1. INTEROFFICE MEMORANDUM
TO: Files
FROM: Corporate Controller
SUBJECT: Variable Interest Analysis – Water Valley, LLC – 829 (2008)
DATE: January 12, 2009
CC: __________, Chief Financial Officer
Background:
Effective October 29, 2008, Crocker Wellspring, LLC (CW), ABC Tax Credit Equity, LLC (ABC) and ABC
Tax Credit Manager II, Inc. (ABCM) formed Water Valley, LLC (WV, the Company) to develop, construct,
operate, and maintain an apartment complex for rental to low-income tenants ages fifty-five (55) and older in
Atlanta, Georgia.
Key facts and provisions of CW’s Operating Agreement are described below, and are referenced as noted by
[xxx]:
Capital Contributions, Percentage Interests & Member Status
Calculated Stated
Capital (a) Capital Percentage
Contributions Percentages Interests Status
Crocker Wellspring, LLC 100 0.0027% 0.0090% Manager
ABC Tax Credit Manager II, Inc. 10 0.0003% 0.0010% Special Member
ABC Tax Credit Equity, LLC (b) 3,739,463 99.9971% 99.9900% Investor Member
Totals 3,739,573 100.0000% 100.0000%
(a) Amounts are literal $$$ amounts.
(b) Capital Contributions are described in detail under Article 5.01(d)
[Article 5.01 (a) – (d)]
General
• Member means any Manager, Investor Member or Special Member. [Article 2, Defined
Terms]
• Except as otherwise provided in the Operating Agreement, no Member shall be entitled to
receive the return of its Capital Contribution. [Article 5.02] (Refer to Investor Member –
Return of Capital Contributions (Repurchase Obligation) section below.)
Manager
• In the event the Company has not timely paid amounts due under the Development
Agreement, the Manager shall contribute an amount equal to such remaining payments, and

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the Company shall apply the monies to settle amounts due. (Manager’s Special Capital
Contribution) [Article 5.01 (b)]
• The Manager shall have the right, but not the obligation, after funding its other obligations
under the Operating Agreement to make “Manager Loans” to fund Operating Deficits of the
Company or to fund other reasonable obligations of the Company. These loans shall accrue
interest at eight percent (8%) compounded annually, and be repayable in accordance with the
protocol described under Articles 11.03 (Distributions: Net Cash Flow) and 11.04
(Distributions: Capital Transactions and Liquidation of Company) described below. [Article
5.07 (a)]
Special Member
• The Special Member’s contribution requirements are listed in the table above. [Article 5.01
(c)]
Investor Member
Regular Contributions
• Subject to the provisions of Article 5.01 (d) and (e) and Article 5.03, the Investor Member
shall make $3,739,463 in total contributions to the Company. [Article 5.01 (d)]
• The Investor Member shall make the total contribution in a series of seven payments
dependent upon the Company’s fulfillment of certain responsibilities.
• First Capital Contribution: After the Company has completed or received the following
items, ABC shall contribute $186,973: [Article 5.01 (d) (i)]
• An ALTA – form title insurance policy in an amount equal to the acquisition
and development cost of the apartment complex which shows the Company is
an owner in fee simple title to the land used for the project.
• A satisfactory environmental assessment report.
• Satisfactory legal and tax opinions as described in Article 5.04.
• Closing of the Construction and Consortium Loans, and approval of
commitments for the Permanent Loan.
• Other due diligence and post closing documents as required.
• Second Capital Contribution: After the Company has completed or received the following
items, ABC shall contribute $186,973: [Article 5.01 (d) (ii)]
• All conditions under Article 5.01 (d) (i) described above have been met.
• Manager’s request for an advance properly supported by a construction budget,
lien wavers, contractor’s schedules of values, sworn statements or other
evidence to prove contractors, subcontractors, and other suppliers have been
paid in full.
• An architect’s certificate that fifty percent (50%) of the construction of the
apartment complex is complete.
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• The Manager Certificate.
• Required endorsements from the Title Company indicating the Company’s fee
simple ownership of the Land, mechanics lien coverage, and other various
endorsements.
• Other documentation as required.
• Items due by date certain of April 1, 2009.
• Third Capital Contribution: After the Company has completed or received the following
items, ABC shall contribute $186,973: [Article 5.01 (d) (iii)]
• All conditions under Article 5.01 (d) (ii) described above have been met.
• Manager’s request for an advance properly supported by a construction budget,
lien wavers, contractor’s schedules of values, sworn statements or other
evidence to prove contractors, subcontractors, and other suppliers have been
paid in full.
• An architect’s certificate that seventy-five percent (75%) of the construction of
the apartment complex is complete.
• The Manager Certificate.
• Required endorsements from the Title Company indicating the Company’s fee
simple ownership of the Land, mechanics lien coverage, and other various
endorsements.
• Other documentation as required.
• Items due by date certain of July 1, 2009.
• Fourth Capital Contribution: After the Company has completed or received the following
items, ABC shall contribute $897,471: [Article 5.01 (d) (iv)]
• All conditions under Article 5.01 (d) (iii) described above have been met.
• A satisfactory updated and recertified as-built survey no more than thirty (30)
days prior to the date of funding.
• As- Built Plans and Specifications.
• Extended Use Agreement.
• The Manager Certificate.
• An architect’s certificate of substantial completion.
• Evidence of payment of construction costs and property taxes
• Required endorsements from the Title Company.
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• Required insurance certificates.
• Other documentation as required.
• Items due by date certain of January 1, 2010.
• Fifth Capital Contribution: After the Company has completed or received the following
items, ABC shall contribute $898,400: [Article 5.01 (d) (v)]
• All conditions under Article 5.01 (d) (iv) described above have been met.
• Achievement of Qualified Occupancy, and proof that tenants qualify under §42
of the Internal Revenue Code.
• Evidence the Minimum Set-Aside Test under §42 (g) of the Internal Revenue
Code has been met with regard to tenants’ incomes.
• Receipt of an audited and approved cost certification of Eligible Basis as
defined under §42 (d) of the Internal Revenue Code
• The Manager Certificate.
• Other documentation as required.
• Items due by date certain of April 1, 2010.
• Sixth Capital Contribution: After the Company has completed or received the following
items, ABC shall contribute $1,121,839: [Article 5.01 (d) (vi)]
• All conditions under Article 5.01 (d) (v) described above have been met.
• Evidence of repayment of the Construction Loan, commencement of
amortization on the Consortium Loan, closing of the CICCAR loan at no more
than $950,000 (unless approved), and closing of the State RPP Loan
• Achievement of Final Closing, including the State Agency Loan, provided the
Investor Member has received fifteen (15) days prior written notice of the date
of Final Closing.
• The Manager Certificate.
• The Investor Member shall have received evidence that the Contractor has
completed all “punchlist” items.
