8.2 Identifying Related Parties and De Facto Agents

ASC 810-10

25-43 For purposes of applying the guidance in the Variable Interest Entities Subsections, unless otherwise specified, the term related parties includes those parties identified in Topic 850 and certain other parties that are acting as de facto agents or de facto principals of the variable interest holder. All of the following are considered to be de facto agents of a reporting entity:

A party that cannot finance its operations without subordinated financial support from the reporting entity, for example, another VIE of which the reporting entity is the primary beneficiary
A party that received its interests as a contribution or a loan from the reporting entity
An officer, employee, or member of the governing board of the reporting entity
A party that has an agreement that it cannot sell, transfer, or encumber its interests in the VIE without the prior approval of the reporting entity. The right of prior approval creates a de facto agency relationship only if that right could constrain the other party’s ability to manage the economic risks or realize the economic rewards from its interests in a VIE through the sale, transfer, or encumbrance of those interests. However, a de facto agency relationship does not exist if both the reporting entity and the party have right of prior approval and the rights are based on mutually agreed terms by willing, independent parties.
1. Subparagraph superseded by Accounting Standards Update No. 2009-17
2. Subparagraph superseded by Accounting Standards Update No. 2009-17
A party that has a close business relationship like the relationship between a professional service provider and one of its significant clients.

ASC 850-10-20 defines the term “related parties” as follows:

Related parties include:

Affiliates of the entity
Entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of Section 825-10-15, to be accounted for by the equity method by the investing entity
Trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of management
Principal owners of the entity and members of their immediate families
Management of the entity and members of their immediate families
Other parties with which the entity may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests
Other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.

8.2.1 Identifying Related Parties

The VIE subsections of ASC 810-10 define related parties as those identified in ASC 850 and certain other parties that are acting in a de facto agency capacity with the variable interest holder. However, identifying which parties meet the definition of a related party of the reporting entity under ASC 850 will often require judgment, especially in complex structures.

Example 8-1

Subsidiary A and Equity Method Investee (EMI) 1 form a joint venture that is a VIE. When identifying its related parties as part of its consolidation analysis, A would consider EMI 1 a related party. Specifically, in accordance with ASC 810-10-25-1, Investor has a controlling financial interest in A; therefore, A is part of the consolidated group. Correspondingly, in accordance with ASC 323-10-15-6, this same consolidated group (through the interests held by Investor) has significant influence over the operating and financial policies of EMI 1. Accordingly, the consolidated group can exert significant influence over EMI 1 to the extent that in a transaction between A and EMI 1, Investor (or the consolidated group) might prevent EMI 1 from fully pursuing its own separate interests and meets the definition of a related party in ASC 850. Therefore, A and EMI 1 are considered related parties in the assessment of which party should consolidate the joint venture.

Example 8-2

Equity Method Investees (EMIs) 1 and 2 form a joint venture that is a VIE. The joint venture was created with at-market terms, and there are no other transactions between EMI 1 and EMI 2. Investor has significant influence over the operating and financial policies of both EMIs 1 and 2. However, assume that both EMI 1 and EMI 2 have a typical corporate governance structure in which Investor is not able to unilaterally make decisions for the investees or influence the decision to form the VIE in a manner that prevents each party from fully pursuing its own interests. Therefore, unless there are other arrangements between EMIs 1 and 2, the related-party relationship is between Investor and the two EMIs, and not between EMI 1 and EMI 2. Accordingly, on the basis of these facts and circumstances, EMI 1 and EMI 2 would not be related parties.

8.2.2 Related Parties Under Common Control

In certain parts of the VIE consolidation analysis, the effects of interests held by the reporting entity’s related parties will depend on whether the related party is “under common control.” Therefore, the determination of whether a related party is under common control could significantly affect the consolidation conclusion.

The Codification does not specifically define common control. However, in paragraph BC69 of ASU 2015-02, the FASB explains that under the VIE model, and specifically in the application of ASC 810-10-25-42, ASC 810-10-25-44A, and ASC 810-10-55-37D, entities under common control would include “subsidiaries controlled (directly or indirectly) by a common parent, or a subsidiary and its parent.”

Example 8-3

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

The parent in a parent-subsidiary relationship does not need to be a separate legal entity. That is, an individual that possesses a controlling financial interest may be identified as a parent. The ASC master glossary defines “parent,” in part, as “[a]n entity that has a controlling financial interest in one or more subsidiaries” (emphasis added).

On the basis of the above description of common control, common ownership does not represent common control. That is, in some instances, two or more reporting entities may have a high degree of common ownership, which would typically result in a conclusion that the reporting entities are not under common control.

Example 8-4

Two unrelated individuals (that have not agreed to vote in concert) each own 50 percent of both Entity A and Entity B, but neither has a controlling financial interest in either A or B. In this case, A and B would be considered related parties with common ownership, but not under common control.

