on the equity interest is economically identical to a put on substantially all of the assets held by the legal entity, it would be appropriate to conclude that (1) the put option protects the equity holders from the expected losses and (2) the legal entity may be a VIE. This would be the case when the put option is held on 100 percent of the equity and the legal entity was designed to hold specified assets. In this scenario, there is no substantive difference between an option to sell all specified assets (as described in Section 5.3.2.2) and a put on 100 percent of the legal entity’s equity.

Note that a put option on an equity investment to the legal entity or another party involved with the legal entity would disqualify the equity from being at risk. See Section 5.2.2.4.1 for further information.

5.3.2.2 Put Option on Assets

The right of a legal entity to put, at a fixed price, a majority of its assets (based on fair values) to another party implies that the holders of equity investment at risk, as a group, lack the obligation to absorb the expected losses of the legal entity. The holders of the equity investment at risk lack the obligation to absorb the expected losses of the legal entity because the purchased put protects the equity holders from the expected losses related to the decrease in value of the assets.

Conversely, the counterparty to a put option on less than a majority of a legal entity’s assets (based on fair values) would hold an interest in specified assets as opposed to a variable interest in the legal entity (as long as the counterparty does not have another variable interest in the entity — see Section 4.3.11). Therefore, the equity investment at risk would continue to have the obligation to absorb the expected losses of the legal entity.

5.3.2.3 Other Variable Interests Held by Equity Investors

The existence of other variable interests between the equity investors or other parties and the legal entity that absorb expected losses may cause the legal entity to be a VIE. If the terms of the arrangement cause the first dollar of expected losses to be absorbed by another interest before the equity investment at risk, the arrangement protects the holders of equity at risk from some portion of the expected losses. This same conclusion applies whether the legal entity enters into an arrangement with the equity investor or with another related or unrelated party.

Example 5-43

Investors B and C each have a 45 percent equity interest in a joint venture, all of which qualifies as equity at risk. Investor D has a 10 percent equity interest in the joint venture that does not qualify as equity at risk. Profits and losses are allocated between the investors according to their ownership interests after payments are made to all other interests in the joint venture.

In this scenario, while D’s equity interest is not considered equity at risk, it still absorbs expected losses and receives residual returns at the same level as the equity at risk. That is, D is not protecting the other equity investors from absorbing the first-dollar risk of loss. Therefore, the equity at risk does not lack the obligation to absorb the expected losses of the legal entity.

Example 5-44

Investors B and C each have a 50 percent equity interest in a joint venture (JV), all of which qualifies as equity at risk. Investor C has also entered into a contract to supply raw materials to JV at prices below those that could be obtained through sales with unrelated third parties (supply contract). The supply contract is considered a variable interest because the equity holders are protected from the losses associated with that contract. That is, the supply contract is reallocating expected losses associated with the below-market pricing from the equity interests directly to C.

In examining how the supply contract absorbs losses before the equity investment at risk, assume that there are no other variable interest holders. The expected losses of JV are $110 and are allocated as follows:

Below-market supply contract — Investor C = $10.
50 percent equity — Investor B = $50.
50 percent equity — Investor C = $50.

In this scenario, the design of JV is such that the supply contract absorbs $10 of expected losses before the equity investment at risk. Although C is an equity holder, the supply contract is not part of the equity investment at risk. Therefore, the equity at risk lacks the obligation to absorb the expected losses of JV.

Example 5-45

An investor owns 100 percent of the equity issued by a legal entity, all of which is considered equity at risk. An unrelated enterprise enters into a contract to purchase finished product from the legal entity at a price equal to the actual costs of production (including costs of raw materials, labor, etc.) plus a 2 percent fixed margin. The purchase agreement is designed so that the purchaser absorbs all variability associated with the production of the finished product. There are no other variable interest holders in the entity.

In this example, because the purchaser absorbs all of the variability related to the manufacturing of the products under the purchase agreement, the investor is protected from some portion of expected losses. Therefore, the equity at risk lacks the obligation to absorb the expected losses of the legal entity.

