New Rules For Off-Balance-Sheet Financing
In most infrastructure deals, a special-purpose company is formed to own the project. The project company often has more than one owner. The question comes up whether one of the owners — or even another participant in the transaction — must “consolidate” the project company, or include the financial results of the project company in a consolidated financial statement that the participant prepares for its own business. Consolidation can be a good thing if the project company has lots of earnings. However, more often than not, consolidation means having to show the debts of the project company as additional debt of the consolidated parent. Therefore, many project sponsors and investors look for ways to keep project companies off their balance sheets.
The accounting rules for when a project company must be consolidated and who must consolidate it became a lot more complicated last year. In late December, the Financial Accounting Standards Board, or FASB, issued a set of guidelines called FIN 46R in an attempt to pull together in one place the new standards for when consolidation is required.
The following is a conversation with Henry Phillips, an expert on the new rules with accounting giant Deloitte. Phillips heads the subject matter team at Deloitte on leasing, and he is also part of a team at Deloitte that fields questions about entity consolidation. He is in the Deloitte national office in Wilton, Connecticut. The questioner is Keith Martin.
MR. PHILLIPS: The title of FIN 46 is “consolidation of variable interest entities.” It is best described as an alternative consolidation model.
MR. MARTIN: Let me come back to what is a “variable interest entity” and why FIN 46 provides an “alternative” consolidation model — alternative to what — but first, is it the case that every special-purpose entity must be consolidated with someone?
MR. PHILLIPS: No. It is common today, and it will be common after the issuance of FIN 46, for certain entities not to be consolidated by anyone. The traditional rule was that an entity had to be consolidated with whomever has control over the entity in the sense of possessing a majority vote. In a traditional voting model, in cases where no one had a majority of the voting stock, no one consolidates. In FIN 46, FASB said that this rule no longer applies to companies it calls “variable interest entities.” In the case of such companies, the decision who has to consolidate is more complicated. In such cases, if no one has the majority of the expected losses of the entity or a majority of the residual returns, then no one will consolidate.
MR. MARTIN: So now we still have the traditional model for some entities and a new rule for variable interest entities. How does one tell whether he has a variable interest entity so that the decision who must consolidate is governed by the new rules?
MR. PHILLIPS: There are several tests for identifying variable interest entities. It might be easier to approach this backwards. It is easier to tell whether one has a “voting entity” that remains governed by the old rules.
In order to qualify as a voting entity, the entity must have equity sufficient to finance its operations without any support from other entities. In addition, the equity holders, as a group, must have the ability to control the venture or the entity. They must also have the obligation to absorb expected losses if they occur, and they must have the right to receive residual returns if they occur.
MR. MARTIN: So equity holders as a group must retain both the downside risks and the upside benefits ...
MR. PHILLIPS:... and the ability to control the entity.
MR. MARTIN: A voting entity must have sufficient equity to finance its operations. What if the owners are required to make ongoing capital contributions — for example, to cover any operating cost deficits? Does it have sufficient equity in that case?
MR. PHILLIPS: Those future funding commitments at the inception of a transaction do not qualify as equity at risk for FIN 46 purposes.
MR. MARTIN: So the entity needs all of the equity it anticipates it will need fully funded at the start? Over what time period? Does it need to be fully funded for 10 years worth of future needs or ...
MR. PHILLIPS: It needs all its equity fully funded. You first apply the test on the effective date of FIN 46 for existing entities or, for new entities, when an investor or sponsor first has to decide whether to consolidate.
MR. MARTIN: So basically the test is that as of today you don’t expect the entity to have to go back into the market to raise more capital.
MR. PHILLIPS: That’s right.
MR. MARTIN: So these are tests to identify what is a voting entity. If one has such an entity, what is the test for whether someone must consolidate it?
MR. PHILLIPS: Then you would apply a traditional consolidation model, which is if someone has a majority of the voting stock, he would be required to consolidate.
