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Under the ASC 810-10 VOE consolidation model, a reporting entity must consolidate any entity in which it has a controlling financial interest.
Controlling financial interest
For entities that are not VIEs, the usual condition for a controlling financial interest is ownership of over 50% of the outstanding voting shares. Under the provisions of ASC 810-10-15-10(a), all majority-owned subsidiaries (i.e., all companies in which a parent has a controlling financial interest through direct or indirect ownership of a majority voting interest) must be consolidated unless control does not rest with the majority owner. See CG 7.2.1 and 7.2.2 for situations where control may not rest with the majority owner.
In some cases, more than a simple majority voting interest may be needed to have a controlling financial interest. For example, an entity may have agreements or bylaws requiring approval from two-thirds of the outstanding voting interests for major decisions, rather than a simple majority. In this case, only a holder of at least two-thirds of the outstanding voting interest would have a controlling financial interest.
For SEC registrants, Regulation S-X 1-02(g) defines “control” as “…the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting shares, by contract, or otherwise.” While the SEC’s definition of control suggests that control may be achieved with a less than majority ownership of the voting shares, the SEC does not list specific criteria that should be considered in making that assessment. Rather, Regulation S-X 3A-02 emphasizes the need to consider substance over form to establish an appropriate consolidation policy in determining whether a less than majority owned entity should be consolidated.
The provisions of S-X 3A-02 were frequently applied by the SEC staff prior to the introduction of the VIE consolidation model. However, many of the situations previously subject to S-X 3A-02 are now in the scope of the VIE guidance since many of these entities are VIEs. Consequently, S-X 3A-02 is referenced less today, but nonetheless, should be considered in determining an appropriate consolidation policy.
Control without majority of voting rights
In some circumstances, a reporting entity may have a controlling financial interest in another entity (which is not a VIE) without owning a majority voting interest. The accounting for these situations should be determined based on the economic substance of the transaction. See CG 7.2.3 to CG 7.2.6.

7.2.1 Assessing control through indirect interest (VOE model)

A reporting entity may control another entity through a combination of both direct and indirect ownership interests held through a controlled intermediate entity. In those cases, it is possible for a reporting entity to have an economic interest of less than 50% of another entity, but still have a controlling financial interest in the entity. Conversely, a reporting entity could have an economic interest of more than 50% of another entity, but lack control because it does not hold a majority voting interest.
Example CG 7-1 and Example CG 7-2 describe scenarios in which indirect ownership may or may not result in control.
EXAMPLE CG 7-1

Control with less than 50% economic interest
Company A has a controlling financial interest in Company B through its 60% ownership interest in Company B. Company B, in turn, owns 40% of Company C. Company A also directly owns 20% of Company C.
Company B and Company C are voting interest entities and all ownership interests represent voting interests. A majority voting interest of an entity is assumed to result in a controlling financial interest.
Should Company A consolidate Company C?
Analysis
Yes. Even though Company A only has an economic interest of 44% in Company C (i.e., its 20% direct interest, plus its 60% of Company B’s 40% direct interest in Company C), Company A does have a controlling financial interest in Company C. Since Company A controls Company B, and thus can control Company B’s 40% voting interest in Company C, plus it has a direct 20% voting interest in Company C, Company A has a 60% controlling voting interest in Company C.
EXAMPLE CG 7-2

No control with more than 50% economic interest
Company A owns 40% of Company B. Company B, in turn, has a controlling financial interest in Company C through its 60% ownership interest in Company C. Company A also directly owns 30% of Company C.
Company B and Company C are voting interest entities and all ownership interests represent voting interests. A majority voting interest of an entity is assumed to result in a controlling financial interest.
Should Company A consolidate Company C?
Analysis
No. Even though Company A has an economic interest of 54% in Company C (i.e., its 30% direct interest, plus its 40% of Company B’s 60% direct interest in Company C), it does not control Company C. Since Company A does not control Company B, Company A would not be able to combine Company B’s 60% interest in Company C with its 30% direct interest in Company C to obtain a controlling financial interest in Company C.

