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
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?
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?
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
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?
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.