MR. MARTIN: And everything else is a variable interest entity, or is this just a way of narrowing the potential class?
Business Scope Exception
MR. PHILLIPS: If an entity does not qualify as a voting entity, then it will be within the scope of FIN 46. There are other scope exceptions to FIN 46 — for example, for certain employee benefit plans and for certain separate accounts of life insurance companies — that take some entities out of FIN 46 and put them back under the traditional voting model. The most significant of these exceptions is the “business scope exception.”
MR. MARTIN: What fits in the business scope exception? It sounds like it should be entities that qualify as standalone businesses. Is that the only test?
MR. PHILLIPS: Basically yes. However, unfortunately, what is a business is not very clearly defined in the accounting literature. A business is a self-sustaining integrated set of activities and assets conducted and managed for the purpose of providing a return to investors. It consists of inputs, processes and outputs to generate revenue.
MR. MARTIN: Suppose several power companies set up a special-purpose company to own a single power plant. Is that special-purpose company a “business” and, therefore, does it fit in the business scope exception, and is the consolidation test for it strictly who has a majority of the vote?
MR. PHILLIPS: It could be a business or it could be a variable interest entity. You need to dig more deeply into the facts and circumstances. I have seen situations in the past where a single power plant does qualify as a business.
MR. MARTIN: Can you give me an example where it would not be a business?
MR. PHILLIPS: We probably need to go back and talk about the fact that the business scope exception cannot be applied with a broad brush. There are other caveats to application of the business scope exception. If the reporting enterprise provided more than half of the total equity, subordinated debt or other forms of financial support to the entity, based on an analysis of fair value of those interests, then the business scope exception is not available to that reporting enterprise.
MR. MARTIN: Stop there. The business scope exception is not as simple as if I have a business, then the test for consolidation is strictly vote? There are exceptions where the fact that the special-purpose entity is a standalone business is not enough?
MR. PHILLIPS: That’s right. You need to look further to make sure you are not barred from using the business scope exception. I think the other common exception in the power industry is if the entity is designed so that substantially all the entity’s activities either involve or are conducted on behalf of the reporting enterprise. In that case, the business scope exception is not available to that reporting enterprise. An example is where a strategic investor that has an equity stake in a project company is also providing more than half the total financial support to the project company. Suppose the strategic investor is a utility. It has a long-term power sales contract with the project company to buy 100% of the electricity from the project. In that case, I think you would conclude that the project company is conducting its activities on behalf of the utility strategic investor. The business scope exception would not be available.
MR. MARTIN: So there are two situations where the business scope exception is not available, even though the project company is a standalone business. Again, if one fits in the business scope exception, then one would look at the vote to determine who must consolidate the project company. The two main exceptions where the business scope exception is not available are, number one, a company that provides more than half the total financial support could not claim the business scope exception and, number two, a company on whose behalf substantially all of the project company’s activities are conducted could not claim it either.
MR. PHILLIPS: The financial support can take the form of equity, debt or other forms of guarantees.
MR. MARTIN: Then why wouldn’t a lender who lends —say — 80% of the cost of the project have to consolidate with the project company, particularly where the loan is made on a nonrecourse basis?
MR. PHILLIPS: A lender could be required to consolidate a project company. That brings up a very good point, and that is historically only equity participants have been required to consolidate entities.
Under the FIN 46 model, the variable interest model, whichever party is exposed to a majority of expected losses of the entity would be required to consolidate it. Thus, for example, if a lender supplied all the subordinated debt, and that debt accounted for 80% of the total financing, it might be required to consolidate the entity.
Variable Interest Entities
MR. MARTIN: I was going down a path of probing when the business scope exception would not bring one back under the traditional rule of consolidating on the basis of who has the majority voting rights. Let me move to the next question. Suppose one can’t get under the traditional rule. The project company is not a voting entity. And the business scope exception is not available. Thus, one is thrown under FIN 46. In that case, what is the test for whether consolidation is required and with whom consolidation is required?