7.2.2 Exceptions to consolidation by a majority owner (VOE model)

Under ASC 810-10, all majority-owned subsidiaries (i.e., all entities in which a parent has a controlling financial interest through direct or indirect ownership of a majority voting interest) must be consolidated, unless control does not rest with the majority owner.
The following are instances where control does not rest with the majority owner:
  • The subsidiary is in legal reorganization or in bankruptcy. Refer to BLG for further discussion.
  • The subsidiary operates under foreign exchange restrictions, controls, or other governmentally imposed uncertainties so severe that they cast significant doubt on the parent’s ability to control the subsidiary. Evidence of such a lack of control includes a parent’s inability to repatriate funds of a subsidiary because of long-term exchange restrictions, political uncertainties, threats of expropriation of a subsidiary’s assets, and other similar situations. Refer to EM 2.
  • The majority owner’s voting rights are restricted by certain approval or veto rights granted to the noncontrolling shareholder, which qualify as substantive participating rights. Refer to CG 7.2.6.
  • The parent is a broker-dealer within the scope of ASC 940, Financial services—brokers and dealers, and has a controlling financial interest in a subsidiary for which control is likely to be temporary. This exception for when control is likely to be temporary should not be analogized to reporting entities that are not broker/dealers. Refer to ASC 940-810-45-1.

7.2.3  Potential voting rights, call options, & convertible instruments

Entities may issue various financial instruments to reporting entities that provide the reporting entities with potential voting rights. For example, entities may issue call options, convertible instruments, and other similar instruments with potential voting rights to reporting entities. Depending on the terms, these instruments, if exercised or converted, may provide the reporting entity with a controlling financial interest in the entity. In these situations, questions may arise as to whether the reporting entity has a controlling financial interest in the entity prior to exercise or conversion of these financial instruments.
Generally, under the voting interest entity model, these types of financial instruments are not included in the determination of whether the reporting entity has a controlling financial interest in the entity as the voting interest entity model is not an effective control model. However, in certain limited circumstances, the terms and conditions of these instruments may make them so highly likely of exercise or conversion that a reporting entity may be deemed to have a controlling financial interest in the entity even though the instruments have not been actually exercised or converted. In making this assessment, a reporting entity should consider all facts and circumstances, including its relationships with the entity and other investors. Although not all inclusive, the reporting entity should consider the following:
  • Terms of the financial instrument – is there a high likelihood that the instrument will be exercised or converted? Is the instrument currently exercisable or convertible? Is the exercise or conversion price significantly in the money or a nominal amount? Does the exercise or conversion period span a long period of time? For example, if an option is currently exercisable with a nominal exercise price, the exercise of the option would likely have no significant effect on the investor and, therefore, the investor may have the ability to currently control the entity. On the other hand, an option that is not currently exercisable and at an exercise price that is not substantially in the money would likely indicate that the exercise of the option is substantive and the investor does not have the current ability to control the entity.
  • Relationships with entity and other investors – is the reporting entity controlling the operational and financial decisions of the entity by virtue of the nature of its relationships with the entity? Is the entity dependent on the reporting entity or vice versa? If so, how critical is that dependency? Does the reporting entity have call or put options with the other investors of the entity?
  • Purpose of the entity – is the entity being used for research and development activities, start-up activities, or marketing activities? Is the entity expected to incur losses in the early years of operations? If so, is this structure being used to avoid recording losses?

