Chapter 5 — Determining Whether a Legal Entity Is a VIE

5.4 Nonsubstantive Voting Rights

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.) . . .

c. The equity investors as a group also are considered to lack the characteristic in (b)(1) if both of the following conditions are present:

The voting rights of some investors are not proportional to their obligations to absorb the expected losses of the legal entity, their rights to receive the expected residual returns of the legal entity, or both.
Substantially all of the legal entity’s activities (for example, providing financing or buying assets) either involve or are conducted on behalf of an investor that has disproportionately few voting rights. This provision is necessary to prevent a primary beneficiary from avoiding consolidation of a VIE by organizing the legal entity with nonsubstantive voting interests. Activities that involve or are conducted on behalf of the related parties of an investor with disproportionately few voting rights shall be treated as if they involve or are conducted on behalf of that investor. The term related parties in this paragraph refers to all parties identified in paragraph 810-10-25-43, except for de facto agents under paragraph 810-10-25-43(d).

For purposes of applying this requirement, reporting entities shall consider each party’s obligations to absorb expected losses and rights to receive expected residual returns related to all of that party’s interests in the legal entity and not only to its equity investment at risk.

Although intended to clarify ASC 810-10-15-14(b)(1) (see Section 5.3.1), ASC 810-10-15-14(c) is generally considered a separate condition in the assessment of a VIE. ASC 810-10-15-14(c)(2) explains that the provision “is necessary to prevent a primary beneficiary from avoiding consolidation of a VIE by organizing the legal entity with nonsubstantive voting interests.” Thus, ASC 810-10-15-14(c) is often referred to as the “anti-abuse provision” since it aims to prevent legal entities from being structured in a manner in which (1) a reporting entity has disproportionately few voting rights and (2) substantially all of the legal entity’s activities either involve or are conducted on behalf of the reporting entity (and its related parties except for related parties under ASC 810-10-25-43(d)) and disproportionately few voting rights are exempt from the VIE model. Such legal entities would be evaluated under the VIE model.

Although intended to address abuse, ASC 810-10-15-14(c) also applies to reporting entities other than those that circumvent the VIE rules. Many legal entities established with valid business purposes may qualify as VIEs under this guidance. Furthermore, a reporting entity that has been determined to have met the “substantially all” criterion does not automatically consolidate the VIE.

When considering this guidance, a reporting entity must perform the following steps:

Step 1 — Determine whether one investor has disproportionately few voting rights relative to that investor’s economic exposure to a legal entity.
Step 2 — Assess whether substantially all of the activities of a legal entity either involve or are conducted on behalf of the investor identified in step 1, including that investor’s related parties and some de facto agents.

If a legal entity satisfies all the criteria in both steps 1 and 2, its voting rights are considered nonsubstantive and it is therefore a VIE. A reporting entity would then evaluate the legal entity for consolidation under the VIE model.

5.4.1 Disproportionately Few Voting Rights (Step 1)

ASC 810-10-15-14(c) reflects the FASB’s belief that having disproportionately few voting rights creates a potential for abuse, since an investor would be unlikely to accept economic exposure in excess of its voting rights. In the assessment of what constitutes “disproportionately few,” the voting rights an investor holds and the exposure to economics retained by an investor are each expressed as a percentage of the respective total. If the percentage of relative voting rights is smaller than the percentage of relative economic exposure, the criterion is met.

Legal entities are often structured with multiple classes of stock, and those classes may carry voting rights that are conditional or that carry different weight. Limited partnerships and limited liability corporations often identify one party — the general partner or managing member — as the decision maker, endowed with all power related to decisions in the ordinary course of business, irrespective of the equity owned by that party. In other circumstances, the exact percentage of total voting rights that an investor holds may not be of specific importance. For example, in a situation in which two investors hold 60 percent and 40 percent of the voting rights, respectively, and a 66.6 percent threshold is required for a decision, each party should be considered to have 50 percent of the voting rights of the legal entity regardless of the actual voting rights held.