• Other documentation as required.
• Items due by date certain of July 1, 2010.
• Seventh Capital Contribution: After the Company has completed or received the following
items, ABC shall contribute $260,834: [Article 5.01 (d) (vii)]
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• All conditions under Article 5.01 (d) (vi) described above have been met.
• Receipt of Form 8609 for the entire apartment complex executed by the
Agency (Georgia Housing Finance Agency)
• Operation of the apartment complex shall have resulted in a Debt Service
Coverage Ratio of 1.15 for the three month period prior to the month in which
the Seventh Capital Contribution is to be made with physical occupancy during
such period of not less than ninety-three percent (93%).
• The Manager Certificate.
• Other documentation as required.
• Items due by date certain of January 1, 2011.
Investor Member
Special Contributions
• For any year that the Investor Member’s Capital Account balance is reduced to or below
zero, the Investor Member may use its discretion to make a Special Contribution to restore a
reasonable capital balance.[Article 5.01 (d) (viii)]
• The Investor Member shall receive interest on this Special Contribution as determined under
Article 5.06, and the interest payment shall be treated as a guaranteed payment. [Article 5.01
(d) (viii)]
• If the Investor Member makes a Special Contribution, the Manager may also use its
discretion to make a contribution of up to the same amount. [Article 5.01 (d) (viii)]
Investor Member
Adjustments to Capital Contributions
• Following determination of Certified Credits (described below) or other evidence of a Late
Delivery Capital Adjustment (described below), the Accountants shall calculate the
Downward Capital Adjustment (described below). If events after this calculation result in a
decrease due to a Late Delivery Capital Adjustment, or there is a subsequent determination
of Certified Credits, then the Accountants shall recalculate the Downward Capital
Adjustment, and the Members or the Company, as appropriate shall make payments as
described under Article 5.01 (e) (ii) (described below). [Article 5.01 (e)]
• Certified Credits mean ninety-nine and ninety-nine one hundredths percent (99.99%) of the
annual Tax Credits that the Accountants certify in writing the Company will be able to claim
during each full fiscal year during the Credit Period for all buildings in the apartment
complex assuming full compliance with §42 of the Internal Revenue Code. [Article 2,
Defined Terms]
• If there is a Downward Capital Adjustment, then the Capital Contributions of the Investor
Member shall be immediately reduced by this adjustment. This adjustment shall reduce the
Fifth Capital Contribution (if it has not been funded). If the adjustment exceeds the total of
all unfunded Capital Contributions (prior to reduction under this provision), then the
Manager shall make a payment to the Company equal to the amount of such excess, and the
Company shall distribute this payment to the Investor Member as a return of its Capital
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Contributions. The Manager’s payment shall constitute a non-reimbursable funding of
Excess Development Costs. It will not qualify as an additional Capital Contribution from the
Manager or a loan payable to him, and will not impact his Capital Account. [Article 5.01 (e)
(i)]
• If there is an Upward Capital Adjustment (subject to the Special Member’s receipt of the
Company’s prior year tax return), then this adjustment will be applied to increase the
Investor Member’s Seventh Capital Contribution. [Article 5.01 (e) (i)]
• Definitions of terms: [Article 5.01 (e) (ii)]
• Certified Credit Capital Adjustment equals the product of (a) Certified Credits
for the Credit Period (excluding any Tax Credits resulting from a change in
qualified basis under §42(f)(3) of the Internal Revenue Code minus$4,159,581
and (b) $0.899 with respect to a decrease in Certified Credits, and $0.80 with
respect to an increase in Certified Credits. This adjustment may be positive or
negative.
• Downward Capital Adjustment means a negative Capital Adjustment.
• Upward Capital Adjustment means a positive Capital Adjustment not to exceed
$300,000
• Capital Adjustment means the sum (i) the Certified Credit Capital Adjustment,
and (ii) the Late Delivery Capital Adjustment.
• Late Delivery Capital Adjustment shall mean for calendar year 2009 and
calendar year 2010 the amount, if any, by which $34,664, and $398,630,
respectively, (as may be adjusted for any Upward Capital Adjustment) exceeds
Actual Credits for such year. If the apartment complex does not achieve
Qualified Occupancy by the end of the first year of the Credit Period, then the
Late Delivery Capital Adjustment shall be the sum of (i) the amount
determined under the preceding sentence and (ii) the positive difference, if any,
between the Projected Credits and the Actual Credits projected to be available
in years 2009 through 2020, applying an annual discount rate of ten percent
(10%), as calculated by the Investor Member at the end of the of the first year
of the Credit Period. For purposes of calculating the Capital Adjustment, the
Late Delivery Capital Adjustment shall be a negative number.
Investor Member
Capital Contributions - Other
• Except as provided under Article 9.01 related to the sale and transfer of Investor Member
interests, the admission of additional Investor Members must be approved by all Members.
[Article 5.01 (g)]
• Except as otherwise provided under law, no Investor Member shall be liable for Company
expenses or obligations. [Article 5.01 (i)]
• If the Manager does not comply with any material provisions of this agreement, the Affiliate
Guarantor fails to perform its obligations under the Affiliate Guaranty, the Project Lender
declares the Company to be in default under any Project Loan, or foreclosure proceedings
have been initiated against the apartment complex, the Company and Manager shall be
considered in default. As a result, the Investor Member may elect to withhold any Capital
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Contribution payable to the Company. Once the default is cured, the Investor Member must
remit these payments to the Company. [Article 5.03]
• If Company environmental reports indicate environmental issues, the Investor Member shall
retain an independent environmental consultant to review these reports on the project. The
fees for this consultant shall not be charged to the Investor Member. The Special Member
shall pay them. [Article 5.01 (j)]
Investor Member
Return of Capital Contributions (Repurchase Obligation)
• If any of the following events occur, the Manager shall notify the Investor Member of such
event: [Article 5.05 (a)]
• The entire apartment complex is not placed in service by December 31, 2009
(or such later date as approved by the Special Member).
• The Company has not received State Designation in 2007.
• The Service Forms 8609 are not issued by the Agency so as to allow the Credit
Period to begin in 2010.
• Final Closing has not occurred by March 31, 2011 (or such later date as
approved by the Special Member)
• The Company fails to meet the Minimum Set-Aside Test and the Rent
Restriction Test by the close of the first year of the Credit Period or at any time
thereafter.
• The Company’s federal income tax basis in the apartment complex as of the
later of December 31, 2007 or six months after the date of the State
Designation is less than ten percent (10%) of the Company’s reasonably
expected basis in the apartment complex as required under §42 (h)(1)(E) of the
Internal Revenue Code.
• At any time before Breakeven Operations, (1) an action is successfully
prosecuted to foreclose, abandon or permanently stop construction of the
apartment complex, or (2) the apartment complex qualifies for less than
seventy percent (70%) of the Projected Tax Credits.
