Chapter 3: Rights arising from other contractual arrangements

A person who has invested money might be able to control what the invested company does if they have vote rights and other decision-making rights that come from a contract

De facto control

De facto control refers to a scenario in which an investor, who owns less than 50% of the voting shares in a company, is considered to have control over the company if they have the practical power to influence its actions.

Power to govern under a shareholder agreement

Three entities, namely A, B, and C, collectively invest in entity D with the purpose of manufacturing footballs. Entity A possesses extensive expertise in the manufacturing of footballs and has innovated new technology to enhance their production. Entities B and C are two financial institutions that have previously provided funding for the activities of company A.

Entity A will supply technology and expertise to entity D, while entities B and C will offer financial support. The distribution of share ownership will be as follows: entity A will hold 40% of the shares, entity B will hold 30% of the shares, and entity C will also hold 30% of the shares. Each entity will designate directors based on their ownership share. As per the shareholders’ agreement, all directors, except for the managing director and the finance director, will be non-executive. Entity A, being highly knowledgeable in the field of football manufacture, will appoint both the managing director and the finance director. Decisions regarding entity D necessitate a simple majority vote.

Entity D’s managing director and finance director, selected by entity A, are given the authority in the shareholder agreement to oversee entity D’s actions, including operational rules and the operating budget. Nevertheless, any requests for substantial additional funding beyond what is necessary to operate entity D’s daily activities must be evaluated by the entire board.

Entity A’s delegation of powers to the directors selected by entity A over the operating policies and budget of entity D, which are relevant activities, suggests that entity A has control over entity D. This is because entity A has the authority to direct entity D’s relevant activities. While the full board still retains certain powers, such as making decisions regarding major increases in financing, these powers may be restricted and primarily serve to offer protective rather than substantive rights. Nevertheless, a more comprehensive examination of these imposed limitations would be necessary to determine if entity A truly had the capacity to control entity D’s pertinent operations. If it is determined that these limitations are only intended for protection, entity A would possess authority over the pertinent operations and, consequently, would exercise dominion over entity D

It is important to carefully evaluate the determination of power in cases like this, as the identification of rights as substantive or protective can be challenging and open to interpretation.

IFRS 10 provides explicit instructions on de facto control, however determining this control is still a subjective and discretionary aspect of accounting. When an investor evaluates whether it possesses de facto control over an investee, it must take into account all pertinent facts and circumstances, which may include

The respective size of the investor’s holding of voting rights relative to the holdings of other vote holders, taking into account the following:
The more rights the investor holds, the more likely it will have the rights needed to direct the investee’s relevant activities.
The more rights the investor holds relative to other vote holders, the more likely it will have the rights needed to direct the investee’s relevant activities.
The number of other investors that must act together to outvote the investor.
The potential voting rights held by the investor and other parties involved in the investee, including other vote holders.
Any rights arising from other contractual arrangements.
Any other additional facts and circumstances that might indicate that the investor has the ability (or does not have the ability) to direct the relevant activities at key decision-making events, such as voting patterns at previous shareholder meetings.

Ownership of less than 50% of voting rights with dispersed shareholding

Entity P possesses a 45% stake in the voting rights of entity Q. Entity Q is a privately held firm, with 11 additional owners each owning a 5% stake in Q’s equity shares. There is no coalition of the other shareholders who jointly hold 55% of the shares. It is not possible to conclude that entity P has effective control based solely on the absolute size of entity P’s shares and the relative proportion of other shareholdings. To ascertain the presence of de facto control, several variables must be taken into account. The criteria in question would encompass:

·        Whether there is an arrangement between the 11 other shareholders to vote together.

·        What the voting patterns of the 11 other shareholders in the past have been.

·        Whether entity P has any other rights arising from other contractual arrangements.

Ownership of less than 50% of voting rights with dispersed shareholding and a shareholder agreement

Entity P possesses a 45% stake in the voting rights of entity Q. Entity Q is a privately held firm, with 11 more shareholders each owning a 5% stake in Q’s equity shares. There is no coalition among the other shareholders that would allow them to collectively vote for their combined 55% ownership.

Entity P, as a shareholder, is given the authority to select, dismiss, and determine the compensation of the key management individuals who are responsible for overseeing the relevant operations of entity Q. Two-thirds of the shareholders must approve any modifications to the agreement.

If there is a shareholder arrangement in place that grants entity P the authority to make decisions on entity Q’s relevant activities, it can be inferred that entity P has effective control. Nevertheless, it is important to consider the presence of the shareholder agreement in addition to voting rights before reaching this judgement. When combined with voting rights, other decision-making rights might empower an investor to actively control the operations of an investee. In this scenario, the authority to choose, dismiss, and determine the compensation of important persons in management is expected to be significant.

Passive majority shareholder

Entity R possesses a 40% stake in the voting rights associated with the equity share capital of entity S. Entity S is under the control of voting rights. A solitary investor possesses the remaining 60%. The investor abstains from attending general meetings. Entities R and S do not have a shareholder agreement or other comparable agreement.

Entity R lacks de facto authority over entity S. Entity R can be outvoted by the passive shareholder at any shareholder meeting. If there is no strong evidence suggesting otherwise, it is presumed that the passive shareholder will prevent entity R from taking actions that go against its own interests. The passive shareholder possesses effective power over entity S by virtue of its voting rights, even if it choose not to exercise them. If the passive majority shareholder is an entity that prepares consolidated financial statements, it should consolidate Entity S.

Sophisticated shareholders

Entity T possesses a 30% stake in the voting rights of entity V. Entity V is owned by five other owners, all of which are venture capital firms or institutional investors known for their active involvement in managing their investments. No individual or entity have a stake greater than 20% in entity V. While they do not attend general meetings, they frequently meet with representatives of entity V and among themselves. There is evidence suggesting that these meetings have influenced the decisions made by entity V’s management.

It is not true that entity T controls entity V. There isn’t a single shareholder in entity V with more voting power than entity T. However, the type of shareholders, the number of shareholders, and the way they talk to entity V and each other affects the decisions made by entity V’s management. This means that entity T doesn’t have the rights to direct entity V’s activities in this area. Entity T can’t make its own choices, look out for its own interests, or use entity V’s assets and activities. Because of how the other partners are set up, they are in a good position to look closely at how entity V works and act as a group if needed.

Temporary shareholding at general meeting

Entity W has the following ownership structure:

·        entity X: 35%;

·        entity Y: 40%; and

·        various small shareholders: 25%.

Entity Y and a majority of the minority shareholders have participated and cast votes at previous annual meetings. During the most recent general meeting of entity W, entity Y abstained from voting, while entity X received enough votes to appoint three of its nominated directors to a board consisting of nine directors. These three directors were the only ones proposed for election in the current year. All other topics that were subject to a shareholder vote were related to regular business activities, and the proposals made by the executive management were approved.

Entity X’s ability to secure the vote and appoint its representatives on the board during a general meeting does not grant it power over entity W. By simply voting at one meeting, it does not guarantee the ability to continuously control the relevant activities of entity W. Entity Y lacks de facto authority over entity W. Despite possessing the largest voting bloc, entity X, along with a majority of the minority shareholders, has the ability to utilise their voting power to obstruct entity Y from implementing its perspective.

Super majority voting in a joint venture

Entity K is owned as follows:

·        40% by entity G (it can appoint four directors);

·        30% by entity H (it can appoint two directors); and

·        30% by entity J (it can appoint two directors).

Entity K is governed by an existing agreement. The shareholders must unanimously vote on the entity’s investment, finance, and distribution policies on an annual basis. Entity G is responsible for the daily management of the entity, however, any important operational decisions must be approved by a vote at the board level, where all directors must reach a consensus.

Entity G lacks effective control over entity K. Entity K’s pertinent actions are governed by all three shareholders through the agreement and unanimous voting. Merely because entity G has the authority to oversee entity K and has the ability to designate a greater number of board members compared to the other two investors, does not imply that it exercises control over entity K. While certain shareholders may not be involved in the day-to-day management of entity K, their lack of participation is limited to operational matters and does not extend to directing entity K’s relevant activities. The corporation is classified as a joint arrangement due to its shared control, and it is not considered a subsidiary of entity G.

Assessing de facto control for an operating entity

·        Entity D manufactures and sells glass bottles to entity G at market price. The majority of sales (95%) are made to entity G; however, entity D can also sell to other customers without additional cost.

·        Entity D was established to allow entity G to gain a steady supply of glass bottles.

·        Entity D issued two classes of shares: entity G holds Class A shares; and the 17 other investors hold Class B shares. Both classes have equal voting rights. Details of the shares are as follows:

Class A shares Class B shares

Holder of shares Entity G 17 other investors

% of total shareholder voting rights attributable to each class 41% 59%

Number of directors appointed by each class of shareholders 5 7

The six largest Class B investors hold 14%, 8%, 7%, 6%, 5% and 4% respectively. All other investors hold less than 3% each. The Class B investors have, in the past, participated actively in meetings and, on occasion, rejected resolutions put forward by entity G. Strategic decisions are made at shareholders’ meetings, and operational decisions are made at directors’ meetings. Daily operations are handled by a manager, based on powers granted by the shareholders and directors.

Question

Does entity G control entity D?

Solution

Entity G does not appear to have authority over entity D in this particular scenario. The exercise of control over entity D primarily occurs through the convening of shareholders’ and directors’ meetings. Entity G lacks majority representation at such meetings. According to IFRS 10, an investor that has less than a majority of the voting rights may nevertheless have effective control if they meet the standards outlined in IFRS 10.

Nevertheless, there appears to be no actual control. At least six Class B investors have the ability to cooperate and overpower entity G by voting. In a similar manner, a group of six directors (excluding the one selected by G) could work together to surpass the voting power of the five directors appointed by entity G.

In accordance with IFRS 10, de facto control was not present in the scenario described in example 6, as it required the collaboration of only two more investors. In accordance with example 7 of IFRS 10, there was ambiguity regarding the collaboration of 11 additional shareholders.

The collaboration among six investors is intermediate. Nevertheless, the remaining 17 investors have consistently engaged in previous meetings and, at times, they have surpassed entity G in voting power. This implies that entity G does not possess effective control over entity D.

According to IFRS 10, if all variables have been taken into account and the situation remains ambiguous, then there is no de facto control. Entity G does not appear to satisfy the standard’s requirement for ‘clear’ proof of de facto control. Sole economic dependency does not necessarily confer authority upon the investor over the investee.

