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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

4.4.3 Other outsourced decision-making considerations

In addition to the general considerations discussed in CG 4.4.2 for outsourced decision-making arrangements, certain structures or contractual arrangements may require further analysis to determine if Characteristic 2 is present.

4.4.3.1 Equity investments with “super” voting rights

Super voting common stock may give a shareholder with less than a majority of the economic interests in an entity control over that entity. This would not cause that entity to be a VIE under Characteristic 2 provided that the super voting common stock is considered equity at risk.
If, however, a shareholder with less than a majority of the economic interests in an entity obtained control of that entity through a management contract, and those rights are not included in the terms of the super voting common shares, then that entity might be considered a VIE absent (1) rights exercisable by the holders of equity at risk, directly or indirectly, that demonstrate that the group does not lack power, or (2) substantive single party kick-out or participating rights. Super voting rights may indicate that there are disproportionate voting rights that would cause the entity to be a VIE under Characteristic 3. See CG 4.5 for further details on Characteristic 3.

4.4.3.2 Shareholder agreements

An entity’s equity investors may enter into a separate contractual arrangement that transfers voting rights. If decision making is determined by a shareholder agreement, and all parties to the shareholder agreement are holders of equity investment at risk, we believe the entity would not be considered a VIE due to the voting arrangement. Such arrangements represent a transfer of voting rights among the group of at risk equity investors, and therefore decision making continues to reside within the group of at risk equity investors.
If an equity investor is granted power over the entity through a shareholder agreement, and that equity investor’s interest does not qualify as equity at risk, then decision making would be outside the equity investment at risk and Characteristic 2 would be present.

4.4.3.3 Participating rights - outside of the equity investments at risk

If substantive participating rights are held by parties other than the holders of the equity at risk, such as a lessee or a lender, it would be difficult to conclude that the group of at risk equity investors has power over the entity’s most significant activities.
For example, if a lender has the ability to veto operating and capital decisions (including decisions that establish an entity’s budgets) and the entity does not have the right or ability to refinance its debt, substantive decision-making ability may not rest with the group of holders of equity at risk. As a result, Characteristic 2 would be present and the entity would likely be considered a VIE.
Example CG 4-11 illustrates evaluation of the impact of participating rights held outside the group of holders of equity at risk.
EXAMPLE CG 4-11
Evaluating the impact of participating rights held outside the group of holders of equity at risk
Entity XYZ owns and operates a theme park. Assume that the decisions that most significantly impact the performance of the entity include maintaining and efficiently operating the existing rides and making capital investments (i.e., incurring capital expenditure for new rides to attract visitors to the theme park). Entity XYZ typically funds its capital investments via a mix of equity and debt financing. However, all capital investment decisions involving new rides require the lender’s approval (one lender), as the new rides are collateral for the debt financing. The lender’s approval of the expenditure for the new ride is considered part of its standard loan underwriting requirements.
Does the lender’s ability to approve capital investment decisions financed by the lender cause Entity XYZ to be a VIE under Characteristic 2?
Analysis
No. The lender’s approval of the expenditure for the new ride is a requirement for securing the debt financing from the lender and is part of the lender’s standard loan underwriting requirements. This type of underwriting requirement is typical in many collateral lending arrangements where the lender approves the project that the funds will be used for. From the lender’s perspective, the approval right is a protective right to ensure repayment of the financing.
On the other hand, if the lender was approving Entity XYZ’s annual operating budgets each year the loan was outstanding, Entity XYZ would likely be considered a VIE under Characteristic 2 since such rights are not typical in loan agreements and the lender can exercise a participating right over an activity of the entity that most significantly impacts its economic performance.
Characteristic 2 may also be present when a party outside the group of at risk equity investors has substantive participating rights. Because the group of at risk equity investors cannot exercise power, the entity would be VIE under ASC 810-10-15-14(b)(1)(ii).

