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The second characteristic of a VIE focuses on whether the “at risk” equity investors have the ability to make decisions that significantly impact the economic performance of the potential VIE. The underlying principle of Characteristic 2 is that if the equity investors lack the power to direct the activities that have the most significant impact on the economic performance of the entity, it can be inferred that a party other than the equity investor(s) most likely controls the entity. In those circumstances, a consolidation model that focuses on relative voting rights may not be useful in identifying which party, if any, holds a controlling financial interest in the entity.

Excerpt from ASC 810-10-15-14(b)

As a group the holders of the equity investment at risk lack any one of the following three characteristics:
1. The power, through voting rights or similar rights, to direct the activities of a legal entity that most significantly impact the entity’s economic performance.

4.4.1 Applying Characteristic 2 to corporations and similar entities

Excerpt from ASC 810-10-15-14(b)

As a group the holders of the equity investment at risk lack any one of the following three characteristics:
1. The power, through voting rights or similar rights, to direct the activities of a legal entity that most significantly impact the entity’s economic performance.
i. For legal entities other than limited partnerships, investors lack that power through voting rights or similar rights if no owners hold voting rights or similar rights (such as those of a common shareholder in a corporation). Legal entities that are not controlled by the holder of a majority voting interest because of noncontrolling shareholder veto rights (participating rights) as discussed in paragraphs 810-10-25-2 through 25-14 are not VIEs if the holders of the equity investment at risk as a group have the power to control the entity and the equity investment meets the other requirements of the Variable Interest Entities Subsections.
01. If no owners hold voting rights or similar rights (such as those of a common shareholder in a corporation) over the activities of a legal entity that most significantly impact the entity’s economic performance, kick-out rights or participating rights (according to their VIE definitions) held by the holders of the equity investment at risk shall not prevent interests other than the equity investment from having this characteristic unless a single equity holder (including its related parties and de facto agents) has the unilateral ability to exercise such rights. Alternatively, interests other than the equity investment at risk that provide the holders of those interests with kick-out rights or participating rights shall not prevent the equity holders from having this characteristic unless a single reporting entity (including its related parties and de facto agents) has the unilateral ability to exercise those rights. A decision maker also shall not prevent the equity holders from having this characteristic unless the fees paid to the decision maker represent a variable interest based on paragraphs 810-10- 55-37 through 55-38.

The application of Characteristic 2 to entities other than limited partnerships (e.g., entities governed by a board of directors, such as corporations) centers on whether the holders of equity at risk, as a group, have rights (through their equity interests) to direct the activities of the entity that most significantly impact its economic performance.
When determining whether Characteristic 2 is present for entities other than limited partnerships, the following tasks should be performed:
  • Identify the capital contributions (i.e., equity investments) that qualify as equity investment at risk.
  • Group those equity investments together as if they were held by a single party.
  • Identify the entity’s most significant activities. This analysis should focus on those activities that significantly impact the entity’s economic performance.
  • Evaluate whether the holders of equity at risk, as a group, have the power, through voting rights or similar rights, to direct the entity’s most significant activities.
  • If decision making has been outsourced to one of the at-risk equity investors through a separate variable interest that does not qualify as equity at risk, determine whether the decision-making rights conveyed through that other variable interest are embedded in the investor’s equity investment.
  • If the holders of equity at risk, as a group, lack rights that constrain the decision maker’s level of authority, consider whether a single party has substantive kick-out or participating rights over the decision maker.

4.4.1.1 How to evaluate whether the equity holders as a group lack power

Determining which activities most significantly impact the entity’s economic performance requires judgment. When an entity’s operations are straightforward or one dimensional, determining whether or not the holders of the equity investment at risk meet the power criterion may not require significant judgment.
In other cases, this analysis may not be so clear cut. The identification of the entity’s significant activities may require consideration of the entity’s purpose and design, specifically, the nature of the entity’s activities and the risks it was designed to create and pass along to its variable interest holders. Reporting entities should carefully review the entity’s governing documents, contractual arrangements the entity has entered into, the entity’s website and/or promotional materials describing the nature of its operations, as well as the terms of the interests it has issued to its investors. A careful review of these arrangements should facilitate the identification of the potential VIE’s significant activities as well as the party that has the power to direct those activities.

