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5.3 Assessing rights held by non-decision makers
Publication date: 31 Jan 2023
us Consolidation guide
In some circumstances, rights held by other variable interest holders should be considered to determine whether such rights convey power (i.e., kick-out or liquidation rights) or prevent a decision maker from exercising power (i.e., participating rights).
5.3.1 Impact of kick-out rights in assessing the power criterion
A reporting entity’s determination of whether it meets the power criterion should not be impacted by the existence of kick-out rights unless a single reporting entity, including its related parties or de facto agents, has the unilateral ability to exercise those rights. Kick-out rights are defined as follows:
Definition from ASC 810-10-20
Kick-Out Rights (VIE definition): The ability to remove the entity with the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance or to dissolve (liquidate) the VIE without cause.
Excerpt from ASC 810-10-25-38C
A reporting entity’s determination of whether it has power to direct the activities of a VIE that most significantly impact the VIE’s economic performance shall not be affected by the existence of kick-out rights or participating rights unless a single reporting entity (including its related parties and de facto agents) has the unilateral ability to exercise those kick-out rights or participating rights. A single reporting entity (including its related parties and de facto agents) that has the unilateral ability to exercise kick-out rights or participating rights may be the party with the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance.
Kick-out rights would not impact a reporting entity’s primary beneficiary assessment unless a single variable interest holder (including its related parties and de facto agents) can exercise a substantive kick-out right. If two or more unrelated parties are required to come together to exercise the kick-out right, it would not impact the power assessment. This definition and threshold differ from the approach used to assess whether a limited partnership is a VIE under Characteristic 2 and also the voting model described in CG 7.3.1. As noted above, a kick-out right may prevent a decision maker from exercising power over a VIE or convey power over an entity’s most significant activities if that right allows the holder to permanently strip the decision maker of its decision-making authority.
Example CG 5-10 illustrates the evaluation of whether a kick-out right is substantive in the primary beneficiary analysis.
EXAMPLE CG 5-10
Evaluating whether a kick-out right is substantive in the primary beneficiary analysis
Evaluating whether a kick-out right is substantive in the primary beneficiary analysis
A limited partnership was formed to develop and operate a mixed-use property. The general partner owns 12% of the outstanding partner interests, and the remaining 88% limited partner interests are held by third-party investors. The partners will fund their capital commitments over time as the property is constructed. Because the equity at risk was not sufficient to develop and operate the property, the LP was determined to be a VIE under Characteristic 1.
Although the general partner has the power to direct the VIE’s most economically significant activities, the limited partners, through a simple majority vote, have the ability to replace the general partner anytime without cause.
Does the kick-out right held by the limited partners demonstrate that the general partner lacks the power to direct the VIE’s most significant activities?
Analysis
No. If a single party has the power to direct a VIE’s most significant activities, that power can be overcome by a kick-out right only when that kick-out right is currently exercisable by a single variable interest holder (including its related parties and de facto agents). Since the kick-out right in this example requires the affirmative vote of a simple majority of the limited partners, it would not be considered substantive and the general partner would be deemed to have power over the entity.
Question CG 5-3
If a kick-out right is exercisable by an entity’s board of directors, can the board be viewed as a single party when evaluating whether the kick-out right is substantive?
If a kick-out right is exercisable by an entity’s board of directors, can the board be viewed as a single party when evaluating whether the kick-out right is substantive?
PwC response
A board is typically comprised of two or more individuals that have a fiduciary responsibility to the entity’s shareholders (i.e., the board should be viewed as a proxy for the shareholder group). In many instances, the ability of the board to exercise a substantive kick-out or liquidation right should be viewed as if that right was exercisable directly by the shareholder group. Therefore, the ability of a board to exercise kick-out or liquidation rights will not influence which party, if any, has power unless a single party (and its related parties and de facto agents) has unilateral control over the board.
