Effect of a Special-Purpose Entity's Powers to Sell, Exchange, Repledge, or Distribute Transferred Financial Assets under FASB Statement No.

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1 Topic No. D-66 Topic: Effect of a Special-Purpose Entity's Powers to Sell, Exchange, Repledge, or Distribute Transferred Financial Assets under FASB Statement No. 125 Dates Discussed: November 20, 1997; January 22, 1998 An FASB staff representative made the following announcement regarding the effect of a special-purpose entity's (SPE) powers to sell, exchange, repledge, or distribute transferred financial assets under FASB Statement No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. Paragraph 26 of Statement 125 prescribes that to be qualifying, an SPE must have a standing at law distinct from the transferor and its activities must be limited permanently by the legal documents that establish it to those activities permitted by paragraph 26(a). Selling, exchanging, or repledging transferred financial assets or distributing them to beneficial interest holders are not identified specifically as permitted activities. However, because many longstanding SPEs are, in some limited circumstances, empowered to sell transferred financial assets, the FASB staff has been asked questions about the impact, if any, that those limited powers to sell, exchange, repledge, or distribute should have on the qualifying status of an SPE. The FASB staff believes that an SPE that has limited powers to sell, exchange, repledge, or distribute (hereafter referred to collectively as sell) transferred financial assets under specified conditions can be qualifying (assuming that the other criteria in paragraph 26 of Statement 125 are met), but only if those powers are in response to a cleanup call as defined in Statement 125, or if all four of the following conditions exist: 1. Those powers and the conditions or events that permit them to be exercised are specified in and limited permanently by the legal documents that (a) establish the SPE or (b) initially Page 1

2 create the beneficial interests in the transferred assets that are subject to those powers. [Note: See Subsequent Developments section below.] 2. Those powers do not result in the transferor or its affiliates maintaining effective control over the transferred assets or over the sale of those assets. Situations in which a transferor or its affiliates maintain effective control over transferred assets include (a) when the transferor or its affiliates have the power, either directly or indirectly, to trigger a condition that enables the SPE to sell the transferred assets unless the triggering of the condition would have significant adverse consequences to the transferor or its affiliates (refer to Examples 1, 2, 3, and 4 in Exhibit D-66A) and (b) when the SPE is required to return transferred assets back to the transferor or its affiliates upon the occurrence of an event that at the time of the initial transfer is probable to occur unless that transfer back to the transferor would result in significant adverse consequences to the transferor or its affiliates. [Note: See Subsequent Developments section below.] 3. The primary objective of those powers is not to realize a gain in the fair value of the transferred assets above their fair value at the time they were transferred to the SPE (refer to Examples 1, 6, and 11 in Exhibit D-66A). Also, those powers do not permit the transferor, its affiliates, or the SPE the discretion to sell transferred assets to maximize the return to all or some portion of the beneficial interest holders (refer to Examples 5 and 9 in Exhibit D-66A). (Notwithstanding, this condition does not preclude beneficial interest holders other than the transferor and its affiliates from having the discretion to "put" their beneficial interests back to the SPE and, thereby, trigger the sale or distribution of the assets. Refer to Example 5 in Exhibit D-66A.) [Note: See Subsequent Developments section below.] 4. Those powers do not permit active or frequent selling and buying of assets (refer to Example 10 in Exhibit D-66A). [Note: See Subsequent Developments section below.] The powers of an SPE to sell transferred assets may affect whether those assets are isolated from the transferor or its affiliates under paragraph 9(a) of Statement 125. In addition, the provisions of this FASB staff announcement address circumstances in which the powers of an SPE to sell transferred assets may affect its "qualifying" status. This FASB staff announcement does not amend, in any way, the requirement that all of the applicable conditions of 9(a), 9(b), and 9(c) of Statement 125 must be met to obtain sale accounting. The Board decided previously that the accounting for a transfer of financial assets subject to a removal of accounts provision will continue to be based on the guidance in Issue No , "Effect of a Removal of Accounts Provision on the Accounting for a Credit Card Securitization," until the Board has the opportunity to reevaluate that decision subject to its Page 2