• Commitments received by the Company for any Project Loans are withdrawn,
and a comparable commitment has not been received within one hundred
twenty (120) days of such withdrawal.
• An Extended Use Agreement is not in effect before the end of the first year of
the Credit Period.
• If any event listed above has occurred, the Investor Member may elect to have the Manager
purchase its interest in the Company, and return its contributed capital. [Article 5.05 (a)]
• Within thirty (30) days of the mailing date of the Investor Member’s notice to elect the
purchase option, the Manager shall pay the Investor Member the following: [Article 5.05
(b)]
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• One hundred percent (100%) of the Investor Member’s Capital Contributions,
• Interest on such contributions at twelve percent (12%) per annum accruing
from the date(s) of the Investor Member’s respective Capital Contributions,
limited by the rate allowed by law, and
• The Investor Member’s cost incurred to purchase a bond to protect such
Member from any Tax Credit Recapture related to a disallowance of any Tax
Credits allocated to the Investor Member prior to the date the Company
purchases the Investor Member’s Interest.
Key Warranties & Covenants
• The Projected Credits are $4,159,584. They are based upon the Manager’s representation that
one hundred percent (100%) of the residential units in the apartment complex will be
occupied by Qualified Tenants. The Manager further covenants that there is and at all times
shall continue to be sufficient eligible basis (as defined in §42(d) of the Internal Revenue
Code) to provide the full amount of the Projected Credits. [Article 4.01 (o)]
• The Company received valid State Designation with respect to the apartment complex in the
amount of $4,160,000 for the apartment complex’s ten year Credit Period on December 28,
2007. The Tax Credit percentage shall be no less than nine percent (9%) because the
apartment complex shall be placed in service between July 30, 2008 and before December
31, 2013. [Article 4.01 (q)]
• The apartment complex is being developed in a manner which satisfies, and shall continue to
satisfy, all tenant income, rent and other restrictions applicable to projects generating Tax
Credits under §42 of the Internal Revenue Code. The Company will comply with the so-
called “40-60 Set-Aside Test” of §42(g) (1) (B) of the Internal Revenue Code, as restricted
under the law, so that at least forty percent (40%) of the units in the apartment complex will
be occupied by individuals with incomes of sixty percent (60%) or less of area median
income, as adjusted for family size. The Company will also comply with the State RPP Loan
set-aside requirements, so that at least forty percent (40%) of the units in the apartment
complex will be occupied by individuals with incomes of fifty percent (50%) or less of area
median income, as adjusted. The apartment complex is not subject to any other rental
restrictions in order to generate the full amount of the Projected Credits. [Article 4.01 (r)]
Guaranties
• Construction Completion Guaranty: After all funds in the Lease-Up Reserve have been used,
subject to approval by the Georgia Housing Finance Agency, the Manager shall be
responsible for the following: [Article 8.10 (a) (i)]
• Achieving satisfactory completion of the construction of the complex.
• Meeting all requirements to obtain unconditional certificates of occupancy for
all units in the apartment complex.
• Fulfilling all actions required to assure the apartment complex satisfies the
Minimum Set-Aside Test and Rent Restriction Test.
• Securing the loans by the Project Lenders.
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• Paying all operating costs of the project prior to Breakeven Operations that are
not paid for by the Company.
• Achieving final closing.
• Excess Development Costs: The Manager is obligated to pay all Excess Development Costs
[Article 8.10 (a) (ii)]. The term Excess Development Costs means all Development Costs in
excess of the proceeds of the Project Loans, operating revenues received prior to Breakeven
Operations, and all Capital Contributions the Investor Member is required to make. [Article
2, Defined Terms)
• Operating Deficit Guaranty: In the event that, at any time during the period commencing on
the achievement of Breakeven Operations and ending on the third anniversary of such date,
an Operating Deficit exists and all funds in the Operating Reserve have been used, the
Manager shall fund the Operating Deficit. The Manager shall not be obligated to provide
such funds to the extent that the cumulative amounts funded would exceed $150,000. These
funds are treated as interest-bearing Operating Deficit Loans, and are subordinated to other
Company loan obligations. [Article 8.10 (b)]
• Tax Credit Compliance Guaranty: If there is a Tax Credit Shortfall, the Manager
unconditionally guarantees within forty-five (45) after the close of the fiscal year to pay the
Investor Member the amount of the Tax Credit Shortfall for that year, and any related
penalties and interest imposed by law. [Article 8.10 (c)(i)]
• Tax Credit Recapture Guaranty: If there is a Tax Credit Recapture Event, the Manager
unconditionally guarantees within forty-five (45) after the close of the fiscal year to pay the
Investor Member the amount of the Tax Credit Recapture, any related penalties and interest
imposed by law. If the event is estimated to result in a decrease in the Investor Member’s
future tax credits, the Manager will also pay the Investor Member for this amount. [Article
8.10 (c)(ii)]
• Project Loan Funding Guaranty: The Manager unconditionally guarantees that the Company
shall receive full funding of the Project Loans on or before December 31, 2010. These funds
do not include “federal subsidies” as defined under §42(i) of the Internal Revenue Code
[Article 8.10 (d)]
• Affiliate Guaranty: Crocker, LLC (Crocker) is an affiliate of the Manager, and is an Affiliate
Guarantor. The Affiliate Guarantor guarantees the obligations of the Manager under the
Operating Agreement and the Developer under the Development Agreement. Crocker, LLC
is also the Developer [Article 2, Defined Terms].
• Affiliate Guaranty of KeyBank National Association Loan: Effective October 29, 2008, the
Company executed a construction loan agreement for a $5,043,058 loan from KeyBank
National Association. Crocker guarantees repayment of the loan. [KeyBank Loan
Agreement]
Allocations of Profit and Losses
Profits and Losses Other Than from Capital Transactions
• Profits and losses shall be determined in accordance with the definition of Profits and Losses
in the Operating Agreement. [Article 11.01 (a)]
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• Profits and Losses means an amount equal to the Company’s taxable income or loss for each
period from all sources determined in accordance with §703(a) of the Internal Revenue
Code: [Article 2, Defined Terms]
• Increased by any income exempt from federal income tax.
• Decreased by any expenditures not deductible in computing taxable income or
chargeable to a capital account under either §705(a) (2) (B) or §704(b) of the
Internal Revenue Code.
• Increased (decreased) based on any gain (loss) resulting from revaluations of
assets required under Treasury Regulation §1.704(b) (2) (iv) (f) (Treasury
Regulation) of the Internal Revenue Code.
• Increased (decreased) based on the adjustment to the gain (loss) resulting from
the disposition of an asset(s) revalued under the provisions of the same
Treasury Regulation.
• Increased (decreased) based on the adjustment to the computation of
depreciation or amortization resulting from the revaluation of asset(s) under the
provisions of the same Treasury Regulation.
