Control Structured entity with Credit-linked notes

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 Structured entity with Credit-linked notes

THE CASE – Assessing control of an issuer of credit-linked notes with limited activities and derivatives that enhance risk

Background and purpose Control Structured entity with Credit-linked notes

A credit-linked note structure may be set up for various reasons, the most common being: to enable a bank to obtain credit protection on loans it holds; and to enable a bank to create marketable securities of a particular risk profile that are attractive to investors. The bank will earn fees from creating and marketing the structure.

Facts Control Structured entity with Credit-linked notes

  • Bank sets up a structured entity (SE), and enters into a credit default swap (CDS) with the SE, for which it pays the SE a premium at market rates. Under the CDS, if a stipulated commercial debt security (‘the Risky Asset’) defaults, the SE will pay to the Bank the par value of that security. Any liability of the SE to the Bank in respect of the CDS has priority to all other liabilities of the SE.
  • Shares of the SE, which are held by independent third parties (for example, a charitable trust), have no significant decision-making rights due to the restrictions imposed by the contractual agreements.
  • SE invests in AAA bonds whose maturity matches that of the CDS and the notes issued by the SE (see next bullet point). In the event that the AAA bonds are downgraded below AAA, the Trustee is required to sell the bonds and buy replacement bonds with an AAA rating.
  • SE issues a single tranche of credit-linked notes (‘the Notes’) to a large number of dispersed, unrelated investors (the ‘note-holders’), which do not form a reporting entity. No individual note-holder owns more than 5% of the notes. The returns on the Notes are linked to the returns from the AAA bonds and the payments on the CDS. The note-holders are represented by a Trustee, which can be removed by a majority vote of the note-holders without cause. The Trustee receives a fixed level of remuneration that is consistent with market rates for its level of services. The Trustee has been assessed to act as an agent for the note-holders under IFRS 10. This example does not therefore consider the requirements for agent/principal in IFRS 10.
  • The SE’s liability in respect of the Notes is limited to the par amount adjusted for CDS receipts/payments. If the SE is not able to repay the notes in full due to a credit event on the CDS, it does not constitute a legal default by the SE (that is, debt holders cannot take actions against the SE such as seizing its assets, placing the SE under liquidation, etc.).
  • However, a default on the notes will arise if the SE is not able to repay the notes due to default of the bonds. If this occurs, both the Bank (if the CDS is a net receivable from the SE) and the note-holders as a group, as represented by the Trustee, have normal powers under bankruptcy laws (for example, seizure of assets, liquidation of SE, etc.) to recover any amounts due from the SE.

Control Structured entity with Credit-linked notes


Analysis under IFRS 10 Control Structured entity with Credit-linked notes

What are the SE relevant activities? Control Structured entity with Credit-linked notes

The following relevant activities exist within the SE: Asset-replacement decision in the event that bonds are downgraded; asset seizure and recovery powers on a default by the SE (for example, if the bonds were to default and amounts were due to the Note-holders and/or the Bank).

Although these decisions are based on contingent events, this does not prevent them from being relevant activities (IFRS 10 B53), and these decisions can potentially affect the returns of the SE significantly if the contingency arises. Accordingly, the SE does have relevant activities.

Who controls the SE? Control Structured entity with Credit-linked notes

There are a number of factors that need to be assessed in order to identify which party controls the SE and thus consolidates it. The Trustee is assessed as acting as an agent in this circumstance and has not been considered further in the analysis of control. Each party is assessed below.

Assessment of being in control by the Bank

IFRS 10 Factor

Assessment

Power

The following indicators suggest that the Bank has the opportunity and incentive to provide itself with power. However, these indicators do not by themselves provide the Bank with power:

  • The Bank was involved in the design of the SE at the inception of the transaction and is the initiator of the transaction; this gives the Bank the opportunity to obtain 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…”. This is not therefore conclusive.
  • The Bank has an implicit commitment to ensure that the SE operates as designed (IFRS 10 B54). However, IFRS 10 B54 also states that this indicator, by itself, does not give an investor power.

