7.2 Power Criterion | DART – Deloitte Accounting Research Tool

7.2.1 General Framework

Although identification of the primary beneficiary requires an evaluation of both characteristics of a controlling financial interest in a VIE, the determination is often based on which variable interest holder satisfies the power criterion since generally more than one variable interest holder meets the economics criterion.

To determine whether it meets the power criterion, the reporting entity must identify the activities that most significantly affect the VIE’s economic performance and then determine which variable interest holder has the power to direct those activities. The reporting entity would take the following steps to identify the party with the power to direct the activities that most significantly affect the VIE’s economic performance:

Step 1 — Evaluate the purpose and design of the VIE and the risks the VIE was designed to create and pass along to its variable interest holders. See Section 7.2.2.
Step 2 — Identify the activities related to the risks identified in step 1 that most significantly affect the economic performance of the VIE. In certain situations in which multiple unrelated variable interest holders direct different activities, the reporting entity must determine which activity most significantly affects the VIE’s economic performance. The party that has the power to direct such activity will meet the power criterion. When making this determination, the reporting entity should consider the activity that results in the most economic variability for the VIE (e.g., expected losses and expected residual returns, which are discussed in Appendix C). See Section 7.2.3.
Step 3 — Identify the party that makes the significant decisions or controls the activity or activities that most significantly affect the VIE’s economic performance. Consider whether any other parties have involvement in those decisions (shared power) or can remove the decision maker (kick-out rights). See Sections 7.2.4 through 7.2.7.

While a VIE often performs a variety of activities, the key to determining whether the power criterion has been satisfied is identifying the activities that are the most significant to the VIE’s economic performance.

7.2.2 Purpose and Design (Step 1)

The first step in identifying the party with the power to direct the activities that most significantly affect the VIE’s economic performance is to evaluate the purpose and design of the VIE, including the risks and associated variability that the VIE was designed to create and pass through to its variable interest holders. The reporting entity should understand how each risk affects the VIE’s economic performance and should identify the activities related to each risk. The assessment should not be limited to the activities that affect the returns to equity holders and should not be performed on the basis of a single point in time. Rather, the power-criterion assessment should be based on the entire life of the legal entity and all of the legal entity’s assets that contribute to its economic performance in the way the legal entity was designed.

The examples in ASC 810-10-55-93 through 55-205 (see Appendix E) illustrate the performance of step 1. For instance, in Case A (a commercial mortgage-backed securitization), the reporting entity determines that the VIE is exposed to the credit risk associated with the possible default by the borrowers. Ultimately, the VIE’s economic performance is most significantly affected by the credit performance of the VIE’s underlying assets; accordingly, the variable interest holder with the power to direct the activities related to managing the VIE’s assets that are delinquent or in default is the primary beneficiary.

When evaluating the purpose and design of the VIE, the reporting entity should consider how the VIE was marketed to investors, the entity’s governing documents, and any other relevant agreements between the VIE and the parties involved with the VIE that could affect its purpose and design.

7.2.3 Risks and Activities (Step 2)

Once a reporting entity has identified the risks the VIE was designed to create and pass through to its variable interest holders, the reporting entity can determine the activities that most significantly affect the economic performance of the VIE. ASC 810-10 does not define “economic performance”; however, the assessment should focus on which activities have the most significant impact on the variability that will be absorbed by the variable interests in the VIE. This determination should be the same as for the VIE analysis (see Section 5.3.1).

In evaluating which party makes the significant decisions or controls the activities that have the most significant impact on the variability that will be absorbed by the variable interest holders, a reporting entity would consider questions such as the following on the basis of its facts and circumstances:

How does each decision impact the risks that the VIE was designed to create and pass along to its variable interest holders?
How does each decision affect the operating margins and cash flows of the VIE?
What decisions increase or decrease the VIE’s revenues and expenses?
How do decisions affect the overall fair value of the VIE?
What is the nature of the VIE’s assets, and how could each decision affect the fair value of those assets?

Some VIEs may have very limited ongoing activities that significantly affect the economic performance of the VIE. For example, in certain securitization structures, the only significant activity is the management of troubled assets. Other entities, such as operating entities, may conduct a wide range of activities. Activities may even include those that have not yet occurred (e.g., the activity will be performed when certain circumstances arise or certain events happen) as long as they will significantly affect the economic performance of the VIE.

In a speech at the 2019 AICPA Conference on Current SEC and PCAOB Developments, SEC Professional Accounting Fellow Aaron Shaw discussed how to assess the power to direct the most significant activities in conjunction with the appropriate identification of the VIE’s purpose and design, as well as the risks and the most significant activities that affect the VIE’s economic performance.

Mr. Shaw provided examples related to the determination of the primary beneficiary in circumstances in which a VIE had multiple activities that affected the legal entity’s economic performance. One example involved a scenario in which the registrant was the lessee of the VIE’s only asset — a single property. The lease term covered substantially all of the property’s economic life, and under the lease, the registrant was required to operate and maintain the property, which included significant structural maintenance during the lease term. At the end of the lease term, the VIE had the right to sell the property. The VIE’s primary purpose was to provide investors with a return on their investment derived from the lease payments and the sale of the property at the end of the lease term. The registrant concluded that although it had multiple variable interests in the VIE, it did not have power over the activities that most significantly affected the VIE’s economic performance.

In response to the registrant’s conclusion, Mr. Shaw noted that in light of the VIE’s purpose and design as well as the risks that the VIE was created to pass along to its variable interest holders, “the risks that caused variability included: lease negotiation risk, lessee credit risk, residual value risk, and operation and maintenance risk.” He stressed that each activity does not necessarily have the same relative weight in a consolidation analysis. For example, the lease term represented substantially all of the property’s economic life. Consequently, lease negotiation risk was not determined to be the most significant risk. In addition, Mr. Shaw explained that “[a]ctivities related to lessee credit risk were not the VIE’s most significant activities because the registrant’s financial condition and the property’s strategic importance mitigated credit risk.”

The SEC staff observed that the activities related to residual value risk and to operation and maintenance risk were the most significant activities because the decisions related to these risks would most significantly affect the VIE’s economic performance. The registrant held the power to direct the decisions related to the property’s operation and maintenance during the lease term that would most significantly affect the VIE’s economic performance. Consequently, the staff objected to the registrant’s conclusion that the registrant did not have power over the activities that most significantly affected the VIE’s economic performance.

The remarks made by Mr. Shaw illustrate the importance of (1) appropriately identifying the risks the VIE was designed to create and pass through to its variable interest holders and (2) determining the activities that most significantly affect the economic performance of the VIE.

7.2.3.1 Risks With No Activities

Reporting entities should consider all risks in assessing whether the power criterion has been met. However, the VIE may be exposed to risks that do not have direct activities related to them, as illustrated in Case E and Case F in ASC 810-10-55-147 through 55-171. In those examples, prepayment is one of the risks the VIE was designed to create and pass through, but since there are no variable interest holders that have the power to direct activities related to the risk, it is not considered in the primary-beneficiary analysis.