Judgment will also be required in the determination of an investor’s economic exposure. Economic exposure in this context incorporates the definition of a variable interest (see Section 2.14 and Chapter 4) by reference to the obligation to absorb expected losses or the right to receive expected residual returns. It is clear, therefore, that the anti-abuse provision is not intended to encompass only the exposure to economics conveyed by the same interests that convey the right to vote. Investors will often have exposure to economics through variable interests in addition to equity interests in a legal entity. Examples include debt financing, decision-maker fees, and guarantees. Finally, an investor’s economic exposure should include implicit variable interests and “activities around the entity,” as described in Section 4.3.10.1.

Though these assessments will require the use of judgment, we generally believe that the threshold for satisfying this criterion will be low. Given the purpose of the guidance, it will often be obvious when voting rights and economic exposure are disproportionate. An investor with a majority of economic exposure and less than a majority of voting rights clearly has disproportionately few voting rights.

If an investor has disproportionately few voting rights, step 2 should be performed (see Section 5.4.2).

The anti-abuse provision focuses on all investors in the legal entity, not only a specific reporting entity. Consequently, if a reporting entity has disproportionately many voting rights, another investor will by default have disproportionately few voting rights, and the condition will be met. A conclusion that the reporting entity alone does not have disproportionately few voting rights is insufficient. Note that under step 1, related parties and de facto agents are ignored (although implicit variable interests and activities around the legal entity through a related party may be relevant, and thus an understanding of the totality of a reporting entity’s variable interests is required). Instead, the focus is on variable interests held specifically by an investor.

5.4.1.1 Impact of Variable Interests in Addition to Equity

When determining whether a reporting entity’s voting rights are proportional to its obligations to absorb the expected losses of the legal entity or to its rights to receive the expected residual returns of the legal entity, a reporting entity must consider all of its variable interests issued by the legal entity, including those held by reporting entities that do not also hold equity investment at risk.

The FASB staff has indicated that the anti-abuse provision requires a reporting entity to consider each possible scenario in determining whether its voting rights are proportionate to its obligations to absorb the expected losses or rights to receive the expected residual returns of the legal entity. Therefore, a reporting entity that holds a voting equity investment at risk and any other variable interest not proportionately held by other equity interest holders (e.g., debt, service contract that is a variable interest, guarantee) will always meet ASC 810-10-15-14(c)(1).

Example 5-48

Enterprises X and Y each contribute $1 million (aggregate equity of $2 million) in exchange for a 50 percent equity interest in an entity. This entitles each enterprise to equal voting rights. Enterprise Y, but not X, also provides subordinated debt. ASC 810-10-15-14(c)(1) is met because Y’s total variable interests, as a percentage of the total of all variable interests of holders of equity investment at risk, are greater than its voting rights (50 percent). This is true even if Y’s specific amount of expected losses and expected residual returns is less than the $2 million equity investment at risk. In other words, although subordinated debt is not expected to absorb any of the expected losses, Y could experience losses or returns that are disproportionate to its 50 percent voting interest.

Example 5-49

Company J and Company E each contribute $500,000 (aggregate equity of $1 million) in exchange for a 50 percent equity interest in a chemical manufacturing entity. This entitles each company to equal voting rights in the entity. Company J, but not E, also receives fees for managing the chemical manufacturing entity. The fees paid to E meet the conditions to be “commensurate” under ASC 810-10-55-37(a) and “at market” under ASC 810-10-55-37(d); however, as a result of E’s equity interests in the chemical manufacturing entity that absorb more than an insignificant amount of the potential VIE’s variability, the condition in ASC 810-10-55-37(c) is not met and the fees therefore represent a variable interest. In this case, ASC 810-10-15-14(c)(1) is met because E’s total variable interests, as a percentage of the total of all variable interests of holders of equity investment at risk, are greater than its voting rights (50 percent). Although the fees paid to E are not expected to absorb any of the expected losses, E could experience returns that are disproportionate to its 50 percent voting interest.

Example 5-50

Company B and Company D are equity investors in Conglomerate T and hold 90 percent and 10 percent voting interests, respectively. Company B has a majority of the voting rights in T (through its 90 percent voting interest) and has a majority of the exposure to T’s profits and losses (through its 60 percent participation). In this case, ASC 810-10-15-14(c)(1) is not met even though B’s voting rights (90 percent) and exposure to T’s economics (60 percent) are not equal. Company B has control of T; therefore, B’s voting rights and economic interests are proportional at either the 90 percent or 60 percent threshold.