8.2.3 Identifying De Facto Agents

The VIE model expands the population of other entities whose interests are considered by the reporting entity in its VIE analysis to include interests of parties that are acting in a de facto agency relationship with the reporting entity. The FASB identified certain relationships that may indicate that one party (the “de facto agent”) may be acting on behalf of another (the “de facto principal”). However, regardless of whether a reporting entity is identified as a de facto agent or a de facto principal, the reporting entity must consider the impact of the related-party relationship throughout the VIE model.

The following sections discuss the de facto agents identified by the FASB in ASC 810-10-25-43:

“A party that cannot finance its operations without subordinated financial support from the reporting entity, for example, another VIE of which the reporting entity is the primary beneficiary” — Section 8.2.3.1.
“A party that received its interests as a contribution or a loan from the reporting entity” — Section 8.2.3.2.
“An officer, employee, or member of the governing board of the reporting entity” — Section 8.2.3.3.
“A party that has an agreement that it cannot sell, transfer, or encumber its interests in the VIE without the prior approval of the reporting entity [that prevents the other party from managing the economics of its interest]. However, a de facto agency relationship does not exist if both the reporting entity and the party have [rights] of prior approval and the rights are based on mutually agreed terms by willing, independent parties” — Section 8.2.3.4.
“A party that has a close business relationship like the relationship between a professional service provider and one of its significant clients” — Section 8.2.3.5.

8.2.3.1 Subordinated Financial Support Received From the Reporting Entity

A de facto agency relationship exists if the other party is financially dependent on the reporting entity or a legal entity consolidated by the reporting entity. Identifying such a de facto agency relationship is typically straightforward.

8.2.3.2 Interests Received as a Loan or Contribution

A de facto agency relationship is generally created when another party receives its interest in the VIE as a contribution or a loan from the reporting entity, even if the loan or contribution only covers a portion of the interest. While this de facto agency is intended to prevent a reporting entity from avoiding consolidation of a VIE by structuring transactions so that another party holds a variable interest in the VIE that the reporting entity is exposed to through the loan, it is not simply an anti-abuse provision. That is, it is on the FASB’s list of de facto agencies; thus, if the de facto agency criteria are met, the parties are generally considered related.

We have historically viewed fixed-price put options to be the economic equivalent of a loan (see Table 5-1 in Section 5.2.2.4.1). That view was premised on the fact that a nonrecourse loan and a purchased put option give an investor similar down-side protections. While we appreciate that some may continue to hold that view, our perspective on the issue has evolved. Although purchased put options and nonrecourse loans provide similar down-side protections, substantive differences between them exist related to form and substance. Notably, a loan provides capital to the investor to make an investment, whereas the purchased put option does not provide any capital to the option’s holder up front. That is, a lender provides capital to the borrower when the lender extends a loan; an option’s writer does not extend financing to the buyer of the put option up front. On the basis of that distinction, we have updated our interpretation related to this matter and believe a purchased put option should be considered analogous to a loan guarantee. The down-side protection provided by the put option is economically equivalent to a guarantee of the financing deployed to invest in the entity.

However, not all interests received as a loan will result in a de facto agency relationship. In very limited situations, two reporting entities need not consider themselves related parties when one of the reporting entities has received its interest as a loan from the other reporting entity. This exception would be limited to scenarios in which the party providing the loan to another party involved with the potential VIE is in the business of extending credit in the normal course of its business. In addition to this requirement, the following factors (not all-inclusive) may indicate that the existence of a loan between two variable interest holders does not create a de facto agency relationship under ASC 810-10-25-43:

The creditor does not control and is not able to significantly influence the debtor.
The debtor receives the full benefits and obligations associated with its financed interest. The debtor’s rights associated with its interest are not affected by the fact that the financing was provided by another variable interest holder.
The debtor was not required to obtain its financing from the creditor. That is, the debtor has the right to obtain its interest in whatever way it chooses (i.e., paying cash or financing the interest with any party it chooses).
The loan is originated in the normal course of business as an arm’s-length commercial transaction. A reporting entity must consider whether the loan was provided at market rates in a manner similar to its consideration of rates provided for comparable transactions.
The lender has full recourse to the debtor’s assets, the debtor’s ability to repay the loan does not depend on the performance of the interest lent, and the creditor is able to pursue any remedy available by law.
The creditor has the right to sell, pledge, or hold the loan.
The debtor has the right to sell or hold the financed interest. Restrictions placed on the financed interest should be considered in a manner similar to the analysis required by ASC 810-10-25-43(d).

