The analysis to determine which reporting entity can make the most significant decisions of the entity becomes challenging when one or more of the significant decisions are only made upon the occurrence of a contingent event(s). In addition to considering the purpose and design of the entity and its significant activities, the reporting entity should consider the likelihood of the contingent event occurring, including the reporting entity’s ability to influence the occurrence of the contingent events. The greater the likelihood of the contingent event occurring, the more weight should be given to those contingent significant decisions when making the determination as to which reporting entity can make the most significant decisions. The reporting entity should also consider whether the contingent significant decisions can be made concurrent with other significant decisions of the entity (e.g., servicing of performing loans and servicing of loans in default) or whether the contingent significant decisions can only be made in sequence and are dependent on the success of previous significant decisions (e.g., research and development activities followed by production and marketing activities).
In situations where the contingent significant decisions can be made concurrent with other significant decisions, the assessment of which reporting entity has the power should consider all significant decisions, including the contingent significant decisions and their likelihood of occurring. The reporting entity with the ability to make the most significant decisions of the entity would meet the power characteristic. Because the assessment of power considered all significant decisions, including the contingent ones, there would likely not be a change in the determination of which reporting entity met the power criterion when the contingencies are resolved.
In situations when the contingent significant decisions are made in sequence and dependent on the success of previous significant decisions, the assessment of which reporting entity has the power over the most significant decisions of the entity should first focus on the likelihood of the contingent significant decisions being made. If it is unlikely, the assessment of the most significant decisions should only consider the current significant decisions until the contingency has occurred. The reporting entity with the ability to make the current significant decisions would likely meet the power characteristic. In these situations, there would likely be a change in the reporting entity with power if a different reporting entity is able to make the significant decisions once the contingency occurs.
Alternatively, if it is likely or relatively certain that the contingent significant decisions will be made, the assessment of the most significant decisions should include all significant decisions, including the contingent ones, in a manner similar to the evaluation of concurrent contingent significant decisions. These assessments are described in:
- Example CG 5-4, Assessing the impact of activities that are contingent upon a future event
- Example CG 5-5, Multiple unrelated parties sequentially direct different activities
- Example CG 5-6, Multiple unrelated parties sequentially direct different activities when there is significant uncertainty
- Example CG 5-7, Evaluating the impact of a contingent shift in power
EXAMPLE CG 5-4
Assessing the impact of activities that are contingent upon a future event
A VIE is created for the purpose of purchasing commercial mortgage loans from a third-party transferor. The VIE finances the purchase of the commercial mortgage loans by issuing fixed-rate debt to third-party investors, and equity to a third party that will also perform special servicing. The transferor retains primary servicing responsibilities over the mortgage loans. Upon the occurrence of a delinquency or default of a mortgage loan, the administration of the loan is transferred to the special servicer. In assessing the purpose and design of the entity, it was concluded that the servicing of loans that are delinquent or in default is the only ongoing significant activity of the VIE.
Which party has the power to direct the activities of the VIE that most significantly impact its economic performance?
Analysis
In this example, the VIE’s activities that most significantly impact its economic performance involve the management of assets that are delinquent or go into default, which is the responsibility of the special servicer. Although the special servicer cannot exercise power over this activity until a contingent event occurs (i.e., the default or delinquency of the mortgage loans), the special servicer would likely be deemed to have power, as this activity has the most significant impact on the VIE’s economic performance.
The special servicer would be deemed to have power because the activity of managing assets that go into default is likely to occur and can also occur concurrent with all other significant activities. Therefore, this activity is included in the assessment of which activities most significantly impact the economic performance of the entity.
EXAMPLE CG 5-5
Multiple unrelated parties sequentially direct different activities
An entity is formed by Company A and Company B for the purpose of building a manufacturing facility. Company A and Company B each own a 50% equity interest in the entity, which was determined to be a VIE. Once construction is complete, the VIE will operate the facility and sell the manufactured goods to third parties unrelated to Company A and Company B. Company A is responsible for directing the significant activities during the construction of the manufacturing facility, while Company B will direct the significant activities related to manufacturing and sales of the finished product after construction of the facility is complete. All the appropriate approvals for the manufacturing site have been obtained (e.g., permits). Company A and Company B have collaborated on similar projects in the past with each party having the responsibility for similar activities. In each case, the construction phase was successfully completed in accordance with the business plan. In addition, Company B was able to begin manufacturing and selling the finished product in accordance with the entity’s original business plan.