7.2.4 Control of the board of directors

A reporting entity may have a controlling financial interest in a less-than-majority-owned entity when the reporting entity has control of the board of directors, and the significant decisions of the entity are made at the board level. For example, a reporting entity may, without owning a majority of the voting shares, have the ability to appoint or elect the majority of the board of directors. These types of situations may be agreed upon and reflected in an entity’s governing documents (articles of incorporation, by-laws, or operating agreements) or by other separate agreements with the shareholders (voting proxies or other contractual arrangements). In making the determination of whether a less-than-majority owner demonstrates a controlling financial interest and should consolidate, the reporting entity should ensure that 1) the significant decisions of the entity are made at the board of directors level, 2) any matters voted upon at the shareholder level are not considered significant decisions, 3) other shareholders or other parties are not able to change the composition of the board of the directors, and 4) the ability to appoint a majority of the board of directors is for a substantial period of time.
In addition, the conditions providing a less-than-majority owner with control of the board may require further consideration of whether the entity is a voting interest entity or a VIE. See CG 4 for guidance on determining whether an entity is a VIE.
Example CG 7-3 and Example CG 7-4 provide additional guidance and factors to consider when assessing whether a less-than-majority-owned entity should be consolidated because of control of the board of directors.
EXAMPLE CG 7-3

Evaluating whether a controlling financial interest exists when one investor has the ability to appoint the majority of the board of directors
Company A and several private equity investors establish Company X. Company A owns 49% of the voting stock of Company X. None of the private equity investors own more than 15% of the voting stock. Through the articles of incorporation of Company X, the board of directors makes all significant financial and operating decisions. Any matters voted on by the shareholders of Company X are considered protective rights. The board of directors will consist of seven directors, four of which will be appointed by Company A as long as Company A owns more than 45% of the voting stock. The significant decisions are made at the board level by simple majority. The articles of incorporation cannot be changed without a supermajority of the vote of Company X’s shareholders. The private equity investors do not have any veto or substantive participating rights (see further discussion in CG 3.4). Assume Company X is not a VIE.
Should Company A consolidate Company X under the voting interest model?
Analysis
Yes. Company A should consolidate Company X under the voting interest model because it has the unilateral right to make the significant financial and operating decisions of Company X as a result of having the right to appoint four of the seven directors.
EXAMPLE CG 7-4

Evaluating a controlling financial interest when voting ownership is widely dispersed
Company A owns 49% of the voting stock of Company B, an established profitable entity. The remaining 51% is widely held and the probability that the entire 51% would vote in concert is remote. Company A does not own any convertible securities, options, or warrants in Company B, and there are no other agreements that affect the voting or management structure of Company B. The directors of Company B are elected by the shareholders of Company B at the annual shareholders meeting by simple majority present, subject to a minimum quorum requirement. The significant decisions of Company B are made at the board level by simple majority vote.
Should Company A consolidate Company B?
Analysis
No. While it is remote that Company A will not be able to elect all of the directors of Company B (as the other shareholders will most likely not all vote, or if they did, would most likely not all vote in unison), Company A does not have the unilateral right or power to direct the significant operational and financial actions of the investee. This unilateral right is generally applied without regard to probability. Thus, absent any other agreements that affect the voting or management structure, Company A should not consolidate Company B as it does not have the unilateral right to appoint the majority of the board of directors of Company B.

7.2.5 Control through contractual arrangements

A reporting entity with less than a majority of voting interests can also gain control of an entity through contractual arrangements. For example, a reporting entity may have:
  • An agreement with other voting interest holders that they will always vote in concert with the reporting entity, thus allowing the reporting entity to have a majority voting interest
  • A minority voting interest, but by virtue of a contract or other arrangement, have the ability to direct the significant decisions and activities of the entity (see also CG 7.4)
The reporting entity should exercise significant care when determining if it has a controlling financial interest in these situations. The reporting entity should perform a careful analysis of the arrangement, including the rights of all the parties (e.g., termination provisions) and the terms of the arrangement. These contractual arrangements may also cause the entity to be a VIE, and therefore subject to the VIE consolidation model. See CG 4 for guidance on determining whether an entity is a VIE.