• All Profits and losses, except those described in Articles 11.02, 11.05, and 11.07 (all
described below) shall be allocated to Members in accordance with their Percentage Interests
as stated [Article 11.01 (b)]
Profits and Losses from Capital Transactions
• Except as provided in Article 11.07, profits and losses recognized from a Capital Transaction
shall be allocated as follows:
• Profits shall be allocated:
• First, to Members with negative Capital Accounts, the portion of gains
(including gains treated as ordinary taxable income) which is in
proportion to such Member’s respective negative Capital Account. No
gain shall be allocated to a Member under this Article once such
Member’s Capital Account is zero. [Article 11.02 (a)]
• Second, to Members in the amounts necessary to increase the Member’s
respective Capital Accounts so that proceeds distributed under Articles
11.04 (e)–(f) (described below related to Distributions of Net Cash Flow
from Capital Transactions) will be distributed in accordance with the
Member’s respective Capital Accounts [Article 11.02 (a)]
• Losses shall be allocated:
• First, to Members with positive Capital Accounts, the portion of losses in
proportion to such Member’s respective positive Capital Account.
[Article 11.02 (b)]
• Second, any remaining loss to Members in accordance with the
economic risk they bear or, if none, the Member’s respective Company
Interests. [Article 11.02 (b)]
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• Any portion of profits treated as ordinary taxable income under §1245 or
§1250 of the Internal Revenue Code related to depreciation recapture shall be
allocated: on a dollar for dollar basis to those Members to whom items of
deduction or loss giving rise to the recapture had been previously allocated.
[Article 11.02 (c)]
Distributions of Cash Flows
Regular Cash Flows
• Net Cash Flow shall be determined separately for each fiscal year or portion thereof, and
shall not be cumulative. Under this Operating Agreement, Net Cash Flow shall be limited to
Surplus Cash available for distribution [Article 11.03 (a)].
• Subject to the Project Lenders’ approval, Net Cash Flow shall be applied or distributed in the
following order :
• First, to the Investor Member until the aggregate amount of distributions made
to the Investor Member under this Article 11.03(b) (i) for the current and all
prior years equals the Assumed Investor Member Tax Liability for the current
and all prior years [Article 11.03 (b) (i)].
• Second, to the Investor Member in an amount equal to any Unpaid Tax Credit
Shortfall, Investor Member Advances, or current or unpaid Asset Management
Fees [Article 11.03 (b) (ii)].
• Third, to the Manager until the aggregate amount of such distributions made to
the Manager under this Article 11.03 (b) (iii) for the current and all prior years
equals the Assumed Manager Tax Liability for the current and all prior years
[Article 11.03 (b) (iii)].
• Fourth, to the replenishment of the Operating Reserve to a minimum balance of
$146,565 [Article 11.03 (b) (iv)].
• Fifth, until all amounts due under the Development Agreement have been paid
in full [Article 11.03 (b) (v)].
• Sixth, following the full payment of amounts due under the Development
Agreement, Net Cash Flow is applied to the pro rata payment of any
outstanding Operating Deficit Loans and Manager Loans based upon the
respective outstanding balances of each [Article 11.03 (b) (vi)].
• Seventh, eighty percent (80%) to the payment of the Incentive Management
Fee [Article 11.03 (b) (vii)].
• Thereafter, forty-nine and ninety-nine hundredths percent (49.99%) to the
Investor Member, fifty percent (50%) to the Manager and one hundredths
percent (.01%) to the Special Member [Article 11.03 (b) (viii)].
Cash Flows from Capital Transactions & Liquidation
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• Except as may be required under Article 12.02 (b) (described below), the proceeds from
liquidation of the Company pursuant to Article 12.02 (b) and the net proceeds from Capital
Transactions shall be distributed in the following order:
• First, to the payment of all Company debts and liabilities (including amounts
related any Project Loan and sale or refinancing expenses) excluding (1)
Company debts and liabilities to the Members or any Affiliate (unless related
to a Project Loan) and (2) all unpaid fees owing to the Manager under this
Agreement [Article 11.04 (a)].
• Second, to fund reserves necessary to settle contingent or potential liabilities
[Article 11.04 (b)].
• Third, to the payment of any debts and liabilities (including unpaid fees) owed
to the Members or any Affiliates in the following order: [Article 11.04 (c)]
• First, to the Investor Member an amount equal to any Unpaid Tax Credit
Shortfall (applied first to accrued but unpaid interest (at the Default Rate)
and then principal) or Investor Member Advances.
• Second, to the payment of any outstanding accrued and unpaid Asset
Management Fees.
• Third, to the Investor Member an amount equal to any Special Additional
Capital Contribution.
• Fourth, to the payment of any outstanding Manager Loans and loans
made by the Manager under Article 8.10(a)(ii) (described above).
• Fifth, amounts due under the Development Agreement.
• Sixth, amounts due with respect to Operating Deficit Loans, if any.
• Seventh, any other debts and liabilities.
• Fourth, to the Manager and Investor Member in proportion to relative amounts
of Net Projected Tax Liabilities (defined below) of the Manager and the
Investor Member’s partners or members and their respective partners or
members until they have each cumulatively received an amount equal to their
respective Net Projected Tax Liabilities [Article 11.04 (e)]
• Finally, the balance ninety percent (90%) to the Manager, nine and ninety-nine
hundredths percent (9.99%) to the Investor Member, and one hundredths
percent (.01%) to the Special Member. [Article 11.04 (f)]
• Net Projected Tax Liabilities are based on the Company’s tax records and any final
adjustments made before the distribution of Capital Proceeds, and mean the cumulative
amounts of each Member’s respective projected liabilities (Projected Tax Liabilities) for any
federal, state, and local taxes (including recapture of Prior Tax Credits) to be imposed on the
Members due to any Capital Transactions from which proceeds are to be distributed, any
prior Capital Transactions (to the extent proceeds from such Prior Capital Transactions equal
to the Projected Tax Liabilities for such prior transactions were not distributed), and any
liquidation of the Company. Such projected liabilities shall be based on estimated tax rates
for each Member. [Article 2, Defined Terms]
• Article 12.02 (b): It is the Members’ intent that any liquidation proceeds shall be distributed
in accordance with each Member’s respective positive Capital Account balance. The
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Members believe that the application of Article 11.04 will accomplish this objective. If upon
liquidation a conflict exists between their intent and the application of Article 11.04, the
liquidator shall allocate the Company’s profits, losses and gains to cause the proceeds to be
distributed in a manner which conforms as closely as possible to the Member’s economic
expectations as set forth in Article 11.04 and their respective Capital Account balances. If the
amounts are insufficient to permit liquidation proceeds to be distributed in accordance with
both Article 11.04 and each Member’s respective positive Capital Account balances, the
proceeds shall be distributed in accordance with each Member’s respective positive Capital
Account balances after the allocations described herein have been made.