Example 8-5

Company A and Company B establish VIE X, each contributing 50 percent of the equity. Company B has a commercial lending subsidiary that provides credit for various business transactions in the normal course of business. Company A, to finance its equity contribution to VIE X, was approved to borrow an equal amount of funds from B’s lending subsidiary. The loan was originated in a manner similar to all other commercial loans of B, A was not required to obtain the funds from B, B has full recourse to all of A’s assets, and there are no restrictions in the lending arrangement on A’s ability to sell or hold its interest in VIE X. On the basis of these facts and circumstances, although A happened to obtain the funds necessary for its investment in VIE X from B’s lending subsidiary, the parties may conclude that a de facto agency relationship does not exist.

Example 8-6

Assume the same facts as in the example above, except that Company B does not make commercial loans in the normal course of its business. Instead, in the formation of VIE X, A and B agreed that A would borrow funds necessary to make its equity investment from B. On the basis of these facts and circumstances (primarily, that B is not in the business of making similar loans), a de facto agency relationship exists. Said differently, the lending arrangement was a primary part of the design and purpose of the formation of X.

8.2.3.3 Officer, Employee, or Member of the Governing Board of the Reporting Entity

A de facto agency relationship will also exist if the other party is an officer, employee, or member of the governing board of the reporting entity. Identifying this de facto agency relationship is typically straightforward.

8.2.3.4 Transfer Restrictions

A de facto agency relationship can be created contractually on the basis of the terms of an arrangement. For example, ASC 810-10-25-43(d) states that a de facto agency relationship is present when a party has entered into an agreement under which it “cannot sell, transfer, or encumber its interests in the VIE without the prior approval of the reporting entity.” However, a de facto agency relationship exists only if having to obtain such approval constrains the other party’s ability to manage substantially all of its economic interest in the VIE. Whether restricting sales or transfers constrains another party depends on the facts and circumstances. Factors to consider in determining whether a restriction constitutes a constraint may include, but are not limited to, the following:

Generally, in the determination of whether a restriction on sales or transfers constrains another party, a phrase in a contractual agreement such as “without prior approval, which cannot be unreasonably withheld” indicates that a variable interest holder is not constrained from managing the economic risks or realizing the economic rewards of its interest. In other circumstances, a phrase like this may indicate that the variable interest holder is in fact constrained. Conversely, a de facto agency relationship is presumed if such language is absent from a contractual agreement or if the agreement only cites narrow specific circumstances that would not typically be encountered under which approval cannot be unreasonably withheld. We believe that this interpretation specifically addresses sales and transfers and should generally not be applied to the evaluation of whether the rights held by a noncontrolling shareholder are substantive participating rights. For a discussion of the effect of such contractual language on the evaluation of whether a noncontrolling interest holder has substantive participating rights, see Section D.2.3.1.
If a party has the ability to realize the economic benefits of its interest by selling that interest without the reporting entity’s prior approval, the party would not be constrained even if the reporting entity’s approval is required for all other transfers or encumbrances of that interest.
If the right of prior approval is designed solely to prevent transfer of the interest to a competitor or to a less creditworthy, or otherwise less qualified, holder, and such parties are not the only potential purchasers of that interest, the party would not be constrained.
A party is constrained if it cannot sell, transfer, or encumber its interest but can manage the risk of owning the interest by hedging that risk.
A right of first refusal (a requirement that gives the holder of the right the ability to match an offer) or a right of first offer (a requirement that the interest holder must first offer to sell its interest to the holder of the right prior to selling it to a third party) generally does not create a de facto agency relationship. This is because these rights would not constrain the variable interest holder from managing its economic interest in the entity.
A restriction that precludes a variable interest holder from selling, transferring, or pledging its interest for a period of time would create a de facto agent relationship during that period. However, once the restriction expires, the party would no longer be considered a de facto agent, and the reporting entity would need to reevaluate its consolidation conclusion.

In addition, as indicated in ASC 810-10-25-43(d), “a de facto agency relationship does not exist if both the reporting entity and the party have right of prior approval and the rights are based on mutually agreed terms by willing, independent parties.” For example, in a typical joint venture structure, transfer restrictions are often imposed on all the venturers to maintain the structure of the joint venture. Since these transfer restrictions “are based on mutually agreed terms by willing, independent parties,” the venturers may not be de facto agents.

Example 8-7

Company X has a $1 million interest in VIE 1. Company Y, another interest holder in VIE 1, must approve all sales and transfers of X’s interest. Company X does not have a similar right of prior approval for sales and transfers of Y’s interest in VIE 1. Company X otherwise may encumber its interest in VIE 1 without the approval of Y; however, financial institutions will only lend X up to $300,000 if X uses its $1 million interest as collateral. Thus, X is able to manage only a portion of its risk by encumbering its interest. Because X cannot realize, by encumbrance, all or most of the cash inflows that are the primary economic benefits of its interest, X is constrained and is deemed to have a de facto agency relationship with Y.