7.2.6 Noncontrolling shareholder rights

ASC 810-10-25-2 through ASC 810-10-25-14 addresses the issue of whether consolidation is appropriate when one shareholder or partner has a majority voting interest in another entity, but the powers of the majority shareholder or partner to control the operations or assets of the investee are restricted in certain respects by approval or veto rights granted to the noncontrolling interest holder(s). A similar concept applies to limited partnerships. The approval or veto rights granted to the noncontrolling shareholder(s) or limited partner(s) may be considered as either protective or participating rights. The ASC guidance noted above applies to corporations and limited partnerships that are not VIEs. It does not apply to entities that carry substantially all of their assets at fair value. This section focuses on noncontrolling shareholder rights relating to corporations. Refer to CG 7.3.2 for discussion about limited partner rights relating to limited partnerships.
The assessment of whether noncontrolling shareholder rights should preclude a majority shareholder from consolidating is a matter of judgment that depends on facts and circumstances. The framework in which such facts and circumstances are judged should be based on whether the noncontrolling shareholder rights, individually or in the aggregate, provide for the noncontrolling shareholder to effectively participate in significant decisions that would be expected to be made in the “ordinary course of business.” This assessment should be made at the time a majority voting interest is obtained and should be reassessed if there is a significant modification to the terms of the rights of the noncontrolling shareholder.
Under this framework, the shareholder with the majority voting interest must assess whether the noncontrolling shareholder’s rights are protective rights or substantive participating rights. Protective rights do not overcome the presumption that a majority shareholder exerts control, while substantive participating rights, even though also protective of the investment, would overcome the presumption of control by the majority shareholder.

7.2.6.1 Protective rights–corporations & similar entities (VOE model)

Protective rights held by noncontrolling shareholders do not preclude consolidation. Protective rights are defined as follows under the voting interest model:

Definition from ASC 810-10

Protective Rights (Voting Interest Entity Definition): Rights that are only protective in nature and that do not allow the limited partners or noncontrolling shareholders to participate in significant financial and operating decisions of the limited partnership or corporation that are made in the ordinary course of business.

ASC 810-10-25-10 provides a list, not intended to be all-inclusive, of noncontrolling shareholder rights that would be considered protective rights and would not preclude the majority voting interest investor from consolidating the investee:

ASC 810-10-25-10

Noncontrolling rights (whether granted by contract or by law) that would allow the noncontrolling shareholder or limited partner to block corporate or partnership actions would be considered protective rights and would not overcome the presumption of consolidation by the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests in its investee. The following list is illustrative of the protective rights that often are provided to the noncontrolling shareholder or limited partner but is not all-inclusive:
  1. Amendments to articles of incorporation or partnership agreements of the investee
  2. Pricing on transactions between the owner of a majority voting interest or limited partner with a majority of kick-out rights through voting interests and the investee and related self-dealing transactions
  3. Liquidation of the investee in the context of Topic 852 on reorganizations or a decision to cause the investee to enter bankruptcy or other receivership
  4. Acquisitions and dispositions of assets that are not expected to be undertaken in the ordinary course of business (noncontrolling rights relating to acquisitions and dispositions of assets that are expected to be made in the ordinary course of business are participating rights; determining whether such rights are substantive requires judgment in light of the relevant facts and circumstances (see paragraphs 810-10-25-13 and 810-10-55-1))
  5. Issuance or repurchase of equity interests.

7.2.6.2 Participating rights–corporations and similar entities (VOE model)

Participating rights are defined as follows under the voting interest model:

Definition from ASC 810-10

Participating Rights (Voting Interest Entity Definition): Participating rights allow the limited partners or noncontrolling shareholders to block or participate in certain significant financial and operating decisions of the limited partnership or corporation that are made in the ordinary course of business. Participating rights do not require the holders of such rights to have the ability to initiate actions.

Participating rights must be substantive in order to overcome the presumption that a majority owner does not have a controlling financial interest in an entity. ASC 810-10-25-11 provides a list, not intended to be all-inclusive, of noncontrolling shareholder rights that should be considered substantive participating rights and would overcome the presumption of consolidation by the holder of a majority voting interest:

ASC 810-10-25-11

Noncontrolling rights (whether granted by contract or by law) that would allow the noncontrolling shareholder or limited partner to effectively participate in either of the following corporate or partnership actions shall be considered substantive participating rights and would overcome the presumption that the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests shall consolidate its investee. The following list is illustrative of substantive participating rights, but is not necessarily all-inclusive:
  1. Selecting, terminating, and setting the compensation of management responsible for implementing the investee’s policies and procedures
  2. Establishing operating and capital decisions of the investee, including budgets, in the ordinary course of business.

