ASC 810-10 Subordination

Certain Derivative Instruments

25-32 For legal entities that issue both senior interests and subordinated interests, the determination of which variability shall be considered often will be affected by whether the subordination (that is, the priority on claims to the legal entity’s cash flows) is substantive. The subordinated interest(s) (as discussed in paragraph 810-10-55-23) generally will absorb expected losses prior to the senior interest(s). As a consequence, the senior interest generally has a higher credit rating and lower interest rate compared with the subordinated interest. The amount of a subordinated interest in relation to the overall expected losses and residual returns of the legal entity often is the primary factor in determining whether such subordination is substantive. The variability that is absorbed by an interest that is substantively subordinated strongly indicates a particular variability that the legal entity was designed to create and pass along to its interest holders. If the subordinated interest is considered equity-at-risk, as that term is used in paragraph 810-10-15-14, that equity can be considered substantive for the purpose of determining the variability to be considered, even if it is not deemed sufficient under paragraphs 810-10-15-14(a) and 810-10-25-45. [FSP FIN 46(R)-6, paragraph 11]

2.19 Determining Whether a Variable Interest Is Subordinated Financial Support

Understanding which variable interests constitute subordinated financial support is important to evaluating an entity under the VIE model in ASC 810-10. For example, ASC 810-10-15-17(d)(3) requires a reporting entity to assess whether it has provided more than half of a potential VIE’s subordinated financial support when determining whether the potential VIE meets the business scope exception. Further, ASC 810-10-15-14 requires a reporting entity to assess the design of the potential VIE’s subordinated financial support when determining whether a potential VIE is a VIE.

Subordinated financial support, as defined in ASC 810-10-20, is “[v]ariable interests that will absorb some or all of a [VIE’s] expected losses.”

Question

Under the VIE model in ASC 810-10, would all variable interests also be considered subordinated financial support?

Answer

No. Interests in an entity that are considered variable interests because they absorb expected losses of the entity are not necessarily subordinated financial support. Variable interests, as defined in ASC 810-10-20, are

“contractual, ownership, or other pecuniary interests in a VIE that change with the changes in the fair value of the VIE’s net assets exclusive of variable interests” (see Q&A 4.02). ASC 810-10-55-19 further indicates that variable interests absorb or receive the expected variability created by assets, liabilities, or contracts of a VIE that are not, themselves, variable interests.

The determination of whether a variable interest is subordinated financial support will be based on how that interest absorbs expected losses compared with other variable interests in the entity. The determination will be based on all facts and circumstances. If the terms of the arrangement cause the variable interest to absorb expected losses before or at the same level as the most subordinated interests (e.g., equity, subordinated debt), or the most subordinated interests are not large enough to absorb the entity’s expected losses, the variable interest would generally be considered subordinated financial support. For example, investment-grade debt and trade accounts payable are variable interests that would generally not be considered subordinated financial support. (See also Q&A 2.01, which addresses whether an interest is a variable interest.)

Example

An investor holds a common-stock investment of $50 and a debt instrument of $60 in an entity. The only other variable interest is $40 of preferred stock held by an unrelated third party. The common and preferred stock are considered equity at risk in accordance with ASC 810-10-15-14(a), and the expected losses of the entity are $80.

The entity is designed so that common and preferred stock absorb expected losses before the debt. The investors are evaluating whether the entity is a VIE under ASC 810-10-15-14(a).

In this example, the equity, preferred stock, and debt are all considered variable interests because they are expected to absorb some of the potential VIE’s variability. However, because the common and preferred stock ($90) are expected to absorb 100 percent of the expected losses ($80), the debt is not considered subordinated financial support.

ASC 810-10

Certain Interest Rate Risk

25-33 Periodic interest receipts or payments shall be excluded from the variability to consider if the legal entity was not designed to create and pass along the interest rate risk associated with such interest receipts or payments to its interest holders.