If both the Risky Asset and the AAA bonds default, the Bank has asset-recovery powers over the SE. The Bank therefore has some decision-making rights over the SE. However, the Bank has less decision-making rights than the Trustee for the note-holders (see below), which has power over asset seizure and recovery, as well as asset replacement in the event of the AAA bonds being downgraded.

When multiple parties have decision-making rights, the party that has the right to direct the activity that most significantly affects returns has power over the investee (IFRS 10 13). The Trustee is likely to be in a stronger position than the Bank to affect returns because:

  • the Trustee also has asset replacement powers; and
  • the credit risk that the Trustee needs to mitigate by exercising its recovery powers is more significant than the credit risk to which the Bank is exposed (see ‘Exposure to variable returns’ below).

The power criterion in IFRS 10 7(a) does not therefore support consolidation by the Bank.

Exposure to variable returns

The CDS principally contributes variability to the SE for the following reasons:

  • The CDS exposes the SE to losses arising from the Risky Asset − for example, if there is a credit event on the risky asset.
  • Although the CDS potentially subjects the Bank to SE’s credit risk, this risk is considered small relative to the risk contributed by the Risky Asset. This risk is further mitigated by the senior status of the CDS and the high quality of the AAA bonds.
  • The SE’s purpose in entering into the CDS is usually one of the following:
    • to mitigate the Bank’s exposure to the Risky Asset by transferring it to the SE; or
    • to improve returns to note-holders by transferring more risk (and returns) to the SE.

In both cases, a view of the CDS as contributor of variability will be more consistent with the purpose and design. For the purpose of assessing exposure to variable returns, it is irrelevant that the Bank’s exposure to CDS variability may be mitigated/ minimised by the Bank’s other assets/ liabilities (that is, whether or not the Bank holds the Risky Asset does not affect the analysis of control).

The CDS therefore principally contributes variability to the SE. As such, the Bank does not have significant exposure to variable returns of the SE.

The ability to use power to affect returns

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

Conclusion

The Bank does not control the SE, as the power criterion does not support consolidation and the Bank does not have significant exposure to variable returns (IFRS 10 B56).

Assessment of being in control by each note-holder

IFRS 10 Factor

Assessment

Power

The SE is economically dependent on the notes to finance its operations, which indicates that there may be a ‘special relationship’ between the note-holders and the SE (IFRS 10 B19(b)(i)). 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.

The note-holders have greater exposure to variability than any other party (see below), IFRS 10 B20 states that, having a large exposure to variability of returns is an indicator that the investor may have power. However, this paragraph also states that this is not conclusive, as the extent of the investor’s exposure does not in itself determine whether an investor has power over the investee.

The Trustee has the following powers:

  • collateral replacement rights in the event of a downgrade; and
  • asset seizure and liquidation rights in the event of a default on the AAA bonds.

As the Trustee is an agent of the note-holders, the question exists as to whether the above powers can be attributed to the note-holders. However, due to the diverse and unrelated nature of the note-holders, none of the note-holders has either the unilateral power to direct the Trustee or a substantive right to remove the Trustee. 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.

In the absence of any conclusive indicator of power, the individual note-holders are unlikely to have power.

Exposure to variable returns

The note-holders absorb the variability from the CDS (IFRS 10 B8), as well as from credit risk on the underlying AAA bonds (although the latter would be low). The structure is designed such that the note-holders absorb variability, as the loan notes are linked directly to the Risky Asset. The Note-holders are therefore exposed to variable returns from the SE.

The ability to use power to affect returns

N/A the note-holders have no power (see factor Power above).

Conclusion

The individual note-holders do not control the SE, as none has power over the SE. A different analysis may result if a single note-holder could unilaterally direct the trustee.

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 Structured entity with Credit-linked notes

None of the parties consolidates the Structured entity.

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