7.2 Power Criterion
ASC 810-10
25-38B A reporting entity must identify which activities most significantly impact the VIE’s economic performance and determine whether it has the power to direct those activities. A reporting entity’s ability to direct the activities of an entity when circumstances arise or events happen constitutes power if that ability relates to the activities that most significantly impact the economic performance of the VIE. A reporting entity does not have to exercise its power in order to have power to direct the activities of a VIE.
25-38F Although a reporting entity may be significantly involved with the design of a VIE, that involvement does not, in isolation, establish that reporting entity as the entity with the power to direct the activities that most significantly impact the economic performance of the VIE. However, that involvement 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 that power. For example, if a sponsor has an explicit or implicit financial responsibility to ensure that the VIE operates as designed, the sponsor may have established arrangements that result in the sponsor being the entity with the power to direct the activities that most significantly impact the economic performance of the VIE.
25-38G Consideration shall be given to situations in which a reporting entity’s economic interest in a VIE, including its obligation to absorb losses or its right to receive benefits, is disproportionately greater than its stated power to direct the activities of a VIE that most significantly impact the VIE’s economic performance. Although this factor is not intended to be determinative in identifying a primary beneficiary, the level of a reporting entity’s economic interest may be indicative of the amount of power that reporting entity holds.
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:
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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.
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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.
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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 7.2.8.
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 (O&M) 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 O&M 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 7.2.8.1.
- 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 7.2.11.
- Is there another party or other parties that direct the same activities but for a different portion of the VIE’s assets? See Section 7.2.8.2.
- Is the reporting entity’s right to exercise power currently available or contingent on the occurrence of some other event(s)? See Section 7.2.10.
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.
7.2.4.1 Consideration of Independent Directors
In situations in which the board of directors is required to include
certain independent directors, the governing documents or contractual provisions may
specify which party (or parties) appoints the independent directors. If the VIE’s
significant decisions are made at the board-of-director level, questions may arise about
how to determine which party has the power to direct the most significant activities of
the VIE when one party has the ability to unilaterally appoint or remove one or more of
the independent directors.
In these cases, in the evaluation of which party has the power to
direct the VIE’s most significant activities, we generally attribute the power
associated with appointing the independent director to the party (if one exists) that
has the unilateral ability to appoint, remove, or replace such independent director.
This analysis may be complex in situations in which an investor has the right to appoint
and approve an independent director, as illustrated in the examples below.
Example 7-1
Investors H and P, two unrelated parties, each have a 50
percent equity interest in LLC, a VIE. LLC has a board of directors that is
composed of five individuals. Two directors, one of whom must be
independent,2 are elected and appointed by H. Three directors, two of whom must be
independent, are elected and appointed by P. The decisions related to the
activities that most significantly affect the economic performance of LLC
are made through a simple majority vote of the board of directors. At face
value, the fact that three of the five members of the board must be
independent may suggest that neither party has power over the VIE’s
significant activities. However, upon further analysis to determine which
party had the right to appoint the independent directors, P would be deemed
to meet the power criterion by virtue of its ability to elect, appoint, or
remove three of the five board members.
Example 7-2
Assume the same facts as in the example above, except that
two of LLC's five directors are elected and appointed by H. Three directors,
two of whom must be independent,3 are elected and appointed by P. At face value, the fact that two of
the five board members must be independent may suggest that no single party
would be deemed to meet the power criterion. However, upon further analysis
to determine which party had the right to appoint the independent directors,
P would be deemed to meet the power criterion by virtue of its ability to
elect, appoint, or remove three of the five board members.
Example 7-3
Entity G, a VIE, was formed on January 1, 20X2. Assume the
following as of that date:
- Investors M and L, two unrelated parties, have a 20 percent and a 25 percent equity interest, respectively, in G.
- The remaining 55 percent equity interest is held by several unrelated shareholders, none of which individually have more than a 50 percent equity interest and are not required, nor do they intend, to vote in concert with one another.
- Entity G has a board of directors that is composed of five individuals. Two are elected and appointed by M, one is elected and appointed by L, and two must be independent.4 The two independent directors are elected and appointed by a majority vote of the shareholders (which include M, L, and the unrelated shareholders that hold the remaining 55 percent equity interest) at the annual shareholder meeting.
The decisions related to the activities that most
significantly affect the economic performance of G are made through a simple
majority vote of the board of directors. In an analysis performed to
determine which party had the right to appoint the independent directors, no
single shareholder would have the ability to elect and appoint the two
independent directors. Therefore, no single party would be deemed to meet
the power criterion by virtue of its inability to elect and appoint a
majority of the five board members.
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
7.2.11.1).
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 7-4
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 7-5
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.
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The following actions cannot be taken without a unanimous vote of the board:
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Removal of the managing member.
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Appointment of a replacement managing member.
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Decisions to make calls for capital contributions.
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Admission of new members.
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Amendments to X’s articles of incorporation.
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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.
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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.
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Investor W is paid a fixed annual fee plus 15 percent of the venture’s profits for serving as managing member.
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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.
7.2.6 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.
7.2.7 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.
7.2.8 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.
7.2.8.1 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
7.2.8.2).
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 7-6
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 7-7
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).
7.2.8.2 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 7-8
Assume the same facts as in Example 7-6, 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 7-9
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. In other words, the party with more power (relative
to other parties) over the significant activities of the VIE would be considered to meet
the power criterion. 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).
7.2.8.3 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, joint or unanimous consent must be required for all decisions
regarding significant activities. In other words, when decisions about the remaining
significant activities are shared, the unilateral ability of one party to make decisions
about one of the VIE’s significant activities would suggest that such party has more
“relative power” over the entity and may be the VIE’s primary beneficiary (i.e., shared
power does not exist). 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
7.2.8.2 for a discussion of multiple parties that perform the same or
different significant activities.
7.2.9 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.
7.2.10 Future Rights and Contingencies (Step 3)
7.2.10.1 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 7-10
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 7-11
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.
7.2.10.2 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 7-12, the latter in Examples 7-13 and 7-14.
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 7-12
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 7-13
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 7-14
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.
7.2.11 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 7.2.11.1 through 7.2.11.3 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
7.2.11.4, 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.”
7.2.11.1 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.
7.2.11.2 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.
7.2.11.3 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.5 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
7.2.10.1 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
7.2.10.2.
7.2.11.4 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.
Footnotes
1
Since the focus is placed on variability, a party with a small
overall ownership percentage in a VIE could be exposed to a significant amount of
the VIE’s variability (e.g., the holder of a residual interest when there is a large
amount of senior interests). Similarly, a party with a large overall ownership
percentage in a VIE may not be exposed to a significant amount of the VIE’s
variability (e.g., if the party holds senior interests in a VIE whose capitalization
also includes substantive subordinated and residual interests).
2
Under SEC rules, an independent director is a member
of the board of directors who has no material connection to the entity
or its management.
3
See footnote 2.
4
See footnote 2.
5
As stated in ASC 810-10-25-14B, “[t]he requirement to dissolve or
liquidate the entire limited partnership upon the withdrawal of a limited partner or
partners shall not be required to be contractual for a withdrawal right to be
considered as a potential kick-out right.” Therefore, a reporting entity must
determine, on the basis of the facts and circumstances, whether the practical result
of the withdrawal will be the required dissolution of the partnership (e.g., the
partnership has only one limited partner and the general partner has a nominal
interest) or its liquidation.