United States: FASB Temporarily Shelves 'Consolidation' Rulemaking Project

Under the most recent draft of the proposed rules, a financial institution engaged, directly or indirectly through an affiliate, in the management of one or more private investment funds might be required to consolidate on its books the assets and liabilities of such funds, with a corresponding minority interest balance reflected on its books, as well. As a result, such a financial institution might face additional regulatory obligations, including increased net capital requirements.

Under traditional accounting standards, a financial institution is not required to consolidate the balance sheet of a private investment fund it manages because in most cases it does not possess sufficient "control" over the managed fund. Current FASB rules define "control" as ownership by a parent entity of a majority interest in a subsidiary entity and, in the absence of majority ownership, require consideration of certain other factors generally not present in private investment fund structures. Thus, a parent enterprise is required to consolidate the balance sheet of a junior affiliate when it owns greater than 50% of such junior affiliate. Financial institutions, however, typically manage investment funds through one of two structures: (1) a subsidiary entity that serves, pursuant to the fund's operating agreement, as general partner or managing member of a fund organized as a domestic partnership or limited liability company; or (2) a subsidiary entity (or the financial institution itself) that serves as investment manager to a fund (e.g., an offshore corporation) pursuant to a management agreement. In neither case does the financial institution (or its affiliate, as the case may be) typically possess an ownership interest in the managed fund greater than 50% nor does it typically satisfy the other factors considered, and, therefore, in neither case will the financial institution be required to consolidate on its financial report the assets and liabilities of such fund.

The proposed new rules contemplate a shift to a more substantive test of control for determining whether or not consolidation is necessary. The Board has identified two essential characteristics of a control relationship: a parent entity's (1) exclusive decision-making authority and (2) its ability to use that authority to increase its benefits and limit its losses. Specifically, the Board defines "control" as "the non-shared decision-making ability of one entity to direct the policies and management that guide the ongoing activities of another entity so as to increase its benefits and limit its losses from that other entity's activities." Under this definition of "control", a financial institution engaged in the management of a private investment fund, either directly or through a subsidiary entity, may be required to consolidate. For example, an investment fund organized as a limited partnership will typically provide for the general partner to have the decision-making authority with respect to the assets of the partnership, and the general partner will exercise such authority in exchange for performance-based compensation. While the general partner's authority may be subject to certain limitations designed to protect the interests of the limited partners, FASB has described those limitations as merely constraining the general partner's non-shared decision-making ability and not as precluding control. FASB has also stated that a parent's ability to increase its benefits and limit its losses is found where a general partner receives a performance-based allocation of net profits of a partnership, notwithstanding a minimal ownership interest in such partnership. Thus, in the typical private fund structure, the more substantive test of control appearing in the draft proposal should result in consolidation of a private fund's assets and liabilities onto the balance sheet of the parent financial institution. Indeed, the current draft of the proposed rules creates a rebuttable presumption of control where the parent entity or its subsidiary is the only general partner in a limited partnership and no other partner or organized group of partners has the current ability to dissolve the limited partnership or otherwise remove the general partner.

The potential consolidation requirement presents a greater problem for large financial institutions that manage investment funds than it does for entrepreneurial managers. Financial institutions will have audited financial statements and, because of the breadth of their operations, are more likely to be subject to regulatory requirements such as net capital requirements. Conversely, an entrepreneurial manager is likely to be indifferent to the consolidation of an investment fund's assets and liabilities on its financial report.

One possible solution to the consolidation problem for large financial institutions is the interposition of an independent committee (approved periodically by the fund's investors) with the power to terminate the fund or terminate the agreement by which the financial institution or its affiliate manages the fund. In this way, the financial institution could credibly argue that it does not have the exclusive ability to manage the fund's activities.

Whether financial institutions will need to resort to new management structures remains to be seen. FASB has delayed announcement of final rules on consolidation repeatedly during the 19-year history of the rulemaking project. The Board had most recently planned to publish final rules on consolidation in the second quarter of this year; however, continued disagreement among Board members on several issues has prevented approval by the required five-member vote. In its announcement of the tabling of the project, the Board stated that it planned to have its staff reassess the proposed rulemaking over the next several months. The Board will then formally reconsider how to proceed with the project during the third quarter of this year.