MR. PHILLIPS: So we have determined that a project company is a variable interest entity. In that case, the first question to ask is whether any of the reporting enterprises — the owners of the project company and other participants in the transaction who are wondering who must consolidate with the project company — is expected to absorb a majority of the expected losses from the project company. If yes, then that person must consolidate the project company.
If no single party is expected to have to absorb a majority of the expected losses, then the focus shifts to whether someone has a right to a majority of the residual returns of the project company. In other words, the focus is to look first at who bears the downside fluctuations in cash flows, and then it shifts to who would benefit from the upside.
MR. MARTIN: What makes returns “residual”? They are left over after what?
MR. PHILLIPS: FIN 46 talks about expected losses and residual returns. Expected losses are the downside cash flow deviations from the mean.
MR. MARTIN: The “mean” is what was expected?
MR. PHILLIPS: Right. And residual returns are the upside variability from the mean.
MR. MARTIN: So the question is, if there is greater loss than expected or greater profit or return than expected, who gets it.
MR. PHILLIPS: That’s exactly right. If expected losses are sufficiently dispersed amongst parties such that no one party holds the majority of the expected losses, then you look at residual returns.
MR. MARTIN: Then let’s go back to the power industry example. A special-purpose entity owns a power plant, and there are several owners of the special purpose entity. Let’s say it is a partnership or LLC with several owners. It has a contract to supply power to a utility. It has also borrowed a lot of money on a nonrecourse basis. The issue is with whom must that special-purpose entity consolidate for reporting purposes. And I guess it turns first on whether it is a voting entity.
MR. PHILLIPS: Correct.
MR. MARTIN: You went through four tests to decide whether it is a voting entity, and the main one seems to be whether it has enough equity to satisfy its needs or whether it will have to rely on the partners to contribute more capital going forward or raise more capital in the market.
MR. PHILLIPS: Correct.
MR. MARTIN: Now, if we conclude that the project company is a voting entity, then it consolidates with whomever holds the majority of the vote. It is that simple?
MR. PHILLIPS: That’s right.
MR. MARTIN: If the project company is not a voting entity, then we must ask whether we fit in the business scope exception, which pulls us back under the voting model?
MR. PHILLIPS: Right.
MR. MARTIN: That’s when things became complicated. On the one hand, this special-purpose project company looks like a standalone business but, at the same time, you said that that’s not enough because if there is someone who provides more than half the total financial support or on whose behalf substantially all of the project company’s activities are conducted, then the business scope exception is not available and one must use the tests in FIN 46 to decide who consolidates.
MR. PHILLIPS: Correct.
MR. MARTIN: So let’s acknowledge that, in the typical power project, most of the financial support comes from the bank that supplies the money on a nonrecourse basis. Doesn’t that necessarily take one out of the business scope exception for the typical power project?
MR. PHILLIPS: It may take the financial institution outside the business scope exception, but it may not deny the business scope exception to an equity participant.
MR. MARTIN: That is a very important point. I thought one looked at the project company itself to determine whether the business scope exception applies. Now you seem to be looking at the participants to see whether each of them can use it. What gives?
MR. PHILLIPS: It is applied at the level of the reporting enterprise.
MR. MARTIN: Then going back to the determination whether the project company is a voting entity, does one look at the reporting enterprise or at the project company?
MR. PHILLIPS: The reporting enterprise must determine whether the business scope exception puts it back under the traditional voting model for that entity.
MR. MARTIN: Take a step back. When one is deciding whether a project company is a voting entity or a variable interest entity, is the focus on the project company or on the reporting enterprise — that is, on the person who is trying to decide whether he must consolidate the project company?
MR. PHILLIPS: In terms of which consolidation model to apply, the focus is on the special-purpose entity.
MR. MARTIN: So only with the business scope exception is the inquiry up at the participant level.
