Technical Line. Consolidation considerations for asset managers FIN 46(R) to ASU What you need to know. Overview. FASB final standard

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1 No April 2015 Technical Line FASB final standard Consolidation considerations for asset managers FIN 46(R) to ASU In this issue: Overview... 1 Background... 2 Money market funds... 3 Variable interest model... 4 Consider purpose and design... 4 Identification of variable interests... 5 VIE determination Primary beneficiary determination Related party provisions Other changes Voting model Effective date and transition Recognition Measurement deconsolidation (carrying amounts) Practicability exceptions Other SEC reporting considerations Appendix: Consolidation flowchart What you need to know The FASB issued final guidance on consolidation that will eliminate the deferral of FAS 167, permanently exempt most money market funds and change both the variable interest and the voting models. Entities will need to re-evaluate their consolidation conclusions and revise their documentation. The new guidance will change the criteria for determining (1) when fees paid to a decision maker or service provider are a variable interest (2) whether an entity is a VIE and (3) whether a reporting entity is the primary beneficiary of a VIE. Today s presumption in the voting model that a general partner controls a limited partnership will be eliminated. For public business entities, it is effective for annual periods beginning after 15 December 2015 and interim periods therein. Early adoption is permitted, including in an interim period. Overview The Financial Accounting Standards Board (FASB or Board) issued Accounting Standards Update (ASU) , Amendments to the Consolidation Analysis. That ASU eliminates the deferral of FAS 167, 1 which allows reporting entities with interests in certain investment funds to follow the consolidation guidance in FIN 46(R), 2 and makes other changes to both the variable interest model and the voting model.

2 The guidance will affect all reporting entities 3 that have variable interests in other legal entities. In some cases, consolidation conclusions will change. In other cases, reporting entities will need to make more disclosures if an entity that currently isn t considered a variable interest entity (VIE) will be considered a VIE under the new guidance. Entities also will need to evaluate their internal controls over financial reporting and make any necessary changes. This publication highlights what reporting entities will have to do differently when they evaluate interests in other entities for consolidation that they currently evaluate for consolidation under FIN 46(R). These interests will have to be evaluated considering changes that result from both ASU and FAS 167, 4 which is codified in Accounting Standards Codification (ASC) 810, Consolidation. We collectively refer to these changes in this publication as changes resulting from the ASU. The flowchart in the appendix to this publication illustrates the approach to consolidation under the ASU. We describe changes in the consolidation evaluation of interests in entities that are currently evaluated for consolidation under FAS 167 in our separate Technical Line, New consolidation guidance will require many entities to re-evaluate their conclusions. Background Before the FASB issued FAS 167 in 2009, a reporting entity was required under FIN 46(R) to perform a quantitative assessment of its exposure to the economic variability of an entity to determine whether it should consolidate a VIE. Also under FIN 46(R), if the variable interests held by the related party group made the group the primary beneficiary, then the party within the related party group that was most closely associated with the VIE would be the primary beneficiary. These related party provisions were considered first before determining the primary beneficiary individually. FAS 167, which superseded FIN 46(R), required a reporting entity to perform a qualitative assessment based on power and benefits. It also required a reporting entity that is evaluating whether it is the primary beneficiary of a VIE to first determine whether it has power and benefits, prior to considering the related party provisions. In response to concerns about the usefulness of asset managers financial statements if they had to consolidate certain funds they manage under FAS 167, the FASB deferred the evaluation of certain investment funds under FAS 167 and said it would develop new guidance to address the asset manager s concerns. As a result, reporting entities with variable interests in investment funds that qualify for the deferral have continued to apply FIN 46(R) to such interests. In 2011, the FASB proposed 5 requiring a decision maker (e.g., an asset manager, a general partner) of a VIE or voting partnership to evaluate three factors to determine whether it was using its power as a principal or as an agent. A decision maker that acts as a principal would have been deemed to have a controlling financial interest and would therefore have consolidated the entities it controlled. In redeliberations, the FASB abandoned the separate principal-agent analysis and decided instead to make targeted revisions to address asset managers concerns. 2 Technical Line Consolidation considerations for asset managers FIN 46(R) to ASU April 2015