4.4.1.2 Identifying an entity’s most significant activities

Identifying the activities of a potential VIE that most significantly impact its economic performance, and assessing how decisions related to those activities could affect the economic performance of the entity, is critical when assessing whether Characteristic 2 is present. Once the entity’s significant activities are identified, it is important to determine whether the decisions related to those activities are made by the group of holders of equity at risk or by parties outside of that group.
The identification of an entity’s most significant activities should focus on those activities that require decisions to be made that meaningfully impact the entity’s key operating metrics and/or business strategy. In other words, those decisions should be substantive.
The activities of an entity that most significantly impact an entity’s economic performance will vary by industry depending on the nature of the entity’s operations. Certain decisions may universally represent a significant activity of an entity, such as negotiating and executing significant acquisitions and strategic alliances, purchasing or selling assets, expanding the entity’s service or product offering, selecting management and determining their compensation, establishing, executing and approving capital and operating budgets, and capital financing (i.e., the issuance of debt or equity).
Other significant activities will be heavily influenced by the nature of the entity’s operations. The following list provides examples of activities that may represent some of the activities that most significantly impact the economic performance of entities operating within those industries:
Industry
Examples of significant activities
Financial services – asset management
  • Establishing the entity’s investment strategy
  • Purchases and sales of underlying investments
  • Exercising voting rights over investees
  • Negotiating key service provider contracts
Financial services – securitization vehicles
  • Identifying, negotiating, and purchasing assets held as collateral
  • Servicing or “working out” loans or other assets held as collateral that are delinquent or in default
Financial services – banking
  • Extending credit / lending standards
  • Decisions to extend loans to borrowers
  • Investing surplus cash
  • Establishing and executing the risk management strategy of the bank
  • Servicing or “working out” loans or other assets held as collateral that are delinquent or in default
Financial services – insurance
  • Underwriting insurance policies
  • Ceding insurance to reinsurers
  • Investing net written premiums received
Broadcasting (television and radio)
  • Negotiating retransmission agreements
  • Programming
  • Advertising
BioPharma and technology
  • Varies depending upon the phase of the entity’s life cycle, although the significant activities over the entity’s life may be:
    • Research and development
    • Sales and marketing (i.e., commercialization of approved drug compounds / biologics / new technologies)
    • Manufacturing of the drug, biologic, or technology
  • The power assessment may require a reporting entity to consider whether the stages of the entity’s life cycle are sequenced and dependent upon each other (i.e., whether there is uncertainty around the entity’s ability to progress from one stage of its life cycle to another)
  • If the stages of its life cycle are dependent upon one another, the entity’s most important activities will change as it progresses through its life cycle
Retail, consumer and industrial products
  • New product development
  • Negotiating supply contracts
  • Manufacturing (e.g., determining quantities of product sold and sourcing of raw material / inputs to production)
  • Sales and marketing
Healthcare (provider)
  • Negotiating provider and payor contracts
  • Employment and compensation decisions (both clinical and non-clinical)
  • Establishing patient care policies and protocol
  • Providing patient care
Real estate (leasing)
  • Selection of tenants
  • Establishing lease terms, including rental rates
  • Maintaining the property
  • Capital expenditures
  • Managing the residual value of the property
Power and utilities (power plants)
  • Varies depending upon the phase of the power plant’s life cycle (refer to UP 10.4.1.2)
The list presented above is not all inclusive and is intended to provide examples of activities that may significantly impact an entity’s economic performance. Reporting entities should evaluate the specific facts and circumstances of each individual situation when identifying a potential VIE’s significant activities.
Decisions that are purely administrative in nature should not be considered a significant activity of an entity. Back office functions that do not meaningfully impact an entity’s overall performance generally should not be considered a significant activity of a potential VIE. For example, accounting, information technology, and human resource functions would generally not be considered a significant activity of a normal operating entity when determining whether the group of at-risk equity investors has the power to direct the entity’s most significant activities.

4.4.1.3 Evaluating entities with limited ongoing decision making

Sometimes an entity’s activities are predetermined at formation and the level of ongoing decision making required is limited. Determining whether such entities are VIEs requires careful consideration of the relevant facts and circumstances, including the entity’s purpose and design.
If the entity’s ongoing decisions are purely administrative in nature, we believe Characteristic 2 would not be present since the group of at-risk equity investors predetermined the entity’s significant activities at formation. Even if the ongoing decisions are made through a variable interest that does not qualify as equity at risk, Characteristic 2 would not be present if those ongoing decisions are insignificant or administrative. In that situation, the decision maker would be unable to direct a single activity of the potential VIE that significantly impacts its economic performance.
When the entity’s ongoing decisions are other than purely administrative, we believe the identity of the party directing those activities and the means through which it exercises decision making becomes increasingly relevant. If those ongoing decisions are directed through a variable interest that does not qualify as equity at risk (refer to CG 4.4.1.4), the nature of the ongoing decisions made by the holder of that variable interest should be carefully considered to determine whether the group of at-risk equity investors lack power.

