Excerpt from ASC 810-10-15-14(b)
As a group the holders of the equity investment at risk lack any one of the following three characteristics:
1. The power, through voting rights or similar rights, to direct the activities of a legal entity that most significantly impact the entity’s economic performance. . . .
2. The obligation to absorb the expected losses of the legal entity. . . .
3. The right to receive the expected residual returns of the legal entity.
As further discussed in
UP 10.4, the primary beneficiary of a VIE is the party that has the power to direct the activities of the VIE that most significantly impact its financial performance, and that also has a financial exposure that could potentially be significant to the entity (obligation to absorb losses or right to receive gains that could be significant to the VIE). Although many parties to the VIE may have significant financial exposure, only one party can meet both of these criteria. The evaluation of the equity holders at risk under
ASC 810-10-15-14(b) is consistent with the approach to determining the primary beneficiary in that it considers the powers held by different parties. Consider the following simplified example.
EXAMPLE 10-1
Equity holder lacks power to direct the most significant activities
M&H Holding Company holds all of the equity interests in Foxglove Power Company (FPC). Big Bank provides financing under a 20-year debt agreement. All capacity, electric energy, and ancillary services from the plant are sold to Rosemary Electric & Gas Company under a tolling agreement, while the steam is sold to an oil refinery. The power purchase agreement provides REG with the right to control operations and maintenance and dispatch. Steam is approximately 15% of the revenue from the plant and the power purchase agreement is not a lease. For purposes of this example, the variable interests are:
• M&H — the equity interests
• Big Bank — the debt financing
• REG — the power purchase agreement
The oil refinery also has a variable interest as a result of the steam agreement.
Analysis
M&H determines that operations and maintenance and dispatch are the activities that most significantly impact the economic performance of FPC. Therefore, M&H concludes that FPC is a VIE because the tolling agreement gives a party other than the holders of the equity at risk (i.e., REG) the power to direct FPC’s most significant activities.
Kick-out rights and participating rights
One of the characteristics that results in a conclusion that an entity is a VIE is that the equity holders do not have the power to direct the activities of the entity that most significantly impact its financial performance. This power may be conveyed through kick-out or participating rights and the existence of or lack of these rights may have a different impact on the VIE analysis depending on whether the entity should be evaluated as a corporation or as a limited partnership (see CG 2.3.3.2).
Assessment for entities evaluated as corporations
If an entity should be evaluated as a corporation and a decision maker arrangement exists, the evaluation of kick-out or participating rights can be summarized in the following three steps:
1. Determine if the decision maker arrangement is a variable interest. If it is not a variable interest, the arrangement does not prevent the equity holders from having the power to direct the activities of the entity that most significantly impact its economic performance.
2. Determine if a substantive kick-out or participating right exists that can be exercised unilaterally. If a substantive right to replace the decision maker can be unilaterally exercised by one party, the equity holders as a group would not lack the power over the significant activities that impact the economic performance.
3. Assess the rights of shareholders and determine if the holders of equity at risk have the power to direct the activities of the entity that most significantly impact its economic performance.
After considering the above three steps, a decision maker that has the power over the significant activities, and that cannot be replaced through a unilateral exercise right, would cause an entity to be a VIE.
For other than decision making arrangements, if an interest holder other than the holders of equity at risk has kick out or participating rights related to the significant activities that can be unilaterally exercised, the equity holders would not have the power over those activities and the entity would be a VIE.
Excerpt from ASC 810-10-15-14(b)(1)(i) – For legal entities other than limited partnerships
If no owners hold voting rights or similar rights (such as those of a common shareholder in a corporation) over the activities of a legal entity that most significantly impact the entity’s economic performance, kick-out rights or participating rights (according to their VIE definitions) held by the holders of the equity investment at risk shall not prevent interests other than the equity investment from having this characteristic unless a single equity holder (including its related parties and de facto agents) has the unilateral ability to exercise such rights. Alternatively, interests other than the equity investment at risk that provide the holders of those interests with kick-out rights or participating rights shall not prevent the equity holders from having this characteristic unless a single reporting entity (including its related parties and de facto agents) has the unilateral ability to exercise those rights. A decision maker also shall not prevent the equity holders from having this characteristic unless the fees paid to the decision maker represent a variable interest
Assessment for entities evaluated as limited partnerships
If the entity should be viewed as a limited partnership, the reporting entity should determine whether the limited partners lack the power to direct the entity’s most significant activities as discussed in
ASC 810-10-15-14(b)(1)(ii). In performing this analysis only rights that are substantive should be considered.
Excerpt from ASC 810-10-15-14(b)(1)(ii) – For limited partnerships
Partners lack the power through voting rights or similar rights, to direct the activities of a legal entity that most significantly impact the entity’s economic performance if neither of the below conditions exist;
(1) a simple majority or lower threshold of limited partners (including a single limited partner) with equity at risk is able to exercise substantive kick-out rights (according to their voting interest entity definition) through voting interests over the general partner(s), and
(2) Limited partners with equity at risk are able to exercise substantive participating rights (according to their voting interest entity definition) over the general partner(s).
If the limited partners do not hold kick-out rights that can be exercised through a simple majority vote or lower, or do not have substantive participating rights, the equity holders as a group would not have the power to direct the significant activities of the entity that impact economic performance and the entity would be a VIE.
