FIN 46: consolidation of variable interest entities under US GAAPs
By Vinod Kothari
Post Enron, there was a substantial controversy about special purpose vehicles and their possible misuse. Special purpose vehicles were publicly seen as a device to dodge tax and accounting scrutiny. A special purpose vehicle is like a secret bank locker: its owner or beneficiary cannot be established on a primary appearance, and it is still safe since it is a hived-off bundle of assets with only specific assets or activities. Since the voting capital in special purpose entities is abysmally low (and would typically be declared for public charity, or otherwise widely dispersed), such entities could not come for consolidation based on their voting capital.
Therefore, US standard setters set on a who-dunnit kind of a mission to spot the real beneficiary of special purpose entities. The result was an interpretation called FIN 46 which deals with consolidation of certain entities on a basis other than voting control. Thus, FIN 46 is an exception to the usual consolidation rules in Accounting Research Bulletin (ARB) 51.
FIN 46 is, therefore, an exception to the normal accounting rule requiring consolidation based on voting control. A new term was coined for this purpose: variable interest entites to which the new consolidation rule would be applicable. A variable interest entity (VIE) is essentially nothing but an accounting jargon for the commercial world phrase "special purpose entity". What the FASB is trying to do here, as is quite common with lots of FASB definitions, is to identify a special purpose entity by its features.
What is a variable interest entity:
The Interpretation identifies two key indicias of an SPE: inadequacy of at-risk capital, and exercise of absentee control by the de facto owner of the entity and not the front-running equity holders who are mere nominalities. There is no substantive definition of a variable interest entity such as the fact that a special purpose entity is not allowed to get into substantive business operations, or the fact that it is structurally bankruptcy-remote and is nothing but an incorporated shell. On the other hand, the FASB thought it appropriate to focus on the two features: inadequacy of capital and lack of control by the apparent voting shareholders. Possibly, that best suits the purpose of the Interpretation as an exception to the general rule where equity holders are regarded as the owners of the entity. Thus, Para C18 states: "The distinction between variable interest entities and other business enterprises is based on the nature and amount of the equity investment and the rights and obligations of the equity investors." Further, Para C20 says: "If the total equity investment at risk is not sufficient to permit the entity to finance its activities, the parties providing the necessary additional subordinated financial support will not permit an equity investor to make decisions that may be counter to their interests. That means that the usual condition for establishing a controlling financial interest—a majority voting interest—does not apply to variable interest entities. Consequently, a standard for consolidation that requires ownership of voting stock or some other form of decision-making ability is not appropriate for such entities."
One of the two features below will possibly lead to the other as well. Therefore, if the entity satisfies any one of the following, it is a VIE
Inadequacy of at-risk capital
The first of the two features is the inadequacy of at-risk capital. Para 5 (a) defining a variable interest entity puts it as thus: "The total equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties. That is, the equity investment at risk is not greater than the expected losses of the entity." There are elaborate clarifications as to what "equity investment" does and does not include. For instance, such investment includes, if reported as equity in the reported statements, the residual beneficiary capital even if not entitled to voting rights. But it does not include amounts provided, directly or indirectly, to equity owners by others: such as by way of fees or contributions, or amounts financed by loans or guarantees about loans by others.
As the adequacy of the at-risk investment is to be tested relative to expected losses, the term "expected losses" itself becomes significant. A complete Annexure (Annexure A) is devoted to illustrating what are expected losses. Briefly, expected losses are not losses in accounting sense, but expected losses in a statistical or financial senses: that is, variability of the residual income of the enterprise. Statistically, the "expected loss" is the probability-weighted fair value of the deviations of various expected outcomes from their mean or expected value.
By Para 9, there is a presumption that if the equity investment is not at least 10% the total assets of the enterprise, it is inadequate, unless there are definite escape routes available: for instance, the expected losses can be shown to be lower than 10% based on quantitative evidence, etc.