3 normal due process procedures. This FASB staff announcement does not affect that earlier Board decision. Reinvesting Proceeds Paragraph 26 of Statement 125 includes "collecting cash proceeds from assets held, reinvesting proceeds in financial instruments pending distribution to holders of beneficial interests, and... distributing proceeds to the holders of its beneficial interests" among the permitted activities of a qualifying SPE. Questions have been raised about how the word proceeds is used in that paragraph and about whether the activity of reinvesting proceeds includes selling or exchanging financial instruments. The FASB staff acknowledges that Statement 125 defines the term proceeds as "cash, derivatives, or other assets that are obtained in a transfer of financial assets, less any liabilities incurred" (paragraph 243). However, in the context of paragraph 26 of Statement 125, the FASB staff believes that the term proceeds describes the cash collections by an SPE that result from (1) holding the transferred assets, for example, from collecting contractually required payments of interest or principal and (2) selling transferred assets within the limits clarified in this FASB staff announcement. That interpretation would allow an SPE that can hold and temporarily invest cash reserves for liquidity and contingency purposes to be considered qualifying. That interpretation does not, however, permit an SPE that can sell those assets in which it has invested cash reserves for purposes of realizing a gain or otherwise maximizing the return to some portion of the beneficial interest holders (and, therefore, violating condition 3 above) to be considered qualifying. Nor does that interpretation permit an SPE that is empowered to actively manage its temporarily invested cash reserves by selling and reinvesting (and, therefore, violating condition 4 above) to be considered qualifying. Those activities require regular investment decisions and Page 3

4 are more indicative of ongoing business activities than the restricted activities of a qualifying SPE (refer to Example 10 in Exhibit D-66A). Transition The guidance in this announcement should be applied as follows: Transfers of financial assets made after February 5, 1998 (the date of the minutes of the January 22, 1998 EITF meeting) to SPEs that are not considered to be qualifying in accordance with this FASB staff announcement would not be accounted for as sales unless the conditions in paragraph 9(b)(1) (as well as the conditions in paragraphs 9(a) and 9(c)) of Statement 125 are met. However, if the SPE is "cured" by March 31, 1998 (as described below), those transfers would be accounted for as sales. (The SEC staff commented that an SPE that meets the conditions of paragraph 9(b)(1) of Statement 125 could not reasonably be considered "qualifying" and, therefore, could not be "cured" under the provisions of this FASB staff announcement. Refer to the Other Observations section below.) Certain SPEs that hold transferred assets on January 22, 1998 have previously not been consolidated by the transferor under the provisions of Issues No , "Impact of FASB Statement No. 125 on Consolidation of Special-Purpose Entities," and No. 97-6, "Application of Issue No to Qualifying Special-Purpose Entities Receiving Transferred Financial Assets Prior to the Effective Date of FASB Statement No. 125." Those SPEs are not required to be consolidated as a result of this FASB staff announcement, even though they are no longer qualifying SPEs. An SPE that did not hold transferred financial assets on January 22, 1998 and that would not be considered qualifying under this FASB staff announcement would be subject to the consolidation provisions of other pertinent generally accepted accounting principles, including the criteria for non-consolidation of an SPE in EITF Abstracts, Topic No. D-14, "Transactions involving Special-Purpose Entities," and Issue No , "Impact of Nonsubstantive Lessors, Residual Value Guarantees, and Other Provisions in Leasing Transactions," as appropriate. Curing a Nonqualifying SPE Paragraph 26 of Statement 125 requires that the activities of a qualifying SPE be permanently limited. However, only for purposes of initially adopting the provisions of this FASB staff announcement, an SPE can be considered qualifying if by March 31, 1998 activities permitted by its legal documents are changed so that any powers causing it to be nonqualifying are eliminated permanently (or "cured"). Page 4