5.3.3 The Right to Receive the Expected Residual Returns of the Legal Entity

ASC 810-10

b. As a group the holders of the equity investment at risk lack any one of the following three characteristics: . . .

3. The right to receive the expected residual returns of the legal entity. The investors do not have that right if their return is capped by the legal entity’s governing documents or arrangements with other variable interest holders or the legal entity. For this purpose, the return to equity investors is not considered to be capped by the existence of outstanding stock options, convertible debt, or similar interests because if the options in those instruments are exercised, the holders will become additional equity investors.

A legal entity is a VIE if the holders of equity investment at risk are “capped” on receipt of the expected residual returns. This is because the owners of equity investment at risk would typically not give away the right to those residual profits and, consequently, the rights allocated to the equity investment at risk in such an entity should be discounted (i.e., application of the voting interest entity model may not yield meaningful results). Rights to residual returns can accrue to parties other than the holders of equity investment at risk in a number of ways, including (but not limited to):

Explicitly stated contractual terms in organizing documents.
Agreements between the owners of equity investment at risk and other counterparties.
Agreements between the legal entity and the owners of equity investment at risk.

The threshold in ASC 810-10-15-14(b)(3) is unlike that established for the obligation to absorb expected losses described in Section 5.3.2, under which the legal entity is a VIE if the equity holders are protected from any expected losses. Under ASC 810-10-15-14(b)(3), the legal entity is a VIE only if the residual returns are capped, a distinction that allows for residual returns to be shared with parties that do not hold equity investment at risk. A cap is an upward limit, a ceiling above which all residual returns are received by a variable interest holder that does not represent equity investment at risk. In practice, because of this distinction, it is rare for a legal entity to qualify as a VIE under this guidance, whereas a legal entity is frequently a VIE because its equity investors at risk are protected from expected losses.

Note that stock options, convertible debt, or similar interests do not cap residual returns because if the options in those instruments are exercised, the holders will become additional equity investors. Similarly, a return to an at-risk equity investor is generally not capped by an outstanding fixed-price call option on the investor’s equity because the holder of the option would become an equity investor if the option were exercised (see Section 5.3.3.2 for an exception to this rule). The distinction in these instruments is the alignment of return and equity ownership. However, it is not correct that only holders of equity investment at risk can share in the residual returns of a legal entity (e.g., profit sharing is permissible as long as it does not cap the return to the equity holders). Likewise, it is not necessary for an equity investment at risk to have the same rights to residual returns as another equity investment; disproportionate profit sharing is permissible as long as it does not result in an impact to the group of holders of equity investment at risk in a manner akin to a cap. Reporting entities should apply judgment in considering the effects of financial instruments and profit-sharing arrangements.

For a legal entity to qualify as a voting interest entity, the rights to its expected residual returns must not be capped. A reporting entity must use significant judgment and evaluate all relevant facts and circumstances to determine whether returns are capped. Investors should not be considered to have the right to receive the expected residual returns of the legal entity if their participation in the return of a legal entity is trivial beyond a specified amount.

The following are examples of situations in which residual returns generally would be considered capped:

The investment manager receives a performance-based fee equal to all investment returns above 15 percent in any annual period.
The legal entity is designed to serve as a profit-sharing vehicle for employees of a sponsoring reporting entity at which all returns on assets of more than 6 percent are allocated to the employees.

The following are examples of situations in which holders of the equity investment at risk generally would not be considered capped:

The investment manager receives a performance-based fee equal to 10 percent of all investment returns up to 15 percent and thereafter shares in investment returns 30/70 with the equity investors.
The legal entity is designed to serve as a profit-sharing vehicle for employees of a sponsoring reporting entity at which 50 percent of the returns on assets of more than 6 percent are allocated to the employees.

Example 5-46

Investors B and C each have a 45 percent equity interest in a joint venture, all of which qualifies as equity at risk. Investor D has a 10 percent equity interest in the joint venture that does not qualify as equity at risk. Profits and losses are allocated according to ownership interests after payments are made to all other interests in the joint venture. Investor D is also entitled to an additional 5 percent of profits (not losses) above a specified threshold.