What types of rights to acquire or dispose of shares might represent potential voting rights?

IFRS 10 requires investors to consider potential voting rights when determining whether they have power. Potential voting rights are rights to obtain voting rights of an investee.

Question

What types of rights to acquire or dispose of shares might represent potential voting rights?

Solution

The following types of rights to buy or sell shares can be used as voting rights, unless the shares themselves don’t give you voting rights. These kinds of rights are often written into company agreements:

Call options – Call options give the person who owns them the right to buy shares owned by the person who wrote the option at a price set by the terms of the option.

Put options – Put options give the person who owns them the right to sell their shares to the person who wrote the option at a price set by the rules of the option.

‘Drag along’ rights – If an investor (the “selling shareholder”) wants to sell its shares, it must first give those shares to other investors (the “other shareholders”). This is called “drag along” rights. When other shareholders don’t want to buy the shares and the selling shareholder starts talking to a third party (the “purchaser”) about selling its shares, that selling shareholder can force other shareholders to sell their shares to the same purchaser on the same terms and conditions. ‘

Tag along’ rights – If an investor (the “selling shareholder”) wants to sell its shares, it must first give those shares to other investors (the “other shareholders”). This is called “tag along” rights. If the other owners don’t want to buy the shares, the person selling them can talk to a third party, called a “purchaser.” If the shareholder selling shares can come to an understanding with the buyer, the other shareholders can make it a condition of the deal that the buyer also buys their shares.

Russian roulette – his kind of deal usually only works for a partner agreement between two people. One shareholder (the “offering shareholder”) gives the other shareholder (the “recipient shareholder”) a notice of sale. People who get the notice will have to either sell all of their shares to the offering shareholder at the price written in the notice, or they will have to buy all of the offering shareholder’s shares at the same price.

It is important to look at the specific facts and situations to see if the possible vote rights are real and give people power.

The factors may not be definitive in establishing the presence of de facto control. An investor should take into account additional elements that could lead to effective control, such as passive shareholders, voting trends in past meetings, and the practical ability to influence the relevant activities of the investee, as outlined.

When an investor has a limited number of voting rights and fewer parties are required to make decisions together, the investor must assess if they have the practical capacity to control the investee’s relevant activities, if there is any special relationship with the investee, and the extent of their exposure to unpredictable returns.

When evaluating the elements and indicators mentioned earlier, more importance is placed on whether the investor has the practical capacity to control the operations of the relevant investee.

If, after conducting an evaluation using the above guidance, an investor is still unable to determine that it possesses authority, it does not possess control over the investee.

Potential voting rights

An entity might own instruments that, if exercised or converted, give the entity voting power over the relevant activities of another entity; these are termed ‘potential voting rights’. Potential voting rights are “rights to obtain voting rights of an investee, such as those arising from convertible instruments or options, including forward contracts” .

Potential voting rights can be expressed through many mechanisms, such as share warrants, share call options, forward contracts, and convertible debt or equity instruments.

When evaluating power, it is important to evaluate three distinct factors in relation to possible voting rights. The following items are listed below:

Only potential voting rights that are substantive should be considered by an investor in its assessment of control over an investee.
Substantive rights alone, or in combination with other rights, might give the investor power over the investee. The investor should also consider the purpose and design of the instrument that includes the potential voting rights, and the purpose and design of any other involvement that the investor has with the investee.
Finally, the investor considers other voting or decision-making rights that it holds and whether those rights give it other decision-making rights relating to the investee’s relevant activities.

When evaluating the purpose and design of an instrument, an investor should carefully examine its terms and conditions, taking into account the explicit expectations, intentions, and reasons behind agreeing to such terms and conditions. Gaining insight into these aspects facilitates comprehension of the objectives of individual investors, the reasons behind their engagement with the investee, the nature of their involvement, and the potential advantages they stand to gain from such involvement.

Disregard the potential voting rights if it is impossible for the holder to exercise them. This situation can occur when the conditions of an agreement lack economic significance. For instance, if the exercise price is intentionally set at an excessively high level or if exercising the rights would cause significant harm to the investor for other reasons. The evaluation of content is predicated on the terms rather than the particular holder’s intentions or financial capacity.

Situations where one investor holds a call option and another holds a put option in the event of a deadlock

Investors X and Y each possess an equal 50% ownership stake in a manufacturing company, referred to as the ‘Investee’. The investors engage in a shareholder agreement, which outlines the following:

The board of directors is responsible for making all decisions. The board consists of four individuals, with two representatives from each investment.

Proposals may be offered to the board by any investor, but majority approval is required for all decisions.

If the board is unable to come to a consensus on a resolution, the issue will be settled through a process of binding arbitration.

In a situation where there is a deadlock, Investor X has the authority to issue a call notice, while Investor Y has the authority to issue a put notice for all of the other investors’ shares, with no exceptions.

The price at which the call and put options can be exercised is determined by an independent valuer based on fair value.

Question

Do the call and put options represent potential voting rights which might provide power over Investee?

Solution

Yes. It’s not fair that owners X and Y have different rights. Investor X has a call option that gives it a possible voting right that will let it get full ownership of the investee. If investor X can currently use this choice, it would usually give it power over the investee, but all the facts and circumstances should be taken into account, as well as the advice in IFRS 10.

An investor Y has a put option that only lets it sell its stake in the investee. It does not give it any extra vote rights. Most of the time, this won’t give Investee any more power. Also, when investor X has control over Investee because of the deadlock call option, investor X has to account for a financial liability in its consolidated financial statements for the deadlock put option that was written to investor Y (a put over the non-controlling interest).

Do ‘tag along’ rights represent potential voting rights which might provide power?

Investors A and B each own 50% of a manufacturing company (‘Investee’). The investors enter into a shareholder agreement which specifies the following:

·        All decisions are taken by the board of directors. The board is formed of four members, comprising two representatives from each investor.

·        Unanimous agreement is needed to take all decisions.

·        In the event that either investor enters into negotiations with a third party to sell its interest, the other investor can exercise its ‘tag along’ rights.

Question

Do the ‘tag along’ rights represent potential voting rights which might provide either of the investors with power over Investee?

Solution

No. The ‘tag along’ rights are an equal exit right that either party could use. They do not let either party take away the other party’s right to vote. Because of this, the “tag along” rights don’t change how much power the Investee has.

Do ‘Russian roulette’ provisions in shareholder agreements represent potential voting rights which might provide power?

Two investors, A and B, each own 50% of a business that makes things (the “Investee”). A shareholder agreement is signed by the owners, which says the following:

·        All decisions are taken by the board of directors. The board is formed by four members, comprising two representatives from each investor.

·        Unanimous agreement is needed to take all decisions.

·        If the board cannot reach agreement on a resolution, either shareholder can exercise the ‘Russian roulette’ clause in the shareholder agreement.

Question

Could the ‘Russian roulette’ provisions provide either of the investors with power over the Investee?

Solution

It’s a matter of perspective. Activating the clause in the shareholder agreement that involves a certain level of risk will lead to one party selling its shares to the other. However, it is important to note that this action could potentially result in either shareholder selling or buying. This is a perfectly balanced equation. As long as both parties have the necessary practical ability, neither will be able to acquire the voting rights of the other. Thus, it has no bearing on determining who holds authority over Investee.

On the other hand, there may be times when one of the holders is unable to actually use its rights. For instance, a shareholder might not have enough money to follow through with a deal to buy. The person who started the deal might send a sale notice to the other person, even though they know that it won’t be taken because of money problems. It is inevitable that the person who starts the deal will buy the other person’s shares. It’s not likely that this will happen very often.

Do ‘drag along’ rights held by multiple investors represent potential voting rights which might provide power?

Investors A and B each possess an equal 50% ownership stake in a manufacturing company, referred to as the ‘Investee’. The investors engage in a shareholder agreement that outlines the following:

·        All decisions are taken by the board of directors. The board is formed of four members, comprising two representatives from each investor.

·        Unanimous agreement is needed to take all decisions.

·        If the board cannot reach agreement on a resolution, the dispute is determined by a binding arbitration.

·        In the event that either investor enters into negotiations with a third party to sell its interest, that investor can invoke the ‘drag along’ rights.

Question

Do the ‘drag along’ rights represent potential voting rights which might provide either of the investors with power over Investee?

Solution

No. The so-called “drag along” rights are an equal exit right that either party could use. They do not let either party take away the other party’s right to vote. As a result, the rights do not include the possibility of voting, which would change how much power the Investee has.

Out of the money options

A and B hold 80% and 20% of the ordinary shares with voting rights in entity C’s shareholders’ general meeting. Entity A sells a 50% interest in entity C to entity D, and also purchases a call option from entity D. The call option can be exercised at any time and has a price that is higher than the market price at the time the option was issued. If the option is exercised, entity A would regain its original 80% ownership interest and corresponding voting rights. The exercise price holds significant economic value and is not intentionally set at a high level.

The option held by entity A is priced higher than the market price on issue and is slightly out of the money at the reporting date. However, it’s important to evaluate if entity A gains any advantages from exercising the option, such as safeguarding interests or acquiring assets. It is important to take into account the purpose and design of the option. If the option is substantial, entity A must consolidate entity C.

Options whose exercise price is fair value

Entity A, B, and C collectively hold 100% of the ordinary shares with voting rights at entity D’s shareholders’ general meeting. Entity A also possesses call options that can be exercised at any given time, based on the fair value of the underlying shares during exercise. If these options are exercised, it would grant Entity A an extra 20% of the voting rights in Entity D, while simultaneously reducing the interests of Entity B and Entity C to 20% each. If the options are exercised, entity A would gain control of more than 50% of the voting power of entity D.

The call options can be exercised at their fair value. Given the circumstances, entity A doesn’t seem to have any clear financial motivation to exercise the option. Entity A should evaluate if there are any additional advantages, such as synergies, that would result from exercising the options. It should also assess if there are any obstacles, whether economic or otherwise, that would prevent it from exercising the option and undermine the significance of the options. IFRS 10 provides examples of barriers that can arise.

If it is determined that the options are significant, entity A would also need to evaluate the purpose and structure of the option instrument, in order to determine whether the options grant it control over entity D.

Management intention

Entities A, B, and C each possess an equal share of the ordinary shares with voting rights at entity D’s shareholders’ general meeting. Entities A, B and C are each entitled to appoint two directors to the board of entity D. Entity A also possesses call options that can be exercised at a predetermined price at any given moment. If these options are exercised, Entity A would gain complete control over the voting rights in entity D. The call options are profitable. Entity A’s management has no plans to exercise the call options, regardless of whether entities B and C vote differently from entity A.

