9.1 Reconsideration Events

A privately held partnership was formed with a contribution of capital from the partners in equal portions to their ownership interests. At inception, the partnership was deemed not to be a VIE. After inception, the partners wanted to protect themselves against the decline in value of the partnership’s sole asset, a rental property. Therefore, the partners paid a premium to a third party for a first-loss residual value guarantee on the partnership’s rental property. In this situation, the residual value guarantee has changed the characteristics of the partnership’s equity investment at risk. This causes the reporting entity to reconsider whether the partnership is a VIE (specifically, it appears that the partnership no longer has the characteristic in ASC 810-10-15-14(b)(2)) because the equity group does not absorb the expected losses related to the decline of the rental property.

Real Estate Entity R, initially determined not to be a VIE, purchases five rental properties by issuing equity and debt instruments. At inception, the equity and debt holders determine that the equity investment at risk is sufficient under ASC 810-10-15-14(a) and ASC 810-10-25-45. Subsequently, R issues subordinated debt to purchase additional rental properties. Because of R’s acquisition of additional assets, which potentially increases R’s expected losses, the variable interest holders involved must reconsider whether R has become a VIE. These transactions were not anticipated when R was formed.

Note that had these transactions been anticipated, in assessing the sufficiency of the equity, R would have needed to consider the variability associated with the substantial uncertainty regarding the acquisition of unidentified real estate at inception as well as the sources of funding for the acquisition. See Section 5.2.3 for additional information.

Entity C is formed by two investors to develop and manufacture a new drug. Assume that C is a voting interest entity and that each investor holds a variable interest in C. Investor A has power over the research and development activities to develop and obtain FDA approval for the drug (stage 1), and those activities most significantly affect C’s economic performance during that stage. Investor B has the power over the manufacturing process, distribution, and marketing of the drug if and when FDA approval is obtained (stage 2), and those activities would most significantly affect C’s economic performance during that stage. The variable interest holders conclude that FDA approval would be considered a substantive contingent event that results in a change in power from Investor A to Investor B. Therefore, the VIE determination should focus on stage 1 activities until the contingent event occurs.

If FDA approval is obtained, C is considered to be undertaking additional activities when C enters stage 2. This is due to the substantive contingency of getting FDA approval, even though stage 2 was anticipated at C’s inception. Therefore, the reporting entity should reconsider whether C is a VIE. Conversely, if FDA approval was not considered a substantive contingency, the reporting entity would not reconsider whether C is a VIE because stage 2 activities would have been considered in the initial assessment. See Section 5.2.4 for additional information.

Three investors form Entity A to purchase real estate property. Each of the three investors contributes $5 million in equity investment at risk and $45 million in subordinated debt. Entity A was deemed a VIE because of insufficient equity investment at risk. The original governing documents stipulate that, 12 months after A’s formation, each investor must contribute an additional $25 million in equity investment at risk. When that additional equity investment is made, A’s VIE status is reconsidered, even though the original governing documents required the subsequent equity investment.

Three investors form Entity A. They designed A to purchase five specific real estate properties. Each investor contributes $5 million in equity investment at risk and $45 million in subordinated debt. Entity A was deemed a VIE because of insufficient equity investment at risk. Upon A’s formation, it purchases the five properties it was designed to purchase. Three of the properties are in stable markets with stable cash flows. However, two are in emerging markets in which stable cash flows are not expected, which could result in significant expected losses. Twelve months after Entity A’s formation, A sells the two properties in emerging markets, which reduces its expected losses. Upon the sale of the two properties, A’s VIE status is reconsidered.

Upon formation, a limited partnership is a VIE because the general partner, along with legal entities under common control or parties acting on its behalf, has sufficient interests to prevent a simple majority (or a lower threshold) of the limited partners from exercising kick-out rights (including liquidation rights) and the limited partners do not have substantive participating rights. After the formation of the limited partnership, the governing documents are amended to permit a simple majority of the limited partners, excluding the general partner (and entities under common control or parties acting on its behalf), to exercise the kick-out rights that accrue to those interest holders irrespective of the holdings of the general partner.

The partners should reassess whether the limited partnership continues to be a VIE. In this example, the holders of the equity investment at risk (i.e., the limited partners) effectively gain power as a result of the general partner’s disposal of its kick-out rights as opposed to losing the power to direct activities (as would be the case if the general partner obtained additional kick-out rights). Furthermore, even though the general partner was initially (upon formation of the partnership) and continues to be part of the equity group, we believe that the right to exercise power over the significant activities of a legal entity is fundamental to the determination of whether a legal entity is a VIE and, if so, whether the holder of a variable interest in the VIE is the primary beneficiary. Accordingly, either a gain or a loss of power to direct the activities of a limited partnership that most significantly affect its economic performance would be deemed a reconsideration event in the context of evaluating the guidance in ASC 810-10-35-4(e).

