Substantive versus protective rights: getting the control assessment right

Short answer: A right that only protects your interest in unusual circumstances does not give you control. A right you can actually use over the decisions that drive returns does. Most disputes about whether to consolidate an entity are really disputes about which of those two a clause in a shareholders agreement is, and about whether anyone wrote the reasoning down.

What the assessment is

Under Ind AS 110 you control an entity when three things are true at the same time: you have power over its relevant activities, you are exposed to variable returns from it, and you can use that power to affect those returns.

Power comes from rights. So the assessment becomes a reading of the rights in the shareholders agreement, the articles, the funding documents and any side agreement, against the question: which activities significantly affect this entity’s returns, and who decides them?

That last question is the one that gets skipped. You cannot classify a right without first agreeing what the relevant activities are. For an operating company they are usually the ordinary commercial decisions: the budget, pricing, hiring, capital spending. For a single-asset entity they may be a handful of decisions taken once, at the start.

Which rights are protective

A protective right guards the holder’s interest without giving any say over the relevant activities. Typical examples are a veto over liquidation or insolvency filings, a veto over a change in the entity’s line of business, a veto over an issue of shares that would dilute the holder, or a lender’s right to take over assets on default.

They share a shape: they bite in exceptional circumstances, not in the ordinary running of the business. A right that can only be used when something has gone wrong is protective.

Which rights are substantive

A right is substantive when the holder has the practical ability to exercise it at the time decisions about the relevant activities need to be taken.

Things that make a right substantive:

• it can be exercised now, not after a condition outside the holder’s control
• exercising it is not blocked by a financial penalty, a price that makes it uneconomic, or terms so unfavourable that nobody would use it
• there is no requirement to get another party’s agreement first
• the holder has a genuine mechanism to use it, including the information and the time

Things that point the other way:

• an option exercisable only on a future event nobody controls
• a veto held by a party with no economic interest in the outcome
• a right held by so many parties that assembling a majority is impractical
• a right the holder has never used when it plainly applied

That last point matters. If a party holds a veto over the annual budget and has approved every budget without comment for five years, that does not make the right protective. But if the same party was never actually asked, you have a question about who is really deciding.

The clauses that cause arguments

Reserved matters lists. Long lists in a joint venture agreement are where most control assessments are won or lost. A reserved matter over the annual operating budget is usually substantive, because the budget drives returns. A reserved matter over a change of auditor usually is not. The list has to be read item by item, not counted.

Rights over the board versus rights over operations. Board composition rights are often the strongest indicator, but only if the board decides the relevant activities. Where a management agreement hands day-to-day decisions to one party, the board seats may matter less than they look.

Call and put options. A call option over the other holder’s shares may be a potential voting right that must be considered. The question is whether it is substantive today, which usually turns on the strike price and on whether it can be exercised at will.

Funding-linked rights. Rights that switch on when a covenant is breached are protective until breach. What changes on breach is a real event, not a disclosure: the control conclusion can flip, and the consolidation has to follow.

De facto agency. Where another party acts on your behalf, its rights are considered alongside yours. This is the hardest one to evidence and the one auditors question most, because the relationship is usually informal.

What auditors ask for

In my experience three things:

1. The list of relevant activities, agreed and written down, for each entity where the conclusion is not obvious.
2. A clause-by-clause assessment of the rights, saying for each whether it is substantive or protective, and why.
3. Evidence that the conclusion was revisited when the agreement was amended, new funding came in, a covenant was breached, or an option became exercisable.

The third one is where groups get caught. A control assessment done at acquisition and never touched again is treated as no assessment at all when the facts have moved.

What I would do

Keep a one-page control memo for every entity that is not a wholly owned subsidiary. Name the relevant activities. List each right and its classification. Record the conclusion and the date.

Then put a trigger on it: any amendment to a shareholders agreement, any new investor, any covenant breach and any option becoming exercisable causes the memo to be re-read. The memo takes an hour when the facts are fresh. Reconstructing it four years later, from documents nobody kept together, takes a week and satisfies nobody.

The consequence of a change is not just a note. Moving an entity from the equity method to full consolidation, or the other way, changes revenue, assets, debt and every ratio your lenders look at. It is worth knowing before the quarter ends, not during it.

Where FINAHQ fits

FINAHQ holds the ownership and consolidation treatment for each entity once, and applies it every period, so changing a conclusion is a change in one place rather than a rebuild of the group workbook. Every figure links back to the journal entry it came from, which is what a control discussion with your auditors usually needs. The consolidation page has the detail, and the topics index collects the reporting changes we write about.

To see what it would be worth on your group, calculate your value or talk to us.

This article is general information, not professional advice. Control conclusions depend on your own agreements and should be discussed with your auditors.