4.4.3.4 Nominee shareholder arrangements

Many reporting entities use nominee shareholders in order to facilitate the consolidation of certain entities. The guidance for nominee shareholders is described in ASC 810-10-20 and 10-25 (see CG 7.4.1). While the guidance was issued to address the consolidation of physician practices by physician practice management entities, the guidance is also relevant to many other entities that utilize nominee shareholders.
Entities that utilize nominee shareholders will likely be VIEs because the entities generally do not have sufficient equity at risk and non-equity holders at risk generally have decision making ability. Examples of structures utilizing nominee shareholders may include: physician practice management arrangements, ownership of entities located in foreign countries that restrict foreign ownership, and local management arrangements in the broadcasting industry. The following example illustrates how a nominee shareholder arrangement may be established.
Assume a foreign investor wishes to acquire an entity located in an Asian country that restricts foreign ownership. In order to effect the acquisition, the foreign investor and the selling shareholder of the Asian entity enter into a contractual arrangement. Under the terms of the contractual arrangement, (1) the foreign investor acquires, for cash, the contractual right to the economic equity interest in the Asian entity from the selling shareholder, (2) the selling shareholder remains the sole legal shareholder of the Asian entity, and (3) the foreign investor retains the right to replace the legal shareholder of the Asian entity at any time by acquiring the shares of the Asian entity from the legal shareholder for a nominal amount, thus effectively retaining all the rights and privileges (voting, dividends, etc.) of the shares of the Asian entity as if it were the legal shareholder of the Asian entity.
Since the requirements for a nominee shareholder are met, as described in ASC 810-10-20 and 10-25, the legal shareholder of the Asian entity would be considered a nominee shareholder of the foreign investor. Generally, the foreign investor, the selling shareholder, and the Asian entity would enter into additional contracts at the same time of the nominee shareholder arrangement, which usually results in the foreign investor consolidating the Asian entity. These additional contracts may include a shareholder voting rights proxy agreement, an equity pledge agreement, and an exclusive business cooperation agreement, among others.

4.4.3.5 Special considerations

Physician practices and other entities often controlled by contract and franchise agreements may require special consideration. Although physician practice management entities are often VIEs, the applicable guidance is discussed in the literature in the context of the VOE model. See CG 7.4 for information on physician practice management 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.

4.4.5 Applying Characteristic 2 to LP’s and similar entities

A separate analysis is required for applying Characteristic 2 to limited partnerships and similar entities due to the unique purpose and design of limited partnerships as compared to corporations. Entities that are determined to be “similar” to limited partnerships would also be subject to this guidance. For example, some entities may be similar to a limited partnership if they have a governance structure that is the functional equivalent of a limited partnership’s governance structure.

Excerpt from ASC 810-10-15-14(b)(1)

ii. For limited partnerships, partners lack that power if neither (01) nor (02) below exists. The guidance in this subparagraph does not apply to entities in industries (see paragraphs 910-810-45-1 and 932-810-45-1) in which it is appropriate for a general partner to use the pro rata method of consolidation for its investment in a limited partnership (see paragraph 810-10-45-14).
01. A simple majority or lower threshold of limited partners (including a single limited partner) with equity at risk is able to exercise substantive kick-out rights (according to their voting interest entity definition) through voting interests over the general partner(s).
A. For purposes of evaluating the threshold in (01) above, a general partner’s kick-out rights held through voting interests shall not be included. Kick-out rights through voting interests held by entities under common control with the general partner or other parties acting on behalf of the general partner also shall not be included.
02. Limited partners with equity at risk are able to exercise substantive participating rights (according to their voting interest entity definition) over the general partner(s).
03. For purposes of (01) and (02) above, evaluation of the substantiveness of participating rights and kick-out rights shall be based on the guidance included in paragraphs 810-10-25-2 through 25-14C.

Understanding the principle behind this guidance requires consideration of the differences between a limited partnership and a traditional corporation. A corporation’s shareholders generally have voting rights that provide them with the power to direct the entity’s most significant activities. Although the corporation’s management team executes the day-to-day decisions, the voting rights held by the corporation’s shareholders allow the shareholders to limit or constrain the management team’s decision-making authority.
In contrast, the general partner of a limited partnership often unilaterally directs the activities of a limited partnership that most significantly impact the entity’s economic performance. Although the limited partners generally lack voting rights consistent with those rights typically held by corporate shareholders, they may have other rights that allow them to effectively constrain the general partner’s decision making authority. Determining whether these rights exist is critical to assessing whether a limited partnership or similar entity is a VIE under Characteristic 2.
The limited partnership (or similar entity) would not be a VIE under Characteristic 2 if the limited partners are able to exercise power in either of the following ways:
  • A simple majority or lower threshold of limited partners (including a single limited partner) with equity at risk can exercise substantive kick-out rights
  • Limited partners with equity at risk can exercise substantive participating rights

Any of these rights, if present, are considered analogous to voting rights held by corporate shareholders that provide those shareholders with power over the entity being evaluated for consolidation. In other words, for a limited partnership (or similar entity) to be a voting interest entity, the limited partners (or members of a limited liability company that is similar to a limited partnership) must have, at minimum, substantive kick-out or participating rights.