ASC 810-10-25-12

The rights noted in paragraph 810-10-25-11 are participating rights because, in the aggregate, the rights allow the noncontrolling shareholder or limited partner to effectively participate in certain significant financial and operating decisions that occur as part of the ordinary course of the investee’s business and are significant factors in directing and carrying out the activities of the business. Individual rights, such as the right to veto the termination of management responsible for implementing the investee’s policies and procedures, should be assessed based on the facts and circumstances to determine if they are substantive participating rights in and of themselves. However, noncontrolling rights that appear to be participating rights but that by themselves are not substantive (see paragraphs 810-10-25-13 and 810-10-55-1) would not overcome the presumption of consolidation by the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests in its investee. The likelihood that the veto right will be exercised by the noncontrolling shareholder or limited partner should not be considered when assessing whether a noncontrolling right is a substantive participating right.

A noncontrolling shareholder does not need to participate in all of the rights described in ASC 810-10-25-11(a) and 11(b) to overcome the presumption that the majority owner controls the entity. As indicated in ASC 810-10-25-12, individual rights should be assessed based on the facts and circumstances to determine if they are substantive participating rights in and of themselves. The ability of a noncontrolling shareholder to approve either the operating or the capital budget could be a substantive participating right and overcome the presumption that the majority owner controls the entity. Furthermore, a noncontrolling shareholder’s right over hiring, firing, or setting the compensation of management could also be a substantive participating right. For example, a right held by a noncontrolling shareholder to veto the setting of compensation of management responsible for implementing the investee’s policies and procedures could itself be considered substantive and overcome the presumption of control by the majority owner when the noncontrolling shareholder can exercise that right without any restrictions or conditions (e.g., no limit on the number of times a noncontrolling shareholder can exercise its right).
For a participating right to be substantive, it does not mean the noncontrolling shareholder must have the ability to initiate actions. Rather, it is only necessary that the noncontrolling shareholder’s approval must be obtained by the majority shareholder in order for the majority shareholder to take certain actions. Further, participating rights may be granted by contract (e.g., as a part of the shareholder arrangement) or by law (e.g., certain countries may require that noncontrolling shareholders interests held by local ownership have certain rights with respect to their ownership interest).
Participating rights: VOE vs. VIE definition
Both the voting interest model and the VIE model have their own definitions of a participating right. The definitions, while similar, can result in different applications. The voting interest model focuses on the right to block or participate in the significant financial and operating decisions of the entity made in the ordinary course of business, while the VIE model focuses on the right to block or participate in the decisions that most significantly impact the VIE’s economic performance. In addition, ASC 810-10-25-2 through ASC 810-10-25-14 provides examples on what constitutes a participating right under the voting interest model, however, it does not provide any examples on what constitutes a participating right under the VIE model. Given these circumstances, practice has developed where the two definitions can result in different outcomes. For example, a right to veto the compensation of management would likely be considered a substantive participating right under the voting interest model, while it might not significantly impact the entity’s economic performance.
Participating rights under the voting interest model would preclude consolidation by a majority shareholder or partner whether exercisable by a single investor or a group of investors. However, under the VIE model, only participating rights exercisable by a single investor (including its related parties and de facto agents) would preclude consolidation.
Under the VIE model, the presence or absence of a participating right may determine whether an entity is a VIE and also which reporting entity may be the primary beneficiary. When assessing whether an entity is a VIE and in particular whether the equity holders as a group lack the power to direct the entity’s significant activities, ASC 810-10-15-14(b) clarifies that substantive noncontrolling shareholder participating rights under the voting interest model do not automatically make the entity a VIE as the holders of equity at risk as a group may still have the power to direct the entity’s significant activities.