3 Money market funds Excerpt from Accounting Standards Codification Consolidation Overall Scope and Scope Exceptions General Entities The guidance in this Topic does not apply in any of the following circumstances f. A reporting entity shall not consolidate a legal entity that is required to comply with or operate in accordance with requirements that are similar to those included in Rule 2a-7 of the Investment Company Act of 1940 for registered money market funds. 1. A legal entity that is not required to comply with Rule 2a-7 of the Investment Company Act of 1940 qualifies for this exception if it is similar in its purpose and design, including the risks that the legal entity was designed to create and pass through to its investors, as compared with a legal entity required to comply with Rule 2a-7. Money market funds that comply with or operate in accordance with Rule 2a-7 are permanently exempt from consolidation. 2. A reporting entity subject to this scope exception shall disclose any explicit arrangements to provide financial support to legal entities that are required to comply with or operate in accordance with requirements that are similar to those included in Rule 2a-7, as well as any instances of such support provided for the periods presented in the performance statement. For purposes of applying this disclosure requirement, the types of support that should be considered include, but are not limited to, any of the following: i. Capital contributions (except pari passu investments) ii. iii. iv. Standby letters of credit Guarantees of principal and interest on debt investments held by the legal entity Agreements to purchase financial assets for amounts greater than fair value (for instance, at amortized cost or par value when the financial assets experience significant credit deterioration) v. Waivers of fees, including management fees. The ASU eliminates the deferral of FAS 167 but permanently exempts a reporting entity from consolidating money market funds that are required to comply with or operate in accordance with requirements that are similar to those in Rule 2a-7 of the Investment Company Act of To determine whether a fund operates in accordance with requirements that are similar to Rule 2a-7, the reporting entity would consider the purpose and design of the fund, including the risks it was designed to create and pass along to its investors. The facts to consider may include, but are not limited to: Limits on the maturities of investments (e.g., short-term securities) Minimum required liquidity of the fund s investments Requirements governing the credit quality of the fund s investments Requirements related to the fund s concentration of risk or diversification of the fund s portfolio The nature of the regulation under which a foreign fund operates 3 Technical Line Consolidation considerations for asset managers FIN 46(R) to ASU April 2015

4 A reporting entity that has an interest in a money market fund that is permanently exempt from being consolidated will be required to disclose any financial support it provided to the fund during the periods presented in the financial statements and any explicit arrangements to provide financial support in the future. Financial support could include capital contributions, standby letters of credit, guarantees of principal and interest, agreements to purchase troubled securities, waivers of fees, including management fees. The FASB decided that issuing a scope exception for interests in money market funds was the most effective way to address constituents concerns that consolidating these funds would not provide decision-useful information. How we see it The criteria money market funds must meet to qualify for the scope exception under the ASU are consistent with the criteria the funds must meet to qualify for the deferral of FAS 167. Therefore, we do not expect a significant change in practice as a result of the FASB providing a scope exception. Variable interest model The first step in the variable interest model considers the purpose and the design of the entity. The ASU changes aspects of the guidance in the remaining steps of the variable interest model, which are to identify variable interests, determine whether the entity is a VIE and identify the primary beneficiary of the VIE. The flowchart in the appendix to this publication highlights these steps in more detail. Consider purpose and design Step 1 Step 2 Step 3 Step 4 Consider purpose and design Identify variable interests Determine whether the entity is a VIE Identify the primary beneficiary of the VIE The VIE model requires a reporting entity to evaluate the purpose and the design of an entity as the basis for determining the entity s variability and to identify the primary beneficiary. The by design approach is a qualitative approach that considers (1) the nature of the risks in the entity and (2) the purpose for which the entity was created in determining the variability the entity is designed to create and pass along to its interest holders. In evaluating purpose and design, a reporting entity should consider the nature of the entity s activities, including which parties participated significantly in the design or redesign of the entity, the terms of the contracts the entity entered into, the nature of interests issued and how the entity s interests were marketed to potential investors. The entity s governing documents, marketing materials and contractual arrangements are often helpful in determining the risks the entity was designed to create and distribute. 4 Technical Line Consolidation considerations for asset managers FIN 46(R) to ASU April 2015