4.4.1.4 Decision making must reside within the equity instrument

Excerpt from ASC 810-10-15-14(b)

If interests other than the equity investment at risk provide the holders of that investment with these characteristics or if interests other than the equity investment at risk prevent the equity holders from having these characteristics, the entity is a VIE.

In some circumstances, a holder of equity at risk may have the ability to make decisions through another variable interest (e.g., decision making arrangement, such as a management contract) as opposed to an at-risk equity investment. If these decisions are made through another variable interest as opposed to the decision maker’s at-risk equity investment, then depending on the facts those rights may not be attributed to the group of at-risk equity investors for purposes of assessing whether Characteristic 2 is present. Consequently, the entity may be considered a VIE.
Determining whether decision making rights are held by the group of holders of equity at risk can be difficult, particularly when one of the equity investors has entered into a separate contractual arrangement with the potential VIE that conveys decision making rights. If the decision maker can sell its equity interest to an unrelated third party, it should consider whether the buyer (transferee) would also be required to purchase or assume the reporting entity’s other variable interest (the decision making arrangement). In other words, the decision maker should determine whether the variable interest that conveys decision making is legally detachable from its at-risk equity investment.
If the other variable interest (e.g., decision maker contract) can be legally separated from the decision maker’s equity investment, we believe the contractual arrangement and at-risk equity investment should be evaluated as two distinct interests. To make this determination, a reporting entity should consider whether it is possible for the decision maker to transfer its equity interest without also transferring its other variable interest that conveys decision making rights. If it is not legally possible to separate the variable interests, then the power to direct the entity’s most significant activities may reside within the group of at risk equity investors. In other words, the decisions making rights exercisable through its other variable interest may be viewed as though they are exercised through the decision maker’s equity interest (i.e., the contractual arrangement would be considered part of the decision maker’s equity interest). Consequently, no decision making exception would be present and the entity would not be a VIE with respect to Characteristic 2.
If the two variable interests are legally separable and decision making is exercisable through the contractual arrangement, further analysis is required to determine whether the entity is a VIE under Characteristic 2. This would require consideration of the rights exercisable by the potential VIE’s at-risk equity investors. Refer to CG 4.4.2 for further details on outsourced decision making for corporations and similar entities.