Investors X and Y form Entity Z to purchase and operate real estate properties. Each investor contributes $25 million in equity at risk. In addition, Investor D loans $5 million to Z. The loan agreement between D and Z includes a clause stipulating that if there is an adverse change that materially impairs the ability of Z to pay back the loan, D can take possession of all the assets of Z and direct the activities that most significantly affect Z’s economic performance. An independent third party must objectively determine whether a material adverse change has occurred on the basis of the terms of the loan agreement (an example of a material adverse change under the loan agreement would be the bankruptcy of Z). At inception, Z is deemed a voting interest entity (the rights of D are considered protective rights in accordance with ASC 810-10-25-38C). The occurrence of a material adverse change under the debt agreement would trigger a reconsideration event, since the holders of the equity investment at risk as a group would have lost the power to direct the activities that most significantly affect Z’s economic performance.

An investment manager creates a fund and retains a 25 percent interest in it. For its role, the investment manager receives remuneration that is customary and commensurate with services performed, including an incentive fee. However, the fee arrangement is considered a variable interest as a result of the investment manager’s 25 percent interest.

In addition, the investment manager has the power to direct the activities that most significantly affect the legal entity’s economic performance (rather than the equity investors). Accordingly, when evaluating whether the fund is a VIE, the investors with equity at risk would not have power (ASC 810-10-15-14(b)(1)). In this case, the investment manager would not be able to apply the override in ASC 810-10-15-14(b)(1) because its fee arrangement is a variable interest (see Section 5.3.1.1.3.1). That is, the investment manager with power would not be acting in a fiduciary capacity on behalf of the equity investors and the fund is therefore a VIE.

Subsequently, the investment manager disposes of its 25 percent interest. As a result, the fee arrangement is no longer considered a variable interest (see Section 4.4.3), and the investment manager is now acting in a fiduciary capacity on behalf of the equity investors. In this case, the investment manager would reconsider whether the fund remains a VIE because a gain or a loss of power to direct the significant activities by the equity investors would be deemed a reconsideration event in the context of evaluating the guidance in ASC 810-10-35-4(e).

Entity X and Entity Y each own 50 percent of the outstanding common stock of Entity Z, a corporation. Entities X and Y share in making all the decisions that most significantly affect the economics of Z. Therefore, X and Y have joint control over entity Z. In addition, X has additional variable interests in Z. As a result, X has disproportionately few voting rights in Z relative to its variable interests. Entity Y owns a 7 percent voting interest in X but is not a principal owner of X. In accordance with ASC 810-10-25-43, X and Y are not de facto agents or related parties. Entities X and Y conclude that Z meets all the conditions in ASC 810-10-15-14 and, accordingly, both account for their interest in Z under the equity method of accounting.

Subsequently, Y acquires an additional ownership interest in X and, in accordance with ASC 850, becomes a principal owner of X, holding 10.5 percent voting ownership of X (the “transaction”). Assume that the conditions in ASC 810-10-35-4(a) through (d) have not been met as a result of the transaction.

We believe that Y must assess the transaction to determine whether the conditions in ASC 810-10-35-4(e) have been met. Although they are related parties after the transaction, X and Y were not related entities before it. The condition in ASC 810-10-35-4(e) is met if the holders of the equity investment at risk, as a group, lose (or gain) power to direct the activities of the legal entity that most significantly affect the legal entity’s economic performance.

ASC 810-10-15-14(b) provides guidance on determining whether the holders of the equity investment at risk, as a group, have power. Therefore, Y would need to consider this guidance when determining whether the condition in ASC 810-10-35-4(e) has been met. In addition, Y would need to assess whether the guidance ASC 810-10-15-14(c) has been met since it describes a condition in which the holders of the equity investment at risk may not have power over the legal entity.

In summary, as a result of the transaction, Y should assess whether ASC 810-10-35-4(e) is met. It should base its assessment on an evaluation of ASC 810-10-15-14(b) and (c). If the condition in ASC 810-10-15-14(b) is not met, it should determine whether ASC 810-10-15-14(c) is met in assessing whether ASC 810-10-35-4(e) is met.