5 Identification of variable interests Step 1 Step 2 Step 3 Step 4 Consider purpose and design Identify variable interests Determine whether the entity is a VIE Identify the primary beneficiary of the VIE In the second step in the variable interest model, a reporting entity determines whether it has a variable interest in the entity being evaluated for consolidation. In doing so, a reporting entity considers the purpose of the entity and the risks that the entity was designed to create and pass along to its interest holders. Equity interests, guarantees, subordinated debt interests and written call options are all variable interests because they absorb risk created and distributed by an entity. Fees received by decision makers or service providers (e.g., asset managers) may represent variable interests depending on the facts and circumstances. Fees paid to a decision maker or service provider Excerpt from Accounting Standards Codification Consolidation Overall Implementation Guidance and Illustrations Variable Interest Entities Implementation Guidance Identifying Variable Interests Fees Paid to Decision Makers or Service Providers Fees paid to a legal entity s decision maker(s) or service provider(s) are not variable interests if all of the following conditions are met: a. The fees are compensation for services provided and are commensurate with the level of effort required to provide those services. b. Subparagraph superseded by Accounting Standards Update c. The decision maker or service provider does not hold other interests in the VIE that individually, or in the aggregate, would absorb more than an insignificant amount of the VIE s expected losses or receive more than an insignificant amount of the VIE s expected residual returns. d. The service arrangement includes only terms, conditions, or amounts that are customarily present in arrangements for similar services negotiated at arm s length. e. Subparagraph superseded by Accounting Standards Update f. Subparagraph superseded by Accounting Standards Update The ASU eliminates certain criteria for evaluating whether fees received by a decision maker or service provider represent a variable interest. In addition, the ASU modified (1) the criteria relating to the evaluation of other interests in the entity, and (2) how interests held by related parties and de facto agents are considered in determining whether a fee is a variable interest. These changes are discussed below. Criteria to be met for fees not to be a variable interest Under the ASU, three criteria must all be met to conclude that fees received by an entity s decision makers or service providers do not represent variable interests in that entity: The fees are compensation for services provided and are commensurate with the level of effort required to provide those services. 5 Technical Line Consolidation considerations for asset managers FIN 46(R) to ASU April 2015

6 The service arrangement includes only terms, conditions or amounts that are customarily present in arrangements for similar services negotiated at arm s length. The decision maker or service provider (and its related parties or de facto agents) does not hold other interests in the VIE that individually, or in the aggregate, would absorb more than an insignificant amount of the VIE s expected losses or receive more than an insignificant amount of the VIE s expected residual returns. However, fee arrangements that expose a reporting entity to risk of loss are automatically considered variable interests and wouldn t be evaluated using the criteria. Under the ASU, mutual fund managers may conclude that their fees satisfy the criteria and therefore are not variable interests in the funds they manage. That s because mutual fund managers generally do not hold an ownership interest beyond their management contracts, or only hold an immaterial ownership interest. Instead, they typically receive a fee that is calculated as a percentage of the net assets they manage (e.g., 75 basis points), which would likely include only terms, conditions or amounts that are customarily present in arrangements for similar services, and the fee is commensurate with the level of effort required to provide those services. Consistent with FAS 167, under the ASU, a decision maker or service provider that holds interests that would absorb more than an insignificant amount of an entity s expected losses or receive more than an insignificant amount of an entity s residual returns will conclude that it has a variable interest. For example, a decision maker or service provider that is a general partner (GP) may hold a significant equity interest in a partnership (e.g., 20%) in addition to a management fee. The GP likely would conclude that this management fee is a variable interest due to the magnitude of the equity interest. How we see it The ASU states that fees for new services could be considered customary, even if there are no comparable arrangements in the marketplace. Careful consideration will be necessary to determine whether a fee arrangement includes only terms, conditions or amounts that are customarily present in arrangements for similar services, particularly for new service offerings or when the fee, service or other interest is unique and not observable in the marketplace. Elimination of criteria considered under FIN 46(R) Reporting entities no longer need to consider the following criteria or factors: The decision maker or service provider is subject to substantive kick-out rights by the vote of a simple majority of the voting interests held by parties other than the decision maker and the decision maker s related parties. The fees are at or above the same level of seniority as other operating liabilities of the VIE that arise in the normal course of the business, such as trade payables. The total amount of the expected fee is large relative to the total amount of the VIE s expected return to its variable interests. The expected variability in fees is large relative to the total expected variability in the fair value of the VIE s net assets exclusive of variable interests. 6 Technical Line Consolidation considerations for asset managers FIN 46(R) to ASU April 2015