5 Other Observations The Board plans to consider further the effect of an SPE's powers to sell, exchange, repledge, or distribute transferred financial assets on the accounting for transfers and to issue a proposed interpretation or amendment of Statement 125. Whether any resulting amendment or interpretation of Statement 125 would retain the views expressed in this FASB staff announcement is uncertain. In its deliberations of the proposed interpretation or amendment, the Board also expects to consider the interrelationship between what constitutes a qualifying SPE and the circumstances in which an SPE should be consolidated. [Note: See Subsequent Developments section below.] The SEC Observer indicated that the SEC staff continues to believe that Statement 125 explicitly limits the permitted activities of a qualifying SPE. Therefore, this FASB staff announcement, including the transition provisions, may not be applied to an SPE whose permitted activities at any time after December 31, 1996 clearly were outside the limited activities of a qualifying SPE as described in Statement 125 and as clarified in this announcement. For example, the SEC staff does not believe that an SPE that has the ability to frequently buy and sell transferred assets in order to maximize the return to beneficial interest holders or that meets the conditions of paragraph 9(b)(1) of Statement 125 (that is, it has the right free of conditions that constrain it from taking advantage of that right to pledge or exchange the transferred assets) reasonably could be considered to meet the restrictive criteria of a qualifying SPE. Subsequent Developments FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, was issued in September Statement 140 affirmed with modification the four conditions in this announcement. Page 5

6 As to condition 1, paragraph 35(b) of Statement 140 provides that a qualifying SPE s permitted activities must be significantly limited, be entirely specified in the legal documents that established the SPE or created the beneficial interests in the transferred assets that it holds, and may be significantly changed only with the approval of the holders of at least a majority of the beneficial interests held by entities other than any transferor, its affiliates, and agents. As a result, condition 1 is affirmed with modification. As to condition 2, paragraph 9(c)(2) of Statement 140 provides that the transferor maintains effective control over, and shall not derecognize, transferred assets if it has the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call. Paragraphs of Statement 140 provide that removal-of-accounts provisions (ROAP) that result in the transferor s maintaining control over specific assets include (a) an unconditional ROAP or repurchase agreement that allows the transferor to specify the assets that may be removed and (b) a ROAP conditioned on a transferor s decision to exit some portion of its business. As a result, condition 2 is affirmed with modification. As to condition 3, paragraph 35(d) of Statement 140 provides that if a qualifying SPE can sell or distribute noncash financial assets to parties other than the transferor, its affiliates, or its agents, it can do so only in response to one of the following conditions: 1. Occurrence of an event or circumstance that (a) is specified in the legal documents that established the SPE or created the beneficial interests in the transferred assets that it holds; (b) is outside the control of the transferor, its affiliates, or its agents; and that (c) causes, or is expected to cause, the fair value of those financial assets to decline by a specified degree below the fair value of those assets when the SPE obtained them (paragraphs 42 and 43) Page 6

7 2. Exercise by a BIH (other than the transferor, its affiliates, or agents) of a right to put that holder s beneficial interest back to the SPE (paragraph 44) Termination of the SPE or maturity of the beneficial interests in those financial assets on a fixed or determinable date that is specified at inception (paragraph 45). As a result, condition 3 is affirmed with modification. As to condition 4, paragraph 35(d) states that if a qualifying SPE can sell or otherwise dispose of noncash financial assets, it can do so only in automatic response to one of the following conditions: 1. Occurrence of an event or circumstance that (a) is specified in the legal documents that established the SPE or created the beneficial interests in the transferred assets that it holds; (b) is outside the control of the transferor, its affiliates, or its agents or would not result in their obtaining the transferred assets; and (c) causes, or is expected to cause, the fair value of those financial assets to decline by a specified degree below the fair value of those assets when the SPE obtained them (paragraphs 42 and 43) 2. Exercise by a BIH (other than the transferor, its affiliates, or agents) of a right to put that holder s beneficial interest back to the SPE (paragraph 44) 3. Exercise by the transferor of a call or ROAP specified in the legal documents that established the SPE, transferred assets to the SPE, or created the beneficial interests in the transferred assets that it holds (paragraphs and 82 85) 4. Termination of the SPE or maturity of the beneficial interests in those financial assets on a fixed or determinable date that is specified at inception (paragraph 45). As a result, condition 4 is affirmed with modification. FASB Interpretation No. 46, Consolidation of Variable Interest Entities, and FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities, address consolidation by business enterprises of variable interest entities, which include many special-purpose entities. Interpretation 46 and Interpretation 46(R) require a variable interest entity to be consolidated by an enterprise if that enterprise will absorb a majority of the entity s Page 7