4.4.2 Outsourced decision making – corporations and similar entities

If a variable interest that is outside the equity investment at risk (e.g., debt interests, management contracts and equity investments that do not qualify as equity at risk) provides the holder of that interest with the power to direct the activities that most significantly impact the potential VIE’s economic performance, then Characteristic 2 may be present and the entity could be considered a VIE.
ASU 2015-02, Consolidation – Amendments to the Consolidation Analysis changed the evaluation of whether the at-risk equity investors (as a group) lack power when decision making is outsourced through a variable interest that does not qualify as equity at risk. In particular, the changes apply if there is a single decision maker that has a variable interest that is separate from (not embedded in) a substantive at-risk equity investment that conveys the power to direct the entity’s most significant activities. If the interest conveying decision making is not a variable interest, then the group of at-risk equity investors are presumed to have the power to direct the entity’s most significant activities and Characteristic 2 would not be present.
The change in how outsourced activities should be assessed resulted from the FASB’s consideration during the redeliberations of ASU 2015-02 of whether a registered mutual fund should be a VIE. Prior to the issuance of ASU 2015-02, a registered mutual fund would have been considered a VIE under the “power” and “economics” version of the VIE model if (1) an outsourced decision maker had power through a variable interest that was not embedded in an at-risk equity investment, and (2) substantive kick-out or participating rights exercisable by a single party did not exist.
The FASB considered the rights exercisable by the shareholders and board of directors of a mutual fund that is registered in accordance with the Investment Company Act of 1940 and determined that these entities should generally be considered voting interest entities. Specifically, the FASB noted that the rights exercisable by a registered mutual fund’s shareholders, either directly or indirectly through the entity’s independent board of directors, are not substantively different from voting rights held by shareholders of a public company (which are generally not VIEs).
The new approach introduced by ASU 2015-02 shifts the focus from single party kick-out or participating rights to the rights that the entity’s shareholders can exercise in the aggregate. If such rights exist and are substantive, it is presumed that the shareholders can constrain the outsourced decision maker’s level of discretion and decision making authority. Application of this approach may result in the conclusion that the shareholders, rather than the outsourced decisions maker (e.g., manager), have the power to direct an entity’s most significant activities.
Although this concept was discussed in the context of a registered mutual fund, it applies to all entities that outsource decision making through variable interests that do not qualify as equity at risk (e.g., management contracts or equity interests that do not qualify as equity at risk). This approach should not be applied to limited partnerships and similar entities as those entities are subject to the separate requirement described in ASC 810-10-15-14(b)(1)(ii).
The approach described in ASC 810-10-15-14(b)(1)(i), which applies to entities that are not limited partnerships or similar entities, can be summarized in the following three steps.
Step 1:  determine if the decision-making fee arrangement is a variable interest
If the decision-making fee arrangement is not a variable interest, then the equity investors as a group do not lack the power to direct the activities of the entity that most significantly impact its economic performance. The nature of that arrangement would indicate that the decision maker is acting in a fiduciary (agent) capacity and is therefore presumed to lack power over the entity’s most significant activities. This is because the decision maker will act in a manner that is primarily for the benefit of the entity’s equity investors. As a result, the entity would not be a VIE under Characteristic 2 and steps two and three would not apply.
Example CG 4-8 illustrates the assessment of the impact of a decision-making fee arrangement that is not a variable interest.
EXAMPLE CG 4-8
Assessing the impact of a decision-making fee arrangement that is not a variable interest
Entity ABC owns and operates data centers in several locations. The data centers house their customers’ servers, provide internet connectivity, and are contractually committed to have the servers operational for 99.97% of the time. Otherwise, Entity ABC would be subject to payment of heavy penalties.
Company A provides maintenance services to Entity ABC that are critical to the data center’s operations. Under the maintenance arrangement, Company A makes all decisions related to the maintenance of the data centers and keeps them operational pursuant to the contractual requirements. Company A has no other interest in the entity.
The maintenance arrangement meets all the conditions in ASC 810-10-55-37 such that the maintenance fee paid to Company A is not a variable interest (i.e., Company A’s fee is at market, commensurate, and Company A has no other economic interests directly or indirectly through its related parties that are more than insignificant).
What is the impact of Company A’s ability to make decisions through its service provider arrangement?
Analysis
In this example, even though Company A makes critical decisions that have a significant impact on the performance of Entity ABC, the maintenance fee is not a variable interest and Entity ABC would not be a VIE under Characteristic 2. If a decision maker or service provider contract is not a variable interest (see CG 3.4), then the decision maker or service provider is acting as an agent of the group of holders of equity at risk and would not have the power to direct Entity ABC’s most significant activities.