7.2.3.2 No Ongoing Activities

In limited situations, the ongoing activities performed throughout the life of a VIE (e.g., administrative activities in certain resecuritization entities, such as Re-REMICs) may not be expected to significantly affect the VIE’s economic performance even though they are necessary for the VIE’s continued existence. In such situations, the primary-beneficiary determination will need to focus on the activities performed and the decisions made at the VIE’s inception as part of the VIE’s design, because in these situations the initial design had the most significant impact on the economic performance of the VIE. However, it would not be appropriate to determine the primary beneficiary solely on the basis of decisions made at the VIE’s inception as part of the VIE’s design when there are ongoing activities that will significantly affect the economic performance of the VIE.

ASC 810-10-25-38F states that a reporting entity’s involvement in the design of a VIE “may indicate that the reporting entity had the opportunity and the incentive to establish arrangements that result in the reporting entity being the variable interest holder with . . . the power to direct the activities that most significantly impact [the VIE’s] economic performance.” However, ASC 810-10-25-38F also notes that a reporting entity’s involvement in the design does not, in itself, establish that reporting entity as the party with power. In many situations, several parties will be involved in the design of a VIE, and an analysis of the decisions made as part of the design would not be determinative, nor would it result in the identification of a primary beneficiary.

In addition, ASC 810-10-25-38G highlights the need for reporting entities to consider situations in which a variable interest holder’s economic exposure is disproportionately greater than its stated power to make decisions that affect the VIE’s economic performance.

Thus, in situations in which (1) the ongoing activities of a VIE are not expected to significantly affect the VIE’s economic performance and (2) one reporting entity holds an economic interest that is so significant that the other interest holders, as a group, do not hold more than an insignificant amount of the fair value of the VIE’s interests (or those interests do not absorb more than an insignificant amount of the VIE’s variability1), it would generally be appropriate to conclude that the reporting entity with that significant economic interest made the decisions at the inception of the VIE or that the decisions were essentially made on the reporting entity’s behalf. Therefore, in such situations, it would be appropriate to conclude, after all facts and circumstances associated with the VIE have been considered, that the reporting entity has a controlling financial interest in the VIE. Conversely, if multiple parties were involved in the design of the VIE and hold a variable interest that is more than insignificant, no party would consolidate the VIE.

When performing this analysis, a reporting entity should evaluate whether, on the basis of the purpose and design of the entity, it should consider the interests held by its related parties. For example, if a reporting entity and an affiliate under common control together absorb all but an insignificant amount of the variability in the VIE, the reporting entity (or the reporting entity in the related-party group) may have a controlling financial interest in the VIE. On the other hand, a related party’s interest in a related-party relationship resulting from a de facto agency (e.g., a transfer restriction as described in Section 8.2.3.4) may not warrant inclusion in this analysis after the purpose and design of the entity and the nature of the related-party relationship have been considered. In evaluating whether one party in a related-party group should be deemed to have both of the characteristics of a controlling financial interest if the ongoing activities of the VIE are not expected to significantly affect the VIE’s economic performance, a reporting entity may consider the factors in ASC 810-10-25-44(a)–(d). The purpose of this evaluation is not to determine whether consolidation of the VIE by one of the related parties is required under the “most closely associated” guidance but rather to assess whether these factors may be indicators that the substance of the arrangement should result in the consolidation of the VIE by one of the related parties. See Section 7.4.2.4 for additional information on these factors.

The analysis described above should be performed on all rights available to the reporting entity even if they are not exercised.

7.2.4 Which Party, if Any, Has the Power (Step 3) — General Considerations

Step 3 in the determination of which party has the power to direct the activities that most significantly affect the VIE’s economic performance is to identify the party that makes the significant decisions or controls the activities that most significantly affect the VIE’s economic performance. Questions to consider in this analysis include, but are not limited to, the following:

Does any party hold the power unilaterally?
Alternatively, do other parties also have relevant rights and responsibilities? For example:
- Is there another party that has to consent to every important decision (shared power)? See Section 7.2.7.1.
- Is there another party that can force the reporting entity to take certain actions?
- Is there another party that can replace the reporting entity without cause (kick-out rights) or liquidate the VIE without cause? See Section 7.2.10.
- Is there another party or other parties that direct the same activities but for a different portion of the VIE’s assets? See Section 7.2.7.2.
Is the reporting entity’s right to exercise power currently available or contingent on the occurrence of some other event(s)? See Section 7.2.9.

As part of this analysis, it is important for the reporting entity to distinguish between the ability to make significant decisions that are expected to be made in the ordinary course of carrying out the VIE’s current business activities and the ability to make decisions in exceptional circumstances or to veto or prevent certain fundamental changes in the VIE’s design or activities. The latter are generally considered protective rights, as discussed in ASC 810-10-25-38C, which do not give the reporting entity the power to direct the significant activities of the VIE.

7.2.5 Decisions Made by a Board and Management (Step 3)

Assessing whether the power criterion has been met can be more complex when decisions are made by different parties and at different governance levels. For example, in some arrangements, a board of directors is established for the VIE; however, one of the investors may serve as the “managing member” or “managing partner” (referred to in this discussion simply as the “manager”) of the VIE. Because certain decisions will be made by the board of directors, and other decisions will be made by the manager, the first step is to determine whether the manager’s fee arrangement is a variable interest in the VIE. If the manager’s fee arrangement is not a variable interest, the manager is only providing management services as an agent on behalf of the equity investors. Consequently, the rights held by the manager would be attributed to the equity investors or the party on behalf of which the manager is required to act. See Section 4.4 for a discussion of evaluating decision-maker fees as variable interests.

If the manager is deemed to have a variable interest, then to determine which party meets the power criterion, a reporting entity must understand which activities are expected to most significantly affect the economic performance of the VIE and the level in the VIE at which those activities are directed. Items to consider include determining the level in the VIE at which the significant operating and capital decisions are made as well as the level at which the operating and capital budgets are set, the level of detail included in the budgets, the process of developing and approving the budget, implications of the budget not getting approved, and other relevant facts.

If the significant operating and capital decisions are made by the board, a manager would not have the power to direct the activities of the VIE that most significantly affect the economic performance because that power would be held by the board, and the manager would effectively be serving as a service provider. Conversely, if a reporting entity concludes that the most significant activities of the VIE are directed at the manager level (and not at the board level), the board would not be considered to have the power to direct the activities that most significantly affect the economic performance of the VIE unless a single equity holder (or a related-party group of equity holders) controls representation on the board (i.e., has more than 50 percent representation on a board requiring a simple majority vote, thereby indirectly controlling the vote of the board), and the board has substantive rights to kick out the manager (see Sections 5.3.1.2.4 and 7.2.10.1).

The examples below illustrate the application of this concept. Assume in these examples that the legal entities being evaluated are VIEs because they have an insufficient amount of equity at risk.

Example 7-1

Investors A and B, two unrelated parties, are investors in Entity X, a manufacturing venture that has one facility. Investor A owns 60 percent of X, and B owns 40 percent of X. Both investors obtained their ownership in X by contributing cash in a ratio equal to their ownership percentages. The terms of the venture arrangement require B to purchase up to 10 percent of the product produced by X at cost-plus. The remainder of the product produced by X is sold to third parties at market rates. Investor B is the managing member of the entity.