In this scenario, while D is entitled to additional profits above a specified threshold, D’s equity interest shares losses and residual returns at the same level as the equity interest (pari passu) of B and C. Although D’s interest has a beneficial feature that the equity investors at risk (B and C) do not have, B’s and C’s returns are not capped. Therefore, the equity at risk does not lack the characteristic in ASC 810-10-15-14(b)(3).

5.3.3.1 Determining the Effect of a Call Option on an Entity’s Assets on the Ability of the Equity Group to Receive Residual Returns

A fixed-price call option written by the legal entity on specified assets of the legal entity that represent more than 50 percent of the total fair value of a legal entity’s assets would be considered a cap on the holders of equity investment at risk right to receive the expected residual returns of the legal entity. However, if the aggregate amount of call options with a counterparty and its related parties is on assets constituting 50 percent or less of the total fair value of a legal entity’s assets, it would not represent a cap on the residual returns of the holders of equity investment at risk.

Example 5-47

Entity A leases equipment to several unrelated lessees under operating leases. Some of the lessees hold fixed-price purchase options on the leased equipment that are exercisable at the expiration of the lease terms. The initial fair value of equipment under one of the leases is more than 50 percent of the fair value of A’s total assets. Therefore, that lessee’s purchase option under that lease would be a variable interest in the legal entity. Because the purchase option would cap the holder of the equity investment at risk’s right to receive residual returns pursuant to ASC 810-10-15-14(b)(3) (i.e., the equity investors at risk of A do not participate in the appreciation in value of the related equipment), A would be a VIE.

5.3.3.2 Determining the Effect of a Call Option on an Entity’s Equity on the Ability of the Equity Group to Receive Residual Returns

As discussed in Section 5.3.3, a return to an at-risk equity investor is generally not capped by an outstanding fixed-price call option on the investor’s equity because the holder of the option would become an equity investor if the option were exercised. However, in determining whether a legal entity is a VIE, a reporting entity should consider the substance of the call option on equity as well as the design of the legal entity. In instances in which the fixed-price call option on the equity is economically identical to a call on the specified assets held by the legal entity, it would be appropriate to conclude that the residual returns to the equity group are capped and that, therefore, the legal entity is a VIE. This would be the case when the call option is held on 100 percent of the equity and the VIE was designed to hold specified assets. In that circumstance, there is no substantive difference between an option to acquire the specified assets (as described in Section 5.3.3.1) and a call on 100 percent of the legal entity’s equity.

Footnotes

Re-REMICs are resecuritizations of real estate mortgage investment conduit securities.

In these specific circumstances, a consent requirement is not substantive unless the other investors of at-risk equity are able to withhold their consent without limitation. Accordingly, consent that cannot be unreasonably withheld is generally not substantive. However, such a conclusion regarding the determination of whether a consent that cannot be unreasonably withheld is substantive should not be applied to other situations, including the evaluation of whether a noncontrolling interest holder has substantive participating rights, as discussed in Section D.2.3. A consent requirement may also not be substantive if the other equity investors are related parties or de facto agents of the decision maker.

Although participating rights must also be considered, as discussed in Section 5.3.1.1.3.5, we do not believe that such rights have the same impact on the VIE determination as kick-out rights in this context.

Paragraph BC49 of ASU 2015-02 states that “[b]arriers to exercise may be different when considering kick-out rights as compared with barriers for liquidation rights and should be evaluated appropriately when assessing whether the rights are substantive.”

Excluding liquidation rights held by the general partner, entities under common control with the general partner, or other parties acting on behalf of the general partner as described in Section 5.3.1.2.3.

As stated in ASC 810-10-25-14B, “[t]he requirement to dissolve or liquidate the entire limited partnership upon the withdrawal of a limited partner or partners shall not be required to be contractual for a withdrawal right to be considered as a potential kick-out right.” Therefore, a reporting entity must consider whether withdrawal will practically result in the required dissolution of the partnership (e.g., the partnership has only one limited partner and the general partner has a nominal interest). All facts and circumstances must be considered in determining whether the withdrawal requires dissolution or liquidation.

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