7 The FASB indicated when it issued FAS 167 that it removed the kick-out rights criterion to promote consistency between the determination of whether a reporting entity has a variable interest in a VIE and whether it is the primary beneficiary of a VIE. As described below on page 19, the FASB concluded when it issued FAS 167 that kick-out rights should not be considered in the primary beneficiary determination unless a single reporting entity (including its related parties and de facto agents) has the unilateral ability to exercise these rights. With ASU , the FASB removed the requirement that a decision maker s fee be at or above the same level of seniority as other operating liabilities of the VIE. The FASB s view is that a decision maker using its power as an agent could still receive a fee that is subordinate to other interests. The FASB also decided with ASU that a reporting entity doesn t need to focus on the magnitude and variability of the fee when evaluating whether a fee or service arrangement is a variable interest, because it concluded that the remaining criteria are sufficient for determining whether a reporting entity is acting as an agent. How we see it We expect the elimination of certain of the fee criteria to result in fewer fee arrangements being considered variable interests. However, these changes increase the focus on determining whether the fees are commensurate and include only customary terms and conditions. Decision makers or service providers that today do not evaluate all of the criteria because it is clear that their fee arrangements are variable interests (e.g., when the equity holders lack substantive kick-out rights, when the fee is subordinate to other operating liabilities) will need to reexamine their arrangements to determine whether the arrangements meet the remaining criteria and therefore are variable interests. Evaluating others interests in the entity a modification When it issued FAS 167, the FASB provided the threshold of more than an insignificant amount for assessing whether a decision maker or service provider holds an interest that would absorb more than an insignificant amount of an entity s expected losses or receive more than an insignificant amount of an entity s residual returns. This language replaces FIN 46(R) s quantitative threshold of trivial, which some have interpreted to mean anything more than zero. Previous consolidation conclusions should therefore be revisited. We believe that an evaluation of the threshold of more than insignificant will require a careful evaluation of the purpose and design of each entity in which the reporting entity has involvement and will require significant professional judgment. In addition, qualitative factors may be relevant in making this determination, such as the nature of the other variable interests held (e.g., senior versus subordinated interests) rather than the pure magnitude of those interests. The following are some additional considerations: We believe that a reporting entity may determine that it can hold a higher dollar amount of senior interests than it could if the interests were subordinated or residual interests and still not meet the more than an insignificant amount threshold. That is, if the senior interest is not expected to absorb a significant amount of expected losses or expected residual returns, a relatively large senior interest (as compared with a more residual ownership interest) would not necessarily cause the service provider s fees to be considered a variable interest. It may be relevant to compare the significance of the interests held by a reporting entity in an entity to the typical interests held by other entities in other similar entities. If the reporting entity s other interests in an entity are significantly higher than those of others providing similar services to similar entities, the reporting entity s interests are more likely to be viewed as significant. 7 Technical Line Consolidation considerations for asset managers FIN 46(R) to ASU April 2015

8 Other interests could include implicit variable interests. An implicit variable interest is an implied monetary interest in an entity that changes with changes in the fair value of the entity s net assets exclusive of variable interests. For example, an implicit variable interest could be an implicit agreement to replace impaired assets held by a VIE, which protects holders of other interests in the entity from suffering losses. In assessing significance, the quantitative approach described in the definitions of the terms expected losses, expected residual returns and expected variability in the ASC Master Glossary is not required and should not be the sole determinant. How we see it We believe that more than insignificant should be interpreted to mean significant. Additionally, because the ASU refers to interests that would absorb expected losses or expected residual returns, we believe that reporting entities will need to consider probability-weighted outcomes over the life of the entity, not current performance or economic conditions. This evaluation will require significant judgment. Related party and de facto agent considerations Excerpt from Accounting Standards Codification Consolidation Overall Implementation Guidance and Illustrations Variable Interest Entities Implementation Guidance Identifying Variable Interests Fees Paid to Decision Makers or Service Providers D For purposes of evaluating the conditions in paragraph , any interest in an entity that is held by a related party of the decision maker or service provider should be considered in the analysis. Specifically, a decision maker or service provider should include its direct economic interests in the entity and its indirect economic interests in the entity held through related parties, considered on a proportionate basis. For example, if a decision maker or service provider owns a 20 percent interest in a related party and that related party owns a 40 percent interest in the entity being evaluated, the decision maker s or service provider s interest would be considered equivalent to an 8 percent direct interest in the entity for the purposes of evaluating whether the fees paid to the decision maker(s) or the service provider(s) are not variable interests (assuming that they have no other relationships with the entity). Indirect interests held through related parties that are under common control with the decision maker should be considered the equivalent of direct interests in their entirety. The term related parties in this paragraph refers to all parties as defined in paragraph , with the following exceptions: a. An employee of the decision maker or service provider (and its other related parties), except if the employee is used in an effort to circumvent the provisions of the Variable Interest Entities Subsections of this Subtopic. b. An employee benefit plan of the decision maker or service provider (and its other related parties), except if the employee benefit plan is used in an effort to circumvent the provisions of the Variable Interest Entities Subsections of this Subtopic. For purposes of evaluating the conditions in paragraph , the quantitative approach described in the definitions of the terms expected losses, expected residual returns, and expected variability is not required and should not be the sole determinant as to whether a reporting entity meets such conditions. 8 Technical Line Consolidation considerations for asset managers FIN 46(R) to ASU April 2015