Entity X’s articles of incorporation state the following about the governance and management of X:

Entity X’s board of directors comprises 10 individuals — 5 selected by A and 5 selected by B.
All significant operating and capital decisions regarding the operations of X, such as establishing operating and capital budgets, determining the pricing of the product produced by X, approving long-term customer contracts, and approving long-term supply contracts for raw materials, must be presented to the board and are determined by a simple majority vote.
The managing member is responsible for ensuring that the day-to-day operations of X are executed in a manner consistent with the operating plan approved by the board and cannot deviate from the operating plan without approval from the board.
The managing member reports to the board on a monthly basis.
Investor B is paid a fixed annual fee for serving as managing member.

Profits and losses of X are split according to ownership percentage. The cost-plus purchase arrangement between B and X represents a variable interest because it is designed such that B reimburses X for all of the actual costs incurred to produce the product B purchases. Therefore, B also absorbs variability in X through the cost-plus pricing terms.

Operating risk (including sales volume risk, product price risk, raw materials price risk, and other operating cost risk) and capital decisions are identified as the risks that will have the most significant impact on X’s economic performance. On the basis of the facts presented, which indicate that the key decisions and activities related to operating risk are directed at the board level, it would be appropriate to conclude that power over X is shared. That is, A and B together, through the board of directors, have the power to direct the activities of X, and the voting structure of X essentially results in decisions requiring the consent of both A and B. Although B serves as the managing member of X, it does not have the power to direct the activities that most significantly affect X’s economic performance, since those decisions are made at the board level.

Example 7-2

Investors K and W, two unrelated parties, are investors in an energy venture, Entity X, an independent power producer with one power plant located in the southwestern United States. Investor K owns 60 percent of X, and W owns 40 percent of X. Both investors obtained their ownership in X by contributing cash in a ratio equal to their ownership percentages. The terms of the venture arrangement require W to purchase up to 20 percent of the power produced by X at cost-plus; however, the remainder of the power produced by X is sold to third parties at market rates.

Entity X’s articles of incorporation state the following about the governance and management of X:

Entity X’s board of directors comprises 10 individuals — 6 selected by K and 4 selected by W.
The following actions cannot be taken without a unanimous vote of the board:
- Removal of the managing member.
- Appointment of a replacement managing member.
- Decisions to make calls for capital contributions.
- Admission of new members.
- Amendments to X’s articles of incorporation.
- Capital expenditures in excess of $100 million. Entity X’s average annual capital expenditures are $20 million. It is not expected that X will have capital expenditures in excess of $100 million.
Investor W is the managing member and makes all significant operating and capital decisions regarding the operations of X, such as establishing operating and capital budgets, determining the pricing of the power produced by X, determining when to operate the power plant, hiring and firing employees, deciding how to manage environmental risk, and negotiating long-term supply contracts for commodities.
Investor W is paid a fixed annual fee plus 15 percent of the venture’s profits for serving as managing member.
Investor W reports to the board on an annual basis.

Profits and losses of X, after payment of W’s managing member fee, are split according to ownership percentage.

Investor W’s equity interest represents a variable interest, as does W’s management fee in accordance with ASC 810-10-55-37(c) (because W’s other interests in X absorb more than an insignificant amount of X’s potential variability). In addition, the cost-plus purchase arrangement between W and X represents a variable interest, because the cost-plus arrangement is designed such that W reimburses X for all of the actual costs incurred to produce the power that W purchases. Therefore, W also absorbs variability in X through the cost-plus pricing terms.

Operating risk (including commodity price risk and environmental risk) and capital decisions are identified as the risks that will have the most significant impact on X’s economic performance. On the basis of the facts presented, which indicate that the most significant decisions and activities related to operating risk are directed at the managing member level, W (the managing member) would be considered to have the power to direct the activities that most significantly affect X’s economic performance. On the basis of the facts and circumstances and the design of X, the rights of the board of directors represent protective rights under ASC 810-10-25-38C. The ability to remove the managing member does not affect the power analysis because no single reporting entity has the unilateral ability to remove W.

Note that if removal of W had been allowed by a simple majority vote of the board of directors, and the removal right had been substantive, K may have been the party with the power to direct the activities that most significantly affect the economic performance of X because K could unilaterally remove W through its majority vote on the board.

7.2.5A Scope of Decision-Making Authority (Step 3)

The scope of a decision maker’s activities is sometimes limited or confined by an agreement, contract, or other means. In these circumstances, the reporting entity must evaluate the substance of the arrangement and determine how the extent of the constraints allow it to have (or prevent it from having) the power to direct the activities that most significantly affect the VIE’s economic performance. In a speech at the 2019 AICPA Conference on Current SEC and PCAOB Developments, SEC Professional Accounting Fellow Aaron Shaw addressed this situation and some related considerations. He noted the following:

The staff recently considered a consultation where a registrant contributed its investable assets into a newly-formed limited partnership in exchange for limited partnership interests. The limited partnership met the definition of a VIE and the VIE’s primary purpose was to manage the investable assets pursuant to broad investment guidelines. The registrant was significantly involved in establishing the investment guidelines and had the contractual right to modify certain aspects of the guidelines. A general partner, who held a variable interest in the VIE, had the unilateral discretion to make investment decisions in accordance with the investment guidelines. The registrant concluded the activity that most significantly impacted the VIE’s economic performance was making investment decisions and that the registrant did not have power over this activity.

The staff evaluated the investment guidelines to determine if the registrant had power over investment decisions through its ability to modify certain aspects of the investment guidelines or whether the general partner had power over the investment decisions through its day-to-day management rights. The staff observed that while the registrant could modify certain aspects of the guidelines, it did not have the ability to significantly limit the general partner’s discretion over current and future investment decisions. Rather, the guidelines were designed to provide the general partner with significant discretion to make day-to-day investment decisions. Accordingly, the staff did not object to the registrant’s conclusion that it did not control the VIE’s most significant activity.

When identifying the party with the power to direct the activities that most significantly affect the VIE’s economic performance, a reporting entity should carefully consider whether there are constraints on decision-making activities and, if so, determine the extent of them.

7.2.6 Decision-Making Activities by an Agent (Step 3)

In some situations, a decision maker may be acting as an agent on behalf of other parties (see Section 4.4 regarding whether a decision-making arrangement is a variable interest). Even if the decision maker is deemed to be acting as an agent (because it does not have a variable interest), the reporting entity should evaluate the substance of the arrangement to determine whether the decision maker is acting on behalf of another variable interest holder that may have power, such as in the circumstances described in ASC 810-10-25-38G. This situation and some related considerations were addressed by an SEC staff member, Professional Accounting Fellow Chris Rogers, at the 2014 AICPA Conference on Current SEC and PCAOB Developments. Mr. Rogers highlighted in prepared remarks that the VIE consolidation analysis does not stop for the other variable interest holders if it is determined that the fee paid to a decision maker is not a variable interest, because another variable interest holder may be the principal with power. He stated:

For purposes of illustration, assume an entity forms an SPE to securitize loans. The design and purpose of the SPE is to finance the entity’s loan origination activities. The entity provides the investors in the SPE with a guarantee protecting against all credit losses. The SPE hires a third party to service the loans and to perform default mitigation activities. Assume the servicer cannot be removed without the consent of investors and its fee is not a variable interest. In thinking through this example, the staff believes that in certain cases it may be necessary to continue the consolidation analysis when it is determined that a fee paid to a decision maker is not a variable interest and further consider whether the substance of the arrangement identifies a party other than the decision maker as the party with power.