The call options seem to be quite significant, as they are currently profitable. The assessment of whether the options are substantive is not influenced by management’s intention, unless this intention is influenced by barriers or practical difficulties, as outlined in IFRS 10.

If the options are substantial, entity A would need to take into account other factors (such as the purpose and design of the option instrument, as well as the apparent expectations, motives, and reasons for agreeing to those terms) in order to evaluate whether the options grant it control over entity D.

Can an option provide power when it is out of the money?

Investors X and Y have ownership stakes of 30% and 70% respectively in a company called ‘Investee’. The control of the company is determined by voting rights. Investor X currently has a call option that can be exercised, but it is currently out of the money. This option is for the shares held by investor Y.

Question

Can the option provide investor X with power over Investee?

Solution

Yes, if it turns out to be real, this kind of choice can give investor X power. Based on all the facts and situations, you will have to make a decision. Here are the important things to think about.

Investment X must gain something from exercising the option for it to be real. The choice has lost all of its value, which could mean that the possible voting rights are not important. But investor X might make money by exercising the option, even though it is out of the money. It might get other benefits, like synergies from exercising the put option, and might make money overall by exercising the option. In that situation, the choice is going to be important.

Assessing control with put and call options

Entity G set up entity I, which makes malt. At first, entity G owned all of entity I. Then, entity G sold half of its shares to entity C and did the following at the same time:

·        entered into a put and call over entity C’s 50% interest; and

·        entered into a series of agreements that stipulate the terms set out in the rest of this case study.

The deal’s goal was to let entity G hire entity C, a farm expert, to give entity G advice, help entity G control production costs, and make sure that entity G always had access to raw materials.

Further information on entity I is as follows:

·        Entity G appoints the CEO;

·        entity C appoints the plant manager (second-in-command).

·        Entity I is contractually required to produce and sell sufficient malt to meet entity G’s needs, although it is also allowed to sell malt to entity C, or to other customers nominated by entity C, if entity I has excess capacity.

·        The selling price of the malt to entity G is based on a formula that takes all costs incurred by entity I, and adds a margin that is calculated to give entity I a 10% gross margin on costs incurred.

·        Agreements require entity C to provide entity I with market intelligence and advice, and to develop and execute supply chain plans to help entity I to acquire raw materials.

·        Entity C receives fees that are commensurate with the services provided.

·        The contracts with entity C are automatically terminated, with no penalties, if either of the options is exercised.

Some of entity I’s important tasks are limited by contracts. For instance, choosing customers and setting the price of malt for sale are both controlled by contracts. Operations decisions, like how much to spend on capital projects, repairs and maintenance, which suppliers to use, who to hire and fire, and other things, are made at meetings of owners and/or directors. For both shareholder and board choices, there must be unanimous agreement.

Terms of put and call options

·        The call option held by entity G allows it to buy 50% of entity I from entity C at fair value. Similarly, the put option held by entity C allows it to sell 50% of entity I to entity G at fair value. On exercise of either the put or the call, entity G gains control of entity I, and the contracts with entity C are terminated.

·        Both puts and calls are exercisable only on the occurrence of any of the following events:

o   change of control, liquidation or bankruptcy of the option writer (for example, entity G can exercise its call if there is a change of control in entity C);

o   entity G and entity C reach a decision deadlock which cannot be resolved; or

o   for the call only, 10 years after the agreement.

·        The options are designed to allow entity C to exit at fair value where the above unanticipated events, or a decision deadlock, make such an exit necessary, so that entity G gains control of entity I.

·        Because the options’ exercise price is at fair value, they are always at the money, including at inception of the options and at each reporting date.

·        In the event of a decision deadlock, it will be beneficial for entity G to exercise the call option to gain control of entity I, because the call option will be at the money (since the strike price is at fair value), due to the synergies between entity G and entity I.

Question

Under IFRS 10, does entity G control entity I?

Solution

Some of the relevant activities are governed by a contract, and it seems that these are set in stone and cannot be altered. Unless there is excess capacity, I am obligated to sell to entity G at the designated price.

Nevertheless, it is crucial to evaluate all contracts and arrangements, such as shareholdings and board representation, that grant rights over the relevant activities of entity I. This assessment will help determine if each investor possesses enough authority to exert control over entity I.

Purpose and design

It can be argued that the entire transaction, including the options, was designed to ensure that entity G maintains control of entity I (IFRS 10 para B48). This indicates a strategic approach to the arrangement.

·        Entity I was set up to supply malt to entity G, while entity C supplies expertise. This suggests that entity I is likely to be set up on behalf of entity G, while entity C’s involvement is mainly advisory.

·        The strike prices of the options are at fair value, which ensure that the strike price does not pose an economic barrier for either party to exercise the option.

Parties involved in the design of entity I

The establishment of Entity I was initiated by Entity G when it was under complete ownership. However, both Entity G and Entity C were involved in the formation of the aforementioned contractual arrangements.

Options

Entity G can gain control of all voting rights in the event of a decision deadlock through the use of put and call options. If either option is chosen, the other agreements will come to an end, enabling entity G to take control of important aspects like customer selection and the selling price of malt. While the options can only be exercised in specific circumstances, they hold significant value. The ability to make crucial decisions is often crucial in determining the course of important activities.

Parties that have a commitment to ensure that entity I operates as designed

Entity G has a strong incentive to ensure that entity I operates smoothly, as it relies on the malt output from entity I. The put and call options indicate that entity C has a viable exit plan, which implies that entity G is highly committed to this aspect.

Other factors in IFRS 10

Entity I’s actions seem to be carried out on behalf of entity G, specifically to guarantee the availability of malt. Entity G meets the power criteria in relation to entity I. Entity G is also affected by the fluctuations of entity I due to its 50% ownership, and there is no evidence to indicate that entity G is not a main participant. Entity G exercises authority on entity I.

If an investor thinks about the vote rights it has now and could have in the future, it might decide that it has power over an investee. This might not be the case, though, if a third party also has possible voting rights that could be used or converted when choices about the relevant activities need to be made. This would weaken the investor’s position. So, when doing the control assessment, it is important to think about all the possible voting rights that other parties may have in the investee and that can be used or changed when decisions about the important tasks need to be made.

Protective and veto rights

An investor must evaluate the nature of its rights, determining if they are protective in nature rather than substantive. Additionally, it is crucial to assess the protective rights held by other investors and whether there are any substantive rights held by other parties that could hinder the investor’s ability to direct the activities of the relevant investee, such as veto rights. There is a distinction between protective rights and substantive rights.Protective rights are defined as “rights designed to protect the interest of the party holding those rights without giving that party power over the entity to which those rights relate” .

An investor with only protective rights will not have control over an investee. Protective rights are typically reserved for extraordinary situations or significant alterations in the investee’s operations.

Nevertheless, rights do not offer protection solely due to their reliance on events or their application in extraordinary situations.

There may be certain activities that an investee engages in, which are only triggered by specific events or circumstances, such as when the assets held by the investee fail to meet their obligations. It is logical that an investor’s decision-making rights may be contingent upon the occurrence of certain events or circumstances. Such rights can have a significant impact and grant authority, even if those events or circumstances have not taken place.

Relevant activities contingent on certain events

Entity A’s sole function is to acquire and manage receivables on a daily basis. Servicing entails the timely collection and transmission of principal and interest payments to entity B, the investor. If the receivables default, entity A has a mechanism in place to transfer the receivables to entity B through a separate agreement. Entity A is not allowed to sell receivables, except under the put provision. Additionally, no party has the authority to liquidate entity A as long as there are any outstanding receivables.

Entity A is under the control of Entity B. This is because the sole activity that has a substantial impact on entity A’s returns is the management of receivables in the event of default. Managing receivables before default is not seen as a significant task, as the necessary actions are predetermined and do not involve making substantial decisions that impact returns. Entity B has complete control over the relevant activity, giving it significant influence over the investee.

This example highlights three additional points. When it comes to structured entities, the consolidation analysis remains unaffected by the following factors:

·        Entity A can only exercise its power on a contingent event (that is, default). This is because a default is the only time when decisions are required. Entity B can decide when decisions are needed, and so it has power, even though it might not be able to make decisions currently.

·        Entity B’s power arises from a separate contract (the put agreement) rather than entity A’s incorporation documents. The put agreement is integral to the overall transaction and to establishing the investee at its inception, and so it should be considered.

·        Management of the defaulted receivables takes place within entity B and not within entity A. However, the put option is integral to the overall transaction, so the entity that manages the defaulted receivables (entity B) has power over the investee (entity A).

Protective rights are put in place to safeguard the interests of the holder, ensuring that they have a say in matters without exerting control over the investee. Therefore, an investor who only possesses protective rights lacks the ability to exert control or hinder another party from gaining control over an investee.

Franchises

IFRS 10 provides detailed guidance on franchises, offering clearer direction on the consolidation of franchisees for franchisors.

Judgement is required to decide whether the franchisor’s rights over its franchisee are substantial or protective in character. IFRS 10 distinguishes between the franchisor’s decision-making rights that safeguard the franchise brand and decision-making rights that have a significant impact on the franchisee’s returns.

The franchisor has no control over the franchisee if other parties currently have the authority to direct the franchisee’s relevant activities.

The less financial support the franchisor provides and the less exposed the franchisor is to the franchisee’s unpredictability of returns, the more likely the franchisor has just protective rights.

Exposure to variable returns

According to the definition of control, an investor must be exposed to, or have rights to, fluctuating returns as a result of its relationship with the investee.

Variable returns are defined as those that are not fixed and may vary as a result of the investee’s performance. Such returns might be positive, negative, or both, and they are not necessarily pecuniary.

A wide variety of possible returns are identified in IFRS 10. Examples include:

Servicing fees.
Changes in the fair value of an investment.
Exposures arising from credit or liquidity support.
Tax benefits.
Access to future liquidity.
Economies of scale.
Cost savings.
Gaining proprietary knowledge.

Other types of variable return

Changes in returns may arise from changes in exchange rates, interest rates, equity prices, commodity prices, credit risk, or residual values. Understanding the source of variability and determining whether an investor is generating or absorbing it is crucial.

IFRS 10 states that returns can be generated indirectly through involvement with an investee, rather than solely within the investee itself. Some instances of this occur when the investor establishes a favourable reputation, takes advantage of cost efficiencies, or enjoys the advantage of future liquidity through its participation in the investee. In addition, returns can extend beyond financial aspects. Synergistic benefits and enhanced reputation are just a few examples of the potential variable returns.