Example 8-8

Assume the same facts as in the example above. In addition, Company X enters into a total return swap with an unrelated third party, Banker 1, to economically hedge its variable interest. Under the total return swap, X will receive cash equal to substantially all of the benefits encompassed in its variable interest during the term of the swap. Under the terms of the swap, X is not acting as an agent for Banker 1. Although X has managed its risk of ownership in VIE 1, X is constrained (because a total return swap is not a sale, transfer, or encumbrance) and is deemed to have a de facto agency relationship with Y.

Example 8-9

Assume the same facts as in Example 8-7, except that VIE 1 is a franchise (that does not meet the business scope exception in ASC 810-10-15-17(d)), and the franchise agreement stipulates that the franchisor must approve any prospective purchases of the franchisee’s interest that are to competitors, less creditworthy purchasers, or purchasers that do not intend to maintain the franchise at the existing level of quality. There are several other potential purchasers that would qualify. The franchisee is not considered constrained under ASC 810-10-25-43(d) because it can still manage its economic interest in VIE 1 through sale and transfer (i.e., the restriction is only on the sale to a nonqualified investor and there are other qualified investors who could purchase the interest).

Example 8-10

Two parties enter into a joint venture for 20 years. The entity does not meet the business scope exception in ASC 810-10-15-17(d) and is determined to be a VIE. The joint venture partners have entered into a five-year lock-up agreement whereby neither party is permitted to sell, transfer, or encumber its interest in the joint venture without the written consent of the other party. Since the two parties both have the right of prior approval, have mutually agreed on the prior approval terms, and are willing, independent parties, the two parties are not considered related parties (i.e., de facto agents) for the term of the lock-up period.

8.2.3.4.1 Effect of a Put Option on Analyzing Transfer Restrictions

In certain situations in which transfer restrictions are contractually in place, a de facto agency relationship may not be present if the restricted party has a separate put option that effectively allows that party to manage its economics through exercise of the put option. The existence of a fair value put option that is currently exercisable for 100 percent of the interest held and with no restrictions may be sufficient to allow the reporting entity holding the put option to manage the economic risks or realize the economic rewards from its interests in a VIE. However, the reporting entity should evaluate all facts and circumstances to determine whether a put option would affect whether a de facto agency relationship exists. For example, fair value should be based on an independent valuation as of the exercise date rather than on a predetermined formula that is not updated to reflect current market conditions. Conversely, if the exercise price of the put option is fixed or at other than fair value, the de facto agency relationship cannot be overcome.

8.2.3.5 Close Business Relationship

A de facto agency relationship can also exist if the reporting entity has a close business relationship with another party. We understand that the intent of this guidance is to prevent potential structuring opportunities in which a reporting entity attempts to avoid consolidation by transferring its variable interests in a legal entity to its professional service providers. In certain situations, a reporting entity may contract with service providers and delegate power to those providers over certain activities to achieve off-balance-sheet accounting. In these cases, inclusion of these service providers as de facto agents would require the reporting entity to consider whether it should consolidate because of the combination of its direct power and economics as well as the power or economics granted to the service provider.

At the 2008 AICPA Conference on Current SEC and PCAOB Developments, an SEC staff member, Professional Accounting Fellow Robert Malhotra, discussed the close business relationship provision. Although his remarks refer specifically to FIN 46(R), the guidance on close business relationships has not changed as a result of Statement 167 and ASU 2015-02. His speech stated, in part:

In the context of paragraph 5(c) of FIN 46R, the staff has been asked whether certain close business associates may be considered related parties under Statement 57 or paragraph 16 of FIN 46R. In this context, the staff believes that close business associates may only be considered related parties if one party can control or can significantly influence the other party to an extent that one of the parties might be prevented from fully pursuing their own separate interest should that party choose to do so. That being the case, the mere past practice or future intent of close business associates to collaborate would be insufficient to conclude the parties are related. The staff believes that this is consistent with the definition of a related party included in Paragraph 24 of Statement 57. [Footnote omitted]

Therefore, reporting entities should carefully evaluate professional service providers as potential close business relationships to determine whether one party controls or significantly influences the other party such that one of the parties might be prevented from fully pursuing its own interest. Reporting entities should examine professional service providers, such as attorneys, investment bankers, and accountants, who help structure a transaction or entity to determine whether the purpose of the structuring was to avoid consolidation (i.e., the service provider is acting solely as an intermediary). Considerations in this analysis should include but not be limited to whether:

The reporting entity does not appear to have a variable interest in the structured entity because the variable interest is held by the service provider.
The service provider lacks other significant sources of income.
The service provider is incentivized to make decisions that align with the reporting entity.
The service provider was significantly involved in the formation and structuring of the legal entity.
The cash flow streams result in “round tripping.”

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