Identifying control – we forgot to be practical!

A European example of identifying control under IFRS 10

Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA); this is from their 24th edition:

  • The issuer is an industrial company that holds 39% of the capital of Company X. The issuer is controlled by Company Y, which is controlled by the controlling shareholder A. Person A also holds 4% of Company X through Company Z. Together with Z, the issuer holds 43% (40% as of January 1, 2017) of the capital in Company X.
  • Apart from the issuer and Company Z, 21 institutional shareholders together hold 37% of the shares of Company X, each of them holding voting rights up to a maximum of 3% (the 10 most important holding together 22%), while the remaining 20% of the shares of Company X are spread among the public. There are no arrangements between either the institutional shareholders or the public to consult with any of the others or to make collective decisions, and the issuer owns no call or put options.
  • The strategic decisions about the relevant activities of Company X are taken by the Board of Directors (BoD). The BoD is composed of 6 members: two representing the issuer, a nonexecutive member and three non-executive independent members. The two members who represent the issuer are also the CEO and CFO of company X (the former being the controlling shareholder A and the latter being the chairman of the BoD of the issuer). The BoD’s decisions are taken by simple majority of votes and the Chairman holds the deciding vote in case of a tie.
  • The BoD has entrusted its day-to-day management and any additional responsibilities to the Executive Committee. The Executive Committee has no members other than the two representatives of the issuer. However, the issuer believed that the BoD is the most important management body of Company X. As only two out of six members represent the issuer, the issuer believed that it had no practical ability to direct the relevant activities of Company X.
  • Since the shareholders appoint and remove the BoD members, the issuer also considered the voting rights held by the shareholders. The issuer argued that in case of opposing views, it would be possible for other shareholders to arrange the presence of an additional number of voting rights (e.g. under a proxy voting mechanism) to prevent the issuer from having the majority of the voting rights at the shareholders’ meeting.
  • Since, according to the issuer, the absolute and the relative size of the issuers’ interest in Company X is inconclusive in determining whether the issuer has rights sufficient to give it power over Company X, the issuer considered additional facts and circumstances. When considering the voting patterns at the shareholders’ meetings over the last 5 years, the issuer argued that even though the issuer acquired more shares, its relative size in the voting rights present at the shareholders meeting remained stable. According to the issuer, this shows a relative increased active participation of other shareholders.
  • The issuer concluded that since it does not have a majority in the BoD, it cannot appoint (approve) the key management personnel who have the ability to direct the relevant activities of the issuer. Furthermore, for the same reasons, the issuer concluded that it can neither direct the investee to enter into, nor veto any changes to, significant transactions for its benefit. Although the key management personnel of Company X are both related parties and current employees of the investor, this key management needs to operate within the limits of the decisions taken by the BoD.

Based on all of this, the issuer concluded that “that there are insufficient elements to demonstrate power of the issuer over Company X” and that it had significant influence over the investee. But the enforcer (as ESMA likes to term it) disagreed, concluding that the issuer did have de facto control. It observed in this regard that the voting rights of the issuer and of Company Z should be considered together when comparing with voting rights held by others; that the voting rights held by the issuer represented a majority of the voting rights of the shareholders represented at the shareholders’ meetings of Company X at least for the last two years; that it had the practical ability to appoint the members of the board of directors, even if it hadn’t yet chosen to do so. Added in with the commonality in CEO and CFO, it’s hard to imagine the enforcer found this an overly tough call.

In this case, the enforcer had so much to work with that it almost undermines the utility of the example – it might have given a bit more pause if the issuer only had (say) a 30% shareholding. But it’s still useful in underlining that such assessments are made on the basis of power and practical ability, regardless of whether those have been exercised. It would be interesting to know if the issuer had some particular motive for preferring equity-accounting over consolidation (such as an undesirable impact on the debt-equity ratio or suchlike). But it really wouldn’t matter…

The opinions expressed are solely those of the author.

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