Step 2: determine if there is a unilateral kick-out or participating right
If the decision-making fee arrangement is a variable interest under the first step, then the reporting entity should consider whether substantive kick-out or participating rights exist. If a substantive right to replace the decision maker or veto (block) all of the entity’s most significant activities exists, then the entity would not be a VIE under Characteristic 2 and step 3 would not apply.
For the purposes of assessing whether a kick-out right or participating rights are substantive when evaluating an entity that is not a limited partnership or similar entity, kick-out rights (which also include liquidation rights) and participating rights should be ignored unless those rights can be exercised by a single party (including its related parties and de facto agents).
Step 3: assess the rights of shareholders
If the decision-making fee is determined to be a variable interest pursuant to ASC 810-10-55-37, and single party kick-out or participating rights do not exist, then the rights held by the entity’s equity investors must be considered to determine whether the at risk equity investors, as a group, lack the power to direct the entity’s most significant activities. Prior to the issuance of ASU 2015-02, the group of at risk equity investors was not considered to have power if a decision maker exercised power over the entity’s most significant activities through a variable interest that did not qualify as equity at risk. In such circumstances, the entity was determined to be a VIE under Characteristic 2 unless a single party (including its related parties and de facto agents) could exercise a substantive kick-out or participating right.
ASU 2015-02 introduced a new approach requiring a reporting entity to first consider the rights exercisable by the holders of equity at risk if substantive single party kick-out or participating rights do not exist. This additional step is required only when decision making over an entity’s most significant activities has been conveyed through a variable interest that does not qualify as equity investment at risk and single party kick-out or participating rights do not exist. If the at risk equity investors have certain rights as shareholders of the entity, then the entity would not be a VIE.
ASC 810-10-55-8A provides an example to illustrate the types of rights that may suggest the holders of equity at risk, as a group, have decision making power over the entity’s most significant activities. The example is written in the context of a series mutual fund and points to various shareholder rights as being present, including the ability to remove and replace the board members and the decision maker, and to vote on the decision maker’s compensation. It should also be noted that ASU 2015-02’s basis for conclusions (BC36) notes that this concept is intended to be applied broadly to all entities other than limited partnerships and similar entities.
Example CG 4-9 illustrates the application of this concept in a non-fund scenario.
EXAMPLE CG 4-9
Determining whether rights held by an entity’s shareholders convey power
Three unrelated companies established an entity to invest in shipping vessels. Company A and B each provide 40% of the capital in exchange for equity interests, and Company C also provides capital in exchange for a 20% equity interest. The entity operates subject to the supervision and authority of its board of directors. Each party has the ability to appoint members to serve on the entity’s board and shares in the entity’s profits and losses in proportion to their respective ownership interests.
The purpose, objective, and strategy of the entity is established at inception and agreed upon by its shareholders pursuant to the entity’s formation agreements. The three companies identified and jointly agreed to the specified shipping vessels in which the entity would invest at formation.
Company C performs all of the daily operating and maintenance activities over the shipping vessels pursuant to an Operating and Maintenance (O&M) agreement. The decisions relating to the operation and maintenance of the vessels are determined to be activities of the entity that most significantly impact the entity’s economic performance. Company C receives a fixed annual fee for services provided to the entity that is at market and commensurate. However, the fee arrangement is determined to be a variable interest because Company C has another significant variable interest in the entity (its 20% equity investment).
A number of decisions require simple majority board approval. These include:
  • The removal and replacement of the O&M manager, without cause
  • Changes in the O&M manager’s compensation
  • The acquisition of new ships
  • The sale of existing ships
  • A merger and/or reorganization of the entity
  • The liquidation or dissolution of the entity
  • Amendments to the entity’s charter and by-laws
  • Increasing the entity’s authorized number of common shares
  • Approval of the entity’s periodic operating and capital budgets
View image
Do the holders of equity at risk, as a group, lack the power to direct the entity’s most significant activities (is the entity a VIE under Characteristic 2)?
Analysis
Notwithstanding the fact that the decision-making fee arrangement is a variable interest, the entity would not be considered a VIE. The board is actively involved in making decisions about the activities that most significantly impact the entity’s economic performance. Among other rights, the board is able to remove the O&M manager without cause and approve its compensation. As the board is elected by the shareholders and is acting on their behalf, the shareholders in effect have power to direct the activities that most significantly impact the economic performance of the entity. Accordingly, the entity would not be a VIE under Characteristic 2.
If the board was non-substantive or lacked the legal authority to bind the entity, then the rights exercisable by the board would be less relevant. In that situation, the rights exercisable directly by the holders of equity at risk would determine whether the group lacks power.