Non-financial returns

Entity H is the only person or thing that can guarantee a great cause. The charity was set up by company H. According to the charity’s articles of organisation, entity H has the power to choose who serves on the board. The board is made up of five people, and each person can vote. The board must act in the best interests of the charity and is in charge of directing its official operations. Entity H lets the charity use its name in marketing and funding materials, and in return, entity H links itself to the charity in promotional materials. A regular source of money for the charity comes from Entity H’s gifts. The charity also gets administrative help from entity H, which handles things like marketing, wages, human resources, and finances.

Entity H is vulnerable to the charity’s changing returns because of its promise. Entity H could lose money if the charity can’t pay its bills. The guarantee could be called in this case. IFRS 10 says that risk to loss from lending money or credit is an example of a variable return. This fits with what was said.

That entity H helps the charity with its paperwork and talks about itself as connected to the charity in its advertising also shows that it could get different amounts of money from the charity. This is because IFRS 10 says an investor could use its own assets along with those of the investee to make their other assets more valuable. From entity H’s point of view, this could include the nebulous benefit of supporting a well-known charity along with its other functions. When it comes to Entity H’s image, how the charity acts will determine whether it has a positive or negative effect. This is an uncertain return that Entity H is exposed to.

Where an investor’s exposure to variable returns includes fees for services provided, should associated costs incurred to deliver those services be included in the assessment of exposure?

A fund manager receives C5 million remuneration for managing the assets of a property fund. This fee covers various services, including:

· Rent administration and collection.

· Accounting and book-keeping.

The fund manager incurs costs, such as employment expenses, in providing these services. Total costs incurred were C3 million. The fund manager’s contract does not allow costs incurred to be recharged to the fund.

Question

Are the variable returns of the fund manager from the above arrangement the gross remuneration of C5 million or the net return (after deducting the associated costs) of C2 million?

Solution

When the fund manager looks at variable returns, they should use a broad method.

The fees that are charged for managing services are not taken out of the fund’s returns. In the same way, the variable returns from an investment don’t take into account how much it costs to pay the investment.

As a result, this deal gives the fund manager a varying return of C5 million.

The above situation may be especially interesting for fund managers, but the ideas behind it are also useful for other types of investors who offer services to investors.

Assessing variability is determined by the substance of the arrangement, regardless of its legal form. As an illustration, contractually fixed interest payments can be considered variable returns, as they subject the holder to the credit risk of the investee. In the same way, fixed asset management fees can be considered as returns that may vary, due to the same underlying factors.

What assets should an investor look to in assessing control?

A Seller transfers legal ownership of receivables worth C100 to a structured entity known as ‘Buyer SE’. As part of the agreement, Buyer SE will provide C93 in cash and commit to returning any additional principal collected from the underlying receivables to the Seller. The Seller is at risk of not collecting the full amount of the underlying receivables, up to C7. Based on the evaluation, it has been determined that the deferred consideration of C7 results in the Seller retaining most of the risks and rewards associated with those receivables under IFRS 9 (IAS 39). The Seller is unable to de-recognize the receivables under IFRS 9 (IAS 39). Similarly, the Buyer SE is unable to recognise those receivables. On the other hand, the Buyer SE records a receivable from the Seller.

From a legal point of view, the Buyer SE owns all of the receivables, while the Seller is only responsible for C7. The Seller owes money to the Buyer SE, so from an accounting point of view, the Seller is a loser to the Buyer SE. This means that the Seller is not affected by the Buyer SE’s changes.

Question

Does the Seller have exposure to the variability of the Buyer SE for the purposes of assessing control under IFRS 10?

Solution

Yes, the Seller is vulnerable to changes in the Buyer SE. IFRS 10 says that the goal and design of an entity must be taken into account. [IFRS 10:B5]. This includes thinking about the risks that the investee was meant to face, the risks that it was meant to pass on to the people involved with the investee, and whether the investment faces any or all of those risks.

As a result, it is important to look at the risks that the Buyer SE faces and the risks that it shares with investors. This risk estimate should be based on an analysis of the Buyer SE’s economic risks.

When it comes to money, the Buyer SE takes on all the risks of the receivables, but the Seller also takes on some of those risks through the deferred consideration method. Because of this, the Seller is open to the fluctuations of the Buyer SE. The Buyer SE’s credit risk could also affect the Seller. For example, if the Buyer SE gets all the money from the underlying receivables but can’t pay the Seller the last C7 because of an unexpected event, the Seller could be at risk.

When an investor has more rights to the different gains that come from its work with an investee, it has a stronger desire to get more rights that give it power. Because of this, a big risk of returns fluctuating means that the investor will probably try to get power to protect its returns. However, this is not proof on its own, and it does not imply that an investor has power over an investee. There are other things that need to be thought about, like whether an investor can tell the investee what to do and whether it can use its power to change the amount of returns (that is, whether it is working as principal or agent). In the asset management business, for example, fund managers almost always deal with variable returns, but the amount of exposure they may not have enough control over may not be enough.

Under IFRS 10, an investor can be exposed to variable returns if their participation in the investee takes in variability from the investee instead of adding to it.

What types of instruments absorb variability from an investee, and which instruments create variability in an investee?

A party that borrows money from an investee at a standard interest rate does not expose the investee to varying returns because it only has to deal with the risk of its own credit. On the other hand, an average shareholder in an investee can handle changes in the investee’s residual returns; this is because the shareholding can handle changes.

It’s not always clear whether a tool adds to or takes away from variability. The instruments in list I should be able to handle the risk of an investee, while the instruments in list II should be able to cause risk.

List I. Instruments that, in general, absorb variability of an investee and, if the holder’s degree of exposure to variable returns is great enough and the other tests in IFRS 10 are met, could cause the holder of such instruments to consolidate the investee:

·        equity instruments issued by the investee;

·        debt instruments issued by the investee (irrespective of whether they have a fixed or variable interest rate);

·        beneficial interests in the investee;

·        guarantees of the liabilities of the investee given by the holder (protecting the investors from suffering losses);

·        liquidity commitments provided to the investee; and

·        guarantees of the value of the investee’s assets.

List II. Instruments that generally contribute variability to an investee and so do not, in themselves, give the holder variable returns and cause the holder of such instruments to consolidate the investee:

·        amounts owed to an investee;

·        forward contracts entered into by the investee to buy or sell assets that are not owned by it;

·        a call option held by the investee to purchase assets at a specified price; and

·        a put option written by the investee (transferring risk of loss to the investee).

Contract that both creates and absorbs variability

A structured entity (SE) owns C2 million worth of good government bonds. It signs a contract with the other party (entity A) that says it will pay entity A C2 million if a certain debt instrument issued by a different company (company Z) goes bad. In exchange for the upfront fee, entity A gets C2 million. The SE doesn’t have any other assets or debts, and it gets its money from investors who buy shares in the company.

The SE was created so that it could make the deal with entity A, protect entity A in case company Z doesn’t pay on a certain debt instrument, and subject the SE’s investors to the credit risk of company Z. If company Z doesn’t pay back a certain loan, entity A might be exposed to the credit risk of the SE.

Question

Does entity A have exposure to variable returns of the SE through its purchased credit default swap?

Solution

Yes, entity A is potentially exposed to the SE’s credit risk, which means it is exposed to the SE’s variable returns. This credit risk is likely to be small compared to company Z’s credit risk, though, because the government bonds are so good. The SE is also funded by equity investors and doesn’t owe any money to anyone else. This lowers the credit risk that entity A might be subject to. It’s likely that the contract added more uncertainty to the SE than it removed, so it probably won’t be enough to make entity A bring the SE together on its own.

Another thing is that the SE’s job is to take on company Z’s credit risk, not to let entity A handle the SE’s exposure to government bonds. With such a goal and design, it’s reasonable to say that the main goal of the deal with entity A was to put more risk on the SE. Because of this, it is not likely that the deal would lead entity A to combine the SE.

Silos

In some situations, an investee’s certain assets and debts may be kept separate from the investee’s other assets and debts. A legal entity can have this kind of setup, which is sometimes called a “silo.” As long as the conditions below are met, the silo is treated as a “deemed separate entity” for the purposes of IFRS 10. This means that an investor in the silo checks to see if it has control of the silo instead of the larger legal entity.

Common instances of silos

A silo is usually not its own legal entity. Instead, it is a group of assets and debts that are legally separate from (and do not share risk with) other assets and debts in the same legal entity.

In real life, silos can happen in the insurance, financial services, and asset management businesses. They are set up to cut down on administrative costs and give sponsors or investors in these structures other financial benefits. Creditors of one part of the same business can’t get to the assets of another part of the same business.

IFRS 10 explains us how to figure out when a silo should be treated as a separate company for accounting purposes. It says that an investor should only treat a silo, which is a part of an investee, as a separate company if the following conditions are met:

The investee’s specified assets (and any related credit enhancements) are the only source of payment for specified liabilities of, or specified other interests in, the investee.

Parties other than the investee with the specified liability do not have rights or obligations related to the investee’s specified assets or to residual cash flows from those assets.
In substance, none of the returns from the investee’s specified assets can be used by any remaining investee, and none of the liabilities of the deemed separate entity are payable from the assets of any remaining investee.

In substance, all of the assets, liabilities and equity of the deemed separate entity are ring-fenced from other investors.

Breaching of ring-fences dependent on contingent events

When considering the criteria for treating a silo as a separate entity, there may be uncertainties if the protective measures around its assets and liabilities are not completely foolproof and could potentially be compromised in certain circumstances. In unlikely situations where breaches may occur without any real impact on business, the term ‘in substance’ in IFRS 10 suggests that the focus should be on the actual substance rather than just the formalities. Therefore, the silo will still be considered a ‘deemed separate entity’ under IFRS 10.

Nevertheless, the phrases ‘if and only if’ and ‘only source of payment’ in IFRS 10 imply a significant requirement for considering a breach as lacking commercial significance. An event with a low probability could potentially hold commercial significance if it is introduced for a legitimate purpose.

This would be evident if the inclusion of that clause was influenced by a factor that investors took into account when making investment decisions. This is a situation that may call for some careful consideration, taking into account the specific details and context.

If an owner in a silo wants to know if they have control of the silo, they should figure out what activities have a big effect on the returns of the silo and how those activities are directed. You have control over the building if you have power, returns, and the ability to change the returns. So, when an investor evaluated control, they would only look at the actions that pertain to the silo and not those of the larger legal entity that the silo is a part of.