Example CG 5-11 illustrates the evaluation of a purchase and sale agreement with a non-refundable deposit.
EXAMPLE CG 5-11
Evaluating a purchase and sale agreement with a non-refundable deposit
Evaluating a purchase and sale agreement with a non-refundable deposit
Company A (reporting entity) enters into a purchase and sale agreement with Company X (entity) under which Company A will buy land and a building from Company X, its sole assets. As part of the agreement, Company A is required to pay a non-refundable deposit to Company X. Company A also has the right to terminate the contract, subject to the loss of its deposit. Assuming that Company A has a variable interest in Company X due to the purchase and sale agreement (see Example CG 5-1 for details), and that Company X is a VIE (see Question CG 4-6 for details), will Company A be considered to meet the power criterion due to its non-refundable deposit to Company X?
Analysis
Potentially. Company A will need to assess whether it has a controlling financial interest in Company X through an evaluation of both the power and losses/benefits criteria in ASC 810-10-25-38. In land purchase option agreements, the buyer may have the rights to decide on amenity and zoning density issues, or for rental property agreements, the buyer may have rights to control leasing decisions. To the extent the purchase and sale agreement transfers the rights to direct the activities that most significantly impact the economic performance of the VIE to the buyer, where the buyer also has a substantive non-refundable deposit, it is likely that the buyer would meet the power criterion.
5.3.2 Evaluating when a kick-out right is substantive
Although ASC 810-10-25-38C does not specifically state that a kick-out right must be substantive to influence which party has power over an entity, we believe the overarching concept of ASC 810-10 supports this view.
For purposes of applying the Variable Interest Entities Subsections, only substantive terms, transactions, and arrangements, whether contractual or noncontractual, shall be considered. Any term, transaction, or arrangement shall be disregarded when applying the provisions of the Variable Interest Entities Subjections if the term, transaction, or arrangement does not have a substantive effect on any of the following:
- A legal entity’s status as a variable interest entity (VIE)
- A reporting entity’s power over a VIE
- A reporting entity’s obligation to absorb losses or its right to receive benefits of the legal entity
Reporting entities should look to ASC 810-10-25-14A when evaluating whether a kick-out right is substantive. We believe a determination should be made as to whether there are any barriers to exercising such rights, such as the following:
- Contractual—Conditions that make it unlikely that a kick-out right can be exercised (e.g., conditions that narrowly limit the timeframe in which the right may be exercised)
- Commercial—Financial penalties or operational barriers that act as significant disincentives for replacing the party
- Commercial—An inadequate number of qualified replacements for the party are available or compensation is inadequate to pay a qualified replacement
- Procedural or informational—The absence in the applicable agreements (or in the applicable laws or regulations) of an explicit, reasonable mechanism that allows the holder to exercise those rights or to obtain the information necessary to exercise them
In addition, a reporting entity should consider whether another variable interest holder has substantive participating rights (refer to CG 4.4). If a single party has substantive participating rights, those rights would prevent the holder of the kick-out right from exercising its power over the decision maker, and therefore no party would consolidate. In other words, the party with the participating rights will have the ability to block decisions related to all of the entity’s most significant activities.
The above list is not all inclusive, and the facts and circumstances of each situation should be carefully considered. Refer to ASC 810-10-55-4N through ASC 810-10-55-4W for additional examples of how to assess kick-out rights.
5.3.3 Liquidation rights held by non-decision makers
The definition of a kick-out right also includes the ability to dissolve (liquidate) a VIE without cause. Accordingly, a single party (including its related party and de facto agents) with the ability to liquidate a VIE would meet the power criterion if that right is substantive.
The guidance is based on the notion that a single party’s ability to liquidate a VIE produces the same outcome for the decision maker as exercising a kick-out right. That is, the decision maker will be permanently stripped of its decision-making rights. The ability of the investors to obtain substantially all of the same specific assets under management and to find a replacement manager with sufficient skills to manage those assets is not relevant to the evaluation of a liquidation right.
