Control in debt restructuring in Structured entity

Following is a case on the assessment whether certain stakeholders in a transaction/structure have obtained control over a certain entity in the transaction in line with the requirements of IFRS 10 Consolidated financial statements. Only one stakeholder can be in control! [IFRS 10 B16] Or no stakeholder is in control. Or one stakeholder is in control and has to consolidate the investigated entity  in its consolidated financial statements. Here is the case. Control in debt restructuring in Structured entity

THE CASE – Assessing control for a debt restructuring structured entity with limited activities 

Background and purpose Control in debt restructuring in Structured entity

A corporate entity (‘the Corporate’) wishes to raise long-term debt with a non-vanilla interest rate – for example, debt whose coupon varies with an underlying index, such as an inflation or equity index. This may be to provide an economic hedge – for example, if some or all of the Corporate’s income tends to vary with inflation − or as part of a wider structured transaction − for example, to achieve tax benefits.

However, the market for such non-vanilla debt is illiquide. The Corporate enters into a transaction involving a structured entity (SE) as described below.

Facts Control in debt restructuring in Structured entity

  • Corporate, in conjunction with a Bank, sets up an SE. Corporate issues the desired non-vanilla notes (the ‘Structured Notes’) to the SE. The returns on the Structured Notes are linked to returns on a specified index (for example, inflation or equity index).
  • The shares of the SE are held by an independent third party − in this case, a charitable trust. However, the share capital is negligible, and the voting rights confer no substantive rights, as all these have been specified by contractual arrangements.
  • Bank enters into a swap (‘the Swap’) with the SE to exchange the index-linked rate on the notes issued for a fixed coupon using a derivative. Payments under the Swap are made on a net basis and are made quarterly to match the coupon payment dates on the ‘Plain Notes’ (see below). If in any period (including on maturity or liquidation) a net payment is due from the SE under the Swap, that payment ranks senior to all other amounts payable by the SE.
  • SE issues vanilla fixed rate notes (‘the Plain Notes’) to note-holders.
  • Note-holders are a dispersed group of numerous investors who do not represent a reporting entity. No individual note-holder owns more than 5% of the notes. They are represented by a trustee (‘the Trustee’). The Trustee can be removed by a majority vote of the note-holders without cause, receives fixed remuneration and has been assessed to act as an agent for the note-holders under IFRS 10. The Trustee is not a related party of the Corporate, Bank or note-holders.
  • As long the Corporate and Bank perform under the Structured Notes and the Swap respectively, there is no need (or permission required) for any party to direct the SE’s activities. The SE will use the cash receipts from the Structured Notes, net of the cash paid or received under the Swap, to service the Plain Notes issued to the market. The SE does not require other activities.
  • The Plain Notes are not guaranteed by either the Bank or the Corporate. However, if the Plain Notes default, the Trustee appointed by the note-holders could seize the assets of the SE and seek payment from the Corporate on the underlying Structured Notes to recover the monies due on the Plain Notes. If the Swap is in a net receivable position from the SE, the Bank can also seek to recover its net receivable position from the assets of the SE. In such a case, the Bank’s claim ranks senior to that of the note-holders.
  • If the Bank defaults while the swap is in a payable position to the SE, the Trustee of the note-holders also has the ability to claim from the Bank on behalf of the note-holders.
  • The Structured Notes give rise to both credit risk (the risk that the Corporate and hence the SE will default) and variability due to the structured coupon. Assume for the purposes of this example that both are significant.

Control in debt restructuring in Structured entity

Analysis under IFRS 10 Control in debt restructuring in Structured entity

Does the SE have relevant activities? Control in debt restructuring in Structured entity

After the SE is set up, no decisions can or will be made unless the Corporate defaults. If the Corporate defaults on the Structured Notes, the SE will default on the Plain Notes. The Trustee of the notes in such cases has the ability to seize the assets of the SE and decide how to recover monies from the Corporate.

Although this decision is based on a contingent event, this does not prevent it from being a relevant activity [IFRS 10 B53]. This decision can potentially affect the returns of the SE significantly if the contingency arises. The SE therefore has relevant activities.