Determining which shareholder rights must exist to demonstrate that Characteristic 2 is not present will depend on the relevant facts and circumstances, including the purpose and design of the entity. If an entity has a substantive board of directors, and the board is actively involved in overseeing the business and can legally bind the entity, we believe the at risk equity investors must have the ability to replace the board to demonstrate that they have power unless they have the substantive ability to directly exercise the same rights held by the board.
If an entity is not governed by a board of directors, or is governed by a board of directors that cannot legally bind the entity, then rights exercisable by the board become less relevant to this analysis. In those circumstances, rights exercisable by the shareholders (directly) should be assessed to determine whether they enable the holders of equity at risk, as a group, to constrain the outsourced decision maker’s level of authority and decision making.
Example CG 4-10 illustrates the determination of whether an at risk equity investor has power through an outsourced decision making arrangement.
EXAMPLE CG 4-10
Determining whether an at risk equity investor has power through an outsourced decision making arrangement
Two unrelated parties, Company A and Company B, form a real estate operating joint venture, with each party holding a 50% interest. The venture’s objective is to acquire properties, lease the properties to third party tenants, and sell the properties on an opportunistic basis.
The venture will be governed by a board of directors (the Board), and Company A and Company B will each be entitled to appoint three of the Board’s six directors. The Board will act through a simple majority vote and in the event of a deadlock, a dispute resolution mechanism will take effect to resolve the issue (binding arbitration).
The Board executed a property management agreement with Company B giving Company B the ability to unilaterally direct leasing, maintenance, tenant selection, and remarketing activities related to the properties owned by the venture (the venture’s most significant activities). The agreement has an initial one-year term and will automatically renew for successive one-year periods unless Company B or the Board elect not to renew the contract. In exchange for services provided, Company B will be entitled to an annual management fee and performance incentive fee entitling Company B to 15% of the venture’s profits once the investors achieve a 15% internal rate of return on their capital contributions. Otherwise, Company A and Company B will share in the profits and losses of the venture proportionately.
Notwithstanding the fact that the fee arrangement is at market and commensurate, Company B’s property management agreement is a separate variable interest given Company B’s other significant economic interest (i.e., its 50% equity interest). The decision making rights exercisable by Company B pursuant to the property management agreement were determined to be separate from its 50% equity investment (i.e., they are not embedded).
As shareholders of the venture, Company A and Company B have the ability to make the following decisions through a simple majority vote:
  • Terminate the property management agreement
  • Approve changes in Company B’s compensation
  • Approve a sale of substantially all of the venture’s assets
  • Liquidate the venture
  • Approve a change in control of the venture
  • Approve a change in the name of the venture
  • Approve the venture’s accounting firm
As Company B directs the venture’s most significant activities through a variable interest that does not qualify as equity at risk, the shareholder rights exercisable by Company A and Company B must be assessed to determine whether Company B, as property manager, or the group of at risk equity investors have the power to direct the venture’s most significant activities.
Does the venture’s group of at risk equity investors lack the power to direct the activities that most significant impact its economic performance?
Analysis
Yes. Although Company A and Company B have the ability to exercise the rights described above as equity investors of the venture, such rights are not sufficient to demonstrate that the group of at risk equity investors have power. At minimum, the equity at risk must have the ability to remove the property manager, remove the Board (since the Board appears substantive), and approve changes in Company B’s property management agreement, including compensation, to demonstrate that the group has power.
In this fact pattern, Company A and B can each replace their designated Board representatives, and Company A has the ability to withhold its consent to change Company B’s compensation. However, the group’s ability to terminate the property management agreement requires the consent of Company B, the property manager. Because Company B, as an equity investor, has the ability to prevent the group of at risk equity investors from terminating Company B’s property management agreement, this kick-out right is not substantive. Accordingly, rights exercisable by Company A and Company B (as at risk equity investors) are not sufficient to demonstrate that the holders of equity at risk, as a group, have the power to direct the venture’s most significant activities.
If Company A does not have the unilateral, substantive right to kick-out Company B as property manager, liquidate the venture, or exercise participating rights, then Characteristic 2 would be present and the venture would be a VIE under ASC 810-10-15-14(b)(1)(ii).

The existence of shareholder rights alone is not sufficient to demonstrate that the holders of equity at risk, as a group, have the power to direct the activities of the potential VIE that most significantly impact its economic performance. A reporting entity should also consider whether such rights are substantive.
Determining whether shareholder rights are substantive requires careful consideration of an entity’s governing documents and may also require an understanding of state law in which the potential VIE is domiciled. Consultation with internal or external legal counsel may be prudent in those situations.
The guidance does not specifically state that these rights must be substantive in order to demonstrate that the at risk equity investors have power. However, we believe non-substantive shareholder rights should not drive the reporting entity’s assessment of whether Characteristic 2 is present. We believe the rights exercisable by the holders of equity at risk, as a group, must be substantive to demonstrate that they have the power to direct the activities of the potential VIE that most significantly impact its economic performance.
To be substantive, we believe the group of at risk equity investors must have the ability to exercise such rights implicitly or explicitly. For example, the following may indicate that the rights held by the at risk equity investors are non-substantive:
  • The potential VIE is not required to hold an annual meeting
  • There is no mechanism for the shareholder group to obtain the identities of the other shareholders and/or convene a general meeting to exercise such rights
  • Exercising such rights requires a supermajority vote of the investors as opposed to simple majority vote or lower threshold
  • The decision maker holds an equity investment in the entity and can prevent the unrelated at risk equity investors from terminating its decision making arrangement
Figure CG 4-2 includes a decision tree for this characteristic applicable to entities that are not limited partnerships or similar entities:
Figure CG 4-2
Decision tree for Characteristic 2 applicable to entities that are not limited partnerships or similar entities