4.4.5.1 Evaluating whether an entity is similar to a limited partnership

To understand whether an entity’s governance structure is similar to a limited partnership, an analysis should be performed based on the facts and circumstances specific to that entity’s formation and governing documents. For example, a limited liability company that is governed by a managing member, as opposed to a board of managers, may be similar to a limited partnership. The evaluation of a limited liability company should consider whether a managing member has sole decision-making authority, similar to the rights held by the general partner of a limited partnership.
Question CG 4-3
Should the separate requirement described in ASC 810-10-15-14(b)(1)(ii) for limited partnerships and similar entities be applied when evaluating whether a trust is a VIE under Characteristic 2?
PwC response
It depends. If the trust is governed by a single trustee that has been granted all day-to-day decision-making abilities, then application of the separate requirement for limited partnerships and similar entities may be appropriate. In that situation, the trustee may be acting in a capacity that is no different from a general partner of a limited partnership.
If the trust is governed by a board of trustees that has the legal ability to make decisions and bind the trust, and the trustee is simply acting as an agent of the trust’s board, then application of the separate requirement applicable to limited partnerships and similar entities may be inappropriate.
Determining whether a trust is governed by a single trustee or a governing body that is similar to a board of directors requires a review of the trust’s governing documents. If a board of trustees exists, it is important to understand whether the board’s decision-making rights are limited to advising the trustee as opposed to having the legal authority to bind the trust. If the board’s role is limited to advising the trustee (i.e., it cannot bind the trust), then application of the separate requirement for limited partnerships and similar entities may be appropriate.
A limited liability company may be governed by a board of members as opposed to a managing member. Much like a corporation’s board of directors, the entity’s board of members votes on all significant decisions impacting the limited liability company’s activities. An evaluation of the limited liability company might consider whether the members have capital accounts similar to limited partners of a limited partnership. This analysis would also take into account what decision-making rights have been granted to the members and how their voting rights are exercised.

Example CG 4-12 demonstrate the determination of whether a limited liability company is similar to a limited partnership.
EXAMPLE CG 4-12
Determining whether a limited liability company is similar to a limited partnership
Company A established a limited liability company (LLC Corp) for the purpose of raising third-party capital to invest in private companies. LLC Corp’s objective is to obtain controlling positions in private companies, improve the performance of the businesses, and liquidate its position within seven years. The third-party investors are issued member interests in LLC Corp in exchange for their capital contributions. Each member has a separate capital account, and LLC Corp’s profits and losses are allocated among the members based on their proportionate ownership of the LLC’s member interests.
LLC Corp is presided over by Company A (the Managing Member). In accordance with LLC Corp’s governance agreements, Company A makes all decisions related to LLC Corp’s investment strategy and makes decisions pertaining to the acquisition and disposition of LLC Corp’s investments. Company A established an independent committee (the Investment Committee) comprised of certain members to advise Company A. The Investment Committee generally cannot bind LLC Corp as its role is advisory in nature. However, the Investment Committee can vote on transactions involving Company A and its affiliates when a conflict of interest may exist. The members of LLC Corp are not otherwise able to exercise any voting rights.
For purposes of applying Characteristic 2, should LLC Corp be evaluated as a limited partnership or as a corporation?
Analysis
We believe that if a managing member has the right to make the significant decisions of the LLC, the LLC would be considered to have governing provisions that are the functional equivalent of a limited partnership. This is the case even if the non-managing members have participating rights or kick-out rights. While the ASC guidance states that a managing member of an LLC is the functional equivalent of a general partner, we believe the managing member should also have the right to make the significant decisions of the LLC to be considered the functional equivalent of a limited partnership (versus a managing member who may be more of an operations manager without the right to make the significant decisions of the entity).
In this example, LLC Corp should be evaluated as a limited partnership for purposes of applying Characteristic 2, as the governance agreements provide the managing member with the right to make all the significant decisions of the LLC.
Company A is the only party authorized to make decisions and to bind LLC Corp, similar to a general partner of a limited partnership. Although the Investment Committee exists, it does not operate in a manner similar to a corporation’s board of directors. The Investment Committee exists solely to advise Company A and cannot bind the LLC, and its ability to vote on transactions involving Company A and its affiliates is protective in nature and exists solely to prevent self-dealing.
In addition, LLC Corp’s members have capital accounts as opposed to ownership units, which also indicates that LLC Corp has attributes that are like a partnership.