9 Under the variable interest model, any interest in an entity that is held by a related party of the decision maker or service provider should be considered in the evaluation of whether a fee constitutes a variable interest. The ASU amends the guidance on how a decision maker considers interests held by related parties (or de facto agents) when evaluating whether other interests are more than insignificant as part of the determination of whether the fee is a variable interest. The ASU introduces the concept of an indirect interest when evaluating interests held by related parties (or de facto agents). To have an indirect interest, a decision maker must have a direct variable interest in a related party that has a variable interest in an entity. Under the ASU, a decision maker or service provider will consider its direct interests, plus its proportionate share of a related party s or de facto agent s interests (i.e., indirect interests). For purposes of this evaluation, the term related parties excludes employees or employee benefit plans of the decision maker or service provider (and their related parties), unless they are used to circumvent the provisions of the variable interest model. If a decision maker concludes that its fee is not a variable interest after evaluating the provisions of ASC and considering any other interests in the entity held by the reporting entity or its related parties or de facto agents, we believe that the decision maker is not required to evaluate the provisions of the VIE model further. How we see it Because the FASB introduced the concept of an indirect interest, some have questioned how a decision maker should consider interests held by a related party that is under common control when the decision maker does not have a direct variable interest in the related party. Based on discussions with the FASB staff, we believe that the FASB intends for the decision maker to treat the entire interest of a related party that is under common control as its own to determine whether it holds other interests that are more than insignificant and, therefore, whether its fee represents a variable interest. Illustration 1 Direct and indirect interests A decision maker (the reporting entity) has a 2% direct equity interest in an entity it is evaluating for consolidation and a 10% equity interest in a related party that owns a 50% equity interest in the entity being evaluated. Also assume that the decision maker s fee arrangement is commensurate with the effort required to provide the services and only includes customary terms, and that the decision maker and its related party are not under common control. Analysis under the ASU Fee and 2% interest Reporting entity 10% Entity Related party 50% We believe, based on discussions with the FASB staff, that the decision maker s total other interests for purposes of determining whether its fee is a variable interest would be 7% (i.e., 2% + (10% x 50%)). Analysis under FIN 46(R) The decision maker s total other interests for purposes of determining whether its fee is a variable interest would be 52% (i.e., 2% + 50%). 9 Technical Line Consolidation considerations for asset managers FIN 46(R) to ASU April 2015

10 VIE determination Step 1 Step 2 Step 3 Step 4 Consider purpose and design Identify variable interests Determine whether the entity is a VIE Identify the primary beneficiary of the VIE In Step 3 of the VIE model, an entity is a VIE under the ASU if it meets any of the following criteria: 1. The entity does not have enough equity to finance its activities without additional subordinated financial support. 2. The at-risk equity holders, as a group, lack any of the following: The power, through voting rights or similar rights, to direct the activities that most significantly impact the entity s economic performance The obligation to absorb an entity s expected losses The right to receive an entity s expected residual returns 3. The legal entity is structured with non-substantive voting rights. The ASU amends the first part of the second criterion. How we see it A reporting entity can demonstrate the sufficiency of equity at risk quantitatively or qualitatively. For example, the reporting entity could show that the entity has the ability to finance its activities without additional subordinated financial support or that it has at least as much as equity as a similar entity that finances its operations with no additional subordinated financial support. We observed that fewer reporting entities relied on a quantitative analysis to demonstrate the sufficiency of equity at risk when they adopted FAS 167. Instead, more reporting entities used a qualitative approach to determine the sufficiency of equity at risk. We would expect a similar trend when adopting the ASU. Under FIN 46(R), some reporting entities may not evaluate all of the conditions to determine whether an entity is a VIE if it is clear that the reporting entity is not the primary beneficiary of the entity because, for example, the reporting entity does not have variable interests that absorb a majority of the entity s expected losses or receive a majority of the entity s benefits. These reporting entities will have to revisit previous consolidation conclusions because the primary beneficiary analysis will change to a qualitative analysis considering power and benefits. In addition, additional disclosures will be required if a reporting entity holds an interest in an entity that is considered a voting interest entity under FIN 46(R) that will be considered a VIE under the ASU. 10 Technical Line Consolidation considerations for asset managers FIN 46(R) to ASU April 2015