5.4.2 Substantially All of the Activities Involve or Are Conducted on Behalf of the Investor With Disproportionately Few Voting Rights (Step 2)

A legal entity that has an investor with disproportionately few voting rights is not a VIE unless substantially all of its activities either involve or are conducted on behalf of that investor (including that investor’s related parties and all but one type of its de facto agents9). This provision is intended to prevent a reporting entity from circumventing the requirements for consolidating a VIE by forming the VIE primarily for its own use with voting rights that do not equate to the allocation of the underlying economic gains and losses of holders of interests in the formed VIE.

Many components of this provision will already be known: the investor with disproportionately few voting rights will have been identified in step 1; that investor’s related parties and de facto agents will be identified; and the legal entity’s activities can be determined on the basis of its purpose and design. However, a reporting entity will need to exercise significant judgment in determining whether the “substantially all” requirement has been met.

Speaking at the 2003 AICPA Conference on Current SEC Developments, an SEC staff member, Eric Schuppenhauer, discussed this provision:

The second part of this provision is where more judgment is involved. In the event that a registrant concludes that it has disproportionately few voting rights compared to its economics, there must be an assessment of whether substantially all of the activities of the entity either involve or are conducted on behalf of the registrant. There is no “bright-line” set of criteria for making this assessment. All facts and circumstances, qualitative and quantitative, should be considered in performing the assessment.

Under ASC 810-10-15-14(c)(2), the term “activities” refers to the business activities of the potential VIE under evaluation. It does not necessarily encompass the economic interests (i.e., the obligation of the interest holders to absorb expected losses or the right of the interest holders to receive expected residual returns). A reporting entity must also understand the business reason why an investor chooses to accept voting rights that are not proportionate to its investment.

“Substantially all” is a high threshold. Generally, if 90 percent or more of the legal entity’s activities either involve or are conducted on behalf of a reporting entity and its related parties, they are presumed to be “substantially all” of the legal entity’s activities. However, less than 90 percent is not a safe harbor. The evaluation should not necessarily be based on the reporting entity’s economic interest(s) in a legal entity. However, significant economic interests in a legal entity may be an indicator that substantially all of the legal entity’s activities either involve or are conducted on behalf of the reporting entity and its related parties.

A reporting entity will generally need to perform a qualitative analysis to determine whether substantially all of the activities of a legal entity either involve or are conducted on behalf of an investor, its related parties, and some de facto agents.10 This “substantially all” terminology is used in a manner parallel to its use in the business scope exception discussed in Section 3.4.4.7 and should be applied in a consistent manner. The following factors, among others, may be useful in the evaluation of whether substantially all of a legal entity’s activities either involve or are conducted on behalf of a reporting entity:

Business relationship of the legal entity and the reporting entity — Does the reporting entity contractually acquire substantially all of the output of the legal entity? Does the legal entity have the substantive ability to provide its output to other entities, or is the legal entity solely tied to the reporting entity?
Type of business conducted by the legal entity — Does the legal entity serve a function beyond providing inputs to the reporting entity (i.e., is the legal entity just an extension of the reporting entity)? Does the legal entity rely on inputs provided exclusively by the reporting entity to conduct its operations?
Economic dependence of the legal entity upon the reporting entity — Does the reporting entity absorb substantially all of the losses of the legal entity? Does the reporting entity have the responsibility to fund losses of the legal entity?
Operational dependence of the legal entity on the reporting entity — Does the reporting entity provide the employees that operate the legal entity’s business?
Origins of the legal entity — Did the reporting entity form the legal entity to perform a specific function that the reporting entity had historically performed on its own?
Ongoing linkage of the entities — Do the reporting entity and legal entity have the ability to put or call the assets of the legal entity in the future under favorable terms?

No single factor is necessarily determinative. The facts and circumstances associated with a legal entity should be considered in total in the assessment of whether ASC 810-10-15-14(c)(2) has been met.

