Protective rights

Protective rights – 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.

Protective rights relate to fundamental changes to the activities of an investee or apply in exceptional circumstances, such as a hostile takeover (see below). However, not all rights that apply in exceptional circumstances or are contingent on events are protective. Because protective rights are designed to protect the interests of their holder without giving that party power over the investee to which those rights relate, an investor that holds only protective rights cannot have power or prevent another party from having power over an investee. In other words: Protective rights do not confer control onto the holder.

Protective rights include:

1. lender’s rights to restrict borrower’s activities that adversely affect its credit risk to the lender’s detriment;
2. rights of a non-controlling shareholder to approve exceptional capital expenditure or debt/equity issues; and
3. rights of a lender to seize assets upon default. (IFRS 10 B28)

Protective rights might include a right to vote on major transactions such as significant asset purchases or to approve borrowings above a specified level. Distinguishing between rights that give power and rights that are protective requires an understanding of the relevant activities of the entity.

Protective rights do not allow a minority shareholder or limited partner to participate in significant decisions expected to be made in the ordinary course of business, and thus do not overcome the presumption of control by the majority owner or the limited partner with a majority of kick-out rights through voting interests.

Effect of protective rights on an assessment of control

IFRS 10 defines the principle of control and establishes control as the basis for determining which entities are consolidated in the consolidated financial statements. An important element of control in IFRS 10 is power. The interpretation discussion related to protective rights and the effect of those rights on power over the investee.

The details of the example discussed were:

• The shares of an operating entity are all owned by one entity, the investor.
• The operating entity enters into a loan arrangement with a bank that contains several covenants. If a covenant is breached, the bank has the right to veto major business decisions (considered to be the relevant activities of the operating entity) and to call in the loan. The bank’s rights are considered to be protective. The investor continues to consolidate the operating entity.
• The entity breaches a covenant. What are the consolidation implications for the investor entity and for the bank? Who now controls the investee—the original investor or the bank?

Two interpretations could arise under IFRS 10:

• View A: when protective rights become exercisable, there is a change in facts and circumstances and the control assessment should be reassessed in accordance with IFRS 10 8. The staff noted that they viewed this is the interpretation that the IASB intended.
• View B: Protective rights can never affect an assessment of control. The Staff noted that IFRS 10 states that; (I) protective rights are designed to protect the interests of the holder without giving power and (ii) protective rights are defined in the Standard as not conferring power. This is the view that the submitter favoured and proposed.

Control and power in IFRS 10

One element of control is power over the investee and in IFRS 10 it states that power arises from rights and these rights can include contractual rights.  Contractual terms such as those contained in a loan agreement could affect an assessment of power.  Any change in the terms of the loan agreement could affect the assessment of control.

Only substantive rights and rights that are not protective are considered in an assessment of power in accordance with the guidance in IFRS 10 B9.  However, the nature of protective rights can change over time and in the above example on a breach.  A breach could trigger the change to a substantive right or at least to a right that could affect the control decision.

In IFRS 10 B26 there are two types of protective right; those that relate to fundamental changes to the activities of an investee and those that apply in exceptional circumstances.  The latter type of protective right would usually be subject to some trigger event that would change the holder’s rights or would give the holder additional rights to the protective right that was held.  These additional rights that should be assessed in the determination of control.

The control assessment is continuous.  So when a “trigger” occurred this would change the basis upon which one would either include or exclude rights from the continuous assessment.  This means that certain rights may now be included in the assessment of control that may not have previously been considered.  At this trigger point one would have to consider all of the current and actual rights as part of an assessment to determine control.  The key consideration is who has power and that the terms substantive right and protective right do not themselves equate to power in themselves but are components that one would consider in the continuous reassessment.

Setting the stage!

‘Protective rights’ is 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.’

Therefore an investor that only holds protective rights does not have power over an investee, neither can they prevent another party from having power over an investee.

Protective rights relate to fundamental changes to the activities of an investee or apply in exceptional circumstances. However, not all rights that apply in exceptional circumstances or are contingent on events are protective.

Because protective rights are designed to protect the interests of their holder without giving that party power over the investee to which those rights relate, an investor that holds only protective rights cannot have power or prevent another party from having power over an investee.

