A structured entity is an entity that has been designed so that voting or similar rights are not the dominant factor in deciding who controls the entity, such as when any voting rights related to administrative tasks only and the relevant activities are directed by means of contractual arrangements. [IFRS 12 para B21].
A structured entity often has some or all of the following features or attributes:
- Restricted activities.
- A narrow and well-defined objective.
- Insufficient equity to permit the structured entity to finance its activities without subordinated financial support.
- Financing in the form of multiple contractually linked instruments to investors that create concentrations of credit risk or other risks (tranches). [IFRS 12 para B22].
Examples of entities that are regarded as structured entities include, but are not limited to, securitisation vehicles, asset-backed financings and some investment funds. [IFRS 12 para B23].
The phrase ‘some investment funds’ suggests that not all funds are subject to the disclosures in IFRS 12. However, the definition of a structured entity is broad, and this determination will require significant judgement. In many cases, the structure of an investment fund (for example, including decision-making rights conveyed through investment management or other agreements, or by non-participating voting shares, rather than through voting rights held by investors) might lead to a judgement that the fund is a structured entity.
Q1 Fund A is an open-ended investment fund that issues unit certificates with no voting rights attached. The relationship between the investment fund and the investors is defined by a contract. The investment manager can only be removed by the regulator in the case of fraud or insolvency in accordance with the laws applicable to the fund. The fund is able to invest in high-quality global equity and debt instruments. Is Fund A a structured entity?
Yes. Fund A is a structured entity, as the relevant activities are directed by means of the investment management contract. This conclusion is not impacted by the fact that a wide investment mandate exists, as the entity does not need to have all of the features in paragraph B22 of IFRS 12 in order to be a structured entity.
The definition of a structured entity in IFRS 12 is not the same as the definition of ‘special purpose entity’ in SIC-12. While the typical features might be similar to those of a special purpose entity, the ‘structured entity’ definition is focused on voting rights and the means by which control is conveyed. Consequently, a structured entity might, but is not required to, have any of the typical features described in paragraph B22 of IFRS 12.
Q2 Fund B is a private equity fund, whose limited partners are not permitted by law to vote or have any other involvement in the management of the fund. The investment manager manages Fund B through the investment management agreement and its status as general partner of the limited partnership. The limited partners cannot remove the investment manager other than for cause. Is Fund B a structured entity?
Yes. The investment manager manages the fund through the investment management agreement and its participation as general partner through the limited partnership agreement. The limited partners cannot remove the investment manager; nor can they vote to direct the investment decisions. Fund B is a structured entity, because the limited partners have no means of control.
Q3 Fund C is an open-ended investment fund that issues unit certificates. The investors meet periodically in unitholder meetings, during which they decide on major proposals of the investment manager, such as plans to merge the fund with others or to wind up. Ongoing decisions about the investing activities are made by the investment manager through the investment management agreement and are not subject to input by investors. Is Fund C a structured entity?
Yes. Fund C is a structured entity, because the relevant activities are directed by means of the investment management contract. The investors’ voting rights give them decision rights only in extraordinary situations. Therefore, the rights are protective in nature and do not give the investors power over the relevant activities of the fund.
Q4 Fund D is an open-ended investment fund that issues unit certificates. The investors meet frequently in unitholder meetings, during which they decide on the investment strategy of the fund and the appointment of the members of the management committee which approves the investment decisions of the investment manager. Is Fund D a structured entity?
No. The units give the investors a substantive right to vote on the principal management strategy of the fund and the ability to decide on the members of the investment committee, which oversees and approves the investment decisions of the investment manager. Consequently, the investors have voting rights which give them power to direct the relevant activities of the fund (that is, to control the fund), evidencing that it is not a structured entity.
Q5 Fund E is a large mutual fund whose unitholders have a vote; however, Fund E’s units are widely held and no annual general meeting is held. Decisions about the investing activities of the fund are made by the investment manager pursuant to an investment management agreement between it and the fund. Unitholders with a combined 75% of the units can table a motion to hold a meeting and vote to remove the investment manager at any time, but this has never happened in the past, and the right is not considered substantive under IFRS 10, because the large number of unitholders required is a significant barrier to exercise.
Unitholders can redeem their units at any time. Is Fund E a structured entity?