While this can require a great deal of judgment, additional scrutiny may be necessary if a decision maker is acting as an agent and one variable interest holder is absorbing all or essentially all of the variability that the VIE is designed to create and pass along. In these situations, stated power may not be substantive, and it may be appropriate to attribute the stated power of the decision maker acting as an agent to the variable interest holder absorbing the variability of the VIE. It is helpful to keep in mind that the level of a reporting entity’s economic interest in a VIE may be indicative of the amount of power that the reporting entity holds. While the VIE guidance states that this factor is not determinative in identifying the primary beneficiary, the staff does believe that the level of a reporting entity’s economics is an important consideration in the analysis and may be telling of whether stated power is substantive. [Footnote omitted]

A reporting entity should carefully consider whether it has identified a principal, especially if a decision maker is acting as an agent on behalf of one variable interest holder that absorbs essentially all of the variability of the VIE.

The above speech was delivered before the issuance of ASU 2015-02. Although the concepts are still relevant, ASU 2015-02 broadened the evaluation of whether a decision maker is acting as an agent by permitting reporting entities to treat decision-maker fees as significant and not as variable interests if (1) they are commensurate and at market (see Sections 4.4 and 4.4.1) and (2) the decision maker does not hold other interests in the VIE that would absorb more than an insignificant amount of the VIE’s variability (see Section 4.4.2.1). We do not believe that the guidance in this speech should generally apply when, for example, a decision maker receives fees that significantly participate in the economic performance of the VIE or the decision-maker fee is a variable interest (see Section 4.4). However, facts and circumstances should be considered in the determination of whether it is appropriate for an investor to consolidate if a decision maker does not have a variable interest.

7.2.7 Multiple Parties Involved in Decision Making (Step 3)

ASC 810-10

25-38D If a reporting entity determines that power is, in fact, shared among multiple unrelated parties such that no one party has the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance, then no party is the primary beneficiary. Power is shared if two or more unrelated parties together have the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance and if decisions about those activities require the consent of each of the parties sharing power. If a reporting entity concludes that power is not shared but the activities that most significantly impact the VIE’s economic performance are directed by multiple unrelated parties and the nature of the activities that each party is directing is the same, then the party, if any, with the power over the majority of those activities shall be considered to have the characteristic in paragraph 810-10-25-38A(a).

25-38E If the activities that impact the VIE’s economic performance are directed by multiple unrelated parties, and the nature of the activities that each party is directing is not the same, then a reporting entity shall identify which party has the power to direct the activities that most significantly impact the VIE’s economic performance. One party will have this power, and that party shall be deemed to have the characteristic in paragraph 810-10-25-38A(a).

The flowchart below illustrates how the party with the power to direct the most significant activities of the VIE is determined when multiple unrelated parties have power over the significant activities.

In the above flowchart, the party that is deemed to have power over the activity or activities that most significantly affect the economic performance of the VIE would be considered the primary beneficiary of the VIE if that party has a variable interest and the obligation to absorb losses of, or the right to receive benefits from, the VIE that could potentially be significant to the VIE.

7.2.7.1 Shared Power

In situations in which multiple unrelated parties are involved in making the decisions related to all the significant activities of a VIE and have shared power, a reporting entity would perform the power-criterion analysis differently than it would if the multiple unrelated parties had power over different activities. ASC 810-10-25-38D states that if power is truly shared among multiple unrelated parties, and no single party has the power to direct the activities that most significantly affect the VIE’s economic performance, there is no primary beneficiary unless a related-party relationship (including de facto agents) exists between the parties that share power. See Section 7.4.2.2 (related-party considerations associated with shared power) and Section 8.2 (identifying related parties and de facto agents). However, if multiple unrelated parties are responsible for different significant activities, power is not shared, and one entity will be the primary beneficiary (see Section 7.2.7.2).

The threshold for concluding that power is shared is high. Such a conclusion can only be reached if all decisions that significantly affect the VIE’s economic performance require consent of the parties with shared power. Specifically, all of the significant decisions must require consent.

In certain situations in which the consent of multiple parties is required for decisions, the governing documents may contain processes for resolving disagreements (e.g., deadlock provisions). It is important to consider whether any party is able to unilaterally break the deadlock in case of disagreement, for example by exercising a veto that results in final approval. In such instances, power will not be considered shared since this ability effectively allows that party to direct the VIE’s activity.

Example 7-3

Companies DD, RS, and BC form Entity MM to operate a marketing agency in New York and Los Angeles. Each company contributed cash in exchange for a 30 percent, 30 percent, and 40 percent equity interest, respectively, upon formation. The companies have no variable interests in MM other than their equity interests. Profits and losses are allocated and distributed among the equity holders in accordance with each equity holder’s respective ownership interest. Entity MM is a VIE because of insufficient equity investment at risk.

Each company appoints one board member to the board of directors. The board hires a management company (PC) to run the day-to-day operations of MM, but all significant decisions, including approval of the operating budget, must be approved by a majority vote of the board.

In this example, the investors do not have shared power because all of MM’s significant decisions require the consent of any combination of DD, RS, and BC. That is, the decisions about the significant activities do not require the consent of each of the parties. In addition, no party meets the power criterion, because no party has a majority of the voting interests.

Even if DD, RS, and BC were related parties (or de facto agents), control would still not be considered shared. Accordingly, they would not perform the related-party tiebreaker test, and a primary beneficiary would therefore not exist (see Section 7.4.2.2).

Example 7-4

Assume the same facts as in the example above, except that all significant decisions must be approved by all members of the board of directors (rather than a majority of them). In this case, power would be considered shared because all significant decisions require the consent of the directors of all of the investors that are unrelated. Entity MM will not have a primary beneficiary because a single party does not have the power to direct the activities that most significantly affect MM’s economic performance.

However, if Companies DD, RS, and BC were related parties (or de facto agents), one party would be identified as the primary beneficiary since the related-party group collectively has power, and shared power cannot exist in a related-party group. The party that consolidates will be the party that is most closely associated with MM, on the basis of the related-party tiebreaker test (see Section 7.4.2.4).

7.2.7.2 Multiple Parties Performing the Same or Different Significant Activities

ASC 810-10-25-38E specifies that if multiple unrelated parties are responsible for different significant activities, and the decisions related to those activities do not require the consent of each party, a reporting entity with a variable interest must determine whether it has the power to direct the activities that have the most significant impact on the economic performance of the entity. One party must be identified as having power in these situations. Paragraph A56 of the Basis for Conclusions of Statement 167 states the FASB’s belief that “as the number of activities of an entity increases, it will be more likely that one decision maker (or governing body) will exist or that decisions about those activities would require the consent of the [reporting entities] involved with the entity.”