However, interest rate fluctuations also can result in variations in cash proceeds received upon anticipated sales of fixed-rate investments in an actively managed portfolio or those held in a static pool that, by design, will be required to be sold prior to maturity to satisfy obligations of the legal entity. That variability is strongly indicated as a variability that the legal entity was designed to create and pass along to its interest holders. [FSP FIN 46(R)-6, paragraph 12]

2.20 Analyzing a MMF for Consolidation

Note: ASU 2010-10 indefinitely defers the amendments in ASU 2009-17 for a reporting entity’s interest in certain entities, including a reporting entity’s interest in an entity that is required to comply with or operate in accordance with requirements that are similar to those included in Rule 2a-7 or the Investment Company Act of 1940 for registered money market funds. See Q&A 1.01 for guidance on determining which consolidation model to apply.

Rule 2a-7 of the Investment Company Act of 1940 regulates MMFs. The rule places certain restrictions on MMFs to help minimize the credit risk of their underlying asset portfolio, including requiring that they:

1. Invest only in highly rated securities with a maturity of 397 days or less.

2. Maintain an asset portfolio with a dollar-weighted maturity of 90 days or less.

3. Establish a board of directors that elects the investment adviser controlled by the fund’s shareholders.

Accordingly, regulated MMFs generally invest in short-term investments, including certificates of deposit, commercial paper and government securities, and pay dividends to shareholders that generally reflect short-term interest rates. Although credit losses in the underlying portfolio of an MMF are possible, they are typically managed with the goal of keeping losses to a minimum. Part of the perceived security of an investment in an MMF is that it is managed with the intent of retaining an NAV of $1 per share. Within certain parameters established by Rule 2a-7, an MMF is allowed to retain its $1 NAV. However, if the market value of the fund assets deviates from amortized cost by more than 50 basis points, the fund is required to record its investments at fair value. If fair value is less than book value, an MMF would be forced to report an NAV of less than $1 (referred to as “breaking the buck”).

Some MMFs have sought to increase yields by investing in highly rated short-term debt issued by SIVs, which issue such debt to buy higher-yielding securities. Debt issued by SIVs may decline in value when the SIV securities default or are downgraded by rating agencies. The realized (or, in the event of downgraded but nondefaulted securities, the unrealized) losses may then cause the MMF to report an NAV of less than $1.

To prevent NAV from falling below $1, an MMF sponsor (that is also the fund’s adviser) may step in and provide credit support to the MMF. This support may include, but is not necessarily limited to, capital contributions, standby letters of credit, guarantees of principal and interest, and agreements to purchase troubled securities at par. Such support is almost never contractually required and, if provided, is given at the sole discretion of the sponsor. See Q&A 2.14 for further discussion.

Historically, an MMF has not been considered a VIE within the scope of the VIE model in ASC 810-10 because (1) the fund was deemed to have sufficient equity investment at risk to finance its activities without additional subordinated financial support and (2) the fund’s group of at-risk equity investors (i.e., the shareholders) had the requisite characteristics of a controlling financial interest. However, the act of providing credit support is a

modification of the MMF’s contractual arrangements that may require the sponsor, as well as the other variable interest holders, to reconsider whether the fund is a VIE (see ASC 810-10-35-4(a)). Often, a sponsor’s support protects the holders of equity at risk (i.e., the shareholders) from the obligation to absorb the expected losses of the MMF that are associated with credit risk (see Q&A 3.36). If the MMF is ultimately determined to be a VIE, each variable interest holder (including the sponsor) would need to determine whether it should consolidate the fund as its primary beneficiary.

ASC 810-10-25-21 through 25-36 address how a reporting entity should determine the variability to be considered in applying the VIE model in ASC 810-10. The VIE model requires the following two-step analysis of the design of the entity:

• Step 1: Analyze the nature of the risks in the legal entity.

• Step 2: Determine the purpose for which the legal entity was created and the variability (on the basis of the risks identified in step 1) the legal entity is designed to create and pass along to interest holders.

In the step 1 analysis, interest rate risk and credit risk are generally identified as the two main risks in an MMF.

In the step 2 analysis, credit risk is usually considered a source of variability that an MMF is designed to create and pass along to its interest holders. However, although the interest earned by an MMF is passed along to its shareholders, there is some question about whether an MMF is designed to create and pass along interest rate risk to its interest holders (see Q&A 2.15).