8 expected losses or is entitled to receive a majority of the entity s expected residual returns or both. Interpretation 46 was issued in January The consolidation requirements of Interpretation 46 apply immediately to variable interest entities created after January 31, The consolidation requirements apply to older entities in the first fiscal year or interim period beginning after June 15, Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. FASB Staff Position FIN46-6, "Effective Date of FASB Interpretation No. 46, deferred the effective date for applying the provisions of Interpretation 46 for: 1. Interests held by a public entity in variable interest entities created before February 1, 2003, if the public entity has not issued financial statements reporting that interest in accordance with Interpretation 46. The application of Interpretation 46 to those interests is deferred until the end of the first period ending after December 15, Nonregistered investment companies accounting for their investments in accordance with the specialized accounting guidance in the AICPA Audit and Accounting Guide, Audits of Investment Companies. Interpretation 46(R) was issued on December 24, 2003, and replaced Interpretation 46. An enterprise with an interest in an entity to which the provisions of Interpretation 46 were not applied as of December 24, 2003, must apply the effective date and transitions provisions in Interpretation 46(R) to that entity. Application by public companies of Interpretation 46 or Interpretation 46(R) to entities commonly referred to as special-purpose entities is required no later than as of the end of the first reporting period that ends after December 15, Public enterprises must apply Interpretation 46(R) to all entities no later than the end of the first reporting period that ends after March 15, 2004 (public enterprises other than small business issuers) or December 15, 2004 (small business issuers). Nonpublic enterprises must apply Page 8

9 Interpretation 46(R) to entities created after December 31, 2003, immediately and to all other entities by the beginning of the first annual period beginning after December 15, An enterprise that has applied Interpretation 46 to an entity prior to the effective date of Interpretation 46(R) shall either continue to apply Interpretation 46 until the effective date of Interpretation 46(R) or apply Interpretation 46(R) at an earlier date. Page 9

10 Exhibit D-66A EXAMPLES OF THE APPLICATION OF TOPIC D-66 Following are some examples illustrating the application of the FASB staff announcement to selected hypothetical powers of an SPE to sell transferred assets. These examples are not intended to be comprehensive and do not consider other powers or activities that could preclude the SPE from being qualifying. Example 1. The SPE has the power to either "put" the transferred assets back to the transferor or to sell those assets to a third party in response to (1) a default by the obligor, (2) a major third-party rating agency downgrade of the transferred assets or the underlying obligor to a rating below a specified minimum rating, or (3) a decline in the fair value of the transferred assets to a value significantly less than their fair value at the time they were transferred to the SPE. Application: The SPE is not precluded from being qualifying (conditions 2(a) and 3). Example 2. The SPE has the power to sell transferred assets in response to a transferor's decision to exit a market or a particular activity. Application: The SPE is precluded from being qualifying because the transferor has the power to directly trigger the conditions that enable the SPE to sell the transferred assets (condition 2(a)). Example 3. The SPE has the power to sell transferred assets (or to "put" transferred assets to the servicer, to a third-party, or back to the transferor or its affiliates) in response to a failure by the transferor or its affiliates as the servicer to properly service transferred assets that could result in the loss of a substantial third-party credit guaranty. Application: Page 10

