A variable interest entity is typically designed for a very specific purpose and to create very specific risks. These risks are then, by design, absorbed by the legal entity’s variable interests. The absorption of variability often creates significant control over the legal entity that is not vested in the voting equity of the entity. The variable interest entity consolidation model is designed to determine which party should consolidate the entity when actual control is not held by the equity investors. This is a complex model to implement in large part because the language is new to most people, and because it is principles based instead of rules based.
One of the more difficult steps is identifying the entity’s risks and the variable interests that absorb those risks. My preferred approach is to go through the balance sheet, the entity’s governing documents (e.g., articles of formation, operating agreement) and other contracts and list out each one’s role in the entity. If it is a creator of variability (it is the source of changes to the entity’s fair value and/or cash flows) then it is by definition NOT a variable interest. Variable interests absorb variability and are therefore the interests that receive the impact of the risk created.
For example, a building is an asset that is subject to changes in its fair value due to shifting real estate market prices, the availability of reasonable financing and other factors. The build is a creator a variability If the building was purchased using mortgage debt, the lender is probably the party most impacted by the buildings changing fair value. If the building declines in value, then the lender is exposed to the risk of not collecting its principal and interest payments. Thus, the lender is an absorber of the building’s negative variability. The entity’s equity investor is probably (in the absence of other variable interests) the party that absorbs the building’s positive variability since the equity investor receives the benefit of any residual value over and above the mortgage balance. However, the equity investor’s interest in the residual value can be shifted contractually to another party. One way to do this is to sell an option on the building. The option holder then absorbs the positive variability since the value of the option is directly affected by the changes in the value of the property relative to the option price.
Here are some common items and contracts found in an entity and the typical role each plays as either a creator or absorber of variability:
Assets – Assets almost always create variability and are usually the greatest source of variability in a legal entity. Assets are rarely variabile interests. Examples of instruments that may assets and that are almost always variable interests include purchased guarantees, put options and similar arrangements (see further discussion below). See ASC 810-10-25-55 to 56.
Accounts payable – Accounts payable are generally not variable interests as long as they are short-term, no subordinate to any other liability, fixed in amount, and not concentrated with one or a few vendors. Accounts payable that do not have these characteristics are likely variable interests.
Debt – Loans to the company, in whatever form they take, can be variable interests because they expose the lender to credit risk (collectability of interest and principal payments) and potentially interest rate risk. Even a collateralized loan is exposed to variability since the collateral, an asset, creates risk and therefore variability. If the collateral value is not sufficient to satisfy the loan, the the lender is exposed to the credit quality of the legal entity. Generally, exposure to variability diminishes as priority claim to assets rise, yet even the most senior debt is ultimately exposed to the variability created by the legal entity’s credit standing.
Equity instruments – equity investors are typically the most subordinate interest in a legal entity and are exposed to the legal entity’s losses and returns. Equity includes instruments and amounts classified in mezzanine and temporary equity. ASC 810 draws a distinction between equity at risk (ASC 810-10-15-14(a) and all other equity for purposes of determining whether a legal entity has sufficient capital to finance its activities, and for certain other purposes. Regardless, equity that is not at risk may still be a variable interest.
Beneficial interests – Beneficial interests can be evaluated is a manner similar to debt, particularly with respect to the general rule that exposure to variability diminishes relative to the level of priority of claim of the legal entity’s assets.
Written guarantees, put options, and similar arrangements – The writer (seller) of guarantees and puts absorbs variability since risk is transferred to the writer. Thus, a written (sold) guarantee, put option or similar arrangement creates variability in the legal entity and are generally not variable interests to the counterparty (buyer).
Written call options – A call option written (sold) by the legal entity on an owned asset is a variable interest. The counterparty has the optional right to buy the asset at a fixed price. If the price increase above the option strike prices, then the call option absorbs this positive variability. If the asset is more than 50% of the entity’s total assets (measured at fair value), then the variable interest is in the legal entity as a whole, not just the subject asset.
Purchased guarantees, puts and similar arrangements – Writer absorbs variability. Guarantees on specific assets need to be evaluated as to whether or not the asset is greater than 50% of the legal entity’s total assets (at fair value). Of so, the the variable interest is treated as a variable interest in the legal entity as a whole, not just the subject assets.
A put option behaves economically similar to a guarantee on an asset and should be evaluated in same way. Guarantees on debt do not receive this treatment and are therefore treated as variable interests in the legal entity.
A purchased call option, on the other hand, is not a variable interest since it creates risk. The option fair value is determined by a number of factors including the fair value of the asset into which it is exercisable. The holder of a call option, in this case the legal entity, is exposed to variability. Thus, a call creates variability in the legal entity.