Question

Should interest rate risk be included in the analysis of a regulated MMF when an entity applies the provisions of the VIE model in ASC 810-10?

Answer

Yes. Interest rate risk is one of the risks a regulated MMF is designed to create and pass along to its interest holders. ASC 810-10-25-25 includes factors a reporting entity should consider when making this determination, including (1) how the legal entity’s interests were negotiated with and marketed to potential investors and (2) the nature of the legal entity’s interests issued.

As stated in its prospectus, a regulated MMF’s interests are negotiated with and marketed to investors as an investment that exposes investors to credit risk (in the form of the risk that the obligor of the fund’s assets will fail to pay interest or principal on the obligations) and interest rate risk (in the form of reinvestment risk associated with the continual need to replace maturing short-term assets at then-current market interest rates). Further, by virtue of their regulatory requirements, MMFs are designed to have minimal credit risk. Including variability in cash flows associated with interest and reinvestment risk is consistent with the stated purpose of a regulated MMF and with the decision that most investors make when becoming involved with a regulated MMF, which is to compare regulated MMF yields with those offered by comparable bank products (i.e., savings accounts and interest-bearing checking accounts).

In addition, the explicit, single-class nature of the interests issued by a regulated MMF exposes the fund’s investors to the variability in net income or losses of the fund. The net income of the fund includes the impact of both credit and interest rate risk. Because a regulated MMF does not have any explicit subordinate class of interest issued that is designed to absorb variability, all variability in net income and variability of the MMF’s assets is, by the pass-through nature of the fund, intended to be passed along to its single class of interest holders.

In informal discussions, the staff of the SEC’s Office of the Chief Accountant has stated that it would not object to registrants applying the view that regulated MMFs are designed to create and pass along interest rate risk to their interest holders. Although not specifically mentioned by the SEC staff, the above guidance would also apply when a registrant analyzes an unregulated MMF that is designed and marketed to be operated in accordance with Rule 2(a)-7. However, the SEC staff did state that this guidance “should not be analogized” to structures other than MMFs.⁶

If an MMF’s sponsor concludes that it is not a primary beneficiary of an MMF on the basis of the above guidance, it should determine the appropriate accounting for and disclosure of the credit support provided to the fund under other applicable GAAP (e.g., ASC 460-10 or ASC 815).

6 This issue was included in the January 10, 2008, EITF Agenda Committee Request. The EITF Agenda Committee, however, did not add this Issue to its March 2008 agenda. For more background on the Issue and the various views considered by the EITF Agenda Committee, see the January

ASC 810-10

Certain Derivative Instruments

25-34 A legal entity may enter into an arrangement, such as a derivative instrument, to either reduce or eliminate the variability created by certain assets or operations of the legal entity or mismatches between the overall asset and liability profiles of the legal entity, thereby protecting certain liability and equity holders from exposure to such variability. During the life of the legal entity those arrangements can be in either an asset position or a liability position (recorded or unrecorded) from the perspective of the legal entity. [FSP FIN 46(R)-6, paragraph 4]

2.21 How to Determine Whether an Embedded Derivative Is Clearly and Closely Related Economically to Its Asset or Liability Host

ASC 810-10-55-31 states:

Some assets and liabilities of a VIE have embedded derivatives. For the purpose of identifying variable interests, an embedded derivative that is clearly and closely related economically to its asset or liability host is not to be evaluated separately.

Question

If an embedded derivative is determined not to require separation from its related asset or liability host in

accordance with ASC 815-15-25-1, can it be assumed that the embedded derivative does not need to be evaluated separately from its host asset or liability pursuant to the VIE model in ASC 810-10?

Answer

Not necessarily. The analysis of whether an embedded derivative should be separately evaluated is different under the VIE model in ASC 810-10.