Although ASC 810-10-25-38E specifically discusses unrelated parties, we believe that it also applies in the evaluation of whether a reporting entity, in a related-party group (in which multiple related parties are responsible for different significant activities, and the decisions related to those activities do not require the consent of each party), individually has the power to direct the activities that have the most significant impact on the economic performance of the entity. A reporting entity in a related-party group first evaluates whether it has individually met both the power criterion (Section 7.2) and the economics criterion (Section 7.3). See Section 7.4 for related-party considerations regarding the primary-beneficiary assessment.

Example 7-5

Assume the same facts as in Example 7-3, except that Company DD performs all activities related to the creative process, Company RS performs all activities related to the customer accounts, and Company BC performs all activities related to the operating and financing decisions. The decisions that require approval by the board of directors are those outside the ordinary course of business (e.g., admitting new investors). All other decisions are made by the respective investors responsible for the processes.

In this example, since multiple unrelated parties are responsible for different activities, and the decisions related to these activities do not require the consent of the other parties, one party will be the primary beneficiary because power is not shared. Determining which activity is the most significant to the economic performance of Entity MM is necessary because the party that controls that activity will be the primary beneficiary.

If the facts in this example were to change such that each party were still responsible for different activities but all significant decisions regarding those activities still required unanimous consent of the board of directors, then power is shared and there would be no primary beneficiary.

When multiple unrelated parties are responsible for the same significant activity or activities that most significantly affect the economic performance of different portions of the VIE, and consent is not required, a party with power over the majority of the significant activity or activities (if such party exists) has power over the VIE. In other words, to consolidate a VIE under the VIE model, the reporting entity must have more “relative power” over the activities that most significantly affect the VIE’s economic performance. The determination of which party has power over the majority of the significant activities will require judgment and an evaluation of all facts and circumstances.

Example 7-6

Investors JX, CL, and OP are unrelated parties and together form Company SOA to operate charters in the northwest. Each investor contributed cash in exchange for a 60 percent, 20 percent, and 20 percent equity interest, respectively, upon formation. The investors do not have any variable interests in SOA other than their equity interests. Profits and losses are allocated and distributed among the equity holders on the basis of each equity holder’s respective ownership interest. SOA is a VIE because of insufficient equity investment at risk.

Company SOA has 10 charters that are similar in size and profitability. Investor JX is responsible for managing six charters, OP is responsible for managing three charters, and CL is responsible for managing the founding charter, with each charter representing approximately 10 percent of the total operations of SOA. Each charter has certain matters that require a vote of the respective charter’s members at the board table; however, these decisions are considered protective (e.g., opening a new line of business).

Since each party performs and directs the same activities (i.e., managing independent charters) without requiring consent of the other parties, the party with power over the majority of the significant activities has power over SOA. In this example, JX would be the primary beneficiary because it has power over six charters that represent a majority of the operations of SOA. The primary-beneficiary determination can be challenging when it is unclear whether one party has power over a majority of the activities, and all facts and circumstances should be carefully considered.

In situations in which two parties perform the same activities, it may be difficult to determine which party has power over a majority of the activities when it appears that both parties equally have power over 50 percent of the activities. Generally, unless the risks related to each party are identical (which is unlikely), one of the two parties must consolidate. However, as the number of parties directing the same activities increases, so does the likelihood that one single party will not have the power over a majority of the activities.

All types of power should be considered in the analysis of which party has the power to direct the activities that most significantly affect the economic performance of the VIE. In some cases, a party with multiple types of power may determine, when those powers are aggregated, that it is able to direct the activities that most significantly affect the economic performance of the VIE. This may occur in situations in which the parties involved with an entity have power over different significant activities and portions of the same significant activities. In these cases, a reporting entity must perform a detailed analysis (as illustrated in the examples in ASC 810-10-55-182 through 55-198) to determine whether its power over certain significant activities, along with its power over portions of other significant activities, identify it as having the power to direct the activities of the VIE that most significantly affect the VIE’s economic performance. For example, if Party A controls an activity that is deemed to significantly affect the economic performance of a VIE and Party B controls four activities, none of which individually affect the economic performance of the VIE as significantly as the activity directed by Party A, but that in the aggregate more significantly affect the economic performance of the VIE, Party B would have the power to direct the activities that most significantly affect the economic performance of the VIE.

In all the situations described above, to be considered the primary beneficiary, the party that has power must also have the obligation to absorb losses of the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE (see Section 7.3).

7.2.7.3 Some Unilateral Decisions and Some Decisions Requiring Consent

In certain situations, one party may unilaterally have power over one decision but another significant decision may require the consent of more than one party. For shared power to exist, all decisions regarding significant activities must require joint or unanimous consent. This view is consistent with that expressed in Chris Rogers’s speech at the 2014 AICPA Conference on Current SEC and PCAOB Developments. Mr. Rogers cited an example in which an entity that is owned equally by two unrelated parties has three significant activities. One entity unilaterally controls one activity, and the other two activities require joint consent by both parties. He stated:

In this example, while certain significant activities do require joint consent, it does not appear that shared power as described in Topic 810 exists. For shared power to exist, the guidance seems to suggest that all decisions related to the significant activities of the VIE require the consent of each party sharing power. When decisions related to a significant activity do not require joint consent, the staff has struggled to find a basis in the accounting literature to support that shared power can in fact exist. This is the case even when it is determined that the significant activities that require joint consent more significantly impact the economic performance of the entity than the significant activities that do not. In situations when shared power does not exist but multiple parties are directing different significant activities, the guidance provides that one party will meet the power criterion in the primary beneficiary assessment. The staff believes an extension of this principle suggests that the party with more power, relative to others, over the significant activities of the VIE should consolidate. In my example, a party’s shared decision making rights over certain significant activities along with its unilateral decision making rights over the remaining significant activity seems to provide that party with a greater ability to impact the economic performance of the VIE compared to the other owner and therefore it should consolidate the VIE. [Footnotes omitted]

Mr. Rogers highlighted the importance of performing the first step in a primary-beneficiary determination (i.e., determining which activities most significantly affect the VIE’s economic performance). In his example, all three activities were determined to be the activities that most significantly affected the VIE’s economic performance. He also noted that the conclusion in his example would be affected if a determination were made that the unilateral activity was not a significant activity, resulting in shared power over the two significant activities.

See Section 7.2.7.2 for a discussion of multiple parties that perform the same or different significant activities.

7.2.8 Substance of Power in Common-Control Groups (Step 3)

One party in a related-party group may appear to exhibit both characteristics of a controlling financial interest in ASC 810-10-25-38A. However, a closer evaluation of the substance of the party’s stated power and economic exposure is often necessary when a single party controls some or all parties in the related-party group, since that controlling party may have the ability to assign power or exposure to economics to a particular party to achieve a preferred consolidation result. A reporting entity should carefully consider the substance of the terms, transactions, and arrangements between the related parties and the parent company when evaluating whether substance (rather than the contractual form) indicates that one party in the related-party group should be deemed to have both of the characteristics of a controlling financial interest. The reporting entity should consider all relevant facts and circumstances in performing such an assessment.