Guarantees, puts and similar arrangements between variable interest holders – These are implicit interests since they do not directly involve the legal entity. These contracts serve to shift exposure to risk among the parties. Since these arrangements affect the losses and benefits absorbed by the parties to the arrangements, they must be evaluated as implicit variable interests.
Total return swaps – Total return swaps purchased by the legal entity transfer risk to the counterparty and are therefore variable interests. If the related owned asset is more than 50% of the legal entity’s total assets measured at fair value, then the variable interest is in the legal entity taken as a whole and not just the specified asset.
Service/decision maker arrangements – Service and decision maker fees receive special treatment under ASC 810. These fees are considered variable interests unless all of the conditions listed in ASC 810-10-55-37: 1) the fee is commensurate with the level of effort required, 2) the fee is senior to other operating liabilities, 3) the service provider (and de facto agents and related parties) do not hold other variable interests in the legal entity, 4) the contract contains customary terms, conditions and amounts, and 5) the total fee and variability thereof are insignificant to the legal entity.
Franchise arrangements – A franchise fee paid by the legal entity that are based on a percentage of revenue, gross profit, net income or some other operational measure of the legal entity absorbs variability and is therefore a variable interest. The fee should be evaluated in a manner similar to service provider/decision maker fee (above). This could be significant to the VIE analysis since franchise agreements provide the franchisor (variable interest holder) with potentially significant powers over the activities of the legal entity.
Operating and capital leases (legal entity is lessor) – The leasing of its assets creates a cash flow stream to the legal entity which is effectively a receivable (an asset) that creates variability in the legal entity. This element of the lease is therefore not a variable interest. However, certain other provisions in the lease may absorb variability. These include: 1) a lessee purchase option if based on a fixed price or formula instead of fair value at the time of exercise, 2) a lessee residual value guarantee, and 3) a lessee renewal option at a price other than fair value at the time of exercise.
Operating leases (legal entity is lessee) – The legal entity as lessee has the opposite effect of the lessor position above. The lease payments absorb variability since the the lessor is subject to the credit standing of the legal entity and its ability to make the payments. The other lease provisions as described above, however, create variability in the legal entity and are therefore not variable interests.
Forward contracts – As a general rule, forward contracts to sell owned assets of the legal entity at a fixed price or based on a fixed-price formula (cost plus a fixed spread) absorb variability and are therefore variable interests.
A similar forward contract to sell an asset not owned by the legal entity typically creates variability (from the asset that must be purchased and delivered) and is therefore not a variable interest.
Alternatively, forward contracts to buy assets based upon a fixed price or fixed-price formula will generally create variability and are therefore generally not variable interests.
Forward contracts can be very difficult to evaluate and their final treatment in the VIE analysis will depend upon the purpose and design of the legal entity. Also, if the forward contract meets the definition of a derivative under ASC 815, the contract should be evaluated as such. See “Derivatives” below. Finally, if the forward contract involves an owned asset that is greater than 50% of the legal entity’s total assets, then the contract is considered a variable interest in the legal entity as a whole, not just the subject asset.
Supply agreements (legal entity is the supplier) – If the supply agreement has a variable cost component, then the counterparty absorbs variability by protecting the legal entity’s equity investment from absorbing losses (whether fully protected or only partially protected).
Derivatives – Derivatives require particular attention since their treatment in VIE analysis is highly dependent upon the design and purpose of the legal entity, and the characteristics of the derivative instrument. A speculative investment in a derivative will generally create variability and the counterparty will therefore generally not hold a variable interest. A hedging arrangement may or may not be a variable interest depending upon the design of the legal entity and the risks its was designed to create. See ASC 810-10-25-21 through 36.
Embedded derivatives require a further consideration. Is the the embedded derivative clearly and closely related with its host asset or liability? If not, then the embedded derivative should evaluated as if a stand-alone instrument as discussed above. Otherwise, the embedded derivative does not require separate consideration. An embedded derivative is not clearly and closely related to its host asset or liability when it introduces leverage as a factor in the settlement amount, is tied to another party in some way (e.g., operational measurements or credit standing), or is tied (i.e., its underlying) to a market-based index or price.
Asset value guarantees – An asset value guarantee issued by the legal entity will create variability and is therefore not a variable interest. A similar guarantee granted in favor of the entity does absorb variability and is therefore a variable interest.
Licenses – A license based on a percentage of revenue or similar measure is a variable interest in the legal entity when the legal entity is the licensee, and a creator of variability in the legal entity (thus not a variable interest) when the legal entity is the licensor.