Who controls the SE? Control in debt restructuring in Structured entity

There are a number of factors that need to be assessed in order to identify which party controls the SE and thus consolidates it. Each party is assessed in turn below using the three factors necessary for control in IFRS 10:

  • power, Control in debt restructuring in Structured entity
  • exposure to variable returns, and Control in debt restructuring in Structured entity
  • the ability to use power to affect returns.

The Trustee is assessed as acting as an agent in this circumstance and has not been considered further in the analysis of control.

Assessment of being in control of the Corporate Control in debt restructuring in Structured entity

IFRS 10 Factor

Assessment

Power

The Corporate was involved in the design of the SE at the inception of the transaction and ultimately is the initiator of the transaction; this may indicate that the Corporate has power or had the opportunity to obtain rights that would have given it power over the SE. However IFRS 10 B51 states that: “..being involved in the design of an investee alone is not sufficient to give an investor control…”

Furthermore, IFRS 10 BC 77 supports this notion, given that there are several parties (Corporate, Bank and Trustees) involved in the design of the SE and final structure. We would therefore need to look to other rights that may give the Corporate power in this circumstance.

It could be argued that the SE’s activities are conducted on behalf of the Corporate for the purpose of raising funds. The SE was designed to conduct activities that are closely related to the Corporate; the Corporate therefore has direct involvement in the relevant activities of the SE. An important point is that if the Corporate did not exist, the SE would not exist, indicating that there may be a ‘special relationship’ between the Corporate and the SE [IFRS 10 B19(b) – (c)]. However, IFRS 10 B19 notes that the existence of an indicator of a special relationship does not necessarily mean that the power criterion is met. It can also be argued that the SE has a special relationship simultaneously with the note-holders and the Bank. The ‘special relationship’ indicator is not therefore sufficient to determine that the Corporate has power over the SE.

Despite the indicators that the Corporate may have been able to give itself power, the Corporate has no ongoing power over the relevant activities of the SE. There are no conclusive indicators that the Corporate has power. So in the absence of other indicators, the Corporate does not have power over the SE.

Exposure to variable returns

The Structured Notes issued by the Corporate and held by the SE create rather than absorb variability in the SE because:

  • the Corporate becomes a debtor of the SE, hence exposing the SE to the Corporate’s credit risk; and
  • the coupons of the Structured Notes are variable based on the underlying index, creating further variability for the SE.

As the Corporate has no other interests in the SE, the Corporate is not exposed to the variability of the returns generated by the SE [IFRS 10 B56]. This is further supported by IFRS 12 B9, which states: “Some instruments are designed to transfer risk from a reporting entity to another entity. Such instruments create variability of returns for the other entity but do not typically expose the reporting entity to variability of returns from the performance of the other entity.”

The Corporate is not therefore exposed to variable returns in the manner envisaged by IFRS 10 B55 – B56.

The ability to use power to affect returns

N/A the Corporate has no power (see factor Power above).

Conclusion

The Corporate has neither power nor exposure to variable returns; the Corporate does not control the SE.

Assessment of being in control by the Bank Control in debt restructuring in Structured entity

IFRS 10 Factor

Assessment

Power

Similar to the corporate, the Bank is a key party involved in the design of the SE at inception. However, the presence of this indicator alone is not sufficient to conclude that the Bank has power over the investee.

It can be argued that the relationship between the Bank and the SE is also special, in that the SE has been set up to allow the Bank to engage in a swap [IFRS 10 B19(c)]. However, IFRS 10 B19 also indicates that the existence of such an indicator of a special relationship does not mean that the power criterion is met.

The bank is also exposed to some variability of the SE (see returns factor below). IFRS 10 B20 states that a large exposure to variability of returns is an indicator that an investor may have power. However, IFRS 10 B20 also states that this factor, in itself, does not determine whether there is power (and indeed, the note-holders are also exposed to variability – see factor below).

The analysis suggests that the Bank has incentives to obtain power, but power is not ‘deduced’, absent further evidence of such power.

One factor that suggests the Bank has power is that the Bank has asset-recovery powers in the event that the SE defaults (for example, if the structured notes default) when the swap is a receivable from the SE. However, the exposure of the Bank in such situations is likely to be small (see ‘Returns’ section below), and correspondingly, the extent of power it can exercise is likely to be limited compared to the power exercisable by note-holders to recover their much larger exposure from the Plain Notes. The senior status of the swap also suggests that the purpose and design was to transfer credit risk exposure and associated powers to the note-holders, not the Bank. The Bank therefore appears to have protective rights to protect its interests, rather than power over relevant activities [IFRS 10 B27].