11 Limited partnerships and similar entities The entity does not have enough equity to finance its activities without additional subordinated financial support. The equity holders, as a group, lack the characteristics of a controlling financial interest. The legal entity is structured with non-substantive voting rights (i.e., anti-abuse clause). For a legal entity not to be a VIE, the at-risk equity holders (as a group) must have all of the following characteristics: 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 Limited partnerships (and similar entities) Corporations (and similar entities) The obligation to absorb an entity s expected losses The right to receive an entity s expected residual returns The ASU changes the evaluation of power when determining whether, as a group, the holders of the equity investment at risk lack the characteristics of a controlling financial interest. Excerpt from Accounting Standards Codification Consolidation Overall Scope and Scope Exceptions Variable Interest Entities Entities A legal entity shall be subject to consolidation under the guidance in the Variable Interest Entities Subsections if, by design, any of the following conditions exist (The phrase by design refers to legal entities that meet the conditions in this paragraph because of the way they are structured. For example, a legal entity under the control of its equity investors that originally was not a VIE does not become one because of operating losses. The design of the legal entity is important in the application of these provisions.) 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 ii. For limited partnerships, partners lack that power if neither (01) nor (02) below exists. The guidance in this subparagraph does not apply to entities in industries (see paragraphs and ) in which it is appropriate for a general partner to use the pro rata method of consolidation for its investment in a limited partnership (see paragraph ). 01. 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). A. For purposes of evaluating the threshold in (01) above, a general partner s kick-out rights held through voting interests shall not be included. Kick-out rights through voting interests held by entities under common control with the general partner or other parties acting on behalf of the general partner also shall not be included. 02. 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). 11 Technical Line Consolidation considerations for asset managers FIN 46(R) to ASU April 2015

12 03. For purposes of (01) and (02) above, evaluation of the substantiveness of participating rights and kick-out rights shall be based on the guidance included in paragraphs through 25-14C. Under the ASU, limited partners with equity at risk lack power if they do not hold kick-out or participating rights over the GP(s). Said differently, assuming the other two characteristics of a VIE are not met, a limited partnership or similar entity will be evaluated for consolidation under the voting model if either of the following conditions is met: A single limited partner, partners with a simple majority of voting interests or partners with a smaller voting interest with equity at risk are able to exercise substantive kick-out rights. Limited partners with equity at risk are able to exercise substantive participating rights. Under the ASU, kick-out rights include the right to remove the decision maker and to dissolve the entity without cause. The ASU also clarifies that limited partners holding participating rights are not required to have the ability to initiate actions for those rights to be considered substantive. A kick-out right or participating right that is not substantive (e.g., because of barriers to exercise) is not factored into the analysis. Barriers to exercise include financial or operational disincentives for removal, conditions that make it unlikely that the rights will be exercised, the absence of an adequate number of qualified replacement decision makers or the absence of an explicit, reasonable mechanism by which the party that possesses the kick-out rights can exercise them. When performing this evaluation, a reporting entity will not consider voting interests held by the GP, entities under common control with the GP or other parties acting on behalf of the GP. Illustration 2 VIE determination: limited partners with kick-out rights A GP forms a fund that is a limited partnership and receives a 2% management fee and a 20% performance fee for management and investment advisory services it provides to the fund, which is considered significant in size relative to the fund s anticipated economic performance. The GP also has a 1% equity interest in the fund. Three limited partners hold the limited partnership interests, which are considered equity investments at risk. The limited partners are allocated profits and losses of the fund in proportion to their ownership interests. The GP makes all of the significant decisions for the fund through its GP interest, but limited partners with a simple majority of voting interests can remove the GP without cause (assume there are no barriers to exercise the kick-out rights). None of the entities are related parties. Entity A (GP) Entity B (LP) Entity C (LP) Entity D (LP) Fee and 1% interest 30% interest 39% interest 30% interest Limited partnership (fund) Analysis under the ASU The fund would not be a VIE because limited partners with equity at risk would be able to exercise a simple majority vote to remove the GP without cause and there are no barriers to exercise those rights. This example assumes that none of the other VIE criteria are met. Analysis under FIN 46(R) The fund would not be a VIE because as a group the holders of the equity investment at risk have the direct or indirect ability through voting rights or similar rights to make decisions about the fund s activities that have a significant effect on the success of the fund. (This example assumes that none of the other VIE criteria are met). 12 Technical Line Consolidation considerations for asset managers FIN 46(R) to ASU April 2015