Distribution of Cash Flows – Other Issues
• Article 11.05 addresses issues related to the minimum required frequency for distributions,
allocation of distributions in the event of a sale or transfer of a Member’s interest or the
admission of new Member, and other miscellaneous tax matters [Article 11.05].
• The allocations under Article 11.07 ensure compliance with the substantial economic effect
and tax basis adjustment regulations under Internal Revenue Code §704. and §754 sections,
respectively. These regulations require the maintenance of capital accounts for each member,
restrict the shifting of allocations between members for tax benefit, and provide for special
allocations in the event a member incurs a capital account deficit [Article 11.07].
Fees
• Development Fee: The Company has entered into a Development Agreement with the
Developer (Crocker) for services related to the construction and development of the
apartment complex. The total development fee is $504,000 [Article 8.11 & Exhibit A to the
Operating Agreement].
• Incentive Management Fee: The Company has entered into an Incentive Management Fee
Agreement with Crocker Wellspring, LLC (Manager) to manage the Company. The Manager
will be paid a non-cumulative fee equal to eighty percent (80%) of the Net Cash Flow
designated for payment of the fee under Article 11.03 (b) (described above) of the Operating
Agreement. [Item 3 – Exhibit B of the Operating Agreement]
• Debts payable to third parties are senior to obligations to pay these fees [Article 11.04]
Management & Other Rights
• Except as otherwise set forth in the Operating Agreement, the Manager has complete and
exclusive discretion to manage and control the Company for purposes of developing and
operating the apartment complex. [Article 8.01 (a)]
• Article 8.01 (b) further emphasizes the broad powers granted to the Manager. Unless
otherwise prohibited in the Operating Agreement or by law, the Manager has sole authority
and discretion to execute all actions necessary or convenient to fulfill the Company’s
purpose. [Article 8.01(b)]
• The Investor Member does not have the right to participate in the management or control of
the business, bind the Company, or conduct business in the Company’s name. [Article 10.01]
• The Manager does not have the authority to execute the following acts: [Article 8.02 ]
• Violate the law or applicable regulations.
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• Violate any material provision of the Regulatory Agreement, Extended Use
Agreement, Loan Agreement, or any material provision of any other Project
Document.
• Undertake any act required to be approved in writing by the Investor Member
unless such authority exists in the Operating Agreement.
• Knowingly rent apartments in the apartment complex such that the Rent
Restriction and Minimum Set-Aside Tests would not be met.
• Admit any person as a Manager or Investor Member, or withdraw as Manager.
• Contravene any Company agreement.
• Execute an assignment for the benefit of creditors.
• Transfer or hypothecate the Manager’s interest as Manager unless allowed in
the Operating Agreement.
• Dissolve the Company.
• File a voluntary petition for bankruptcy.
• Refinance, prepay or materially modify any mortgage or long-term liability of
the Company, or sell, grant an option to acquire, mortgage, encumber or
otherwise transfer any interest in the Company, or borrow funds or participate
in a merger with another entity.
• Materially change any Company accounting method or practice.
• Make any expenditure or incur any liability on behalf of the Company in
excess of $25,000 which is not in the budget consented to by the Special
Member, except for emergency repairs to the apartment complex.
• Assign rights to Company property except for business purposes.
• Take any action which would terminate the Company for tax purposes under
§708 of the Internal Revenue Code, or amend or revoke any election related to
the Low Income Housing Tax Credits under §42.
• Undertake any action without the consent of the Special Member or Investor
Member for which prior consent is required.
• Approve any increase in the fees to the Manager or Affiliate of the Manager.
• Change the Manager’s ownership or control.
• Allow this agreement to be amended.
• The Special Member shall have the right to remove the Manager for the following reasons:
[Article 6.05]
• The Manager commits acts of fraud, misconduct or gross negligence.
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• The Manager violates any material provision of the Regulatory Agreement,
Extended Use Agreement, Loan Agreement, or any material provision of any
other Project Document.
• The Manager violates any material provision of the law, Operating
Agreement, guarantee or payment provisions, or warranties.
• The Manager commits an act which would cause the Company to be in
default on the Project Loan which cannot be cured or the period for cure has
expired.
• The Manager fails to operate the Company to protect its favorable tax status
as a limited liability company.
• The Manager causes a recapture or reduction in Certified Credits beyond
which the Manager has funded pursuant to the Tax Credit Compliance
Guaranty.
• The Manager violates securities laws.
• The Manager causes the Investor Member to be liable for obligations in
excess of its Capital Contributions.
• The Manager fails to discharge the Management Agent of the apartment
complex if cause exists for removal.
• The Affiliate Guarantor defaults on the Affiliate Guaranty.
• The amount of Actual Credits for any year are, or are projected by the
Accountants to be, less than eighty-five (85%) of the Projected Credits for
the year.
• The amount of Certified Credits for any year are, or are projected by the
Accountants to be, less than eighty-five (85%) of the Certified Credits for
the year if Certified Credits have been determined and adjustments to the
Capital Contribution of the Investor Member have been made as may be
required under Article 5.01(e).
• Cause for removal as a Manager of an Affiliated Company exists pursuant to
the Affiliated Company’s Operating Agreement.
• The Manager fails to obtain dismissal of any case against the Manager for
the appointment of a Trustee for the Manager or in bankruptcy.
Risk of Loss & Other Financial Assumptions
• Risk Associated with Construction & Project Loan Guaranty: Crocker, LLC solely
guarantees the $5,043,058 KeyBank Loan. This loan is to be repaid with the Members’
equity contributions and other permanent loans when funded. The project and financial
projections are structured to ensure enough money exists at the times needed, or ample time
exists to secure it before payments are due. To date, the only times Crocker has been required
to fund under this guaranty has been when payments on the loan were due before equity had
been received. In both cases, the amount was small (<$150,000) and the advance was
reimbursed from equity within several months. Crocker Finance has concluded risk
associated with performance on this guaranty is minimal.
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• Risk Associated with Cost Overruns & Operating Guaranty: The project is planned two
years in advance, and cost estimation errors and overruns are almost inevitable. However, the
Investor Member minimized their risk by compelling Crocker to commit to fixed estimates at
the project closing, and enter into this guarantee. As noted above, Crocker has substantial
experience in developing, managing and operating low-income housing projects.
Furthermore, Crocker is the Developer in this deal, and will have direct control over
completing the project. In two similar arrangements, Crocker’s funding of these guaranties
resulted in absorbing cost overruns of less than $150,000. Crocker Finance has concluded
risk associated with performance on this guaranty is minimal.
