What Is a Variable Interest Entity (VIE)?
A variable interest entity (VIE) refers to a legal business structure in which an investor has a controlling interest despite not having a majority of voting rights. This is because the controlling interest is arranged via a contractual relationship rather than direct ownership. Characteristics include a structure where equity investors do not have sufficient resources to support the ongoing operating needs of the business. In most cases, the VIE is used to protect the business from creditors or legal action.
A business that is the primary beneficiary of a VIE must disclose the holdings of that entity as part of its consolidated balance sheet.
- A variable interest entity (VIE) refers to a legal business structure in which an investor has a controlling interest despite not having a majority of voting rights.
- Investors in VIEs do not participate in residual gains or losses.
- Variable interest entities are often established as special purpose vehicles (SPVs) to passively hold financial assets or to actively conduct research and development.
- Under the Federal securities laws, public companies have to disclose their relationships to VIEs when they file their 10-K forms.
How a Variable Interest Entity (VIE) Works
Variable interest entities (VIEs) are often established as special purpose vehicles (SPVs) to passively hold financial assets or to actively conduct research and development. For example, a company may establish a VIE to finance a project without putting the whole enterprise at risk. However, just as other SPVs have been misused in the past, these structures are frequently used to keep securitized assets off corporate balance sheets.
VIEs are set up with a unique structure where investors do not have a direct ownership stake in the entity but rather have special contracts, which specify the terms & rules and pledge a percentage of profits. Therefore, in a VIE, the investor does not participate in residual profits or losses that usually come with ownership. The contracts don't provide for voting rights either.
Reforms in the wake of the global financial crisis were meant to do away with some of the asset-backed security industry’s pre-crisis practices. But thanks to lobbying efforts by the banks, which had warned of dire consequences should they have to bring subprime mortgage-backed securities back onto their books, the Financial Accounting Standards Board (FASB) relaxed the rules for VIEs, enabling banks to continue stashing loans in off-balance-sheet entities.
Under the Federal securities laws, public companies have to disclose their relationships to VIEs when they file their 10-K forms. FASB Interpretation Number 46, which is the Financial Accounting Standards Board’s interpretation of the Accounting Research Bulletin (ARB) 51, outlines the accounting rules that corporations must follow with respect to VIEs. Several revisions to the original 2003 FASB Rule 46 have taken place, with the most recent occurring in 2009 in response to the 2008 financial crisis.
In particular, many of these regulations are set out to determine who the actual beneficiary of a VIE is in order to improve transparency and financial reporting. According to the most recent standards, the beneficiary firm would meet both of the following:
- It has the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance
- It has the obligation to absorb losses of the entity that could potentially be significant to the variable interest entity or the right to receive benefits from the entity that could potentially be significant to the variable interest entity.
Additionally, a beneficiary firm is required to assess whether it has an implicit financial responsibility to ensure that a VIE operates as designed when determining whether it has the power to direct the activities of the VIE that most significantly impact the entity’s economic performance.
If a company is the primary beneficiary of such an entity—namely has a majority interest in the VIE—then the holdings of that entity must be disclosed on the company's consolidated balance sheet. But if a company is not the primary beneficiary, consolidation is not required.
However, companies are required to disclose information concerning VIEs in which they have a significant interest. This disclosure includes how the entity operates, how much and what kind of financial support it receives, contractual commitments, as well as the potential losses the VIE could incur.
What Are Examples of Variable Interest Entities (VIEs)?
VIEs can come in many forms and will be organized depending on the needs of the beneficiary company. Some examples may include operating leases, subcontracting arrangements, and offshore companies, among others.
How Does a VIE Work?
VIEs are legally contractual obligations between a beneficiary firm and some third-party. Because the nature of the association between the two entities is contractual, is it not considered to be a form of ownership. This allows the VIE structure to circumvent various rules and regulations around reporting and in some cases, taxation.
What Are Chinese VIEs in the U.S.?
More than 100 Hong Kong- and Chinese-based corporations are structured as VIEs in the United States. These include well-known companies like Alibaba, Tencent, Baidu, JD, and NetEase, among others. The VIE structure allows these firms to get around Chinese regulations that prevent foreign capital investments in certain types of Chinese companies (e.g., those involved in telecommunications or media).