As discussed in CG 4.4.5.5, we believe redemption rights are legally and economically different from liquidation rights. That is, a redemption right represents an obligation to return capital to an investor at the investor’s request. If an investor exercises its redemption right, it generally will be unable to strip the decision maker of its power over the entity. Therefore, redemption rights should generally be disregarded when assessing the power criterion.
There may be certain cases where a redemption right is not substantively different from a liquidation right. This could be the case when a VIE has a single investor that could force a liquidation of the entity upon exercising its redemption right.
5.3.4 Impact of participating rights in assessing the power criterion
Participating rights are defined as the ability to block or participate in the actions through which a decision maker exercises the power to direct the activities of a VIE that most significantly impact the entity’s economic performance.
Definition from ASC 810-10-20
Participating Rights (VIE definition): The ability to block or participate in the actions through which an entity exercises the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance. Participating rights do not require the holders of such rights to have the ability to initiate actions.
Participating rights should generally not be considered in assessing whether a decision maker has the power to direct activities that most significantly impact a VIE’s economic performance unless the following conditions are met:
- The participating right is exercisable by a single variable interest holder (including its related parties and de facto agents)
- The participating right gives the single variable interest holder the ability to veto all decisions related to the VIE’s most significant activities
Participating rights over decisions related to some of the significant activities may also be relevant when assessing relative power. Refer to CG 5.2.4 for further discussion on relative power.
Like a kick-out right, participating rights should be considered when assessing the power criterion only when they are substantive.
Question CG 5-4
If a single party can exercise substantive participating rights, would that variable interest holder meet the power criterion?
If a single party can exercise substantive participating rights, would that variable interest holder meet the power criterion?
PwC response
Typically, no. Unlike a kick-out right, participating rights by themselves do not convey power. A participating right can only prevent another party from exercising power. This distinction is driven by the fact that a participating right limits the holder to vetoing, blocking, or participating in an action as opposed to initiating an action. For that reason, a substantive participating right typically only prevents another party from having power. However, there may be instances when substantive participating rights, when considered along with the variable interest holder’s (or its related parties and de facto agents’) other decision-making rights over significant activities, may result in that variable interest holder (or some other party in the related party group) having power.
The definition or threshold used to evaluate whether participating rights are substantive in the VIE model is not aligned with the voting model. Consequently, the impact of a participating right may produce different consolidation results under the VIE and voting models. See further discussion in CG 7.3.2.
Unlike a participating right, a protective right allows the holder to block or veto a decision or activity that is expected to occur outside the ordinary course of business (i.e., fundamental changes in the activities of an entity). Therefore, protective rights do not impact the power assessment as such rights are designed to protect the interest of the party holding the right(s).
Definition from ASC 810-10-20
Protective Rights (VIE definition): Rights are designed to protect the interests of the party holding those rights without giving that party a controlling financial interest in the entity to which they relate. For example, they include any of the following:
- Approval or veto rights granted to other parties that do not affect the activities that most significantly impact the entity’s economic performance. Protective rights often apply to fundamental changes in the activities of an entity or apply only in exceptional circumstances. Examples include both of the following:
- A lender might have rights that protect the lender from the risk that the entity will change its activities to the detriment of the lender, such as selling important assets or undertaking activities that change the credit risk of the entity.
- Other interests might have the right to approve a capital expenditure greater than a particular amount or the right to approve the issuance of equity or debt instruments.
- The ability to remove the reporting entity that has a controlling financial interest in the entity in circumstances such as bankruptcy or on breach of contract by that reporting entity.
- Limitations on the operating activities of an entity. For example, a franchisee agreement for which the entity is the franchise might restrict certain activities of the entity but may not give the franchisor a controlling financial interest in the franchisee. Such rights may only protect the brand of the franchisor.
Determining whether a right is protective or participating is judgmental. Refer to CG 4.4 for further discussion.