4.4.5.2 Kick-out rights

The mere existence of kick-out rights does not necessarily demonstrate that the limited partners have power over the limited partnership (or similar entity). The kick-out rights must be substantive to demonstrate that the group of at-risk equity investors (i.e., the limited partners) has power. Kick-out rights will be considered substantive only when they are exercisable by a simple majority vote of the entity’s limited partners (exclusive of the general partner, parties under common control with the general partner, and other parties acting on behalf of the general partner) or a lower threshold (as low as a single limited partner) based on the limited partners’ relative voting rights. A limited partner’s voting rights are often determined by its relative capital account balance.
The substance of kick-out rights granted to an entity’s limited partners may be called into question when there are economic or operational barriers to exercising such rights that must be overcome, for example:
  • Conditions that make it unlikely that the rights will be exercised
  • Financial penalties or operational barriers that the limited partners would face upon exercise of kick-out rights
  • An inadequate number of qualified replacements for the current decision maker, or when the level of compensation paid to the decision maker is inadequate to attract a qualified replacement
  • The lack of an explicit mechanism, by matter of contract or law, to allow the holder to exercise the rights or to obtain the information necessary to exercise the rights

The FASB provides further guidance for determining whether kick-out rights constitute a simple majority in several case studies found in ASC 810-10-55-4N, which introduce the concept of the “smallest possible combination." The first step is to identify the smallest combination of limited partner interests that would be considered a simple majority. The next step would be to consider whether that combination meets the voting threshold included in the partnership agreement to remove the general partner. If the smallest combination of limited partner interests that constitute a simple majority also hold enough interests to meet or exceed the voting threshold in the partnership agreement, the kick-out rights would meet the simple majority requirement under ASC 810. If it does not, the kick-out rights would not be considered substantive, and the partnership would be considered a VIE.
For example, assume that a limited partnership agreement requires a 70% vote of the limited partners to remove the general partner, and there are three limited partners with limited partnership interests and voting rights representing 25%, 35%, and 40%. In evaluating the first step described above, a combination of any two of the three limited partners constitutes a simple majority; however, the smallest combination of limited partnership interests that would constitute a simple majority would be the partners holding a 25% and 35% interest, for a combined total of 60%. In applying the second step, one would determine whether the smallest combination of interests (i.e., 60%) would meet or exceed the 70% threshold required in the partnership agreement to remove the GP. Since 60% would fall below the requirement of 70%, the kick-out rights included in the agreement would not be considered substantive and the partnership would be considered a VIE. Alternatively, if the threshold provided in the partnership agreement to remove the GP was 50%, the kick-out rights would meet the simple majority requirement under ASC 810.
As noted above, ASC 810-10-55-4N provides more example that illustrate this concept.
It is important to note that the general partner’s interests and rights may impact this assessment as well. The simple majority assessment in ASC 810 only includes the votes of the limited partners unrelated to the general partner. In other words, when one is determining the smallest possible combination of limited partners (unrelated to the general partner) that constitute a simple majority, the denominator should be adjusted to remove the voting rights held by the general partner or limited partners that are related to the general partner.
For example, assume the general partner owns a 10% interest in the limited partnership and all partners are permitted to vote on the removal of the general partner in proportion to their ownership interests. Further, assume that the LP interests are owned by 90 limited partners, all unrelated to the general partner, each with a 1% ownership interest. In evaluating the first step, a simple majority would be calculated under ASC 810 by adjusting the denominator to remove the 10% interest held by the general partner. As a result, the smallest combination of limited partners to constitute a simple majority of voting interests under ASC 810 would be 46 limited partners or more than 45% of the voting interests (50% of 90%).
In applying the second step, the smallest combination of interests (i.e., 46%) would need to meet or exceed the threshold required in the partnership agreement to remove the GP. If the partnership agreement includes a threshold of 50% of all voting interests to remove the general partner, the simple majority requirement in ASC 810 would not be met and the kick-out rights would not be substantive. The same analysis would be required if limited parties that are related to the general partner are entitled to vote on the removal of the general partner.
Question CG 4-4
Does the ability of a general partner and/or its related parties to participate in a vote to kick out the general partner of a limited partnership cause the limited partnership to be a VIE under Characteristic 2?
PwC response
It depends. If a simple majority (or lower threshold) of the unrelated limited partners lack the substantive right to remove the general partner, then the entity would be considered a VIE under Characteristic 2 (assuming the limited partners do not have substantive participating rights). For example, assume an entity has 12 limited partners, 10 of which are unrelated to the general partner and each holds an equal amount of the limited partnership’s kick-out rights through voting interests. If the partnership agreement requires a simple majority of the 10 unrelated limited partners to remove the general partner, the limited partners would not lack power and the entity would not be a VIE under Characteristic 2.
On the other hand, if the partnership agreement required a vote of a simple majority of all 12 limited partners (i.e., 7 limited partners) to remove the general partner, this kick-out right would not be substantive. In this case, the kick-out right lacks substance because it requires a higher percentage (70% or 7 of 10 limited partners) than a simple majority of the unrelated limited partners (6 of 10 limited partners would be a simple majority) to effect the removal of the general partner. Assuming the limited partners do not have any substantive participating rights, the limited partners would lack power and the entity would be a VIE under Characteristic 2.