• Risk Associated with Tax Credit Compliance & Tax Credit Recapture Guaranty: As
Developer and Manager of the project, Crocker Wellspring, LLC must ensure the property
complies with The United States Department of Housing and Urban Development (HUD)
and the Internal Revenue Code rules to qualify for low-income housing tax credits and other
tax benefits. Since the qualifying rules are complex, the management team and their advisers
subject the project to inspections and audits each year to ensure compliance with the rules. If
issues are identified, these timely reviews typically allow management time to cure the
problems. In similar situations, Crocker Finance’s experience has been that these problems
have been minor and did not imperil a project’s tax status. Crocker Finance estimates that the
risk of a tax disqualification is less than one percent (1%), and is therefore remote.
• CW has nominal capital in WV compared to the Investor Member’s contribution.
Furthermore, worst case estimates of losses CW would absorb on fulfillment of the
guaranties are between $300,000 to $500,000 in total considering the guaranties noted in the
above paragraphs.
• The apartment complex has a tax credit compliance of fifteen (15) years with an extended
land use agreement of thirty (30) years. Due to the extended life of the complex, Crocker
Finance is unable to reasonably estimate a sales price and associated net cash flows (net of
loan settlements and taxes) for it at these future dates. However, Crocker Finance believes
that cash available for distribution after settling the loans, investor's capital balances, and any
tax liability from the transaction will be minimal. Thus, the preferential ninety percent
(90%) allocation to the Manager (CW) under Article 11.04 (f) (described above) will likely
be minimal.
• CW may earn an Incentive Management Fee as described under the Fees Section above. The
specific cash flow balance on which this fee is calculated is described under the
Distributions of Cash Flows - Regular Cash Flows Section above. According to Crocker
Finance’s Summary Proforma (Distributable Cash Flow line), total cash flow before
reduction to arrive at the balance on which the Incentive Fee is calculated will average only
approximately $15,000 per year. Crocker Finance estimates the cash flows available for
application of the eighty percent (80%) fee will be at or near zero. Thus, the Incentive Fee
may be a minimal to zero.
• Schedule H – Projections (Summary of Operating Partnership Benefits) projects that the
Investor Member will receive $5,378,889 of cumulative benefits from the Company, and
$1,639,426 in benefits net of return of capital.
• Total returns to the Investor Member are estimated to be far more substantial than benefits
CW will receive for the following reasons:
• Profits and losses are generally distributed in accordance with each
Member’s respective percentage.
• CW has a very small ownership percentage compared to the Investor
Member.
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• The preferential ninety percent (90%) allocation of certain cash flows, the
Incentive Management fee, and any other cash flows described above are
estimated to be minimal or zero.
• The Development Fee payable to Crocker, LLC (a related party to CW) is
$504,000.
• In other words, CW and Crocker, LLC’s total returns are estimated to vary
little from the $504,000. As stated above, the Investor Member’s total net
returns are estimated to be $1,639,426.
Issue:
How should Crocker Wellspring, LLC account for and disclose its investment in Water Valley, LLC under
Generally Accepted Accounting Principles (GAAP) applicable in the United States?
Authoritative Literature:
Five authoritative pronouncements provide guidance for resolving this issue. The pronouncements are as
follows:
• Accounting Research Bulletin (ARB) No. 51, Consolidated Financial Statements,
• FASB Statement No. 94, Consolidation of All Majority-owned Subsidiaries,
• Emerging Issues Task Force (EITF) Issue No. 04-5, “Determining Whether a General Partner,
or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the
Limited Partners Have Certain Rights”,
• AICPA Statement of Position (SOP) 78-9, Accounting for Investments in Real Estate
Ventures,
• FASB Interpretation No. 46 (Revised) (FIN 46(R), the Interpretation), Consolidation of
Variable Interest Entities.
ARB No. 51:
Paragraph 2 of ARB No. 51 indicates that the usual condition for a controlling financial interest is ownership
of a majority voting interest in the entity, unless control does not rest with the majority. A minority interest’s
rights to veto certain actions may nullify the majority’s control. Absent these rights, ARB No. 51 would
generally require an entity to consolidate another entity if it owned more than fifty-percent (50%) of it.
FASB Statement No 94:
FASB Statement No. 94 eliminated three exceptions to the general rule under ARB No. 51, and it requires
consolidation of all majority-owned subsidiaries even if they have "nonhomogeneous" operations, a large
minority interest, or a foreign location. FASB Statement No. 94 does not consider the issue of temporary
control or situations in which control does not rest with the majority owner due to bankruptcy, reorganization,
or other reasons, and these exceptions remain.
EITF Issue No. 04-5:
EITF Issue No. 04-5 provides additional guidance in resolving control of an entity based on facts and
circumstances. It generally applies tests of whether the limited partners may exercise substantive
participating rights as a means to determine whether the general partner controls the entity. Substantive
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participating rights are essentially rights to veto or stop certain actions in the normal course of business, and
are disproportionate to the minority’s ownership percentage.
SOP 78-9:
SOP 78-9 provides that a controlling investor in a real estate venture should account for its investment under
the principles of accounting applicable to investments in subsidiaries. Paragraphs 5, 7, and 9 of the SOP
discuss guidance for corporate joint ventures, general partnerships, and limited partnerships, respectively.
Paragraph 9 specifies that general partners should apply this standard for a limited partnership only if they
have substantive control. In short, SOP 78-9 directs an investor to apply the basic consolidation tests to
determine if an investor should consolidate its investment in a real estate venture.
FIN 46 (R):
General
FIN 46(R) requires the primary beneficiary of a variable interest entity (VIE) to consolidate the VIE in its
financial statements.
Paragraph 3 of FIN 46(R) states the term entity refers to any legal structure used to conduct activities or to
hold assets. Examples of such structures include, but are not limited to corporations, partnerships, limited
liability companies, grantor trusts, and other trusts.
Paragraph 2 (c) of FIN 46(R) states that variable interests in a variable interest entity are contractual,
ownership, or other pecuniary interests in an entity that change with changes in the fair value of the entity’s
net assets exclusive of variable interests. Equity interests with or without voting rights are considered variable
interests if the entity is a variable interest entity, and to the extent that the investment is at risk as described in
paragraph 5 of the Interpretation.
Qualification as a Variable Interest Entity
Paragraph 5 of FIN 46(R) states that an entity is subject to consolidation if any one of the following
conditions exists:
The total equity investment at risk is not sufficient to permit the entity to finance
its activities without additional subordinated financial support provided by any
parties, including equity holders. For this purpose, the total equity investment at risk:
• Includes only equity investments in the entity that participate significantly in
profits and losses even if those investments do not carry voting rights
• Does not include equity interests that the entity issued in exchange for
subordinated interests in other variable interest entities.