The decisions made during both the construction phase and the subsequent manufacturing and sales stage are determined to have a significant impact on the economic performance of the entity. Neither Company A nor Company B have any other variable interests in the VIE.
Which party would be deemed to meet the power criterion?
Analysis
Given Company A’s positive historical experience in completing similar projects and the expectation that construction will be successfully completed, Company B may be deemed to meet the power criterion throughout the life cycle of the entity (even during the construction phase) since the activities over which it has power (manufacturing and sales) are more likely key drivers of the entity’s economic performance. Even though the significant activities are sequential and the manufacturing and sales activities are dependent on the successful completion of the construction activities, the significant activities in both phases should be included in the assessment of power.
If, on the other hand, significant uncertainties existed with respect to the construction (e.g., zoning and design issues) and/or Company A did not have positive historical experience in successfully completing similar projects, Company A may be deemed to meet the power criterion during the construction phase with the power shifting to Company B at or near completion. In this case, only the construction activity would be included in the initial assessment of which reporting entity can make the most significant decisions of the entity since there is significant uncertainty about the completion of the construction phase of the project.
EXAMPLE CG 5-6
Multiple unrelated parties sequentially direct different activities when there is significant uncertainty
An entity is formed for the purpose of developing, manufacturing, and distributing a pharmaceutical drug candidate. The entity is determined to be a VIE. The VIE obtains legal title to the drug candidate and plans to perform further research and development in order to obtain approval from the FDA for commercialization of the drug. The drug is currently in Phase I clinical trials and there is significant uncertainty regarding the likelihood of the drug reaching FDA approval.
Company A, a variable interest holder, is responsible for all decisions regarding the activities of the VIE throughout the FDA approval process. Company B, a variable interest holder, will be responsible for all significant activities once FDA approval is received, including manufacturing, marketing, and distribution of the drug. It is determined that the activities performed during both the initial stage (research and development) and subsequent stage (manufacturing, marketing, and distribution) will have a significant impact on the economic performance of the VIE.
Which party would be deemed to meet the power criterion?
Analysis
Both Company A and Company B have the power to direct significant activities of the VIE that will impact its economic performance. However, Company B’s power is contingent upon the successful development of the drug and receipt of the required approvals.
Since there is significant uncertainty regarding FDA approval at the assessment date, and the manufacturing, marketing, and distribution activities are sequential and dependent on the success of the research and development activities, the determination of power should be based on the significant activities that exist during the initial stage (i.e., research and development activities). Therefore, it is likely that Company A would meet the power criterion during the initial stage since it has the power to direct the activities that will have the most significant impact on the VIE’s economic performance during that initial stage.
Once the uncertainty regarding the receipt of FDA approval has lapsed, the determination of which variable interest holder meets the power criterion should focus on which party has the power to direct the significant activities during the remaining life of the entity (i.e., manufacturing, marketing, and distribution), which is likely to be Company B in this example. In other words, once the FDA approval contingency has been met, it is likely that the party determined to meet the power criterion will change.
EXAMPLE CG 5-7
Evaluating the impact of a contingent shift in power
A VIE is created for the purpose of purchasing fixed-rate residential mortgage loans from a transferor. The entity finances the purchase of the mortgage loans by issuing three tranches of securities, a senior tranche that is guaranteed by an unrelated financial guarantor (FG Company), a subordinate tranche, and a residual interest. The transferor (and holder of the residual interest) retains servicing responsibilities over the mortgage loans. Upon a substantive predefined event of default (which is triggered based upon a significant amount of delinquencies of the underlying assets), FG Company has the right to remove the transferor and assume the role of servicer.
Which party would be deemed to meet the power criterion?
Analysis
As servicer, the transferor is responsible for servicing the non-performing loans, which includes contacting borrowers in default, determining if and when a borrower should be granted a loan modification, as well as determining when to foreclose on the collateral underlying a delinquent mortgage loan. Based on the purpose and design of the VIE, servicing of non-performing loans may be determined to have the most significant impact upon the economic performance of the entity. If that is the case, the transferor, in its role as servicer, would meet the power criterion.
However, once the predefined event of default is triggered, FG Company would meet the power criterion. FG Company would be deemed to meet the power criterion because it would have the ability to replace the transferor as servicer at any time once the predefined event of default is triggered. As a result, there would be a change in the party with power.