If it turns out that the funder is in charge, the silo should be merged. Then, the other investors in the entity will have to leave out that part of the investee when they figure out how much power they have.

Jurisdiction’s laws and regulations

A telecom operator has formed a partnership with an insurance company, where the insurance company establishes an insurance cell within its legal entity. This cell is utilised by the telecom operator to provide mobile handset insurance to its customers.

The cell management agreement stipulates that the insurer will levy a 5% fee on the gross premiums generated by the cell to oversee its operations. The telecom operator is eligible to receive all profits generated by the cell, once the insurer’s management fee and any policyholder claims have been paid. Furthermore, the telecom operator must adhere to the cell’s solvency requirements as outlined in the contract (specifically, regulatory capital). If the cell’s solvency drops below the specified threshold, the telecom operator must inject more capital.

Question

When assessing whether a silo is a deemed separate entity, does the entity need to consider whether the silo’s assets are legally ring-fenced?

Solution

An Entity must ascertain if the assets of a specific division are legally protected according to the laws and regulations of the jurisdiction. This is important when determining if the division is considered a separate entity under IFRS 10.

In certain jurisdictions, the laws of the jurisdiction acknowledge these structures as safeguarded insurance cells. Within a secure insurance cell, the creditors of the cell (both current and future insurance claimants) can only rely on the assets of the cell and its sponsor – in this instance, the telecom operator. Furthermore, the assets of the cell are not accessible to creditors of other similar cells within the insurance entity. Thus, the telecom operator must take into account the consolidation of a separate entity, such as a protected insurance cell.

In certain situations, these structures can be established as vulnerable cell structures, where the telecom operator acquires a distinct class of share (such as Preference share A123). Claims arising from insurance contracts written by cell A123 are paid out of cell A123’s assets, ensuring financial stability. If the assets of cell A123 are not enough to cover the cell’s debts, the telecom operator will need to inject more capital. Nevertheless, if the telecom operator is unable to fulfil such a request, such as in the case of bankruptcy, the creditors of cell A123 can make a claim against the insurer’s overall assets or the assets of other cells. Although it is unlikely that the ring-fencing of cell A123 would be breached, there is still a possibility of such events occurring and causing significant financial consequences. Thus, an unprotected cell is not considered a separate entity and is instead treated as part of the larger insurance entity.

Contractual terms that introduce ringfencing

A new fund is being established to invest in a range of financial instruments. The fund intends to distribute units to investors, granting them a share of a designated portfolio of assets (a sub-fund). The contracts establishing the fund clearly outline that the fund’s responsibilities to the unit holders are restricted to the designated portfolio of assets.

Can an entity achieve ring-fencing for the purposes of IFRS 10 via contract, if specific liabilities are exempt from the ring-fence under local laws?

Solution

The determination of whether a sub-fund is considered a separate entity relies on the examination of the potential creditors associated with each sub-fund. Although the contractual liabilities (the units) only have a claim on the silo’s assets, it’s important to note that statutory liabilities, such as tax and regulatory fees, may not be subject to the same ring-fencing provisions. In this scenario, the sub-funds are not considered as distinct entities. However, in cases where the fund is not subject to tax and regulatory fees, such as when taxes and levies are directly charged to the investors, the contractual agreement alone may be enough to classify the silos as separate entities.

Credit enhancements

A bank establishes a vehicle to finance the purchase of a collection of debt assets from external asset sellers. These assets consist of various financial instruments such as mortgages, credit card receivables, car loans, trade receivables, and securities. The vehicle will be split into five conduits, each containing a distinct pool of assets that are exposed to specific risks. Each conduit will issue around C500 million of loan notes to investors in order to finance the acquisition of the pool of debt assets.

The bank offers a credit enhancement to each of the conduits.

Question

Does the presence of a credit enhancement mean that the silo is not a deemed separate entity?

Solution

The analysis under IFRS 10 will be influenced by the structure of the credit enhancement. IFRS 10 considers ‘related credit enhancements’ as part of the assets that solely cover specific liabilities or interests of the investee. Typically, the credit enhancement is implemented as a broad enhancement that is distributed across all the conduits.

As an expert in financial matters, I can illustrate how banks can lower interest rates on loans. One effective method is by offering a pool of C 100 million in assets or guarantees as a programmed credit enhancement. This improvement guarantees that the loan notes of each conduit are given a AAA rating. Without the programmed-wide credit enhancement, the loan notes would have received an A rating.

If a conduit’s pool of loans incurs losses, they will be covered by the silo-specific credit enhancements. Any remaining losses will be covered by the programmed-wide credit enhancement. There are no restrictions on the amount that any one conduit can access. However, once the guarantee is depleted, it will not be replenished. In this example, the conduits do not meet the criteria of being considered a separate entity, as the credit enhancement is not tailored to the specific silo.

However, in the scenario where the programmed-wide credit enhancement is only C 100,000 and the loan notes do not receive an improved credit rating, the conduits may be considered as separate entities. IFRS 10 introduces a new requirement where the assets of the deemed separate entity must be clearly separated from the other assets of the overall entity, using the term ‘in substance’. Given the minimal impact of the programmed-wide credit enhancement on the credit rating of the loan notes issued, it seems that the amount is insignificant. Therefore, the presence of this credit enhancement would not hinder the classification of these conduits as separate entities. It is important to carefully consider the reasons behind the provision of the nominal programmed-wide credit enhancement. Conduits would only meet the requirement of being treated as a separate entity if there is no commercial justification for the programmed-wide credit enhancement. If the credit enhancement has a valid commercial rationale, even in rare or exceptional cases, the conduits will not be considered separate entities.

In different scenarios, the credit enhancement could be offered through the bank’s investment in a subordinated note issued by the conduits. Although the credit enhancement has the potential to enhance the credit rating of the notes issued, it is important to note that the credit enhancement is limited to the conduit and its pool of assets. In these cases, due to the unique characteristics of the credit enhancement, the conduits would be considered as distinct entities.

Contingent rights and obligations

Creditors of a silo have a legal claim solely against the assets of the silo in the ordinary course of business, as per the established regulations. Nevertheless, in the event of a specific occurrence (referred to as the contingency), the creditors of the silo are entitled to make claims against the overall entity’s or another silo’s general assets (such as through a cross default clause). The regulator mandates that the entity must maintain regulatory capital equivalent to 5% of its total silo assets.

Question

Is the condition for treatment as a silo satisfied where a silo’s creditors have a claim against the general assets of the wider legal entity, if a contingent event occurs?

Solution

The analysis will be contingent upon the nature of the event in question. The silo will not be treated as a separate entity in cases where the event is remote, but it may still be a possibility. As an illustration, creditors can make a claim on the entity’s general assets if the FTSE 100 experiences a 20% decline in value during the four-week period before the default.

If the event involves the regulator removing the silo’s ring-fence protection, which is a public interest right, and the regulator has never utilised or is unlikely to utilise this power, then the condition for treatment as a deemed separate entity may be met. It is important to understand the reasons behind the regulator’s requirement for the entity to hold 5% of total assets as regulatory capital. These reasons may indicate a significant breach of the silo.

Breach in the event of fraud

A bank establishes a vehicle to finance the purchase of mortgage loans from external asset sellers. The vehicle will be divided into several conduits, each containing a distinct pool of assets with specific risks. Each conduit will issue around C 500 million of loan notes to investors in order to finance the acquisition of the mortgage loans. A substantial portion of the acquired loans will consist of self-certified mortgage loans.

The claims of the note-holders are protected and limited to the assets of the specific conduit. Nevertheless, in light of the issues surrounding income misrepresentation, the bank has decided to allocate a pool of C50 million in assets to mitigate losses incurred by a conduit in cases where a borrower has deceitfully acquired a loan.

Question

Where a silo’s ring-fencing can be breached in the event of fraud, will the silo be a deemed separate entity?

Solution

The conduits will not be considered as separate entities, as the misrepresentation of income levels is a common business risk associated with self-certified mortgage loans. If a silo is breached due to fraud, it will be considered significant if the silo was intentionally designed to allow for such breaches in the event of fraud, such as when a borrower misrepresents information.

However, in the event of a significant fraud committed by the bank setting up the conduits, the silos might be considered as separate entities, with their ring-fence potentially being breached. In such situations, the organisation must assess the probability of fraudulent activities and evaluate if the silo’s purpose and design are equipped to handle such instances.

Link between power and variable returns – Principal and agent

IFRS 10 provides clear instructions on how to evaluate whether a decision maker is acting as an agent or a principal.

Which types of entity are affected by the principal/agent guidance?

The entities that will be impacted by this guidance will vary. In the asset management industry, it can have an impact on various entities and structures that involve multiple parties, where one party has been given the authority to direct the activities of an investee. Other industries that could be affected by this guidance include financial services, construction, extractive, and real estate.

Below are some common situations where the principal/agent guidance might be relevant:

·        A fund manager establishes, markets, manages and invests in a fund that also has third-party investors.

·        A corporate delegates powers to another entity to manage a specific business activity (for example, where an entity enters into an outsourcing arrangement).

·        A servicer collects and distributes cash flows, performs other administrative tasks and works out defaulted assets in a securitization structure.

How might the principal/agent guidance affect the asset management industry?

Power, the act of exerting influence or control, must be accompanied by the ability to generate returns and the flexibility to adjust those returns in order to create and maintain power.

Typically, asset managers in the asset management sector are granted extensive authority by the majority of funds. This authority is usually outlined in an investment mandate that was created when the fund was established, frequently by the fund manager. Investment mandates specify the investment manager’s abilities and authority to make decisions on investments.

Applying control principles to asset managers is intricate due to the combination of their authority and the fluctuating returns they receive from the assets they manage through asset management fees, regardless of their personal stake in those funds.

The principal/agent guidance aids in determining whether a party is primarily acting on behalf of other investors or mostly acting for its own advantage.

The guideline on delegated authority primarily offers criteria for assessing authority and financial gains; for the most part, it does not establish clear thresholds for determining the level of authority or the extent of exposure to fluctuating returns that would classify a decision maker as either a principal or an agent. Considerable discernment may be necessary.

Assessment of whether a decision maker is acting as principal or agent

A decision maker is “an entity with decision-making rights that is either a principal or an agent for other parties” .

An agent is a party engaged to act on behalf of another party (the principal or principals). A principal can delegate some of its decision-making authority over an investee to an agent; the agent does not control the investee when it exercises such powers on behalf of the principal.