Impact of kick-out rights on Characteristic 2
The following examples illustrate the impact of kick-out rights on the assessment of whether an entity is a VIE under Characteristic 2 for limited partnerships.
EXAMPLE CG 4-13
Simple majority kick-out rights exercisable by a single limited partner
A limited partnership has three independent limited partners, A, B, and C, none of which have any relationship with the general partner. Limited partners A, B, and C hold 70%, 20%, and 10% of the limited partnership’s kick-out rights through voting interests, respectively. The partnership agreement requires a simple majority vote of the kick-out rights through voting interests to remove the general partner. There are no barriers to exercising the kick-out rights, and the limited partners do not have any substantive participating rights. Assume the limited partnership would not be a VIE under any other characteristic.
Is the limited partnership a VIE under Characteristic 2?
Analysis
No. In this example, the partnership agreement requires a simple majority vote of the limited partnership’s kick-out rights through voting interests to remove the general partner and the general partner cannot vote. As the limited partners are not related to the general partner, the kick-out right provided by the partnership agreement is consistent with the kick-out requirements in ASC 810-10-15-14(b)(1)(ii). Limited partner A with 70% of the kick-out rights through voting interest is able to unilaterally remove the general partner. Therefore, the limited partners would not lack the power to direct the significant activities of the limited partnership. Since none of the other VIE criteria are met, the limited partnership would be considered a voting interest entity.
Under the voting interest model, limited partner A has a controlling financial interest and would consolidate the entity as it can unilaterally exercise its kick-out rights through voting interests to remove the general partner and none of the other limited partners have any substantive participating rights.
EXAMPLE CG 4-14
Kick-out rights exercisable by the limited partners
A limited partnership has three independent limited partners, none of which have any relationship with the general partner. Each limited partner holds an equal amount of the limited partnership’s kick-out rights through voting interests (33.3%). The partnership agreement requires a simple majority vote of the kick-out rights through voting interests to remove the general partner. There are no barriers to exercising the kick-out rights, and the limited partners do not have any substantive participating rights. Assume the limited partnership would not be a VIE under any other characteristic.
Is the limited partnership a VIE under Characteristic 2?
Analysis
No. In this example, the partnership agreement requires a simple majority of the limited partners to remove the general partner and the general partner cannot vote. As the limited partners are not related to the general partner, the kick-out right provided by the partnership agreement is consistent with the kick-out requirements in ASC 810-10-15-14(b)(1)(ii). Therefore, the limited partners would not lack the power to direct the significant activities of the limited partnership. Since none of the other VIE criteria are met, the limited partnership would be considered a voting interest entity.
Under the voting interest model, as no single limited partner has a simple majority of the kick-out rights through voting interests to unilaterally remove the general partner, none of the limited partners (nor the general partner) would consolidate the entity.
EXAMPLE CG 4-15
Kick-out rights exercisable by the general partner and the limited partners
A limited partnership has three independent limited partners, A, B, and C, none of which have any relationship with the general partner. Limited partners A, B, and C hold 40%, 25%, and 25% of the limited partnership’s kick-out rights through voting interests. The general partner does not have any kick-out rights through its general partner interest, but holds a 10% limited partner interest which includes kick-out rights through this voting interest. The partnership agreement requires a simple majority vote of the kick-out rights through voting interests to remove the general partner. There are no barriers to exercising the kick-out rights, and the limited partners do not have any substantive participating rights. Assume the limited partnership would not be a VIE under any other characteristic.
Is the limited partnership a VIE under Characteristic 2?
Analysis
Yes. In this example, the partnership agreement requires a simple majority of the limited partners to remove the general partner. However, ASC 810-10-15-14(b)(1)(ii) requires that kick-out rights through voting interests held by the general partner and its related parties be disregarded when performing the simple majority kick-out test. Therefore, further analysis is required to determine if the kick-out right is consistent with ASC 810-10-15-14(b)(1)(ii).
In order to determine if the kick-out rights are consistent with ASC 810, the reporting entity must determine whether there is a substantive difference between the partnership’s kick-out right and the simple majority requirement under ASC 810.