13 Illustration 3 VIE determination: no substantive kick-out rights or participating rights Assume the same facts as in Illustration 2, but the fund s limited partnership agreement stipulates that the limited partners can only remove the GP for cause (e.g., if the fund goes into bankruptcy or the GP breaches its contract). Analysis under the ASU The fund would be a VIE because (1) a single limited partner, partners with a simple majority of voting interests and partners with a smaller voting interest with equity at risk are not able to exercise substantive kick-out rights over the general partner and (2) limited partners with equity at risk are not able to exercise substantive participating rights over the general partner. See Illustration 5 for the primary beneficiary determination. Analysis under FIN 46(R) The fund would not be a VIE because as a group, including the GP, the holders of the equity investment at risk have the direct or indirect ability through voting rights or similar rights to make decisions about the fund s activities that have a significant effect on the success of the fund. (This example assumes that none of the other VIE criteria are met.) Illustration 4 VIE determination: investment vehicle for multiple funds Manager forms a partnership so that multiple funds can invest in a single investment. Fund A, Fund B and Fund C own 40%, 35% and 24% of the equity interests of the investment vehicle, respectively. Manager is the GP for the investment vehicle and for each of the funds, and has power through its management contract. Manager, Fund A, Fund B and Fund C are related parties, but are not under common control. In exchange for providing its services, Manager receives fees that are deemed to be variable interests, but such fees do not provide benefits. The funds do not have the ability to kick out the GP from being the manager of the investment vehicle or substantive participating rights with respect to the investment vehicle. Manager (GP to all) Fee from each Fund (assumed to be related parties) Fund A (LP) Fund B (LP) Fund C (LP) Fee and 1% interest 40% interest 35% interest 24% interest Limited partnership (investment vehicle) Analysis under the ASU The investment vehicle would be a VIE because a simple majority of limited partners cannot kick-out the GP and do not hold substantive participating rights. Analysis under FIN 46(R) The investment vehicle would be a VIE because as a group the holders of the equity investment at risk lack the direct or indirect ability through voting rights or similar rights to make decisions about the investment vehicle s activities that have a significant effect on the success of the investment vehicle, because the power held by the Manager comes through its management contract. See Illustration 10 for the primary beneficiary determination. 13 Technical Line Consolidation considerations for asset managers FIN 46(R) to ASU April 2015

14 Corporations and similar entities The entity does not have enough equity to finance its activities without additional subordinated financial support. The equity holders, as a group, lack the characteristics of a controlling financial interest. The legal entity is structured with non-substantive voting rights (i.e., anti-abuse clause). For a legal entity not to be a VIE, the at-risk equity holders (as a group) must have all of the following characteristics: 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 Limited partnerships (and similar entities) Corporations (and similar entities) The obligation to absorb an entity s expected losses The right to receive an entity s expected residual returns Excerpt from Accounting Standards Codification Consolidation Overall Scope and Scope Exceptions Variable Interest Entities Entities A legal entity shall be subject to consolidation under the guidance in the Variable Interest Entities Subsections if, by design, any of the following conditions exist (The phrase by design refers to legal entities that meet the conditions in this paragraph because of the way they are structured. For example, a legal entity under the control of its equity investors that originally was not a VIE does not become one because of operating losses. The design of the legal entity is important in the application of these provisions.) 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 i. For legal entities other than limited partnerships, investors lack that power through voting rights or similar rights if no owners hold voting rights or similar rights (such as those of a common shareholder in a corporation). Legal entities that are not controlled by the holder of a majority voting interest because of noncontrolling shareholder veto rights (participating rights) as discussed in paragraphs through are not VIEs if the holders of the equity investment at risk as a group have the power to control the entity and the equity investment meets the other requirements of the Variable Interest Entities Subsections. 01. 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 14 Technical Line Consolidation considerations for asset managers FIN 46(R) to ASU April 2015