Yes. Even though Fund E’s unitholders have votes, the fact that they are not substantive indicates that the votes are not the dominant factor in deciding who controls the fund. Fund E’s relevant activities are directed by means of contractual arrangements (that is, the investment management agreement), so the fund is considered a structured entity.
A starting point to assess whether or not an investment fund is a structured entity might be to consider whether decisions about the relevant activities (such as the investing activities of the fund) are made through the investment management or other agreements rather than the units. Where the decisions are made through the investment management agreement, an assessment must be made as to whether or not the investors have substantive rights that give them the ultimate discretion over decisions being made about the relevant activities. If the unitholders do have power to approve or override the decisions of the asset manager, the fund is less likely to be a structured entity.
Q6 Fund F has only five limited partners, and they can remove the investment manager without cause by simple majority vote at any time. The investment manager has determined that the limited partners’ kick- out rights are substantive when it assessed whether or not it has power for the purpose of applying IFRS 10.
Can the kick-out rights be considered ‘similar rights’ to voting rights that are the ‘dominant factor’ in deciding who controls the entity, for the purposes of assessing whether Fund F is a structured entity?
Yes. It is possible for kick-out rights to be ‘similar rights’ to voting rights that are the ‘dominant factor’ in deciding who controls the entity; however, this will not always be the case, and significant judgement might be required.
Not all kick-out rights are the same, and they can be more or less substantive depending on their terms and the specific facts and circumstances that apply. Judgement will be required as to whether or not they are the dominant factor in assessing who controls an investment fund. This might be difficult because, in the principal–agent analysis, the judgement will often be based on a combination of economic interest and power. This means that some investment funds might be structured entities and others might not, and the presence or absence of substantive kick-out rights could be a key determining factor in some cases.
Q7 Fund G’s investment manager can be removed at any time through a majority vote of the independent board of directors. In addition, the board of directors can override investment decisions made by the investment manager at any time and without cause. The board of directors consists of five members who are appointed by the shareholders.
Can the rights of the independent board of directors be considered ‘similar rights’ to voting rights that are the ‘dominant factor’ in deciding who controls the entity?
Yes. In Example 14 of IFRS 10, the rights of the board of directors are considered substantive, and thus could be considered as ‘similar rights’ that could be the ‘dominant factor’ in deciding who controls an entity. If so, Fund G might not be a structured entity in accordance with IFRS 12.
Q8 Same fact pattern as Fund G in Q7, but the board of directors is appointed by the asset manager. The manager has the right to remove any of the board members at any time and without cause.
Can the rights of the board of directors be considered ‘similar rights’ to voting rights that are the ‘dominant factor’ in deciding who controls the entity?
No. The rights of the board of directors are not substantive, because the investment manager has discretion to appoint and remove its members, so the fund is a structured entity.
Q9 Fund H issues non-participating voting shares which are held by the investment manager and non-voting participating shares which are subscribed to by investors. The investors are not able to remove the investment manager or to vote on any investment decisions. Is Fund H a structured entity?
Yes. The voting shares convey power over the entity, but they do not provide any exposure to the variable returns thereof (that is, they not participating). As a result, the voting shares alone will not be the dominant factor in assessing who controls the fund, and consequently Fund H is a structured entity.
Q10 Limited Partnership I was set up by J Ltd (general partner) to buy and lease out a property. J Ltd holds 85% of the voting rights, and the remaining 15% are held by a limited partner. J Ltd is solely responsible for the management of Limited Partnership I. Limited Partnership I leases out the property to a lessee, who is not related to any of the partners, through a lease contract with a term of 15 years. The lessee has the option to purchase the property at the end of the lease term for CU6 million, and the expected fair value of the property at that date is CU8 million.
The relevant activity which most significantly affects the returns of Limited Partnership I is the management of the residual value of the property (that is, determining what to do with the property at the end of the lease term), over which the lessee is considered to have power through its purchase option. Is Limited Partnership I a structured entity?
Yes. Limited Partnership I is a structured entity, because it has been designed in a way that voting rights are not the dominant factor in deciding who controls the relevant activities. Despite the fact that Limited Partnership I could be set up using voting rights, the definition in paragraph B21 of IFRS 12 requires consideration of whether voting rights are the dominant factor when directing the relevant activities of the entity. The relevant activity of Limited Partnership I is the management of the residual value of the property, and the purchase option gives the lessee the power to direct this activity.