Example 5-51

Two investors, Enterprise A and Enterprise B, form a joint venture (JV) solely to manufacture steel. Enterprises A and B contribute cash of $80 million and $20 million, respectively, to fund JV, and each investor has 50 percent of the voting rights. In addition, 90 percent of JV’s manufactured steel is sold to A, and 10 percent is sold to third parties.

In this scenario, JV satisfies ASC 810-10-15-14(c)(1) because A’s share in losses of JV is disproportionate to its voting rights (80 percent share of losses compared with 50 percent voting rights). JV also satisfies ASC 810-10-15-14(c)(2) because substantially all of JV’s activities (90 percent of the output) are conducted on behalf of A, the investor with disproportionately few voting rights. Therefore, since the equity investors as a group lack the characteristic in ASC 810-10-15-14(b)(1) (i.e., both conditions in ASC 810-10-15-14(c) have been met), JV is a VIE.

Conversely, if JV were to sell 50 percent or more of its manufactured steel to unrelated third parties, JV would not be a VIE. If sales to A are greater than 50 percent but less than 90 percent, judgment should be used in the determination of whether JV meets both criteria in ASC 810-10-15-14(c) when no other activity besides sales is relevant to the evaluation.

Example 5-52

An investment hedge fund (Entity Z) is established by a 99 percent limited partner (Enterprise A) and a 1 percent general partner (Enterprise B). Enterprise B manages the hedge fund and makes all decisions. Enterprise A cannot remove B except for cause. Therefore, the voting rights are not proportional to the share of expected losses and expected residual returns of Z. Substantially all of Z’s activities would be considered to be on behalf of A because Z is established to invest its money and provide a return to A. Therefore, because Z meets both conditions of ASC 810-10-15-14(c), it would be deemed a VIE.

Conversely, if limited partner interests were held by a larger number of unrelated limited partners, Z would not be considered a VIE under ASC 810-10-15-14(c). Note, however, that Z would be deemed a VIE under ASC 810-10-15-14(b) in both scenarios because the limited partner and partners do not have substantive rights to kick out the general partner.

Example 5-53

Entity X is formed by Enterprise A and Enterprise B with equity contributions of $80 million and $20 million, respectively. Each investor has a 50 percent voting interest. Entity X’s activities consist solely of purchasing merchandise from A and selling and distributing it to third-party customers.

Entity X satisfies ASC 810-10-15-14(c)(1) because the voting rights of the investors are not proportional to their obligation to absorb X’s expected losses. Therefore, X’s investors must consider ASC 810-10-15-14(c)(2).

While the “outputs” of X are not transactions with A or B, the business of X represents another distribution or sales channel for A’s merchandise. Entity X appears to be an extension of A’s business because it is so closely aligned in appearance and purpose. Entity X has been designed so that substantially all of its activities either involve or are conducted on behalf of A (the investor that has disproportionately few voting rights). Therefore, ASC 810-10-15-14(c)(2) is met, and X is a VIE.

Example 5-54

Enterprise A and Enterprise B form Entity Y with equity contributions of $80 million and $20 million, respectively. Each investor has a 50 percent voting interest. Entity Y has contracted to purchase all of its raw materials from A. Entity Y is one of several customers of A. Entity Y uses these raw materials to manufacture products to sell to third-party customers identified by Y.

Entity Y meets ASC 810-10-15-14(c)(1) because the voting rights of the investors are not proportional to their obligation to absorb the expected losses of the legal entity. Therefore, the investors of Y must consider ASC 810-10-15-14(c)(2).

Entity Y sells its products directly to third parties. That is, the “outputs” of Y are not transactions conducted directly with A or B. Even though all of the raw materials of Y are provided by A, Y does not appear to be an extension of A’s business and would not be considered to be designed so that substantially all of its activities either involve or are conducted on behalf of the investor that has disproportionately few voting rights. (This is different from the situation in the previous example.) Therefore, ASC 810-10-15-14(c)(2) is not met, and Y is not a VIE.

Footnotes

This condition specifically excludes de facto agents resulting from a unilateral transfer restriction under ASC 810-10-25-43(d). See Section 8.2 for a discussion of de facto agents.

See footnote 9.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.