The second feature of a VIE is that the equity owners are not those who really run the show: they are there just as a legal facade. This is obvious because if the equity is insignificant and substantive risk absorption is taking place by those who would have a subordinated investment at stake, the latter would not let the equity owners run the business. Therefore, if the equity holders lack any of the following indicias of financial control, the entity is a VIE:
(a) The entity either has no voting capital, or the voting capital does not have the discretion relating to the entity's activities. Usually, SPEs are either pre-programmed, so as to rule out discretion, or the decision-making is done by some named director who is otherwise not a majority on the Board.
(b) The equity owners are not exposed to expected losses, either because of an absorption thereof by other subordinated investors, or due to guarantees from others.
(c) The equity owners do not have the right to enjoy the residual returns of the enterprise, for instance, by capping the same.
What is a variable interest:
Once we establish an entity as a VIE, we need to establish who the variable interest holder is. In practice, it would be more difficutl to answer this question than to simply identify a variable interest entity. By definition, "The investments or other interests that will absorb portions of a variable interest entity’s expected losses if they occur or receive portions of the entity’s expected residual returns if they occur are called variable interests." [Para 6] That is to say, he who bears those expected losses or enjoys expected residual returns, which are sealed off from the equity owners, are the variable interest holders. While equity is an investment, a variable interest does not have to be an investment, indicated by the use of the words "investment or other interest". For instance, ability to earn variable fees is a variable interest.
Consolidation based on variable interests:
In case of VIEs, consolidation will not be based on equity, but based on variable interests. That is, the one who has a majority of the variable interests will consolidate the VIE. Such majority holder is called the primary beneficiary. The word "primary beneficiary" is a euphemism, since, in cases wehre the variable interests are asymmetrically divided: one entity absorbs the expected losses and another enjoys the residual rewards, consolidation will be based on losses. The position of primary beneficial interest is to be established after taking into account the interests held by all "related parties", the latter term meaning the same as under FAS 57. In addition, the holdings of de facto agents of the beneficiary shall also be included. The de facto agents, under Para 16, include the following:
- Other VIEs of which the beneficiary is the primary beneficiary.
- A party whose contribution was funded by the beneficiary
- An officer, agent, or governing board member of the beneficiary.
- A party that has an agreement that it cannot sell, transfer or encumber its interest without the consent of the beneficiary, or one which is connected with the beneficiary due to close business relationship such as that between a service provider (say a law firm) and a client.
Exception for QSPEs:
The Interpretation is not applicable to QSPEs covered by Para 35 of FAS 140, or grandfathered SPEs under the previous accounting standard FAS 125. While this exception is a major relief for larger part of the securitization industry, the problem of consolidation is focussed in cases where the SPE does not qualify under FAS 140. See earlier in this Chapter on QSPEs. Also note that on 30th April 2003, the FASB decided to amend the conditions for QSPEs to make these conditions more elaborate.
Impact of FIN 46 on structured finance:
Rating agency Standard and Poor's in early April narrated the results of a survey of the opinions of the structured finance industry, nearly 2 months after the effective date for implementation of FIN 46. It reported that "the majority of securitization professionals worldwide report that they are overwhelmingly frustrated, skeptical and confused by the new set of rules for off-balance-sheet financing, characterizing it as an unnecessary and costly burden on an otherwise healthy market. Moreover, the regulation fails to adequately tackle the problem of corporate malfeasance that it was originally designed to address, market participants said." "Respondents were consistently incisive, reproachful and vehement in their criticism of FASB's year-long process of developing and vetting FIN 46, conveying in strong, pointed language their dissatisfaction with FASB's responsiveness to the securitization market and their disappointment with the final Interpretation, which many construe as an overly broad, "over-reaching" measure which is treating a very specific abuse (inadequate and misrepresentative corporate disclosure)."
A total of 470 participants from the US and Europe participated in the survey. Most also felt that the market will adapt itself with new structures which simply cosmetically re-engineer SPEs to fall out of the definitions of the Interpretation.