A simple majority under ASC 810, which would exclude the voting rights held by the general partner, would require a vote greater than 45% (50% of 90%). The smallest possible combination of limited partners that comprise a simple majority of the kick-out voting rights under ASC 810 would be limited partners B and C or 50% of the partnership’s voting rights. However, under the partnership agreement, limited partners B and C would not be able to remove the general partner since their contractual kick-out rights would only be 50% and would not meet the simple majority threshold required by the partnership agreement to remove the general partner. Therefore, the limited partners would lack the power to direct the significant activities of the limited partnership and the entity would be considered a VIE. In addition, as the limited partners do not have any substantive participating rights, the general partner would consolidate the entity.
EXAMPLE CG 4-16
Kick-out rights exercisable by the general partner and the limited partners
A limited partnership has four independent limited partners, none of which have any relationship with the general partner. The four independent limited partners A, B, C, and D each hold 20% of the limited partnership’s kick-out rights through voting interests. The general partner does not have any kick-out rights through its general partner interest, but holds a 20% limited partner interest which includes kick-out rights through this voting interest. The partnership agreement requires a simple majority vote of the kick-out rights through voting interests to remove the general partner. There are no barriers to exercising the kick-out rights, and the limited partners do not have any substantive participating rights. Assume the limited partnership would not be a VIE under any other characteristic.
Is the limited partnership a VIE under Characteristic 2?
Analysis
No. In this example, the partnership agreement requires a simple majority of the limited partners to remove the general partner. However, ASC 810-10-15-14(b)(1)(ii) requires that kick-out rights through voting interests held by the general partner and its related parties be disregarded when performing the simple majority kick-out test. Therefore, further analysis is required to determine if the kick-out right is consistent with ASC 810-10-15-14(b)(1)(ii).
In order to determine if the kick-out rights are consistent with ASC 810, the reporting entity must determine whether there is a substantive difference between the partnership’s kick-out right and the simple majority requirement under ASC 810.
The smallest possible combination of limited partners that comprise a simple majority of the kick-out rights through voting interests under ASC 810 would be any three of the independent limited partners or 75% (60%/80%). Any three of the independent limited partners would also be able to remove the general partner since their kick-out rights through voting interests would be 60% (60%/100%) and would meet the simple majority threshold required by the partnership agreement to remove the general partner. Therefore, the limited partners would not lack the power to direct the significant activities of the limited partnership. Since none of the other VIE criteria are met, the limited partnership would be considered a voting interest entity.
Under the voting interest model, as no single limited partner has a simple majority of the kick-out rights through voting interests to unilaterally remove the general partner, none of the limited partners (nor the general partner) would consolidate the entity.
EXAMPLE CG 4-17
Supermajority kick-out rights exercisable by a single limited partner
A limited partnership has three independent limited partners, A, B, and C, none of which have any relationship with the general partner. Limited partners A, B, and C hold 70%, 20%, and 10% of the limited partnership’s kick-out rights through voting interests, respectively. The partnership agreement requires a vote of at least 67% of the kick-out rights held by the limited partners through voting interests to remove the general partner. There are no barriers to exercising the kick-out rights, and the limited partners do not have any substantive participating rights. Assume the limited partnership would not be a VIE under any other characteristic.
Is the limited partnership a VIE under Characteristic 2?
Analysis
No. In this example, the partnership agreement requires a supermajority vote of the limited partnership’s kick-out rights through voting interests to remove the general partner. Therefore, further analysis is required to determine if the kick-out right is consistent with ASC 810-10-15-14(b)(1)(ii).
In order to determine if the kick-out rights are consistent with ASC 810, the reporting entity must determine whether there is a substantive difference between the partnership’s kick-out right and the simple majority requirement under ASC 810.
Limited partner A would be able to remove the general partner since its kick-out rights through voting interests would be 70% and would exceed the threshold required by the partnership agreement of 67% to remove the general partner. Limited partner A’s kick-out rights through voting interests would also meet the simple majority requirement under ASC 810. Therefore, the limited partners would not lack the power to direct the significant activities of the limited partnership. Since none of the other VIE criteria are met, the limited partnership would be considered a voting interest entity.
Under the voting interest model, limited partner A has a controlling financial interest and would consolidate the entity as it can unilaterally exercise its kick-out rights through voting interests to remove the general partner and none of the other limited partners have any substantive participating rights.