MR. PHILLIPS: That’s right.
MR. MARTIN: And what question must the participant ask to determine whether the business scope exception lets him consolidate or not on the basis of voting rights?
MR. PHILLIPS: The question is whether the special-purpose entity can qualify as a business on a standalone basis. However, even if the answer is yes, it can, the business scope exception is unavailable to that reporting enterprise — or participant — if the reporting enterprise provided more than half the total financial support or substantially all the activities of the project company are conducted on behalf of the reporting enterprise. FASB has said it will not allow that reporting enterprise to claim the business scope exception because it is too closely involved with the project company.
MR. MARTIN: Therefore, you may have some participants deciding whether to consolidate the project company based on vote and others doing so based on how expected losses or residual returns are shared.
MR. PHILLIPS: That’s right.
MR. MARTIN: How can that be? Then you could have consolidation with more than one entity.
MR. PHILLIPS: I think that potential may exist. However, the hope is that only one reporting enterprise will have to consolidate the entity.
MR. MARTIN: Come back then to the power plant model. There are two main situations where a participant in a deal cannot assert that the business scope exception lets it decide whether to consolidate based on who has the majority vote. One is where the participant provides more than half the total financial support for the project company and the other is where substantially all of the activities of the project company are conducted on behalf of that participant.
MR. PHILLIPS: There is no bright line to determine what is “substantial,” but I would say it is more than 90% of the activities.
MR. MARTIN: Are substantially all the activities conducted on behalf of a utility that buys 100% of the electricity output?
MR. PHILLIPS: It is a highly subjective test. The best example of activities conducted on behalf of a participant may be an affordable housing project where the general partner is in the business of developing real estate and the limited partner is investing mainly for the tax benefits. The question is whether substantially all the activities are conducted on behalf of one of the parties. Most accountants have concluded the answer is no because both partners have a purpose for being in the transaction.
MR. MARTIN: Focusing still on the power project where you have a bank supplying 80% of the financing on a nonrecourse basis, the bank may not have to consolidate the project company. Here is the analysis. The project company is not a voting entity. The bank cannot use the business scope exception. Therefore, the question whether to consolidate is decided under the variable interest rules. Under those rules, the bank does not have to consolidate because it does not bear a majority of the expected losses — or does it?
MR. PHILLIPS: It is unlikely that a bank would have to consolidate. When the bank makes a loan, it does so on the basis of a cash flow model that suggests that the loan will be repaid even in a worst case scenario. It also requires that the project company be sufficiently capitalized so that the equity would bear the majority of the expected losses.
MR. MARTIN: There is a margin for error leaving room for unexpected losses to be absorbed by the equity.
MR. PHILLIPS: A bank would not normally lend into a transaction where it is expecting to bear a majority of the losses.
MR. MARTIN: And what about a utility that buys all the output from the power project? It is possible that substantially all the activities of the project company are considered conducted on behalf of the utility. Therefore, the utility cannot use the business scope exception to argue that consolidation should be determined strictly on the basis of who has the majority vote. However, at the same time, the utility does not have to consolidate because, under FIN 46, it’s likely that the utility will not bear a majority of the expected losses from the project.
MR. PHILLIPS: Right. But be careful because, in some transactions, the utility offtaker might also be an equity participant in the transaction or be a guarantor of the debt. In such cases, the analysis is more complicated.
MR. MARTIN: I can see bad facts arising. What if the power contract has a tracking account where the utility overpays for electricity in the early years with the expectation that it will recover the overpayments in later years?
MR. PHILLIPS: It becomes a tougher case. If the project were to fail and the project go into bankruptcy, the utility might lose the balance in the tracking account. The utility has potentially a significant variable interest in the project company.
Operating Joint Ventures
MR. PHILLIPS: There is one other exception to the business scope exception that we should talk about. If the reporting enterprise participated significantly in the design of the entity, then the business scope exception is not available to that reporting enterprise unless the entity is either an operating joint venture or a franchisee.
