A European example of a significant judgment made under IFRS 10
As part of its activities, the European Securities and Markets Authority (ESMA) organizes a forum of enforcers from 30 different European jurisdictions, all of whom carry out monitoring and review programs similar to those carried out here by the Canadian Securities Administrators. ESMA recently published some extracts from its confidential database of enforcement decisions on financial statements, covering twelve cases arising in the period from February 2014 to March 2015, with the aim of “strengthening supervisory convergence and providing issuers and users of financial statements with relevant information on the appropriate application of IFRS.” There’s no way of knowing whether these are purely one-off issues or more widespread, but some of them certainly have some relevance to matters discussed within Canadian entities once in a while. Here’s one:
- “The issuer is a listed holding company that holds 49.99% of entity A’s shares and accounted for entity A as an associate. The fact pattern was as follows:
- Including the issuer, entity A had 15 shareholders. The largest shareholders of entity A, apart from the issuer, were entity C which held about 3.4% of entity A’s shares and entity D that held about 28.3% of entity A’s shares. Entity C was controlled by the founder of the issuer, who had a significant shareholding in the ultimate parent of the issuer. Entity D was controlled by a number of the initial founders of entity A.
- The rest of about 18.3% of the shares were held by 12 shareholders that were either entity A’s founders or their descendants. Entity D and the 12 shareholders that were either entity A’s founders or their descendants were bound by a agreement. However this agreement did not encompass voting rules but only a mutual right of first refusal if one of them wished to sell its shareholding in entity A.
- The Board of Directors of entity A consisted of 5 members. Entity A disclosed in its financial reports that 3 of these 5 board members were representatives of the issuer. One of them was at the same time the founder of the issuer, a major shareholder of the issuer’s parent company and a board member of the issuer. This founder of the issuer was also the general manager of entity A and all its subsidiaries. The second board member of entity A that was considered to be a representative of the issuer is the CEO of the issuer and the third one was a family member of the founder of the issuer and a major shareholder in the issuer’s parent company without any own direct shareholding in entity A.
- There had not been complete owner representation, either personally or by proxy, at the last two annual general meetings of entity A.”
The issuer considered that it didn’t control entity A as it didn’t hold the majority of voting rights; it also claimed it didn’t have the power to instruct two of the three entity A board members characterized as its representatives. The enforcer (as ESMA likes to term it) disagreed, concluding that the issuer did have the practical ability to direct the relevant activities of entity A.
Those of us who grew up in a pre-IFRS 10 environment for assessing matters of control and consolidation can likely have some sympathy with practitioners who might feel uneasy about consolidating an entity in which they hold less than 50% of the voting rights – after all, whatever the current lay of the land, there’s always the theoretical possibility of everyone else banding against you. But IFRS 10 deals in practicalities and probabilities, and in this case the issuer didn’t have too many of those on its side. The report amasses an impressive barrage of arguments in favour of the enforcer’s conclusion, including looking in detail at the composition of the other shareholders and the likelihood of them ever voting as a block against the issuer, and looking at the conduct of past meetings to identify a low degree of investor activism.
With regard to board composition too, the analysis looks at what has happened and is likely to continue happening in practice, rather than at absolute authority: “Although the issuer did not have a contractual right to appoint the general manager or a majority of the board of directors of entity A, the enforcer considered the fact that the general manager of entity A was the founder, board member and a large shareholder of the issuer, showed the issuer’s ability to appoint the key management personnel. In addition to that, the fact that the issuer has been able to sustain a majority representation in the board of directors through several changes in the composition of the board from 2010 onwards showed that it could dominate the election process. Besides, all the representatives of the issuer, constituting the majority of entity A’s board of directors were related parties to the issuer according to paragraph 9 of IAS 24, Related Party Disclosures.”
It’s a useful example, particularly in illustrating the range of factors to be considered in making the determination – obviously a 49.99% holding carries a lot of weight by itself (presumably such a percentage holding would often be motivated exactly by the desire to achieve a certain accounting outcome), but the enforcer seems to have looked at just about everything else one could think of. It’ll be interesting over time to accumulate further fact patterns and to see how the various elements play off against each other in different circumstances.
The opinions expressed are solely those of the author