The Bank therefore fails the power criterion in IFRS 10 7(a) on the grounds that the Bank does not have substantive rights that allow the Bank to direct those activities of the SE that have the greatest impact on the SE’s returns [IFRS 10 13].

Exposure to variable returns

The Bank is exposed to variable returns given the nature of the Swap. The Swap is designed to absorb some of the variability in relation to the SE’s returns, as it absorbs the variability inherent in the index that is included in the structured coupon and exchanges it for a fixed amount.

Our view is that certain plain vanilla derivatives may contribute rather than absorb variability or may be ‘typical customer supplier relationship’ in the definition of ‘interest’. This would imply that such derivatives do not constitute ‘interests’ and do not therefore give rise to exposure to variable returns. However, the Swap is not a ‘plain-vanilla derivative’ or a ‘typical customer supplier relationship’, as the Bank was involved in setting up the SE to whom it issued this Swap, with the objective of transferring the SE’s specific exposure to index variability to the Bank.

In addition, if the Bank was owed monies under the swap agreement on the occurrence of default, it would be exposed to the risk of loss (credit risk). However, its exposure to credit risk is limited because

  • the swap is settled regularly so the amount outstanding is likely to be relatively small,
  • the Bank may owe money under the Swap rather than be owed an amount by the SE, and
  • the Bank would be paid before the note-holders.

There is therefore some support to indicate that the Bank is exposed to some variability in returns, primarily via absorbing the variability associated with the structured coupon on the notes.

The ability to use power to affect returns

N/A the Corporate has no power (see factor Power above).

Conclusion

The Bank does not appear to have power over the SE; it does not therefore control the SE.

Although the Bank does not control the SE, it holds an interest in an unconsolidated structured entity. The Bank should therefore make the disclosures required by IFRS 12 24 – 31.

Assessment of being in control by each note-holder Control in debt restructuring in Structured entity

IFRS 10 Factor

Assessment

Power

The SE is economically dependent on note-holders to finance its operations [IFRS 10 B19(b) (i)], which indicates a ‘special relationship’ may exist between the note-holders and the SE. However, the fact that there is an indicator of a special relationship does not necessarily mean that the power criterion is met.

The note-holders are also exposed to variability (see next factor Exposure to variable returns). A large exposure to variability of returns is an indicator of power. However, this exposure in itself does not determine whether the investor has power. Further, all note-holders, as well as the Bank, have exposure. This indicator is not therefore conclusive in determining who should consolidate.

The Trustee, acting as agent of the note-holders, has powers upon default by the Corporate. However, due to the diverse and unrelated nature of the note-holders, and the fact that a majority vote is required to remove the Trustee, none of the note-holders have the unilateral power to direct the Trustee or its powers over the SE. The Trustee’s powers cannot therefore be attributed to any individual note-holder. This is consistent with IFRS 10 B59, which states that when an agent acts for multiple principals, each of those principals still needs to assess whether it has power.

The individual note-holders are therefore unlikely to have power.

Exposure to variable returns

Each note-holder has exposure to significant downside variability, as this relationship has been designed so they absorb most or all of the variability arising from a default by the Corporate. On such a default, the only other party that may be owed amounts by the SE is the Bank; but its exposure to credit risk is limited as:

  • the swap is settled regularly so the amount outstanding is likely to be relatively small,
  • the Bank may owe money under the Swap rather than be owed an amount by the SE, and
  • the Bank would be paid before the note-holders.

The ability to use power to affect returns

N/A the Corporate has no power (see factor Power above).

Conclusion

None of the note-holders individually has sufficient power to constitute control. If one note-holder had the power to direct the trustee unilaterally, a different analysis may result.

Although the note-holders do not control the SE, they hold an interest in an unconsolidated structured entity. The note-holders should therefore give the disclosures required by IFRS 12 24 – 31.

Overall conclusion Control in debt restructuring in Structured entity

None of the parties consolidates the Structured Entity. Control in debt restructuring in Structured entity

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