Absent the de facto agency rules, a reporting entity could avoid consolidation of a VIE by “parking” its interests with a third party and controlling that party’s actions by restricting its ability to sell, transfer, or encumber its interest. We believe that the FASB’s rationale was to identify situations where the restricted party (the party that must obtain approval) is acting as an agent or de facto agent on behalf of another reporting entity or, in the case of cross transfer restrictions, where the reporting entity and the restricted party may be acting in concert. The FASB acknowledged that the evaluation of these types of situations would be heavily dependent on particular facts and circumstances and that judgment would be required to assess the substance behind the approval rights contained in a particular agreement.
Whether or not transfer restrictions create a de facto agency relationship under the VIE model is dependent mainly on two factors: (1) whether the “restricted” party has the ability to realize (or manage) its economic interest in the entity and (2) the reasons and economic rationale behind the restrictions placed on that party. The FASB believes that a party possesses the ability to manage its economic interest if the party has the right to sell, transfer, or encumber its interest in that entity without prior approval. If a party has any of these rights, a de facto agency relationship would not exist. For example, if a party has the right to sell its interest without prior approval but must obtain such approval to transfer or encumber that interest, and it is feasible that such party has the ability to realize its economics through a sale, no de facto agency relationship would exist.
As mentioned previously, mutual transfer restrictions do not cause a de facto agency relationship if the parties have the right of prior approval and the rights are based on mutually agreed terms by willing, independent parties. This exception to the de facto agency concept for transfer restrictions may prove helpful for many joint venture arrangements that are determined to be VIEs. Many joint ventures include mutual transfer restrictions. Without providing relief in situations when there are mutual transfer restrictions, even if the joint venture partners are determined to have shared power, one of the parties would have been required to consolidate the entity. This result seemed to be inconsistent with the notion that no party should consolidate if there is shared power. As a result, the FASB provided an exception from the definition of de facto agency relationships for mutual transfer restrictions.
Regarding the economic rationale behind the transfer restrictions, if the approval rights over the sale of the interest are merely to prevent the party from selling its interest to a competitor or to a less creditworthy (or otherwise less qualified) holder and there are a sufficient number of non-competitive or creditworthy buyers, the restriction would not necessarily create a de facto agency relationship. For example, a franchise agreement between the franchisee and the franchisor gives the franchisor the right to approve the sale of the franchise. If the contractual transfer restriction only prevents the sale of the franchise to a less-than-creditworthy buyer, it would normally not create a de facto agency relationship, provided there are sufficient creditworthy, potential buyers of the franchise. In practice, the economic rationale of the approval rights or transfer restrictions may not always be evident, and considerable judgment will be needed.
Care should also be taken when evaluating whether a restricted party has the means to realize the economics associated with its interest in the entity. If a restricted party only has the right to encumber (pledge) its interest in the entity without prior approval, but the characteristics of the interest do not allow the restricted party to monetize a substantial portion of the interest’s fair value (say, below 80%) through that right, it would be difficult to conclude that the restricted party has the ability to realize the economics of its interest.
If the restricted party has the ability to obtain all or most of the cash flows associated with its interest in the entity without prior approval, there is no substantive transfer restriction for purposes of this analysis.
Preparers should consider involving legal counsel, as well as the appropriate level of company management, when assessing the “design” of these restrictions.
Rights of first refusal
A right of first refusal exists in many arrangements and requires a variable interest holder to provide notice to another variable interest holder setting forth the price and payment terms for which a transferred interest is proposed to be sold. The non-transferring variable interest holder would have the right and option to purchase the transferring variable interest holders’ interest at the same price. We believe that a right of first refusal generally does not create a de facto agency relationship because the variable interest holder is not constrained from managing its economic interest in the entity.
Rights of first offer
A right of first offer requires a variable interest holder to first offer to transfer its interest to another variable interest holder prior to selling it to a third party. Under these circumstances, the holder of the right of first offer would have the ability to bid to purchase the seller’s interest. The seller can decide to accept or reject such bid; however, it cannot sell its interest to another party at a price lower than the price bid by the holder of the right of first offer. The right of first offer may provide some constraint over the seller’s ability to sell its interest to a party of its own choosing. However, we believe that a right of first offer provision does not create a de facto agency relationship among parties because the seller is not constrained from managing its economic interest in the entity.
Approval that cannot be unreasonably withheld
A party may have an agreement that it cannot sell, transfer, or convey its interest in the entity without the prior approval of the reporting entity, and such approval cannot be unreasonably withheld. At issue is whether such a clause would result in a de facto agency relationship. As with any other transfer restriction, we believe there is a rebuttable presumption that such provisions create a de facto agency relationship. A reporting entity can overcome that presumption if (1) it can conclude that the approval right would not prevent the restricted party from selling its interest to a qualified or other third party (specifically considering the reasons for which approval can be withheld) and (2) there are a sufficient number of such qualified buyers to provide a non-restricted market. Oftentimes, the assistance of legal counsel is necessary to interpret the “unreasonably withheld” provision of the agreement and support the entity’s conclusion.
In certain agreements, the variable interest holders in an entity may be precluded from selling, transferring, or pledging its interest for a particular time period. For example, consider a fact pattern in which Party A and Party B each own 50% of the equity in Entity X. Party A and Party B have entered into an arrangement whereby during the first 5 years, Party B is precluded from selling, transferring, or encumbering its interest in the entity. In this fact pattern, Party B is a de facto agent of Party A because there is an unconditional contractual restriction on Party B from selling, transferring, or pledging its interest. Once the lock-up period expires, Party B would no longer be considered a de facto agent, which might result in a change in the primary beneficiary conclusion. Evaluating lock-up periods requires considerable judgment.