7.2.6.3 Evaluating whether participating rights are substantive

Determining whether a participating right is substantive requires judgment. For noncontrolling shareholder rights to be considered substantive, there should be no significant barriers to the exercise of the rights (i.e., conditions, financial penalties, or other operational hurdles making it difficult or unlikely that they could be exercised). As explained in ASC 810-10-25-12, once it is determined that there are no significant barriers to exercise, the likelihood that the rights will be exercised by the noncontrolling shareholder should not be considered when assessing whether a noncontrolling right is a substantive participating right. Noncontrolling shareholder participating rights that are not substantive would not preclude consolidation by an investor who has a majority voting interest in the entity.
ASC 810-10-25-13 provides several factors to consider when assessing whether a participating right is substantive.

ASC 810-10-25-13

The following factors shall be considered in evaluating whether noncontrolling rights that appear to be participating are substantive rights, that is, whether these factors provide for effective participation in certain significant financial and operating decisions that are made in the investee’s ordinary course of business:
  1. Consideration shall be given to situations in which a majority shareholder or limited partner with a majority of kick-out rights through voting interests owns such a significant portion of the investee that the noncontrolling shareholder or limited partner has a small economic interest. As the disparity between the ownership interest of majority and noncontrolling shareholders or between the limited partner with a majority of kick-out rights through voting interests and noncontrolling limited partners increases, the rights of the noncontrolling shareholder or limited partner are presumptively more likely to be protective rights and shall raise the level of skepticism about the substance of the right. Similarly, although a majority owner is presumed to control an investee, the level of skepticism about such ability shall increase as the investor’s or limited partner’s economic interest in the investee decreases.
  2. The governing documents shall be considered to determine at what level decisions are made—at the shareholder or limited partner level or at the board level—and the rights at each level also shall be considered. In all situations, any matters that can be put to a vote of the shareholders or limited partners shall be considered to determine if other investors, individually or in the aggregate, have substantive participating rights by virtue of their ability to vote on matters submitted to a shareholder or limited partner vote.
  3. Relationships between the majority and noncontrolling shareholders or partners (other than an investment in the common investee) that are of a related-party nature, as defined in Topic 850, shall be considered in determining whether the participating rights of the noncontrolling shareholder or limited partner are substantive. For example, if the noncontrolling shareholder or limited partner in an investee is a member of the immediate family of the majority shareholder, general partner, or limited partner with a majority of kick-out rights through voting interests of the investee, then the rights of the noncontrolling shareholder or limited partner likely would not overcome the presumption of consolidation by the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests in its investee.
  4. Certain noncontrolling rights may deal with operating or capital decisions that are not significant to the ordinary course of business of the investee. Noncontrolling rights related to decisions that are not considered significant for directing and carrying out the activities of the investee’s business are not substantive participating rights and would not overcome the presumption of consolidation by the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests in its investee. Examples of such noncontrolling rights include all of the following:
    1. Location of the investee’s headquarters
    2. Name of the investee
    3. Selection of auditors
    4. Selection of accounting principles for purposes of separate reporting of the investee’s operations.
  5. Certain noncontrolling rights may provide for the noncontrolling shareholder or limited partner to participate in certain significant financial and operating decisions that are made in the investee’s ordinary course of business; however, the existence of such noncontrolling rights shall not overcome the presumption that the majority owner shall consolidate, if it is remote that the event or transaction that requires noncontrolling shareholder or limited partner approval will occur. Remote is defined in Topic 450 as the chance of the future event or events occurring being slight.
  6. An owner of a majority voting interest or limited partner with a majority of kick-out rights through voting interests who has a contractual right to buy out the interest of the noncontrolling shareholder or limited partner in the investee for fair value or less shall consider the feasibility of exercising that contractual right when determining if the participating rights of the noncontrolling shareholder or limited partner are substantive. If such a buyout is prudent, feasible, and substantially within the control of the majority owner, the contractual right to buy out the noncontrolling owner or limited partner demonstrates that the participating right of the noncontrolling shareholder or limited partner is not a substantive right. The existence of such call options, for purposes of the General Subsections, negates the participating rights of the noncontrolling shareholder or limited partner to veto an action of the majority shareholder or general partner, rather than create an additional ownership interest for that majority shareholder. It would not be prudent, feasible, and substantially within the control of the majority owner to buy out the noncontrolling shareholder or limited partner if, for example, either of the following exists:
    1. The noncontrolling shareholder or limited partner controls technology that is critical to the investee.
    2. The noncontrolling shareholder or limited partner is the principal source of funding for the investee.