ASC 815-15-25-1 lists three criteria for separation of an embedded derivative from the host contract:

a. The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.

b. The hybrid instrument is not remeasured at fair value under otherwise applicable [GAAP] with changes in fair value reported in earnings as they occur.

c. A separate instrument with the same terms as the embedded derivative would, pursuant to ASC 815-10-15, be a derivative instrument subject to the requirements of this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)

If the embedded derivative meets criterion (a) but not criterion (b) or (c), it should not be separated from its host contract under ASC 815. However, because the embedded derivative is not clearly and closely related to the host contract, a reporting entity should evaluate the derivative separately to determine whether there is a variable interest under ASC 810-10. In other words, the VIE model in ASC 810-10 only requires an analysis of whether the derivative is clearly and closely related economically to its asset or liability host (i.e., ASC 815-15-25-1(a)). For additional guidance on deciding whether the embedded derivative is clearly and closely related economically to the asset or liability host in accordance with the VIE model in ASC 810-10, see ASC 815-15-25-16 through 25-29, ASC 815-15-55-165 through 55-226, and any other relevant guidance on the phrase “clearly and closely related.”

Example

Enterprise A leases equipment (the only asset of Entity B) from B for a monthly payment of $10,000 for 36 months.

The lease agreement includes a residual value guarantee provision in which A guarantees that the fair value of the leased equipment will be no less than $25,000 at the end of the 36-month term. The lease is an operating lease pursuant to ASC 840.

The hybrid instrument embodies a host contract (the operating lease) and an embedded derivative (the residual value guarantee provision). The residual value guarantee provision is not clearly and closely related to the operating lease because the economic characteristics and risks of the guarantee are different from those related to the cash flows of the operating lease. Therefore, the hybrid instrument meets the criterion in ASC 815-15-25-1(a). As a result, the residual value guarantee must be evaluated separately from the host operating lease (a nonvariable interest) pursuant to paragraph ASC 810-10-55-31.

The operating lease host, an equivalent of an account receivable, creates variability and therefore is not a variable interest in B. As discussed in ASC 810-10-25-21 through 25-36, the residual value guarantee transfers the risk of certain of the entity’s assets to the lessee and accordingly is deemed a variable interest in B. That the instrument should not be separated from the operating lease host pursuant to ASC 815 because it fails to meet the criterion in ASC 815-15-25-1(c) does not change the analysis under the VIE model in ASC 810-10.

ASC 810-10

25-35 The following characteristics, if both are present, are strong indications that a derivative instrument is a creator of variability:

a. Its underlying is an observable market rate, price, index of prices or rates, or other market observable variable (including the occurrence or nonoccurrence of a specified market observable event).

b. The derivative counterparty is senior in priority relative to other interest holders in the legal entity. [FSP FIN 46(R)-6, paragraph 13]

25-36 If the changes in the fair value or cash flows of the derivative instrument are expected to offset all, or essentially all, of the risk or return (or both) related to a majority of the assets (excluding the derivative instrument) or operations of the legal entity, the design of the legal entity will need to be analyzed further to determine whether that instrument should be considered a creator of variability or a variable interest. For example, if a written call or put option or a total return swap that has the characteristics in (a) and (b) in the preceding paragraph relates to the majority of the assets owned by a legal entity, the design of the legal entity will need to be analyzed further (see paragraphs 810-10-25-21 through 25-29) to determine whether that instrument should be considered a creator of variability or a variable interest. [FSP FIN 46(R)-6, paragraph 13]

2.22 Applying the Guidance in ASC 810-10-25-35 and 25-36

ASC 810-10-25-35 and 25-36 provide guidance on determining whether a derivative instrument is a variable interest, stating:

The following characteristics, if both are present, are strong indications that a derivative instrument is a creator of variability:

b. The derivative counterparty is senior in priority relative to other interest holders in the legal entity.

If the changes in the fair value or cash flows of the derivative instrument are expected to offset all, or essentially all, of the risk or return (or both) related to a majority of the assets (excluding the derivative instrument) or operations of the legal entity, the design of the legal entity will need to be analyzed further to determine whether that instrument should be considered a creator of variability or a variable interest.

For example, if a written call or put option or a total return swap that has the characteristics in (a) and (b) in the preceding paragraph relates to the majority of the assets owned by a legal entity, the design of the legal entity will need to be analyzed further (see paragraphs 810-10-25-21 through 25-29) to determine whether that instrument should be considered a creator of variability or a variable interest.

In document Consolidation of Variable Interest Entities A Roadmap to Applying the Variable Interest Entities Consolidation Model. March 2010 (Page 67-76)