At the 2014 AICPA Conference on Current SEC and PCAOB Developments, Chris Rogers addressed the concept of nonsubstantive power in common-control scenarios. He cautioned that although care should be taken in the identification of nonsubstantive power in common-control scenarios, related parties under common control do not always need to be evaluated under the related-party tiebreaker guidance:

The staff has received several questions recently regarding whether the related party tie-breaker guidance always must be considered when determining which party in a common control group is the primary beneficiary of a VIE. While common control arrangements do require careful consideration to determine if stated power is in fact substantive, the staff does not believe there is a requirement to consider the related party tie-breaker guidance or that that guidance is necessarily determinative unless no party in the common control group individually meets both characteristics of a primary beneficiary. [Footnotes omitted]

In evaluating whether one party in a related-party group under common control should be deemed to have both of the characteristics of a controlling financial interest, a reporting entity may consider the factors in ASC 810-10-25-44(a)–(d). The purpose of considering these factors is not to determine whether consolidation of the VIE by one of the related parties under common control is required under the “most closely associated” guidance but rather whether these factors may be indicators that the substance of the arrangement should result in the consolidation of the VIE by one of the related parties.

For example, a legal entity may be designed so that the relationship and significance of its activities are related to one of the related parties in a common-control group and substantially all of the activities involve or are conducted on behalf of that same related party, but the stated power arrangement indicates that another party in the related-party group has power over the activities that most significantly affect the legal entity’s economic performance. In such a scenario, the stated power may not be substantive.

See Section 7.4.2.4 for guidance on determining which party in a related-party group is most closely associated with a VIE.

7.2.9 Future Rights and Contingencies (Step 3)

7.2.9.1 Forward Starting Rights

Forward starting rights (such as call options and put options conveyed pursuant to contracts in existence as of the balance sheet date) are often central to the design of a VIE and therefore should not be disregarded in the primary-beneficiary analysis. While the existence of such rights, in isolation, may not be determinative in the identification of the party with power over the activities that are most significant to a VIE’s economic performance, such rights often help a reporting entity understand the purpose and design of a legal entity and therefore may be useful in the primary-beneficiary determination.

Economic performance is a concept that involves the anticipated performance of the VIE over its remaining life. Accordingly, assessing power over the activities that most significantly affect a VIE’s economic performance requires a consideration of all contractual rights and obligations during the VIE’s remaining life, including those that are currently exercisable (such as a currently exercisable call option) and those that will arise in the future (e.g., a call option or a residual value guarantee on a leased asset at the end of the lease term) pursuant to contracts in existence on the evaluation date. Relevant considerations in both situations (i.e., currently exercisable rights and forward starting rights) may include the pricing of the feature (e.g., fixed exercise price or fair value exercise price and whether the option is in the money as of the evaluation date) and other business factors (e.g., whether a reporting entity holds a call option on an asset that is critical to its business operations).

Significant decisions often must be made over time about the strategic direction of traditional operating entities, and forward starting rights may, in the future, shift the power over the strategic direction of those same activities from one variable interest holder to another (e.g., call options exercisable on a future date or other forward starting contracts). Decisions must also routinely be made about capital and resource deployment (or redeployment) because an operating entity is not always tied to a particular asset or business strategy. Consequently, significant power over current and future economic performance may be vested in the hands of the party with the substantive ability to make unilateral decisions about strategic or operating activities before the exercise or consummation of forward starting rights. That is, we believe that the VIE model is based on the notion of current power (i.e., which variable interest holder has the current power over significant activities) and generally should not take into account call options exercisable on a future date or other forward starting rights that transfer power in the future. Typically, call options or forward starting rights do not give a variable interest holder a controlling financial interest in a traditional operating entity before the transfer of power. For example, as a result of its forward commitment to purchase the equity interests of a VIE that will provide control as of the closing date or at a point in time in the future after closing, a reporting entity generally would not have a controlling financial interest (and therefore would not apply acquisition accounting under ASC 805) until power transfers. However, all facts and circumstances should be considered, including whether a call option has a de minimis exercise price and substantively represents a kick-out right. A business combination (and a deconsolidation by the party transferring power) should not occur until the reporting entity obtains a controlling financial interest as of the date the forward starting right is exercised and there has been an effective transfer of power.

This concept applies to both (1) VIEs with a limited range of activities that are intended to operate over a finite life (e.g., single-lessee leasing entities) and (2) traditional operating entities that are VIEs and do not have a finite life. A finite life could be stipulated in the formation documents that establish the VIE or could be implied through the expected useful life of the asset or assets residing in the VIE. Although forward starting rights should be considered in the primary-beneficiary analysis of both types of VIEs, such rights (depending on their terms and the design of the entity) are more likely to have a meaningful impact on the analysis of VIEs whose life or range of activities is limited. The narrower scope of the significant activities of a VIE whose life or range of activities is limited is more likely to be considered in the VIE’s initial design.

Example 7-7

Entity A and Entity B each own 50 percent of the equity in Entity C, an operating entity. Entity A holds a future call right on B’s interest in C. However, B has the substantive ability to make strategically significant unilateral decisions until its interest is bought out. In this example, A’s future call right may not change the power analysis under ASC 810-10-25-38A. However, all facts and circumstances would need to be considered, including the pricing of the call option and other business factors.

Example 7-8

Entity A is created and financed to purchase a single property to be leased to Entity B for five years under an operating lease. Entity B must provide a first-loss residual value guarantee for the expected future value of the leased property at the end of the lease term and has a fixed-price purchase option to acquire the leased property at the end of the lease term. In accordance with its design, A will not buy or sell any other assets (i.e., A is a single-asset leasing entity). In this example, A was designed to provide B with the risks and rewards of ownership of the leased asset. Even though the purchase option is not exercisable until the end of the lease term, it is central to the design of A and would be considered in the primary-beneficiary analysis.

7.2.9.2 Contingencies

Future power can also be conveyed to a variable interest holder only upon the occurrence of a contingent event. Questions have arisen about whether such a variable interest holder can be the primary beneficiary of the VIE before the occurrence of that contingent event. When a party can direct activities only upon the occurrence of a contingent event, the determination of which party has power will require an assessment of whether the contingent event results in a change in power (i.e., power shifts from one party to another upon the occurrence of a contingent event) over the most significant activities of the VIE (in addition, the contingent event may change what the most significant activities of the VIE are) or whether the contingent event initiates the most significant activities of the VIE (i.e., the VIE’s most significant activities only occur when the contingent event happens). The former situation is illustrated in Example 7-9, the latter in Examples 7-10 and 7-11.

The determination of whether the contingent event results in a change in power over or initiates the most significant activities of the VIE will be based on a number of factors, including:

The nature of the activities of the VIE and its design.
The significance of the activities and decisions that must be made before the occurrence of the contingent event compared with the significance of the activities and decisions that must be made once the contingent event occurs. If both sets of activities and decisions are significant to the economic performance of the VIE, the contingent event results in a change in power over the most significant activities of the VIE. However, if the activities and decisions before the contingent event are not significant to the economic performance of the VIE, the contingent event initiates the most significant activities of the VIE.