See ASC 810-10-55-4N to ASC 810-10-55-4W for additional illustrative implementation guidance for assessing kick-out rights for limited partnerships.

4.4.5.3 Participating rights

Substantive participating rights held by limited partners would also demonstrate that the partnership is a voting interest entity under Characteristic 2. A participating right allows the holder to veto or block a significant decision of an entity being evaluated for consolidation.
Unlike a kick-out right, a participating right does not convey power since it does not allow the holder to initiate the action or decision. A participating right allows the holder to prevent another party from exercising power over a decision or significant activity of the potential VIE.
Determining whether a participating right is substantive requires consideration of the decisions or activities that the holder of the participating right may block (veto). The threshold, or level of decisions or activities the holder must be able to block (veto) to demonstrate that a participating right is substantive varies depending upon the nature of the entity and the consolidation model being applied.
Participating rights over a limited partnership or similar entity are evaluated differently than other entities when determining whether Characteristic 2 is present. The threshold established by the voting interest model to assess whether a participating right is substantive should be applied when determining whether a limited partnership or similar entity is a VIE under Characteristic 2. ASC 810-10-25-5 defines a participating right as the right to block or participate in significant financial and operating decisions that are made in the ordinary course of business. As such, a limited partnership or similar entity would not be a VIE under Characteristic 2 if the limited partners have the ability to block at least one significant operating or financial decision made in the ordinary course of business.

4.4.5.4 Evaluating the impact of liquidation rights

A partnership’s governing documents often provide its limited partners with the right to liquidate the partnership without cause. Kick-out rights include both removal and liquidation rights. Liquidation rights provide the holder with the ability to effectively remove the entity’s decision maker by dissolving the entity.
The outcome for the decision maker will be the same regardless of whether it is kicked out or the entity is liquidated (i.e., it will be stripped of its ability to exercise power).
If the group of at-risk equity investors has the ability to liquidate a partnership, that liquidation right must be substantive to demonstrate that Characteristic 2 is not present. Specifically, reporting entities should consider whether the limited partners would be subject to financial or operational barriers that would act as a disincentive to exercising the liquidation right. In addition, the reporting entity should consider whether a reasonable mechanism exists to allow the unrelated limited partners to exercise the right.
Liquidation rights would not be substantive when operational or financial barriers exist that would disincentivize the unrelated limited partners from exercising the right. A liquidation right would not be substantive if the unrelated limited partners lack an explicit mechanism to exercise the liquidation right, for example, when they are unable to obtain the identities of the other limited partners to convene a general meeting and/or when they lack the ability to call a general meeting.