Substantive rights vs. Protective rights

When assessing whether an investor has power, the investor considers only substantive rights and not protective rights.

Substantive rights relate to relevant activities. Examples of substantive rights: Voting rights held by the majority shareholder giving it the current ability to unilaterally direct relevant activities Right of Non-controlling interest to approve or block decisions relating to the relevant activities

Protective rights relate to fundamental changes to the activities of the investee or apply in exceptional circumstances. Examples of protective rights: Right of NCI to approve capital expenditure greater than that required in ordinary course of business or approve the issue of debt or equity Right of the lender to seize assets of a borrower if the borrower defaults

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Example – protective rights and control

The board of directors of Pacific Plc have decided to dispose of a major subsidiary that accounts for a significant portion of their revenues and assets as they have decided to restructure the entity.

For this decision to be passed, it will require the approval of 75% voting rights held by shareholders.

One of the shareholders, Atlantic Plc holds a 15% stake in the group and has a “golden vote” (deciding vote). Atlantic Plc is unhappy with the proposed transaction.

Atlantic Plc can veto/block the decision (it has protective rights), it cannot make an alternate suggestion, therefore this is representative of Atlantic Plc having significant influence over Pacific Plc but not control.

What Is a Hostile Takeover?

A hostile takeover is the acquisition of one company (called the target company) by another (called the acquirer) that is accomplished by going directly to the company’s shareholders or fighting to replace management to get the acquisition approved. A hostile takeover can be accomplished through either a tender offer or a proxy fight.

The key characteristic of a hostile takeover is that the target company’s management does not want the deal to go through. Sometimes a company’s management will defend against unwanted hostile takeovers by using several controversial strategies, such as the poison pill, the crown-jewel defense, a golden parachute or the Pac-Man defense.

IFRS versus US GAAP

US GAAP	IFRS
Like IFRS, under the non-VIE model, protective rights are related to fundamental changes in the activities of an investee, or are rights that apply only in exceptional circumstances. As such, they cannot give the holder power or prevent other parties from having power and therefore control over the investee, like IFRS. [ASC 810‑10‑25‑10, 25‑38C]	PROTECTIVE RIGHTS are related to fundamental changes in the activities of an investee, or are rights that apply only in exceptional circumstances. As such, they cannot give the holder power or prevent other parties from having power and therefore control over an investee. [IFRS 10 14, IFRS 10 B26–B28]

Other IFRS and protective rights

IFRS 16 Leases: Protective rights: A supplier’s protective rights, in isolation, do not prevent the customer from having the right to direct the use of an identified asset in a lease contract. Protective rights typically define the scope of the customer’s right to use the asset without removing the customer’s right to direct the use of the asset. Protective rights are intended to protect a supplier’s interests (e.g., interests in the asset, its personnel, compliance with laws and regulations) and might take the form of a specified maximum amount of asset use, a restriction on where an asset may be used or a requirement to follow specific operating instructions.

IFRS 15 Evaluation alternative use: An asset may not have an alternative use due to contractual restrictions. For example, units constructed for a multi-unit residential complex may be standardized; however, an entity’s contract with a customer may preclude it from transferring a specific unit to another customer. Protective rights – e.g., a customer having legal title to the goods in a contract – may not limit the entity’s practical ability to physically substitute or redirect an asset, and therefore on their own are not sufficient to establish that an asset has no alternative use to the entity.
In the absence of a contractual restriction, an entity considers:

• the characteristics of the asset that will ultimately be transferred to the customer; and
• whether that asset, in its completed form, could be redirected without a significant cost of rework.

The focus is not on whether the asset can be redirected to another customer or for another purpose during a portion of the production process – e.g., up until the point where significant customization begins to occur. For example, in some manufacturing contracts the basic design of an asset may be the same across many contracts, but the customization of the finished good is substantial. Consequently, redirecting the asset in its completed state to another customer would require significant rework.

IFRS 11 Joint arrangements: ‘Relevant activities’ can be interpreted fairly broadly, but it can be aligned to the existing requirement in IAS 31 of ‘financial and operational decisions’ of a joint arrangement. Relevant activities essentially are the major decision-making rights, but they are not the types that provide a party joint control.

Protective rights