If a reporting entity concludes that the contingent event initiates the most significant activities of the VIE, all of the activities of the VIE (including the activities that occur after the contingent event) would be included in the evaluation of whether the reporting entity has the power to direct the activities that most significantly affect the VIE’s economic performance. In such instances, the party that directs the activities initiated by the contingent event would be the reporting entity with the power to direct the activities that most significantly affect the economic performance of the VIE.

If a reporting entity concludes that the contingent event results in a change in power over the most significant activities of the VIE, the reporting entity must evaluate whether the contingency is substantive. This assessment should focus on the entire life of the VIE. Some factors that a reporting entity may consider in assessing whether the contingent event is substantive include:

The nature of the activities of the VIE and its design.
The terms of the contracts the VIE has entered into with the variable interest holders.
The variable interest holders’ expectations regarding power at inception of the arrangement and throughout the life of the VIE.
Whether the contingent event is outside the control of the variable interest holders of the VIE.
The likelihood that the contingent event will occur (or not occur) in the future. This should include, but not be limited to, consideration of past history of whether a similar contingent event in similar arrangements has occurred.

If the contingent event is substantive, then the analysis of which party has power would not take into account decisions that would be made after the contingency is resolved until the contingency is actually resolved.

Further, assumptions about which activities will most significantly affect the economic performance of a VIE may change as the primary-beneficiary determination is continually reassessed. Any new assumptions should be considered upon such primary-beneficiary reconsiderations. Finally, a business combination or change in control would generally be considered a contingent event that results in a change in power over a VIE because the occurrence of those events represents a substantive contingency.

Example 7-9

Entity Heisenberg is formed by two investors (WW and JP) to develop and manufacture a new drug in New Mexico. Assume that Heisenberg is a VIE and that each investor holds a variable interest in Heisenberg. Investor WW has power over the research and development activities associated with the drug (stage 1) as well as obtaining FDA approval and those activities most significantly affect Heisenberg’s economic performance during that stage. Investor JP has the power over the manufacturing process, distribution, and marketing of the drug (as well as protecting its patented formula) if and when FDA approval is obtained (stage 2), and those activities would most significantly affect Heisenberg’s economic performance during that stage. In determining which investor has the power to direct the activities that most significantly affect the economic performance of Heisenberg, each investor should assess whether the contingent event (FDA approval) results in a change in power over the most significant activities of Heisenberg (in addition, the contingent event may change what the most significant activities of Heisenberg are) or whether the contingent event initiates the most significant activities of Heisenberg.

Entity Heisenberg was designed such that there are two distinct stages during its life, and the variable interest holders expect that the second stage will only begin upon FDA approval. Also, the activities and decisions before and after FDA approval are significant to the economic performance of Heisenberg (in this example, they are different activities directed by different parties). In addition, the variable interest holders conclude that there is substantial uncertainty about whether FDA approval will be obtained and that the approval is outside their control. For these reasons, in the absence of evidence to the contrary, FDA approval would be considered a substantive contingent event that results in a change in power from WW to JP. Therefore, the primary-beneficiary determination should focus on stage 1 activities until the contingent event occurs, and WW (the investor that has power over the research and development activities) would initially have the power to direct the most significant activities of Heisenberg. If FDA approval is obtained, the primary-beneficiary determination would focus on stage 2 activities, and JP (the variable interest holder that has the power over the manufacturing process, distribution, and marketing of the drug) would have the power to direct the most significant activities of Heisenberg.

Example 7-10

Entity C, a VIE, is formed by Companies A and B to construct a power plant over the next three years. Entity C will subsequently operate the power plant throughout its useful life. Companies A and B have experience successfully constructing power plants with similar proven technology. Power over all construction decisions is shared by A and B, and A will unilaterally direct all of the significant activities after construction. Both of these actions are deemed to significantly affect the economic performance of C. Further, it was concluded that the decisions made after construction most significantly affect the economic performance of C.

In this example, although there are two phases (i.e., construction and operation), on the basis of historical experience, entry into the operation phase upon completion of the power plant is not a substantive contingent event. Therefore, the decisions made during construction and operations would be considered in the determination of which party meets the power criterion. Since decisions related to operations most significantly affect C’s economic performance and A unilaterally controls the operations of C, A would be deemed to have the power over the most significant activities.

By contrast, if C was intended to be built with unproven technology and was required to obtain significant regulatory approvals, and its ability to obtain those approvals was uncertain, the completion of construction could be considered a substantive contingent event. In that case, the initial power analysis would focus on the decisions during the construction phase.

Example 7-11

A VIE is created and financed with fixed-rate bonds and equity. All of the bonds are held by third-party investors. The VIE uses the proceeds to purchase commercial mortgage loans. The equity is held by a third party, which is also the special servicer. The transferor of the loans retains the primary servicing responsibilities. The primary servicing activities performed are administrative and include collection of payments on the loans and remittance to the interest holders, administration of escrow accounts, and collections of insurance claims. Upon delinquency or default by a borrower of a commercial mortgage loan, the responsibility for administration of the loan is transferred from the transferor (in this case, the primary servicer) to the special servicer. Furthermore, the special servicer, as the equity holder, has the approval rights for budgets, leases, and property managers of foreclosed properties. The special servicer concludes that the design of the VIE and the VIE’s governing documents allow the special servicer to adequately monitor and direct the performance of the underlying loans when necessary.

In this situation, the contingent event (delinquency or default by a borrower) initiates the activities that most significantly affect the economic performance of the VIE (i.e., the management of the VIE’s assets that are delinquent or in default). The activities and decisions made before delinquency or default by a borrower (the primary servicing responsibilities) are not significant to the economic performance of the VIE. Although the special servicing activities are performed only upon delinquency or default of the underlying assets, the special servicing activities are expected to most significantly affect the economic performance of the VIE and therefore the special servicer meets the power criterion. A reporting entity that has the power to direct the most significant activities of a VIE does not have to exercise that power.

7.2.10 Kick-Out Rights and Participating Rights

ASC 810-10

25-38C A reporting entity’s determination of whether it has the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance shall not be affected by the existence of kick-out rights or participating rights unless a single reporting entity (including its related parties and de facto agents) has the unilateral ability to exercise those kick-out rights or participating rights. A single reporting entity (including its related parties and de facto agents) that has the unilateral ability to exercise kick-out rights or participating rights may be the party with the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance. These requirements related to kick-out rights and participating rights are limited to this particular analysis and are not applicable to transactions accounted for under other authoritative guidance. Protective rights held by other parties do not preclude a reporting entity from having the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance.

Kick-out rights can affect the power criterion and should be considered in the primary-beneficiary assessment only if the rights are held by a single party (and its related parties and de facto agents), can be exercised without cause, and are substantive. If these conditions are met, then the holder of the kick-out rights may be the party that meets the power criterion since it can remove the decision maker, managing member, or variable interest holder responsible for making the most significant decisions.

The ASC master glossary defines a kick-out right for a VIE as 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.” See Sections 7.2.10.1 through 7.2.10.3 for further discussion of kick-out rights.