11 The SPE is not precluded from being qualifying because the loss of a substantial thirdparty guaranty would represent a significant adverse consequence to the transferor and its affiliates (condition 2(a)). Example 4. The SPE has the power to sell transferred assets in response to the transferor or its affiliates violating a nonsubstantive contractual provision (that is, a provision for which there is not a sufficiently large disincentive to ensure performance). Application: The SPE is precluded from being qualifying because the transferor directly has the power to trigger conditions that would enable the SPE to sell the transferred assets and that would not have significant adverse consequences to the transferor or its affiliates (condition 2(a)). Example 5. The beneficial interest holders in an SPE other than the transferor and its affiliates may "put" their beneficial interests in the transferred assets back to the SPE in exchange for (1) a full or partial distribution of those assets, (2) cash (which may require that the SPE sell those assets to the transferor or a third party or issue beneficial interests to comply with the put), or (3) new beneficial interests in those assets. Application: The SPE is not precluded from being qualifying (condition 3). Example 6. The SPE is obligated to sell transferred assets under an option contract written by the SPE that entitles parties other than the third-party beneficial interest holders to "call" those assets and, under that arrangement, permits the SPE to trigger a sale and effectively recognize an appreciation in the fair value of the transferred assets. Application: The SPE is precluded from being qualifying (condition 3). However, an SPE that holds assets subject to a call provision that accelerates the maturity of underlying Page 11

12 transferred assets (for example, a prepayable mortgage) would not be precluded from being qualifying. Example 7. The SPE's original legal documents schedule a sale or an auction, other than in response to a cleanup call as defined in Statement 125, of the transferred assets at the end of the life of either the SPE or the beneficial interests in the transferred assets and the transferor effectively maintains a call option on the transferred assets through its involvement in the sale or auction process (for example, if the transferor (1) is permitted to bid an amount higher than fair value for those assets and (2) retains the residual interest in an SPE entitling it to receive all of the resulting gain from the sale of transferred assets). Application: The SPE is precluded from being qualifying because that arrangement results in the transferor maintaining effective control over the transferred assets (condition 2). Example 8. The SPE's original legal documents schedule a sale or an auction, other than in response to a cleanup call as defined in Statement 125, of the transferred assets at the end of the life of either the SPE or the beneficial interests in the transferred assets and the transferor is permitted to participate in the sale or auction. The transferor and its affiliates are precluded from bidding an amount above fair value for the transferred assets, and the sale or auction process includes obtaining bona fide offers from participants other than the transferor or its affiliates. Application: The SPE is not precluded from being qualifying because the transferor cannot effectively "call" the transferred assets (condition 2). (However, a pattern of the transferor or its affiliates obtaining transferred assets through scheduled sales or auctions may suggest that they are bidding amounts greater than fair value and, therefore, maintaining effective control over the transferred assets.) Page 12

13 Example 9. The SPE has the power to sell transferred assets on two specified dates such that the SPE effectively has discretion to decide which transferred assets to sell on each date or otherwise has the ability to recognize an appreciation in the fair value of the transferred assets. Application: The SPE is precluded from being qualifying because the SPE's discretion to sell transferred assets permits it to recognize a gain in the fair value of those assets (condition 3). Example 10. The SPE has the power to temporarily reinvest proceeds in assets that require sales substantially before their contractual maturities. Application: Interest rate risk significantly affects the fair value of assets that are to be sold substantially before their maturity and, therefore, reinvesting proceeds in those assets would often (1) provide opportunities to sell assets for purposes of realizing a gain or (2) involve frequent purchases and sales of assets and other investment decisions that are more indicative of ongoing business activities. An SPE that is empowered to engage in those purchases or sales activities would be precluded from being qualifying (refer to the "Reinvesting Proceeds" section of Topic D-66 and conditions 3 and 4). Example 11. The SPE has the power to sell marketable equity securities to a third party upon a 10 percent decline from their highest fair value if that "highest fair value" is more than 10 percent above the fair value of those assets at the time they were transferred to the SPE. Application: The SPE is precluded from being qualifying because the power to sell is designed to realize a gain in the fair value of the transferred assets above their fair value at the time they were transferred to the SPE (condition 3). Page 13