5.3.5 Evaluation of call options in assessing the power criterion
Call options (i.e., the right to purchase equity interests held by an investor of an entity) are common in joint ventures and other types of co-investment structures. For example, one investor in a joint venture may grant another investor the right to purchase its equity interest for a fixed price, at fair value, or at a price determined based on a formula (i.e., a purchased call option from the option holder’s standpoint). As a result of exercising the option, the holder (purchaser) of the call option may receive sufficient shares or equity to gain power over the entity.
Call options that require the writer of the option to deliver cash at settlement (net cash settled call options) do not convey power. The holder of the option will not gain the power to direct the activities that most significantly impact the VIE’s economic performance upon settlement of the option since it does not receive equity interests or its associated rights. Therefore, net cash settled call options should be disregarded when performing the power assessment.
The VIE model does not specifically address how physically settled purchased call options that give the holder of the call the ability to exercise power over the VIE upon exercise should be considered. The ensuing discussion assumes the call option will be physically settled such that the shares underlying the option would allow the holder to exert power over the VIE upon exercise of the option and delivery of the shares. When evaluating whether the call option conveys power to the holder, the analysis should consider the voting rights exercisable through the shares underlying the option, as well as any other rights that may transfer to the holder upon exercising the option. While there are similarities between kick-out rights and call options, the holder of a call option is generally required to make a significant cash payment to exercise the option. Therefore, we believe call options are economically different from kick-out rights, except in cases when the cash payment is minimal (e.g., call options exercisable at a nominal strike price).
Call options should be carefully considered to determine if they provide the holder with power over the entity. We believe that the following factors should be considered in making this evaluation:
- Whether the option is currently exercisable. An option that is not currently exercisable, and only becomes exercisable upon a contingent future event or through the passage of time, would generally not be considered to provide the holder of the call option with power over the entity.
- The strike price and other key terms of the call option. If the call option has an exercise price at fair value, it would be unlikely that the call option in and of itself would provide the holder with power. However, if the option’s exercise price is based on a fixed amount or an amount derived by a formula, the intrinsic value of the option should be considered. If the call option is deep in the money, the substance of the arrangement may provide the holder of the call option with power over the entity.
- The substance of the call option. If the call option can be exercised over some but not all of the remaining voting interests whereby the reporting entity obtains control of the VIE, it may indicate that the holder of the call option has power. For example, if the reporting entity holds 49.9% of the voting shares and can exercise an option to acquire 0.2% of the voting shares, and thus obtain control of the VIE, the reporting entity should evaluate whether their call option is substantively a kick-out right. Whereas if the reporting entity could only exercise an option to acquire the entire remaining outstanding interest (as opposed to exercising in small increments), the call option may be less akin to a kick-out right.
- The overall level of control held by the holder of the option. The holder may have the ability to make decisions that most significantly impact the economic performance of the VIE through other variable interests held by the option holder (including its related parties/de facto agents).
- Barriers to exercise the option. Factors that could prevent or limit the ability of the option holder to exercise the call option (e.g., due to illiquidity, regulatory concerns, or other factors) may lead to a conclusion that the holder does not have the power over the VIE through the call option.
- Conditions that make exercise not prudent, feasible, or substantially within the control of the holder. For example, when the counterparty to the call option (i.e., the writer of the option) controls technology that is critical to the VIE or is the principal source of funding for the VIE.
The shares received as a result of the exercise of a purchased net share settled call option may provide the holder with power over the entity. When a net share settled option is exercised, it does not require any investment or outlay of cash by the holder. In these cases, the option holder often already has a sizeable investment in the entity.
When the holder of a call option is precluded from exercising the option until a future date (e.g., after 5 years) or a specific event occurs, the call option should not be considered when assessing the power criterion until it becomes exercisable.
Many of the criteria noted above require continuous monitoring by a reporting entity.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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