Participating rights can also affect the power criterion and should be considered in the analysis, but as described in Section 7.2.10.4, they will have a different impact on the power analysis than kick-out rights. The ASC master glossary defines participating rights as 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.”

7.2.10.1 Substantive Kick-Out Rights

For kick-out rights to be substantive, there cannot be any significant barriers to their exercise. Although it is in the general section of ASC 810-10, the guidance in ASC 810-10-25-14A notes that barriers to the exercise of kick-out rights include 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.

A reporting entity should consider all relevant facts and circumstances — including the effect of related parties and de facto agents, which can be complex and difficult to understand — in determining whether kick-out rights are substantive. However, in the absence of a significant barrier to exercise, a kick-out right holder’s intent to not exercise that right does not preclude the kick-out right from being substantive.

7.2.10.2 Board of Directors Typically Is Not a Single Party

Because ASC 810-10-25-38C specifically states that kick-out rights can only be considered if they are held by a single party, questions have been raised about whether a board of directors could be considered a single party in the primary-beneficiary assessment. Typically, the board of directors is merely an extension of the reporting entity’s equity holders. A board is usually established to act solely in a fiduciary capacity for the equity holders and generally consists of more than one individual. The kick-out rights held by the board are essentially the kick-out rights shared by the equity holders who elected the board. Therefore, the board should not be considered a single party, and the kick-out rights held by the board should not be considered in the determination of whether a reporting entity is a VIE’s primary beneficiary. Similarly, a shell entity that serves as the feeder for the investments of multiple limited partners generally cannot be considered a single entity.

However, in certain situations, a single equity holder (or a related-party group of equity holders) may control representation on the board of directors (i.e., has more than 50 percent representation on a board requiring a simple majority vote, thereby indirectly controlling the board’s vote). In these situations, a kick-out right held by the board of directors, if substantive, may be considered a unilateral right of a single party.

Even though a board of directors generally may not be viewed as a single party in the determination of whether a single party holds a kick-out right, when the board has the ability to remove a decision maker, managing member, or other party that makes decisions, the board will often actually possess the power over the most significant activities. That is, the decision maker, managing member, or other party will be restricted from unilaterally controlling the most significant decisions by the governance at the board or shareholder level. See Section 7.2.5 for a discussion of how to determine whether the most significant activities are directed at the board level or at the manager level.

7.2.10.3 Withdrawal and Liquidation Rights

Liquidation rights are considered equivalent to kick-out rights and should be evaluated in a manner similar to kick-out rights in the determination of whether a party meets the power criterion. In paragraph BC49 of ASU 2015-02, the FASB explains that it “decided 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.”

Paragraph BC49 further indicates that the Board considered, but rejected, requiring reporting entities to evaluate liquidation rights in a manner similar to kick-out rights on the basis of the guidance in Statement 167 before ASU 2015-02. Such an evaluation would be performed “only when it is reasonable that upon liquidation, the investors will receive substantially all of the specific assets under management and can find a replacement manager with sufficient skills to manage those assets.” The Board stated that it “ultimately rejected this view because the outcome for the decision maker is the same regardless of whether the holders of those rights have the ability to obtain the specific assets from the entity upon liquidation or identify an alternative manager [because if] the holders exercise their substantive liquidation rights, similar to kick-out rights, the decision maker’s abilities would be removed.”

Therefore, any liquidation right should be considered a kick-out right and would affect the determination of the primary beneficiary and whether an entity is a VIE if the right (1) is substantive and (2) gives a single reporting entity (including its related parties and de facto agents) the unilateral ability to liquidate an entity. Paragraph BC49 also indicates 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.”

It is important to distinguish liquidation rights from withdrawal rights since ASC 810-10-25-14B indicates that a reporting entity’s unilateral right to withdraw from an entity that does not require dissolution or liquidation of the entire legal entity “would not be deemed a kick-out right.” A reporting entity should make this distinction on the basis of the specific facts and circumstances. A withdrawal right represents a liquidation right only if its exercise would result in the liquidation (or dissolution) of the entire entity. This may be the case when an entity has only a single investor, or an entity’s formation documents require the dissolution of the entity upon exercise of the withdrawal right (e.g., the exercise of the withdrawal right may result in a decline in the amount of the entity’s remaining assets to a level that triggers dissolution, and the dissolution cannot be prevented). Withdrawal rights that do not require the dissolution or liquidation of the entire entity do not represent liquidation rights and therefore should not be considered kick-out rights.2 Furthermore, when the exercise of a withdrawal right does require the dissolution or liquidation of the entire entity, the right should only affect the determination of the primary beneficiary if the right (1) is substantive and (2) gives a single reporting entity (including its related parties and de facto agents) the unilateral ability to liquidate a legal entity.

Special consideration is also necessary when a liquidation right (or a withdrawal right that represents a liquidation right) is exercisable in the future. In these situations, the right should be evaluated in the same manner as other forward starting rights. See Section 7.2.9.1 for a discussion of forward starting rights in a primary-beneficiary assessment. A reporting entity will need to use judgment to distinguish between forward starting liquidation rights that are not subject to a contingency (i.e., rights that are exercisable simply upon the passage of time) and forward starting liquidation rights whose exercise in the future depends upon the occurrence or nonoccurrence of a specified future event. The latter situation is discussed in Section 7.2.9.2.

7.2.10.4 Participating Rights

In a manner similar to kick-out rights, participating rights are only considered in the primary-beneficiary assessment if the participating rights are held by a single party (and its related parties and de facto agents) and are substantive. The VIE definition of participating rights is different from the voting interest entity definition. (See Table 1-1 in Section 1.4 for differences between the voting interest entity model and the VIE model.)

ASC 810-10 — Glossary

Participating Rights (VIE Definition)

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.

To be deemed substantive, a participating right must allow the holder to block or participate in all of the activities that most significantly affect the VIE’s economic performance. That is, a participating right will not be substantive if a VIE has three significant activities and the holder can only block decisions related to one of the three significant activities. Participating rights are contrasted with protective rights, which are designed to protect the interests of a party holding those rights (see Section 2.7 for the VIE definition of protective rights).

If deemed substantive and unilaterally exercisable, the participating right prevents another party from having power. However, unlike kick-out rights, a participating right does not convey power to the holder of the substantive participating right because it only allows the holder to block or participate in decisions as opposed to make decisions.

For entities other than limited partnerships, the evaluation of participating rights in the primary-beneficiary assessment is consistent with the evaluation of participating rights in the determination of whether the equity holders have power in the VIE assessment. In other words, for entities other than limited partnerships, the VIE definition of participating rights is used for both the VIE and the primary-beneficiary assessment. However, for limited partnerships, the VIE definition is used for the primary-beneficiary assessment whereas the voting interest entity definition is used for determining whether the equity holders have power in the VIE assessment. See Section 5.3.1.1.3.5 for a discussion of the effect of substantive participating rights on the VIE assessment under the VIE definition of participating rights for entities other than partnerships. See Section 5.3.1.2.7 for a discussion of the effect of substantive participating rights on the VIE assessment for limited partnerships.