15 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 based on paragraphs through Under the ASU, a reporting entity that is determining whether the at-risk equity holders of a corporation have power would first evaluate the shareholders voting rights to determine whether they are substantive, that is whether the voting rights enable the equity holders to make decisions over the activities that most significantly affect the economic performance of the entity (e.g., revenues, expenses, margins, gains and losses, cash flows, financial position). The determination of the significant activities and the manner in which the decisions are made about those activities should be considered in the context of the entity s purpose and design. Examples of substantive decisions that affect economic performance may include the ability to purchase or sell significant assets, to incur significant additional indebtedness, to raise capital, or to liquidate the entity. In addition, we believe that the assessment of power in evaluating whether an entity is a VIE generally should be consistent with the assessment of power when determining the primary beneficiary of a VIE. That is, we believe that activities a reporting entity identifies for purposes of determining whether the entity is a VIE should be the same activities that are identified when determining the primary beneficiary of a VIE (discussed below). In the Basis for Conclusions of ASU , the FASB describes a two-step approach to determine whether the shareholders have power to direct the activities that most significantly impact the entity s economic performance: Step 1 Consider substantive shareholder rights first. In other words, substantive shareholder voting rights have primacy over the rights of others and should be evaluated first in determining whether the at-risk equity holders have power through voting rights over the activities of a legal entity that most significantly impact the entity s economic performance. This may be the case, for example, when the equity holders voting rights provide them with the power to elect the entity s board of directors and the board is actively involved in making the decisions about the activities that most significantly impact the entity s economic performance. Step 2 Evaluate the substance of unilateral kick-out or participating rights. Only if the equity holders do not have power through voting rights should a secondary analysis be performed to evaluate whether a decision maker has that power through a contractual arrangement. If a decision maker (whose fee is a variable interest) has the power to direct the activities of the legal entity that most significantly impact the entity s economic performance, the entity will be a VIE unless a single at-risk equity holder has substantive kick-out or participating rights. Therefore, with respect to corporations, when the at-risk equity holders (or a board of directors on behalf of the equity holders) outsource decision making about the activities that most significantly impact an entity s economic performance to a third-party decision maker (e.g., through a contractual arrangement), the equity holders lack power and the entity is a VIE if (1) the decision maker has a variable interest in the entity through its contractual arrangement, (2) a single at-risk equity holder cannot unilaterally exercise a substantive kick-out right to remove the third-party and (3) the equity holders (or board of directors on behalf of the equity holders) cannot otherwise constrain the decisions the third party can make (e.g., through budget oversight). 15 Technical Line Consolidation considerations for asset managers FIN 46(R) to ASU April 2015

16 In contrast, consider a corporation that is created to hold certain investments. None of the investors has voting rights, but one investor, an asset manager, makes all significant decisions for the corporation under the terms of a service agreement entered into at the inception of the corporation and cannot be kicked out. Under terms of the agreement, the asset manager is required to own a substantive equity investment at risk while it provides the services. In this example, the corporation would be a VIE because the other shareholders do not have any voting rights that constrain the discretion used by the asset manager. Kick-out rights refer to 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. A kick-out right or participating right that is not substantive (e.g., because of barriers to exercise) is not factored into the analysis, as discussed on page 12. How we see it We believe that when a unilateral kick-out right is not present or is not substantive, the entity may not be a VIE if the at-risk equity holders are able to exercise other voting rights (e.g., kick-out rights) by a simple-majority vote. Reporting entities should carefully re-evaluate their VIE determinations and consolidation conclusions when a corporation they are evaluating has outsourced decision making about significant activities to a decision maker or service provider and it appears that the decision maker or service provider has power. In these circumstances, a reporting entity will need to exercise judgment. Series funds The variable interest model and the voting model apply to all legal entities, with limited exceptions. ASC 810 defines legal entity as any legal structure used to conduct activities or to hold assets. Questions have arisen about whether series funds are legal entities for purposes of the consolidation guidance. To resolve these questions, the ASU clarifies that in a series fund structure (i.e., multiple series or mutual funds within one umbrella entity), each individual fund required to comply with the Investment Company Act of 1940 for registered mutual funds (the 1940 Act) is considered a legal entity as defined in US GAAP based on its characteristics and should be evaluated separately for consolidation. The 1940 Act requires that each fund: Have its own investment objectives and policies Have its own custodial agreement Have its own shareholders separate from other series funds Have a unique tax identification File separate tax returns with the Internal Revenue Service Have separate audited financial statements Be considered by the Securities and Exchange Commission (SEC) staff to be a separate investment company in virtually all circumstances for investor protection afforded by the 1940 Act The ASU also illustrates the determination of whether a corporation is a VIE in an example involving series funds. In this example, the shareholders could constrain a decision maker s discretion over the activities that most significantly impact the funds economic performance 16 Technical Line Consolidation considerations for asset managers FIN 46(R) to ASU April 2015