An agent does not combine the investee, as the required connection between authority and exposure to fluctuating returns is absent. On the other hand, a principal has the ability to oversee the activities of an investee, which are performed by an agent, and may experience fluctuating returns. In situations like this, the principal must consolidate the investee as its subsidiary.

A decision maker may not always function as an agent, as they are obligated to prioritise the interests of other parties based on contractual or legal obligations. Under certain circumstances, the decision maker may receive a significant portion of the investee’s variable returns due to the decisions it has made. As a result, it could be evaluated as a principal rather than an agent. The decision maker may have a primary focus on serving its own interests.

Is an intermediate holding company an agent of its parent?

Holdco, a subsidiary fully owned by Parent, possesses complete ownership of Opco, an operational company. The sole purpose of Holdco is to maintain investments in Opco. Holdco issues listed debt and is obligated, according to local regulations, to prepare consolidated financial statements, as mandated by IFRS.

Question

Is Holdco an agent, or de facto agent, of Parent (and therefore does not control Opco) if:

·        Parent and Holdco have the same managing directors;

·        Holdco’s managing directors are Parent’s employees; or

·        Holdco is managed by a trust office that is contractually bound to act fully in accordance with Parent’s decisions?

Solution

No. A individual or object that makes decisions is only an agent (or de facto agent) if someone else gives it the power to make decisions. IFRS 10 says, “An investor may give an agent the power to make decisions on certain issues or on all activities that are relevant.” When deciding if it controls an investee, the investor must treat the person it has given the power to make decisions as if they were directly owned by the investor.

In all three cases, Holdco directly controls Opco because it owns the company’s shares. The vote power that Opco’s shares give Holdco’s management lets them tell Opco what to do. Holdco, the company, has both a direct stake in and control over Opco. It doesn’t matter how much Parent is represented on or controls Holdco’s governing body. Anyone who wants to control Holdco can do so by becoming an agent of Holdco. In the same way, anyone who owns Holdco can get to Opco’s returns through Holdco.

For starters, Holdco, not Parent, has power over Opco, so Parent has not given any power to Holdco. This means that Holdco is not Parent’s servant. Holdco should merge with Opco because it is also vulnerable to changes in Opco’s results.

To figure out if the person making the choice is an agent or a principal, they need to look at their overall relationship with other people involved with the investee.

Where power and benefits are split between two parties in a group, what factors should be considered in determining which one is the de facto agent of the other?

Parent Company owns both Fund Manager and Sister Company, which are its two fully owned companies.

There is a 15% stake in Fund Manager in the Investment Fund that they run. Fund Manager gets a small fee based on the market for managing Investment Fund, which doesn’t give them much more exposure to profits that can change. The management agreement gives Fund Manager the power to make decisions about the actions that affect the Investment Fund.

There are several outside partners who own the other 49% of Investment Fund, along with Sister Company’s 36% stake.

Joint financial records are made by both Fund Manager and Sister Company.

Question

In determining who controls Investment Fund, what factors should be considered in assessing whether Sister Company is a de facto agent of Fund Manager, or vice versa? Is it possible, under IFRS 10, that neither Sister Company nor Investment Fund would be judged to be the de facto agent of the other?

Solution

IFRS 10 says that it takes judgement to decide if one party is a de facto agent of another, taking into account both the nature of the connection and how the parties interact with each other. Because of this, more information is needed to make this assessment, and the estimate itself will depend on the specific facts and circumstances.

When making the decision in a group setting, some of the things that should be taken into account are, but are not limited to:

·        Purpose of the split of power and exposure to variable returns between the entities. For example, has Sister Company engaged Fund Manager to act on its behalf by managing its assets, or has Sister Company been instructed by Parent Company to hold units on behalf of Fund Manager?

·        Contractual agreements between the entities that might provide information on which party is providing instructions to the other.

·        How the entities interact with each other in practice. For example, does Sister Company meet directly with Fund Manager to discuss performance and strategy? Does Sister Company have the ability to remove Fund Manager and replace it with an alternative manager? Has Sister Company agreed to vote in accordance with instructions from Fund Manager or Parent Company?

·        Relative size of holdings of the entities and exposure to variable returns.

For example, do the relative sizes indicate that one entity is more likely to be an agent of the other?

Based on the specific details and situation, it is possible that none of the subsidiaries within the group are considered to be acting as a de facto agent of another subsidiary. As a result, no subsidiary would be required to consolidate the investee, although the parent company would still do so.

Once a de facto agent has been identified, the principal will evaluate whether it has sufficient control over the investee. According to IFRS 10, the principal must take into account the decision-making rights of its de facto agent, as well as its indirect exposure to variable returns through the de facto agent, when assessing control. As an illustration, if we were to view Fund Manager as the main entity, it would take into account the ownership of Sister Company when determining if it has enough exposure to unpredictable returns to exert control over Investment Fund.

This holding would be included solely for the purpose of the control assessment. Even if Fund Manager believed it had control over Investment Fund, it would still have a non-controlling interest of 85% (subtracting its 15% direct holding in Investment Fund from 100%); and if Sister Company believed it had control over Investment Fund, it would still have a non-controlling interest of 64% (subtracting its direct holding of 36% in Investment Fund from 100%).

IFRS 10 outlines four key factors that should be taken into account. There are two situations that play a decisive role in the assessment, while in all other cases, it becomes a matter of judgement. It is important to consider all four factors together when determining whether a decision maker is a principal or an agent. The factors can be classified into the power and returns criteria outlined in IFRS 10 as follows:

Indicators relating to power;

Scope of decision-making authority;
Rights held by other parties;
Indicators relating to exposure to variable returns;
Remuneration of the decision maker;

Decision maker’s exposure to variable returns from other interests that it holds in the investee.

Indicators of power and exposure to variable returns in the asset management industry

When evaluating an investor’s control over an investee, it is important to take into account any limitations or restrictions on that control.

Take the asset management industry, for instance. An asset management agreement grants the asset manager authority over the fund’s pertinent operations, such as day-to-day management. On the other hand, it’s possible for the investors to remove the asset manager at their discretion through a majority vote, given that there are only a handful of investors in the fund. It appears that the asset manager’s control over the fund is restricted by the removal rights of other parties.

When evaluating an investor’s exposure to variable returns, it’s important to take into account the size and fluctuation of the returns they receive (both expected and maximum) from the investee. This should be compared to the overall returns expected from the investee’s activities.

For example, in the asset management industry, a manager’s exposure to a fund’s variable returns might be limited to the on-market management fees that it receives. The manager might be an agent, where the fees do not expose it sufficiently to magnitude and variability of returns. In other circumstances, the manager might be exposed to variable returns through some or all of management fees, performance fees, carried interest, and investments in the fund. Management should analyze carefully whether all sources of returns in aggregate, along with consideration of the asset manager’s power over the fund, are sufficient to indicate that the manager is a principal.

Different weight should be applied to each factor based on the facts and circumstances.

Ability to remove without cause (kick out rights)

If a single investor has the authority to remove the decision maker without cause, then the decision maker is considered an agent. Having this factor is crucial as it eliminates the need for any additional evaluation according to IFRS 10.

Scope of decision-making authority

IFRS 10 requires the decision maker to consider the scope of its decision-making authority, including:

The activities that are permitted by the decision-making agreement and by law, and whether these are relevant activities. For further guidance on relevant activities.
The level of discretion that the decision maker has in directing the relevant activities.

Delegated rights insufficient to provide power

Entity A owns all of Entity B’s shares. The people on the board of entity B are chosen by entity A, and entity B’s management follows the plan set by entity A. An entity B is a call centre that works for an entity A. The actions that are relevant to entity B are those that help entity A. Because entity A wants to save money, entity B will only be used as a call centre for now. However, entity A could change this, as shown by the fact that entity B used to handle payments for entity A and the larger group.

The boards of entities A and B have told entity B to hire entity P, a company that specialises in running call centres, to run the call centre. Entity P and Entity B have an outsourcing agreement that lets entity P hire the call centre workers and needs entity P to run the call centre within the budget that is set in the agreement. The management of Entity B can either keep the contract, look for a new source, or take over the call centre on their own when the contract is up.

In this case, entity P is not seen as having power over entity B because it can’t direct the activities that matter (that is, it can’t help entity A). The activities in question are still managed by entity A, which chooses the board members and decides what entity B does, such as whether to go ahead with or stop the outsourcing deal.

It is important to know what an investee is meant to do and the risks that it was created to take on and pass on to its owners. It will be easier to tell what part the person making the decision plays and whether they are acting as a principal or an agent.

A person or group making decisions is not always an agent if their power is limited by a contract. The person making the choice might still have power over an investee if they can still direct the investee’s activities, even if they are limited.

Restrictions on power over relevant activities

The investment mandate of a fund may impose restrictions on the asset manager’s investment choices. However, the asset manager still retains control over all the relevant activities that can impact the fund’s returns.

It’s possible that the asset manager played a role in establishing the fund and defining its objectives, allowing the decision maker to acquire certain privileges and wield influence.

Asset managers typically possess significant decision-making authority, regardless of their involvement in establishing the asset management mandate. The scope of this mandate can vary, ranging from broad to narrow. However, in order to assess their level of control, it is necessary to take into account the other factors outlined in IFRS 10.

Rights held by other parties

Parties other than the decision maker may possess voting or other rights over the investee. These factors can hinder the decision maker’s ability to exercise authority independently. Other parties may possess significant rights, similar to the importance of voting rights. An investor must carefully evaluate whether these rights effectively empower the holder to influence and control the activities of the investee. These factors play a crucial role in determining the substance of rights:

Are there any barriers to exercising the rights, such as financial penalties or incentives that might deter the holder from exercising its rights?
Do one or more parties need to agree in order to exercise the rights, and is there a mechanism in place for the rights to be exercised?
Would the parties with the rights benefit from their exercise?

Other parties are not required to exercise their rights in order for them to hold significance. A party that possesses the current capacity to oversee pertinent activities holds the authority, even if it has not yet exercised its right to do so.

Removal rights serve as a prime illustration of significant rights held by other parties. Removal rights can be defined as the ability to strip the decision maker of their authority to make decisions.

If a single investor has the authority to remove the decision maker without cause, then the decision maker is considered an agent. When multiple parties need to agree on removing a decision maker, it’s important to take into account the number of parties involved and whether there is a mechanism in place for them to collectively exercise their right to remove the decision maker, if they wish to do so. The more parties involved in the decision to remove a decision maker, the less importance is given to that right.