4.4.4 Franchise business models

The use of franchises is prevalent in the retail and consumer industry. In a typical franchise arrangement, a company will license the right to use its name, trademarks, and general operating philosophies and practices to individuals or entities in varying geographic regions. The franchisor will allow the operator (franchisee) to use its trademark and distribute goods or provide services in exchange for a royalty or franchise fee. The franchisor typically retains responsibility for regional or national advertising, and negotiates terms with approved vendors from whom the franchisees are required to purchase their raw materials. In doing so, the franchisor creates synergies in the form of cost reductions and broad-based marketing that is intended to benefit the franchisee group as a whole.
Franchise agreements differ greatly from company to company, and a careful analysis of these arrangements is necessary to determine whether the franchisor has rights that cause the franchisee to be a VIE under Characteristic 2.
Franchise agreements typically require a franchisee to strictly adhere to specific, standardized operating protocols. In many cases, the franchisor’s policies and procedures stipulate the following:
  • Policies and procedures for running the business, including personnel policies
  • That the owner of the franchise location, as well as the franchisee’s employees, must be trained by the franchisor
  • Usage of the franchisee’s logo or trademark
  • Usage of the franchise location’s store and appearance
  • Uniforms to be worn by employees
  • Hours of operation
  • Procurement and supply of raw materials
  • The territory in which the franchisee is authorized to operate within

Although the stipulations imposed by a franchisor may, on the surface, appear to limit the franchisee’s ability to operate autonomously, they do not necessarily cause the franchisee to be a VIE under Characteristic 2. In most cases, franchisees are required to conform to stipulations imposed by the franchisor to ensure the quality of the franchisor’s products or services is uniform and consistent across all locations. That is, the requirements imposed by the franchisor are generally intended to protect the value of the franchisor’s brand (i.e., the franchisor’s rights are protective in nature) as opposed to allow the franchisor to exercise power. The ability of any party to exercise protective rights does not cause an entity to be a VIE under Characteristic 2.
Conversely, if the stipulations imposed by the franchisor are designed to enable the franchisor to control the franchisee’s operations, then Characteristic 2 may be present and the franchisee may be a VIE. The determination of whether a franchisor’s rights are protective in nature can be judgmental and requires careful consideration of the relevant facts and circumstances.
Since many of the franchisee’s activities are predetermined by the franchise agreement, the focus of this analysis should shift to the franchisee’s activities that the holders of equity at risk can direct. This analysis should not consider decisions that are administrative or inconsequential as those decisions pertain to activities of the entity that do not significantly impact the entity’s economic performance.
We believe a franchisee may have the power to direct the franchisee’s most significant economic activities when (1) the stipulations imposed by the franchisor are designed to protect its brand, rather than to convey power over its franchisee’s most significant activities, and (2) the franchisee has the discretion to make all other important decisions impacting the economic performance of the franchisee, such as:
  • The daily delivery of quality products or services to customers
  • Establishing and executing capital and operating budgets
  • Execution of the franchisor’s operating systems
  • Establishing the pricing of products or services sold at the franchise location
  • Hiring, scheduling, terminating, and setting the compensation of the franchise’s employees

In addition, we believe the fact that the franchisee voluntarily agreed to operate the business in accordance with the franchisor’s established rules and regulations may demonstrate that the holders of equity at risk, as a group, have power. That is, the success or failure of the franchisee primarily rests with the franchisee’s owners as opposed to the franchisor. The list described above is not all inclusive and the facts and circumstances specific to each franchisee should be carefully considered.
Situations where a franchisor extends a loan or owns equity in a franchisee should be closely evaluated to determine whether the franchisee or the franchisor has the power to direct the franchisee’s most significant activities. As the level of economics held by the franchise owners decreases, the ability of the owner of the franchisee to exercise power over the entity’s economically significant activities should be evaluated with skepticism. Conversely, as the franchisor’s level of economic ownership in a franchisee increases, the likelihood that its decision making rights have migrated from protecting its brand to impacting the economic performance of that franchise location will increase.
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