MR. MARTIN: What does it mean to participate in the design? What is an example?
MR. PHILLIPS: Suppose a new project company is formed. It has a power company and a financial investor as the partners. They were both actively involved with forming the entity and negotiating the operative documents in the transaction. Both partners would have participated significantly in the design of the entity. That means neither can rely on the business scope exception. They are both thrown under FIN 46 when deciding who has to consolidate the entity. But there is a way out. If the project company is considered a joint venture entity, then they are back under the voting model to decide who consolidates.
MR. MARTIN: What does it mean to be an operating joint venture?
MR. PHILLIPS: Let’s just go through the analysis. We conclude that the project company is a standalone business. However, both of the partners participated significantly in designing the entity. Thus, at first glance, it looks like neither can claim the business scope exception that would let the decision whether to consolidate turn solely on who has the majority vote. But the company is an operating joint venture. That throws it back into the voting rights model. It is an operating joint venture because each of two partners has 50% of the vote.
MR. MARTIN: To have an operating joint venture, the partners have to share equally in voting rights? What happens if there are three partners?
MR. PHILLIPS: Joint venture typically means no one party controls. If you have two partners, the vote would have to be 50-50. If you have three, the vote would have to be a third, a third, a third.
MR. MARTIN: And “operating” must mean it runs a real business; it is not just collecting rents or dividends?
MR. PHILLIPS: That’s right.
MR. MARTIN: And if you have an operating joint venture, then you are back in the voting rights model.
I am starting to appreciate why accountants like those decision-tree diagrams with lots of arrows and questions. If the answer is “yes,” then it leads to another question with arrows splitting off “yes” or “no” from it. The diagrams look like electrical circuitry.
If you have an operating joint venture, by definition, no one controls the vote, so is there consolidation of such entities?
MR. PHILLIPS: If such an entity qualifies as a voting entity, then no one would consolidate it. That’s why a number of project companies today are structured as operating joint ventures so that no one party consolidates the entity.
MR. MARTIN: It seems the key, at least keeping power plants as the focus, is one should be careful not to give anyone a dominant vote. If everyone has an equal say, then — by definition — the project is an operating joint venture, which then means the decision whether to consolidate can turn strictly on vote. And there would never be consolidation.
MR. PHILLIPS: That’s right.
Principals and Agents
MR. MARTIN: I heard you say in a speech last week that it is also important who in a transaction is a “principal” and who is an “agent.” Why are these labels important?
MR. PHILLIPS: The labels are important in some power plant transactions as well as some of the more common tax structures with affordable housing and synthetic fuel. These terms are only significant if you are under the variable interest model. Thus, we have concluded that we are under FIN 46. We do not have a voting entity. We have a variable interest entity.
The first thing you need to determine with a variable interest entity is whether any of the participants in the transaction is a related party. Related-party relationships are deemed to exist if a party cannot finance its operations without the support of a reporting enterprise. Someone who is an officer, employer or governing member of the board of a reporting enterprise is a related party. One of the more significant situations where a relationship may exist is where a reporting enterprise has agreed that it cannot sell, transfer or convey its interest in the project company without the prior approval of another participant in the transaction. That creates a de facto agency relationship.
MR. MARTIN: Again, why do I care whether someone is a principal and someone else is an agent?
MR. PHILLIPS: Let’s assume for a moment that there are transfer restrictions on our holdings, either equity or debt holdings in the project company. These transfer restrictions create a principal and agent relationship. FIN 46 requires that we figure out who is the principal and who is the agent. The principal must aggregate the agent’s interest as if it was also part of the principal’s holding in the project company.
This makes it more likely that the principal will have to consolidate the project company.