4.4.5.5 Evaluating the impact of redemption rights

With very limited exceptions, redemption rights held by the limited partners of a partnership should not be considered equivalent to kick-out or participation rights. A redemption right differs from a kick-out or liquidation right legally and economically.
Legally, an investor’s redemption of its interest does not provide the holder with the ability to remove the decision maker. Rather, it provides the investor with the ability to liquidate its investment without impacting the decision maker’s ability to make ongoing decisions. In other words, a redemption right is simply a liquidity feature inherent in the investor’s equity interest as opposed to a right to remove the decision maker.
There may be instances when a limited partnership or similar entity has a single investor who has the right to redeem its interest at any time. We believe the facts and circumstances of those situations should be carefully considered to determine whether the single investor’s ability to redeem its interest should be viewed as a substantive liquidation right. If the redemption of the investor’s interest would result in a liquidation of the entity, or the termination of all substantive operating activity within the entity, then that redemption right may be no different than a liquidation right.
Example CG 4-18 illustrates the determination of whether a redemption right represents an in-substance liquidation right.
EXAMPLE CG 4-18
Determining whether a redemption right represents an in-substance liquidation right
Company A established a limited liability company (LLC Corp) for the purpose of raising third-party capital to invest in liquid publicly listed securities. LLC Corp’s objective is to acquire and hold undervalued securities and then to dispose of them on an opportunistic basis.
A single investor, Company B, which is unrelated to Company A, holds 99.9% of LLC Corp’s member interests. Company B acquired its 99.9% member interest in exchange for cash. Company A, LLC Corp’s managing member, holds the remaining 0.1% equity interest, which it acquired in exchange for a nominal cash contribution. LLC Corp is similar to a limited partnership from both a governance and ownership perspective (i.e., not governed by a board of directors and its members have separate capital accounts).
Company B has the ability to redeem its interest in LLC Corp at any time. If Company B redeems its interest and LLC Corp has no other members, Company A is required to wind down LLC Corp’s operations. Company B is not otherwise able to liquidate LLC Corp or replace Company A as LLC Corp’s managing member.
Does Company B’s ability to redeem its interest represent an in-substance liquidation right?
Analysis
Yes. Since Company B is the sole member of LLC Corp, and LLC Corp is required to wind down its operations if Company B exercises its redemption right, this is no different than Company B having the ability to unilaterally liquidate LLC Corp. Because Company B has the ability to strip Company A of its decision making rights as managing member of LLC Corp upon exercising its redemption right, Characteristic 2 is not present and LLC Corp is not a VIE under ASC 810-10-15-14(b)(1))(i).

4.4.5.6 Outsourced decision making arrangements – LP’s

In some cases, determining whether power is held by the general partner or another party can be challenging. This is particularly true when there are separate management contracts held by the general partner’s related parties. In such instances, the following questions should be considered:
  • What is the ownership structure of/relationship between the general partner (managing member) and the related party that holds the investment management agreement (i.e., are the entities commonly controlled)? In the event that the general partner and the related party are under common control, and the substance of the arrangement is that the investment decisions are effectively made by the general partner (due to the common control relationship of the related party and the general partner), it could be inferred that the significant decision-making rights reside with the general partner.
  • Does the general partner have the legal right to sell/transfer its decision-making rights to an unrelated entity? If the general partner transfers its general partnership interest to a third party, the right to appoint the manager automatically also transfers to the third party. This would be indicative of the decision-making rights residing in the GP interest.
  • Does the general partner have the legal right to terminate the investment management agreement? If the general partner has the legal right to terminate the management agreement at any time and at its sole discretion, the general partner has most likely retained the substantive decision-making rights over the limited partnership. All factors, including penalties associated with early termination, should be considered to determine whether or not the termination right is substantive.
If, after considering the factors described above, it is determined that the outsourced decision maker has substantive decision-making rights (as opposed to the general partner), the limited partners must have substantive kick-out or participating rights over the outsourced decision maker. Otherwise, Characteristic 2 will be present and the limited partnership will be a VIE.
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