Removal rights

IFRS 10 states “… In situations where there is more than one principal, each of the principals shall assess whether it has power over the investee by considering the requirements…”.

The fund manager, who is a decision maker, acts as an agent for the fund they manage, which has multiple investors. What factors should be considered when deciding which investors, if any, should consolidate the fund?

Investors A, B, and C have allocated their investments in proportions of 15%, 30%, and 55% respectively to a fund that is being managed by an external fund manager. The fund manager possesses extensive authority to make investment decisions, and the investors do not have the ability to influence or reject these decisions. The fund manager can only be removed through a unanimous vote from all three investors, and it has been determined to be an agent under IFRS 10.

Question

Should any of investors A, B and C attribute the fund manager’s decision-making powers to itself when it considers whether it has power over the fund?

Solution

An agent does not have control over an investee. In accordance with the guidance provided in IFRS 10 paragraph B58. The manager does not have control over the fund. Instead, its main role is to represent the interests of the other investors, also known as the principals.

Nevertheless, while an agent is tasked with acting on behalf of and for the benefit of another party or parties (the principal(s)), it’s important to note that this doesn’t automatically imply that any one of the principals has control over the entity.

When there are multiple principals involved, it is important for each principal to evaluate their control over the investee. This evaluation should take into account various factors outlined in the consolidation framework (IFRS 10), such as power, exposure to variable returns, and the ability to use that power to influence returns.

Take, for instance, a fund with numerous investors spread out across different locations. Each investor holds a small portion of the fund and lacks the authority to remove the fund manager, dissolve the fund, or dictate the manager’s decisions. As a result, none of the investors would possess any control.

In contrast, when one investor holds a significant portion of the fund and the remaining investors are scattered, and that investor has the practical capacity to oust the fund manager or influence its choices, it is probable that the investor possesses authority and governs the fund.

Based on the facts in this example, it is important for investors to understand that they should not assume the fund manager’s decision-making authority. The fund manager acts as a representative for all three investors. Since the agent represents multiple principals, each principal needs to evaluate their own authority. The fund manager cannot be directed or removed by any individual investor. Thus, each of them individually lacks the power to guide the fund’s pertinent endeavours.

Annual re-appointment

When other parties have the power to remove important elements, it suggests that the decision maker is acting as an agent. Does the need to reappoint the decision maker every year count as a substantive removal?

Fund X is overseen by a fund manager, who must be selected by the board of Fund X each year. The board members are completely independent from the fund manager and are chosen by other investors. Other fund managers in the industry are capable of providing the fund management service. The annual appointment requirement serves as a useful tool for the board to potentially replace the fund manager if needed.

Question

Is the annual appointment requirement a substantive removal, right?

Solution

Yes, this is likely to be a substantive removal right. [IFRS 10 para B72 example 14C]. The fund manager should consider the removal right, along with other relevant factors (including its fees and other exposure to variable returns), in order to determine whether it is an agent.

Removal right with a one-year notice period

Fund X is overseen by a fund manager, who can be replaced by the board of Fund X with a one-year notice period. The board members of Fund X are chosen by the investors, who are mostly independent of the fund manager. This ensures that there is no conflict of interest between the board members and the fund manager. Other fund managers in the industry are capable of providing the fund management service.

Question

Is the removal right a substantive right, given that a one-year notice period is required?

Solution

From our perspective, there is a distinction between appointing an asset manager for a specific duration and entering into an open-ended contract with the ability to terminate it by giving notice. The reappointment right establishes a framework that evaluates the asset manager’s performance in a favorable manner. The right to removal is only exercised when the service is deemed unacceptable. It can be inferred that if an asset manager is hired for a one-year term, their services will not be unsatisfactory from the very beginning of their appointment. In our perspective, a one-year reappointment right is more likely to have significant impact compared to a one-year notice term, as the extended notice period may create obstacles to its implementation.

The guidance on substantive rights is relevant when considering notice periods. Questions that an asset manager should ask, in assessing the impact of notice periods on the principal/agent determination, include:

·        How long is the notice period?

·        Is there only a short window during which notice can be given?

·        Will the decisions taken within the notice period significantly affect the returns of the fund?

When making decisions, it is important to take into account all relevant parties, not just the investors, in order to determine whether someone is acting as an agent or a principal. As an illustration, it is important to evaluate the rights held by the investee’s board of directors. When an independent board of directors, separate from the decision maker, exercises their authority on behalf of the investors, the impact is often significant. In certain cases, the rights held by boards may have a protective nature rather than being substantive. Some boards are appointed to ensure that the decision maker follows the entity’s governing documents, such as a fund’s investment mandate. However, these boards do not have the authority to make decisions or remove the fund manager, unless there is a breach of contract.

When an independent board has the authority to exercise removal rights, it tends to have a more significant impact compared to when those rights are given to a large group of investors.

Rights similar to removal rights: liquidation rights

An entity F establishes, markets, and manages a closed-end fund, fund B, with expertise and precision. Fund B has four investors: R, S, T, and U. Investor R holds a 40% stake, while the remaining stakeholders each have an equal share of 20%. If investor R decides to withdraw its investment from the fund, the fund will be liquidated as per the investment mandate. The investments in the fund have the potential to be realized within a reasonable timeframe, with minimal loss of value. Investor R stands to gain if it decides to exercise its right.

Investor R has certain liquidation rights that could be seen as significant, suggesting that the fund manager lacks authority. However, there are other factors that need to be taken into account in order to determine whether the fund manager is acting as an agent.

Remuneration

Considering the level of remuneration of the decision maker is crucial in determining their role as a principal or an agent. If the decision maker’s remuneration is significantly higher and more unpredictable than the returns from the investee’s activities, it suggests that the decision maker holds a higher position.

For the decision maker to be effective, its compensation:

needs to be commensurate with the services provided; and
must include only terms, conditions or amounts that are customarily present in arm’s length arrangements for similar services and requiring similar skills.

The person making the choice cannot be an agent if the above-mentioned pay conditions are not met. However, these factors by themselves are not enough to prove that the person making the decision is an agent. You should also think about who has the power to make decisions, what rights other people have, and how vulnerable you are to changes in returns.

Is a decision maker that is remunerated at market rate necessarily an agent?

An equity fund is entrusted to a fund manager (‘FM’) who has extensive investment powers. The fund manager is entitled to an annual fee of 2% of the net asset value of the fund, which aligns with the fee structure of comparable funds.

Question

Can the fund manager conclude that it is an agent for fund investors, and therefore does not control the fund, by virtue of the fact that it only receives market remuneration?

Solution

No, this is not enough for the fund manager to decide that it is an agency. You should also think about the other things in IFRS 10. One thing that should be taken into account is if the fund manager has a direct interest in the fund. The fund manager also has to think about how much and how often it will be paid compared to the results of the investments. For the sake of the connection, a fund manager might decide to lower its fee if the fund isn’t making much money. This would keep the return for the other clients the same and make the fund manager’s return less stable. IFRS 10 gives examples that show how to evaluate this kind of risk.

A fund manager is a principal if the fees they accept are not fair for the work they do and if the management agreement doesn’t only include terms, conditions, or amounts that are common in deals for similar services and skill levels made between two parties without any ties to each other. The opposite is not true, though: the fact that the fund manager is paid based on the market is not enough to prove that they are an agent. Still, a manager who gets paid based on the market and has no personal stake in a fund is probably just an agent.

Exposure to variability of returns from other interests

When making decisions, it’s important to take into account the potential fluctuations in returns that may arise from various factors, such as remuneration and other interests in an investee. Some other interests to consider are:

An investment in the investee.
Guarantees of the investee’s performance or its assets.
Funding support provided to the investee.

When evaluating exposure to variability of returns from other interests in the investee, it is important for a decision maker to consider the following:

The magnitude and variability of its exposure to variable returns. The greater the magnitude and variability associated with its economic interests, considering its remuneration and other interests in aggregate, the more likely it is that the decision maker is a principal.
Whether its exposure to variability of returns is different from that of the other investors and, if so, whether this might influence its actions (for example, where a decision maker holds subordinated interests in, or provides other forms of credit enhancement to, an investee).

An individual in a position of authority should assess their level of risk in relation to the overall fluctuation in returns of the entity they are investing in. This assessment focuses mainly on the projected returns from the investee’s activities, while also considering the decision maker’s potential exposure to the investee’s fluctuations in returns.

When a decision maker has authority but gains minimal returns or faces minimal risk, it suggests that the decision maker does not use their power for personal gain. Put simply, it suggests that the person making the decision holds a position of authority. On the other hand, when a person in a position of authority has significant influence and is heavily impacted by the ups and downs of outcomes, it can be said that this person uses their power to their advantage and is thus considered a principal. IFRS 10 does not provide specific guidelines regarding the percentage of interests held or the levels and types of fees to determine whether a decision maker’s returns are sufficient for it to be acting as a principal. On the other hand, IFRS 10 necessitates the consideration of all factors and provides illustrative examples to aid in understanding the assessment process.

Agent versus principal: fund manager as agent

A fund manager sets up, markets, and oversees a controlled public fund. People were told that investing in the fund would give them access to a diversified portfolio of widely traded equity securities.

IFRS 10 criteria Additional facts relevant to assessment of IFRS 10 criteria

Scope of decision maker’s authority ·        Fund manager is subject to the defined parameters set out in the investment mandate.

·        Within the defined parameters, the fund manager has discretion about the assets in which to invest.

Rights held by other parties ·        Investors do not hold any substantive rights to remove the fund manager, but can redeem their interests within particular limits set by the fund.

·        The fund is not required to establish, and has not established, an independent board of directors.

Remuneration of decision maker ·        A market-based fee equal to 1% of the fund’s net asset value.

·        The fees are commensurate with the services provided, and the remuneration agreement includes only terms, conditions and amounts that are customarily present in arm’s length arrangements for similar services.

Decision maker’s exposure to variability from other interests ·        Fund manager has a 10% pro rata investment in the fund.

·        Fund manager does not have any obligation to fund losses.

The fund manager’s compensation and investments don’t seem to put them at such a high risk of profits going up and down that it would be clear that they are a principal. The fact that the fund manager can only make decisions within the limits spelled out in the investment mandate further supports the idea that the fund manager acts as an agent.

Agent versus principal: fund manager (various)

A fund manager creates, promotes, and oversees a fund that offers several investors investment options. These instances are taken individually. Each sample has pertinent facts shown in the table below.