Suppose you have two equity participants and a bank that lent money to the project company. There are restrictions on the transferability of the equity instruments as well as on the debt instrument. One of the parties is the principal and the other two are agents. The principal will have to consolidate the project company because it would have to aggregate the other parties’ holdings.
MR. MARTIN: So we have established that there are related parties, at least how the accounting literature defines it. How does one then determine who is the principal and who is the agent?
MR. PHILLIPS: You must weigh several factors to determine if you are the principal or the agent. In addition to other criteria, you must assess the significance of the activities of the entity to the various parties in the related party group and the various parties’ exposure to the expected losses of the entity.
MR. MARTIN: The concepts are too abstract. Is it possible a utility buying all the electricity from a power plant is an agent or a principal of some other participant in that deal?
MR. PHILLIPS: That is possible. If you are the offtaker under a long-term power sales contract and there are transfer restrictions on the other debt and equity participants, you might conclude that, because the activities of the entity are more closely associated with your company because you are the only power company in the transaction, you may have to aggregate the other interests.
MR. MARTIN: The utility would be the principal in that case?
MR. PHILLIPS: The utility would be the principal and the primary beneficiary, and the primary beneficiary is the company that is required to consolidate the project company.
MR. MARTIN: Surely you would have to find more than just a transfer restriction and the fact that the utility is buying all of the output?
MR. PHILLIPS: True. Other indicators are given weight. Another important indicator is how much exposure each of the parties has to losses in the project company.
MR. MARTIN: In plain English, a principal is what — somebody who has such control over the entity that it really ought to be viewed as his?
MR. PHILLIPS: That’s right. This is really an anti-abuse provision that prevents companies from disaggregating their interests among members of a related-party group.
Wind Farms and Synfuel
MR. MARTIN: Just a couple other questions briefly: I believe I heard you say in a speech that the guarantor in an affordable housing project — somebody who guarantees that the equity investors will get a minimum return — must normally consolidate the project. Is that right?
MR. PHILLIPS: Right. I think that would normally be the case.
MR. MARTIN: And if, in a wind farm, there was a guarantor who guaranteed the equity investors a minimum return, the guarantor would end up consolidating the operations of the wind farm, including the debt.
MR. PHILLIPS: I think there is a high likelihood that the guarantor would have to consolidate because when you go through the expected losses, if anybody is expected to lose in that transaction, it is the guarantor.
MR. MARTIN: Does it matter what level the guarantee is? I assume there would be a tranche of losses that would have to be borne by the equity before the guarantor suffers.
MR. PHILLIPS: It turns on the facts and circumstances. If there was a tranche of loss that the equity would have to bear before the guarantee kicks in, then perhaps the equity would have to consolidate the project. Or, perhaps no one would be required to consolidate because the risk has been adequately dispersed.
MR. MARTIN: Who consolidates in synthetic fuel deals where the sponsor sells the project to an institutional equity for quarterly payments that are tied to the amount of tax credits?
MR. PHILLIPS: Those are interesting structures. In the pay-as-you-go structure, the investor puts in its cash as it takes out tax credits. FIN 46 is applied at inception. At inception, the institutional investor really would not have any money at risk. However, FIN 46 also goes on to talk about trigger points along the way where you have to reassess whether or not you must consolidate the entity. The trigger points in this case probably arise each time the investor puts more money into the deal. However, because the investor only puts in money as he takes out tax benefits, if anyone is going to consolidate, it is probably the sponsor, assuming he retains a small fractional interest as the operating partner.
MR. MARTIN: Last question — have you seen any change since Enron went bankrupt in people’s eagerness to keep things off balance sheet? Are they less eager to do so?
MR. PHILLIPS: Enron and the new standards that have been issued by the Financial Accounting Standards Board have not only focused attention on the recognition of certain assets and liabilities on a company’s balance sheet, but they have also led to enhanced disclosure of these types of transactions. I think they have been a significant deterrent to off-balance-sheet transactions. People are not pressing accounting distinctions as closely as they might have in the past.