Impact of protective rights
Partial definition from ASC 810-10-20
Protective Rights: Rights 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.
The inclusion of protective rights in an agreement does not impact the analysis of whether an entity is a VIE in the same way as kick-out or participating rights. Protective rights are common in project financing agreements and in long-term power purchase agreements, which often include provisions allowing the debt holder or power off-taker to assume operational responsibility for the plant if the operator defaults. Rights that are exercisable only in the event of default are protective rights and would not trigger the conclusion that an entity is a VIE. The definition in ASC 810-10-20 includes examples of protective rights as follows:
• Approval or veto rights that do not affect the activities that most significantly impact the entity’s economic performance. Protective rights often apply to fundamental changes in the entity’s activities, such as: (1) sale of important assets or activities that change the credit profile of the entity; or (2) capital expenditures over a certain limit or the issuance of new equity or debt.
• The ability to remove the primary beneficiary in cases such as bankruptcy or breach of contract.
• Limitations on operating activities that may restrict certain activities but do not provide a controlling financial interest (such as rights held by a franchisor over activities of a franchisee).
These concepts are further illustrated in the following simplified examples.
EXAMPLE 10-2
Protective kick-out rights
Assume the same facts as in Example 10-1. However, M&H Holding Company has the responsibility to obtain fuel for Foxglove Power Company and it also controls operations and maintenance (as opposed to Rosemary Electric & Gas Company). M&H concludes that fuel procurement and operations and maintenance are the most significant activities affecting the potential profit or loss of FPC. As a result of this change, further assessment is required to determine whether FPC is a VIE.
The power purchase agreement provides REG with the right to assume operational responsibility for the facility in the event of a default under the contract. M&H considers how this right impacts the evaluation of whether FPC is a VIE.
Analysis
REG’s ability to remove M&H in the event of a default under the contract is an example of a protective right and does not impact the evaluation of whether FPC is a VIE. The parties should further assess whether FPC is a VIE under one of the other provisions of
ASC 810-10-15-14.
EXAMPLE 10-3
Operational kick-out rights
Assume the same facts as in Example 10-2, however, the power plant is held in a partnership entity, Foxglove Power Partners (FPP). M&H Holding Company holds a 2% general partnership interest and manages the day-to-day operations of the plant. FPP has class A limited partnership interests held by three limited partners. It also has class B limited partnership shares held by one limited partner. The class B shares are mandatorily redeemable and are accounted for as a liability by FPP. As such, the class B shares are not considered equity at risk because the interest is not classified as equity by FPP.
The limited partners provided their own equity and together have approval over all major operating decisions, including financing, the annual budget, operations and maintenance schedules, and major contracts. In addition, they have the ability to rescind the general partner’s management agreement (without cause) through a simple majority vote.
Analysis
As discussed in CG 2.3.3.2, in this case, since the entity is a partnership and functions like a partnership, the limited partners would need to hold substantive kick-out rights for the entity to not be a VIE under
ASC 810-10-15-14(b)(1). Substantive kick-out rights exist and can be exercised by a simple majority vote or lower threshold. Therefore, the criteria under
ASC 810-10-15-14(b)(1) are not met (although the partners also need to consider whether FPP is a VIE under one of the other provisions of
ASC 810-10-15-14). However, if the rights were held by only the limited partner with the mandatorily redeemable shares such that it had the ability to act unilaterally, FPP would be a VIE.
Obligation to absorb losses/right to receive returns
In accordance with
ASC 810-10-15-14(b)(2) and (b)(3), an entity also meets the definition of a VIE if the equity holders lack the obligation to absorb expected losses or the right to receive the expected residual returns of the entity. When evaluating these provisions, a reporting entity should consider:
• Expected losses — consider whether the equity holders as a group are required to absorb the entity’s expected losses on a “first-dollar loss” basis until the equity is depleted. In other words, there should not be a mechanism or arrangement that protects the equity holders from losses on their investment.
• Expected residual returns — an entity is a VIE if the equity investors’ return is capped or other variable interest holders share in the residual cash flows at an amount that is considered significant relative to the level of expected residual returns.
Sample features that may trigger VIE accounting under this guidance include:
• A guarantee on returns of an equity investment by the entity itself, or by other parties that are involved with the entity, that provides the equity holder with protection against losses (e.g., a return on investment may be guaranteed for tax-equity holders in a renewable energy “flip” structure, when the investment is equity under U.S. GAAP)
• A residual value guarantee that provides the equity holders with protection against losses (e.g., a plant lessee guarantees a specified power plant value at the end of the power purchase agreement)
• A put option held by the entity at a specified price that provides the equity holder with protection against losses (e.g., the entity holds an option to put the power plant to the off-taker at some point during or at the end of the power purchase agreement at a specified price)
• A call option written by the entity may function to limit the equity holders’ right to receive residual profits (e.g., if the power plant can be called by the off-taker at some point during or at the end of the power purchase agreement at a specified price)
• An arrangement whereby the power plant off-taker shares in profits from sales of other by-products by the entity, thereby capping the equity holders’ ability to earn returns
Some of these arrangements may also trigger VIE accounting under
ASC 810-10-15-14(a) because they may provide subordinated financial support or indicate the equity investment was not at risk.