Facts and circumstances

IFRS 10 criteria Additional facts relevant to assessment of IFRS 10 criteria Scope of decision maker’s authority Examples A–C

The fund manager must make decisions in the best interests of all investors and in accordance with the fund’s governing agreements.

Despite this, the fund manager has extensive decision-making authority to direct the fund’s relevant activities.

Rights held by other parties

Examples A, B

The investors can remove the fund manager by a simple majority vote, but only for breach of contract.

Remuneration of decision maker

Examples A–C

A market-based fee of:

1% of assets under management; and

Decision maker’s exposure to variability from other interests

Example A

Example C

20% of profits, if a specified profit level is achieved.

The remuneration agreement only contains terms, conditions, and quantities that are typically found in arm’s length agreements for comparable services. Fees are commensurate with services rendered. The goal of the compensation is to balance the fund manager’s interests with those of the other investors.

The directors on the fund’s board of directors are not affiliated with the fund manager.

Every year, the board selects the fund manager.

The fund manager doesn’t have to pay for losses that are bigger than its 2% investment. Look at the IFRS 10 standards Extra information that is important for judging the IFRS 10 standards A Case Study The manager of the fund is an agent:

The fund manager is not exposed enough to be a partner with the 2% investment and the pay that comes with it.

The rights of the other investors to fire the fund manager are defensive because they can only be used if the fund manager broke the contract.

The fund manager can only make decisions that are in line with what the fund’s governing agreements say.

Situation B The amount of money the fund manager invests in the fund determines whether the fund manager is a principal or an agent. For example, a 20% investment plus pay might be enough to prove that the fund manager is a principal.

Different situations will have different amounts of risk that will make the fund manager be seen as a principal.

As in Example A, the rights of the other owners to get rid of the fund manager are strong.

Example C The fund manager is an agent: The investors have substantive rights to remove the fund manager, and the board of directors provides a mechanism to exercise these rights. [IFRS 10 para B72 examples 14A to 14C]. FAQ 26.123.3 – Agent versus principal: asset manager as principal Reference to standard: IFRS 10 para B72 Reference to standing text: 26.123 Industry:

IFRS 10 criteria Additional facts relevant to assessment of IFRS 10 criteria

The services performed by the fund manager could be performed by other fund managers.

Example B

Scope of decision maker’s authority

The asset manager manages the asset portfolio by making investment decisions within the parameters set out in the investee’s prospectus.

Rights held by other parties

The asset manager can be removed at any time, without any specific reason, by a simple majority decision of the other investors. The other equity and debt investors consist of a diverse group of individuals and organizations who are not connected and lack a means to collaborate.

Remuneration of decision maker

The asset manager charges fees based on the assets under management and any profits earned, subject to a specified level. The fees are determined based on market rates and are fair for the services offered. The agreement for compensation only includes standard terms, conditions, and amounts that are typically found in similar service arrangements. The compensation ensures that the fund manager’s interests are in line with those of other investors.

Understanding the potential impact of other interests on decision making

The asset manager has a significant stake of 35% in the investee’s equity.

The asset manager seems to have a significant role and therefore holds control: With a 35% equity stake and the fees involved, the asset manager has enough exposure to be considered a principal. In this situation, the emphasis on the right to remove the asset manager without cause is reduced. This is because exercising this right is not easy and would require a coordinated effort from a large number of widely dispersed investors.

Agent versus principal: sponsor of multi-seller conduit as principal

A decision maker (the ‘sponsor’) sponsors a multi-seller conduit (‘MSC’).

IFRS 10 criteria Additional facts relevant to assessment of IFRS 10 criteria

Scope of decision maker’s authority

The sponsor establishes the terms of the MSC. The sponsor: manages the operations of the MSC; approves the transferors permitted to sell to the MSC; approves the assets to be purchased by the MSC; and makes decisions about the MSC’s funding. The sponsor must act in the best interests of all investors.

Rights held by other parties

The investors do not hold substantive rights that could affect the sponsor’s decision-making authority.

Remuneration of decision maker

The sponsor receives a market-based fee that is commensurate with the services that it provides, and the remuneration agreement includes only terms, conditions and amounts that are customarily present in arm’s length arrangements for similar services.

Decision maker’s exposure to variability from other interests

The sponsor is entitled to any residual returns of the MSC. The sponsor provides credit enhancement that absorbs losses of up to 5% of all of the MSC’s assets, after losses are absorbed by the transferors. The sponsor provides liquidity facilities to the MSC. Liquidity facilities are not advanced against defaulted assets.

The sponsor appears to be a principal and thus has control:

The sponsor’s exposure to variability of returns is different from that of other investors, arising from both the sponsor’s entitlement to residual returns and the credit enhancement and liquidity facilities that it provides. The exposure to liquidity risk is exacerbated by the fact that MSC uses short-term debt to fund medium-term assets.

The sponsor has extensive authority over those decisions (such as transferor selection, asset selection, and funding) which are likely to be the activities that most significantly affect the MSC’s returns.

The obligation to act in the best interest of all investors does not prevent the sponsor from being a principal.

Situations where there is more than one principal

When multiple principals are involved, each one should evaluate their control over the investee by taking into account various factors in the consolidation framework. These factors include power, exposure to variable returns, and the capacity to utilize power to influence returns.

Determination of principal in the asset management industry

A person who makes decisions (like a fund manager) might be seen as an agent for the fund that they are in charge of, which has many clients. Then, it should be thought about which (if any) of the investors owns the fund and should therefore be merged with the others.

For instance, if a fund has a lot of investors spread out across the world, each with a small stake, and none of them has the power to fire the fund manager, close the fund, or tell the fund manager what to do, then none of the investors would have control.

On the other hand, if one investor has a big stake in the fund and the other investors are spread out, that one investor probably has power and runs the fund. This is because they have the power to fire the fund manager or tell the fund what to do.

Determination of principal of a fund

Investors A, B, and C each put 15%, 30%, and 55% of their money into a fund that is run by a third-party manager. The fund manager can make a lot of decisions about investments, and the buyers can’t tell them what to do or stop them. It takes a unanimous vote from all three owners to fire the fund manager, and IFRS 10 says that the manager is an agent.

The fund manager doesn’t have to pay for any losses that happen after that payment. The Case C

The fund manager is seen as an agent, which means it doesn’t run the fund. It is mostly working for the other owners, who are called “principals.”

Investors A, B, and C should think about whether they should make decisions for the fund manager instead of the fund manager.

One of the principals does not always control an agent, even though an agent “is a party primarily engaged to act on behalf of and for the benefit of another party or parties (the principal(s))”.

The buyers shouldn’t think that they have the power to make decisions like the fund manager does. Everyone in the fund works for the fund manager. Since the agent works for more than one principal, each principal should decide if the agent has power. No one owner has the power to fire or tell the fund manager what to do. Because of this, none of them can run the fund’s important tasks on their own.

De facto agent

When investing, a person should think about the relationships they have with other people and whether those other people are working on their behalf (that is, they are de facto agents). To find out if there is a de facto agent connection, you need to look at the types of relationships the investor has with different people and how they talk to each other.

The term ‘de facto agent’ describes agents who are acting on behalf of investors, even where there is no contractual arrangement in place. A party can be a de facto agent where the investor has, or those that direct the relevant activities of the investor have, the ability to direct that party to act on the investor’s behalf. The investor should consider its de facto agent’s decision-making rights and its indirect exposure, or rights, to variable returns through the de facto agent, together with its own, when assessing control of an investee.

IFRS 10 identifies a number of possible de facto agent/principal relationships, including:

Related parties of the principal.
Parties that received interests in the investee as a contribution or loan from the principal.
Parties that agreed not to sell, transfer or encumber their interests in the investee without the principal’s approval.
Parties that cannot finance operations without subordinated financial support from the principal.
Parties that have largely similar governing body members or key management personnel as the principal.
Parties that have close business relationships with the principal.

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Chapter 3: Rights arising from other contractual arrangements

De facto control

Power to govern under a shareholder agreement

Ownership of less than 50% of voting rights with dispersed shareholding

Ownership of less than 50% of voting rights with dispersed shareholding and a shareholder agreement

Passive majority shareholder

Sophisticated shareholders

Temporary shareholding at general meeting

Super majority voting in a joint venture

Assessing de facto control for an operating entity

What types of rights to acquire or dispose of shares might represent potential voting rights?

Potential voting rights

Situations where one investor holds a call option and another holds a put option in the event of a deadlock

Do ‘tag along’ rights represent potential voting rights which might provide power?

Do ‘Russian roulette’ provisions in shareholder agreements represent potential voting rights which might provide power?

Do ‘drag along’ rights held by multiple investors represent potential voting rights which might provide power?

Out of the money options

Options whose exercise price is fair value

Management intention

Can an option provide power when it is out of the money?

Assessing control with put and call options

Protective and veto rights

Relevant activities contingent on certain events

Franchises

Exposure to variable returns

Other types of variable return

Non-financial returns

Where an investor’s exposure to variable returns includes fees for services provided, should associated costs incurred to deliver those services be included in the assessment of exposure?

What assets should an investor look to in assessing control?

What types of instruments absorb variability from an investee, and which instruments create variability in an investee?

Contract that both creates and absorbs variability

Silos

Common instances of silos

Breaching of ring-fences dependent on contingent events

Jurisdiction’s laws and regulations

Contractual terms that introduce ringfencing

Credit enhancements

Contingent rights and obligations

Breach in the event of fraud

Link between power and variable returns – Principal and agent

Which types of entity are affected by the principal/agent guidance?

How might the principal/agent guidance affect the asset management industry?

Assessment of whether a decision maker is acting as principal or agent

Is an intermediate holding company an agent of its parent?

Where power and benefits are split between two parties in a group, what factors should be considered in determining which one is the de facto agent of the other?

Indicators of power and exposure to variable returns in the asset management industry

Ability to remove without cause (kick out rights)

Scope of decision-making authority

Delegated rights insufficient to provide power

Restrictions on power over relevant activities

Rights held by other parties

Removal rights

Annual re-appointment

Removal right with a one-year notice period

Rights similar to removal rights: liquidation rights

Remuneration

Is a decision maker that is remunerated at market rate necessarily an agent?

Exposure to variability of returns from other interests

Agent versus principal: fund manager as agent

Agent versus principal: fund manager (various)

Agent versus principal: sponsor of multi-seller conduit as principal

Situations where there is more than one principal

Determination of principal in the asset management industry

Determination of principal of a fund

De facto agent

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