• Does not include amounts provided to the equity investor directly or
indirectly by the entity or by other parties involved with the entity (for
example, by fees, charitable contributions, or other payments), unless the
provider is a parent, subsidiary, or affiliate of the investor that is required to
be included in the same set of consolidated financial statements as the
investor. [Emphasis added]
• Does not include amounts financed for the equity investor (for example, by
loans or guarantees of loans) directly by the entity or by other parties
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involved with the entity, unless that party is a parent, subsidiary, or affiliate
of the investor that is required to be included in the same set of consolidated
financial statements as the investor.
As a group, the holders of the equity investment at risk lack any one of the
following characteristics of a controlling financial interest:
• The direct or indirect ability through voting rights or similar rights to make
decisions about an entity’s activities that have a significant effect on the
success of the entity. The investors do not have that ability through voting
rights or similar rights if no owners hold voting rights or similar rights (such
as those of a common shareholder in a corporation or a general partner in a
partnership).
• The obligation to absorb the expected losses of the entity. The investor or
investors do not have that obligation if they are directly or indirectly
protected from the expected losses or are guaranteed a return by the entity
itself or by other parties involved with the entity.
• The right to receive the expected residual returns of the entity. The investors
do not have that right if their return is capped by the entity’s governing
documents or arrangements with other variable interest holders or the entity.
The equity investors as a group also are considered to lack characteristic (b) (1) if
(i) the voting rights of some investors are not proportional to their obligations to
absorb the expected losses of the entity, their rights to receive the expected residual
returns of the entity, or both and (ii) substantially all of the entity’s activities (for
example, providing financing or buying assets) either involve or are conducted on
behalf of an investor that has disproportionately few voting rights. For purposes of
applying this requirement, enterprises shall consider each party’s obligations to
absorb expected losses and rights to receive expected residual returns related to all of
that party’s interests in the entity and not only to its equity investment at risk.
Fees Paid to a Decision Maker
In measuring variable interests, fees paid to a party acting as a decision maker for the entity can be
excluded in certain instances. Paragraphs B19 through B21 provide guidance on this issue.
Paragraph B19 states basic rules for determining whether these fees can be excluded:
Fees paid to a decision maker shall not be considered variable interests if all of
the following conditions exist:
a. The fees are compensation for services provided and are commensurate with the
level of effort required to provide those services. Paragraph B21 describes factors
that may indicate that fees exceed the level of compensation that would be
commensurate with the services provided.
b. The fees are at or above the same level of seniority as other operating liabilities of
the entity that arise in the normal course of business, such as trade payables.
c. Except for the fees described in conditions (a) and (b), the decision maker and the
decision maker’s related parties do not hold interests in the variable interest entity
that individually, or in the aggregate, would absorb more than a trivial amount of
the entity’s expected losses or receive more than a trivial amount of the entity’s
expected residual returns.
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d. The decision maker is subject to substantive kick-out rights, as that term is
described in paragraph B20. [emphasis added]
Primary Beneficiary
Paragraph 15 of FIN 46(R) states that a primary beneficiary of a variable interest entity is the enterprise that
consolidates it. Paragraph 14 of the Interpretation provides guidance for determining the primary beneficiary:
An enterprise shall consolidate a variable interest entity if that enterprise has a
variable interest (or combination of variable interests) that will absorb a majority
of the entity’s expected losses, receive a majority of the entity’s expected residual
returns, or both. An enterprise shall consider the rights and obligations conveyed
by its variable interests and the relationship of its variable interests with variable
interests held by other parties to determine whether its variable interests will
absorb a majority of a variable interest entity’s expected losses, receive a majority
of the entity’s expected residual returns, or both. If one enterprise will absorb a
majority of a variable interest entity’s expected losses and another enterprise will
receive a majority of that entity’s expected residual returns, the enterprise
absorbing a majority of the losses shall consolidate the variable interest entity.
Paragraph 16 of FIN 46 (R) and FASB Statement No. 57 jointly provide guidance on attributing related
parties’ interests to another party to determine if that party qualifies as the primary beneficiary of a variable
interest entity. Paragraph 16 states:
For purposes of determining whether it is the primary beneficiary of a variable
interest entity, an enterprise with a variable interest shall treat variable interests in
that same entity held by its related parties as its own interests. For purposes of this
Interpretation, the term related parties includes those parties identified in FASB
Statement No. 57, Related Party Disclosures, and certain other parties that are acting
as de facto agents or de facto principals of the variable interest holder. The
following are considered to be de facto agents of an enterprise:
a. A party that cannot finance its operations without subordinated
financial support from the enterprise, for example, another variable
interest entity of which the enterprise is the primary beneficiary
b. A party that received its interests as a contribution or a loan
from the enterprise
c. An officer, employee, or member of the governing board of the
enterprise
d. A party that has (1) an agreement that it cannot sell, transfer, or
encumber its interests in the entity without the prior approval of
the enterprise or (2) a close business relationship like the
relationship between a professional service provider and one of its
significant clients. The right of prior approval creates a de facto
agency relationship only if that right could constrain the other
party’s ability to manage the economic risks or realize the
economic rewards from its interests in a variable interest entity
through the sale, transfer, or encumbrance of those interests.
[emphasis added]
Paragraph 24 of FASB Statement No. 57 (as Amended) defines the term related parties to include the
following:
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Affiliates of the enterprise; entities for which investments in their equity
securities would, absent the election of the fair value option under FASB Statement
No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, be
required to be accounted for by the equity method by the enterprise; trusts for the
benefit of employees, such as pension and profit sharing trusts that are managed by
or under the trusteeship of management; principal owners of the enterprise; its
management; members of the immediate families of principal owners of the
enterprise and its management; and other parties with which the enterprise may deal
if one party controls or can significantly influence the management or operating
policies of the other to an extent that one of the transacting parties might be
prevented from fully pursuing its own separate interests. Another party also is a
related party if it can significantly influence the management or operating policies of
the transacting parties or if it has an ownership interest in one of the transacting
parties and can significantly influence the other to an extent that one or more of the
transacting parties might be prevented from fully pursuing its own separate interests.
Summary
In summary, a primary beneficiary is the enterprise that absorbs over half of a variable interest entity’s
expected losses or returns. For this test, the absorption of losses is predominant to the absorption of gains.
In conclusion, an enterprise is required under FIN 46 (R) to consolidate an entity only if both of the following
tests are met:
• the entity is a variable interest entity,
• and the enterprise is the primary beneficiary.
Analysis:
ARB No. 51 & Statement No. 94:
Crocker Wellspring, LLC owns .009% of WV. Since CW does not have a majority interest in WV, ARB No.
51 would not require CW to consolidate it.
However, CW is granted very broad power as Manager under the Operating Agreement. As a result, EITF 04-
5 and SOP 78-9 will be evaluated to determine whether CW controls WV and must consolidate it. In general,
these pronouncements taken together require a general partner of a limited partnership to consolidate it,
unless the limited partners’ rights nullify the general partner’s control. As discussed below, CW’s interest in
WV is analogous to a general partner’s interest in a limited partnership.