Many factors can influence whether a participating right is substantive. Investors should not only refer to the list above, but also keep in mind that there could be other factors that could influence their assessment. These factors could be different from entity to entity, depending on an entity’s operations.
The two main underlying principles of a substantive participating right is that (1) the right over the decision has to be expected to be made in the ordinary course of business, and (2) it has to be expected to have a significant effect on the financial and operating decisions of the entity. If both of these principles are not present, the right would not be a substantive participating right. The ordinary course of business assessment is based on the specific entity’s business and can be different from business to business and also industry to industry.

7.2.7 Assessing individual noncontrolling shareholder rights

In addition to the factors above, ASC 810-10-55-1 provides various examples of how to assess individual noncontrolling shareholder rights. These examples should not be considered all-inclusive. Judgment should be applied based on the specific facts and circumstances in each arrangement in order to determine whether the rights of the noncontrolling shareholder should be considered protective or participating, and if participating, whether the rights are substantive.

ASC 810-10-55-1

Examples of how to assess individual noncontrolling rights facilitate the understanding of how to assess whether the rights of the noncontrolling shareholder or limited partner should be considered protective or participating and, if participating, whether the rights are substantive. An assessment is relevant for determining whether noncontrolling rights overcome the presumption of control by the majority shareholder or limited partner with a majority of kick-out rights through voting interests in an entity under the General Subsections of this Subtopic. Although the following examples illustrate the assessment of participating rights or protective rights, the evaluation should consider all of the factors identified in paragraph 810-10-25-13 to determine whether the noncontrolling rights, individually or in the aggregate, provide for the holders of those rights to effectively participate in certain significant financial and operating decisions that are made in the ordinary course of business:
  1. The rights of the noncontrolling shareholder or limited partner relating to the approval of acquisitions and dispositions of assets that are expected to be undertaken in the ordinary course of business may be substantive participating rights. Rights related only to acquisitions that are not expected to be undertaken in the ordinary course of the investee’s existing business usually are protective and would not overcome the presumption of consolidation by the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests in its investee. Whether a right to approve the acquisition or disposition of assets is in the ordinary course of business should be based on an evaluation of the relevant facts and circumstances. In addition, if approval by the shareholder or limited partner is necessary to incur additional indebtedness to finance an acquisition that is not in the investee’s ordinary course of business, then the approval by the noncontrolling shareholder or limited partner would be considered a protective right.
  2. Existing facts and circumstances should be considered in assessing whether the rights of the noncontrolling shareholder or limited partner relating to an investee’s incurring additional indebtedness are protective or participating rights. For example, if it is reasonably possible or probable that the investee will need to incur the level of borrowings that requires noncontrolling shareholder or limited partner approval in its ordinary course of business, the rights of the noncontrolling shareholder or limited partner would be viewed as substantive participating rights.
  3. The rights of the noncontrolling shareholder or limited partner relating to dividends or other distributions may be protective or participating and should be assessed in light of the available facts and circumstances. For example, rights to block customary or expected dividends or other distributions may be substantive participating rights, while rights to block extraordinary distributions would be protective rights.
  4. The rights of the noncontrolling shareholder or limited partner relating to an investee’s specific action (for example, to lease property) in an existing business may be protective or participating and should be assessed in light of the available facts and circumstances. For example, if the investee had the ability to purchase, rather than lease, the property without requiring approval of the noncontrolling shareholder or limited partner, then the rights of the noncontrolling shareholder or limited partner to block the investee from entering into a lease would not be substantive.
  5. The rights of the noncontrolling shareholder or limited partner relating to an investee’s negotiation of collective bargaining agreements with unions may be protective or participating and should be assessed in light of the available facts and circumstances. For example, if an investee does not have a collective bargaining agreement with a union or if the union does not represent a substantial portion of the investee’s work force, then the rights of the noncontrolling shareholder or limited partner to approve or veto a new or broader collective bargaining agreement are not substantive.
  6. Provisions that govern what will occur if the noncontrolling shareholder or limited partner blocks the action of an owner of a majority voting interest or general partner need to be considered to determine whether the right of the noncontrolling shareholder or limited partner to block the action has substance. For example, if the shareholder or partnership agreement provides that if the noncontrolling shareholder or limited partner blocks the approval of an operating budget, then the budget simply defaults to last year’s budget adjusted for inflation, and if the investee is a mature business for which year-to-year operating budgets would not be expected to vary significantly, then the rights of the noncontrolling shareholder or limited partner to block the approval of the operating budget do not allow the noncontrolling shareholder or limited partner to effectively participate and are not substantive.
  7. Noncontrolling rights relating to the initiation or resolution of a lawsuit may be considered protective or participating depending on the available facts and circumstances. For example, if lawsuits are a part of the entity’s ordinary course of business, as is the case for some patent-holding companies and other entities, then the noncontrolling rights may be considered substantive participating rights.
  8. A noncontrolling shareholder or limited partner has the right to veto the annual operating budget for the first X years of the relationship. Based on the facts and circumstances, during the first X years of the relationship this right may be a substantive participating right. However, following Year X there is a significant change in the exercisability of the noncontrolling right (for example, the veto right terminates). As of the beginning of the period following Year X, that right would no longer be a substantive participating right and would not overcome the presumption of consolidation by the investor with a majority voting interest or limited partner with a majority of kick-out rights through voting interests in its investee.