EITF No. 04-5:
WV is a limited liability company, not a partnership. It does not have a general partner as the term is used for
a limited partnership. EITF No. 04-5 applies to a general partner in a limited partnership or similar entity. In
fact, paragraph 3 of the EITF indicates that it applies to limited liability companies that are functionally
equivalent to a limited partnership. Thus, EITF No. 04-5 can provide insight into the issue of which member,
if any, controls WV.
A limited partnership has two key attributes:
• a general partner which manages the entity and has unlimited risk,
• a limited partner or partners whose risk is limited to their capital invested.
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WV is functionally equivalent to a limited partnership for the following reasons:
• CW is functionally equivalent to a general partner in a limited partnership. This is true because:
• it has broad power to manage WV,
• CW and Crocker (a related party to CW) have agreed to guaranty loans and other
obligations for WV. This exposes CW to risk in excess of its capital investment.
• CW acts in a capacity analogous to that of a Trustee or Trust Manager.
• ABCM only functions in a capacity analogous to that of a Trust Protector overseeing
the fiduciary responsibilities of a Trustee.
• ABC is functionally equivalent to a limited partner in a limited partnership. This is true because:
• it has no requirement to contribute additional capital or guaranty loans to WV,
• It has ceded broad powers to CW, and cannot participate in management.
Paragraph 6 of the EITF indicates that a general partner in a limited partnership is presumed to control the
limited partnership regardless of the extent of the general partner’s ownership interest in the limited
partnership, unless the limited partners have substantive participating rights. Since CW’s interest in WV
is analogous to a general partner’s interest in a limited partnership, and these rights may be nullified only in
the event of actions by CW best characterized as illegal, irresponsible, or reckless, CW maintains
substantive control over WV.
SOP 78-9:
SOP 78-9 specifies that general partners in a limited partnership should apply the SOP if they have
substantive control. As noted above under the EITF No. 04-5 analysis, CW is analogous to a general partner
in a limited partnership and has broad control over WV. Furthermore, paragraph 9 of the SOP states that if
this presumption of control is not overcome by the rights of the limited partners and a single general partner
controls the limited partnership, the general partner should consolidate the limited partnership and apply the
principles of accounting applicable for investments in subsidiaries. Since CW is the sole member in WV with
control analogous to a general partner in a limited partnership, and these rights may be nullified only in the
event of extreme actions by CW, CW maintains substantive control over WV. Thus, SOP 78-9 requires CW
to consolidate WV.
FIN 46 (R):
Variable Interest Entity Test
WV is a limited liability company, and meets the definition of an entity as described in FIN 46(R). Therefore,
it is potentially subject to evaluation as a VIE.
Absent extreme actions by CW, ABCM cannot replace CW as Manager. As a result, CW effectively controls
WV. Therefore, WV meets the control test under paragraph 5 of the Interpretation.
WV’s net income and losses will be allocated pro rata to the Equity Owners. However, CW’s and Crocker’s
obligations to provide construction, loan, and tax credit guaranties directly protect ABC from losses.
Therefore, WV meets the loss absorption test under paragraph 5 of the Interpretation.
CW’s ownership interest and percentage of total capital in WV are .009%. WV’s members generally share
profits, losses, and cash flows in proportion to their ownership interests. However, CW and Crocker may
guaranty debt and other liabilities of the Company. Any guaranty could increase CW’s exposure to potential
losses. Thus, CW is effectively obligated to absorb losses in excess of its ownership interest. The Operating
Agreement cedes most management and effective voting control to CW, however. Therefore, ABC has
capital contributions at risk, but effectively no voting rights. Finally, substantially all of WV’s activities
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involve or are conducted on behalf of ABC, a member which has disproportionately few voting rights.
Therefore, WV meets the disproportionate loss absorption test under paragraph 5 of the Interpretation.
Since WV meets the control, loss absorption and disproportionate loss absorption tests under paragraph 5 of
FIN 46 (R), CW’s interest in WV qualifies as a variable interest in a variable interest entity.
Primary Beneficiary Test
Although WV is a variable interest entity, FIN 46 (R) requires CW to qualify as a primary beneficiary of WV
in order to consolidate its financial results. Under paragraph 14 of FIN 46(R), a primary beneficiary is the
enterprise that will absorb over half of a variable interest entity’s expected losses or returns. Paragraph 16
requires that a member’s and a related party’s involvement in the entity must be evaluated to measure these
losses and returns. Under paragraph 16, Crocker, LLC qualifies as a related party to CW. Thus, fees paid to
both Crocker and CW must be evaluated to determine whether they are includable in the determination of
WV’s primary beneficiary.
Expected Losses
WV’s members generally share profits and losses in proportion to their equal percentage interests. CW only
has a nominal capital and percentage interest in the Company. However, Crocker and CW are obligated to
guarantee loans and other obligations for the Company. Thus, CW could absorb a majority of WV’s losses.
Under a worst case scenario, Crocker Finance has estimated that Crocker and CW would absorb only
$300,000 to $500,000 in losses, however. (This scenario is described in detail under the Risk of Loss & Other
Financial Assumptions Section.) This is far less than the Investor Member’s capital account balance of
$3,739,463. Furthermore, the Investor Member may not receive a return of its Capital Contribution except in
limited cases. Thus, Crocker and CW will not absorb a majority of WV’s losses.
Expected Returns
Based on the broad power conferred upon CW, it qualifies as a decision-maker in WV. As noted above,
Crocker and CW are related parties, and will receive Development, Incentive Management and other fees
from WV. Under paragraphs B19 through B21, the fees paid to them are treated as fees paid to a decision-
maker, and are only excludable from measurement of variable interests if all of four tests enumerated under
paragraph B19 are met. One of those tests is that payment of these fees must be senior to or at the same level
as debts payable to others. They are not. Thus, these fees are includable in measuring the CW’s expected
returns. Even with the inclusion of these fees, the Investor Member would receive more expected returns
then CW would receive. (This scenario is described in detail under the Risk of Loss & Other Financial
Assumptions Section.)
FIN 46 (R) Conclusion
Since CW will not absorb a majority of WV’s expected losses or returns, it does not qualify as the primary
beneficiary of WV, and is not required to consolidate it under FIN 46 (R).
Conclusion
Neither FIN46 (R) nor ARB No. 51 requires CW to consolidate Water Valley, LLC. Supplementary
guidance under SOP 78-9 must be applied to resolve the issue of whether Crocker Wellspring, LLC is
required to consolidate Water Valley, LLC. Since Crocker Wellspring, LLC’s interest in Water Valley, LLC
is similar to a general partner’s interest in a limited partnership, Crocker Wellspring, LLC must consolidate
Water Valley, LLC under SOP 78-9.
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