When assessing whether noncontrolling shareholder rights are participating or protective, the reporting entity should consider all facts and circumstances, including any contractual provisions, including the examples below, that limit, constrain, or otherwise override the rights of the noncontrolling shareholder.
  • The noncontrolling shareholder only has the right to approve the acquisition or disposition of assets over a certain dollar limit. The reporting entity should determine whether that dollar limit causes the right to be non-substantive. For instance, if the entity’s long-term plan projects that the dollar limit would not be exceeded in the ordinary course of business, the noncontrolling shareholder’s veto right may not be considered substantive.
  • In the event of a disagreement between the reporting entity and the non-controlling shareholder, there is a dispute resolution mechanism in place that ultimately allows the reporting entity to prevail. For example, the noncontrolling shareholder can only veto the appointment of an executive position three times and after the third time, the reporting entity is able to make the appointment solely on its own. In this case, the noncontrolling shareholder’s veto right may not be considered substantive because even though the majority shareholder might have to make four attempts to appoint the executive it desires, four attempts would likely not be considered overly burdensome, and the majority shareholder ultimately has the ability to appoint the executive position.
  • The provision may not allow the noncontrolling shareholder to effectively participate in the entity’s significant financial and operating decisions. For example, if the reporting entity and the non-controlling shareholder cannot agree on the operating budget, the current year budget defaults to last year’s budget adjusted for inflation or some other factor. If the entity is a mature business for which year-to-year operating budgets are not expected to vary significantly, the noncontrolling shareholder’s veto right may not be considered substantive as the rights do not allow the noncontrolling shareholder to effectively participate in a significant decision. Alternatively, consider an example where a reporting entity and the noncontrolling shareholder cannot agree on the operating budget and the disagreement is resolved and decided by an independent arbitrator. In this case, regardless of the arbitration outcome, the participating right would be considered substantive since the reporting entity would not be able to make the decision regarding the operating budget unilaterally.
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