Got special-purpose entities? Get cover.
The off-balance-sheet structures that Enron executives apparently used to deceive shareholders and enrich themselves have become a scarlet letter in the capital markets. Just ask Adelphia Communications Corp. The cable-service provider’s credit rating was recently downgraded and its stock dropped by nearly 50 percent after it disclosed $2.7 billion in off-balance-sheet debt housed in so-called special-purpose entities (SPEs) but guaranteed by Adelphia. Even the stocks of such corporate giants as General Electric Co. and General Motors Corp., both of which make extensive use of SPEs in their finance operations, have been rattled by fears of hidden risks and liabilities not reflected in their financial statements. “With all the focus on SPEs, we realized we should provide more details about them to investors,” says GM spokesman Jerry Dubrowski.
Particularly when the Securities and Exchange Commission demands it. In January, the SEC issued new guidance on corporate disclosures of off-balance-sheet transactions in time for 2001 10(k) filings. Companies are now expected to address all such activities in one place and in language comprehensible to financial-statement users — no small feat, given the complicated contractual relationships that SPEs can often entail.
More important, by mid-May the Financial Accounting Standards Board is expected to propose new rules to ensure that unconsolidated SPEs are truly independent of their sponsoring companies. The likely means to achieve that will be an increase in the investment requirement of outside third parties from the current 3 percent. And in deference to outraged politicians and backpedaling regulators, FASB intends to expedite its usual process and issue final rules by September or earlier to take effect for fiscal years beginning after December 15, 2002.
It won’t be pretty. SPEs are not just the playthings of unscrupulous executives at high-flying companies; they are widely used by U.S. companies across a variety of industries for purposes that even FASB says are often legitimate. Financial-services providers use them to sell assets from their balance sheets to institutional investors and reduce their capital requirements. Large manufacturers use them to finance customer purchases. Pharmaceutical companies use them to create research-and-development joint ventures with biotech firms. And hundreds of companies use them to finance real estate through tax-friendly leasing transactions. Tougher rules on SPE consolidation could affect virtually every Fortune 500 company. “This is a very big deal,” says an attorney who specializes in the independent power production industry, which also makes extensive use of SPEs. “I can’t think of an industry that won’t be affected by this.”
The 10 Percent Solution
The effects will be easy enough to see. “Corporate balance sheets are going to be a lot bigger next year,” says Robert Willens, an accounting analyst with Lehman Brothers. Currently, the assets and liabilities of an SPE don’t have to be consolidated if an independent third party makes an investment of at least 3 percent of the entity’s total capital and exercises voting control over the SPE.
The 3 percent outside interest is supposed to guarantee that companies undertake transactions with SPEs as they would with any independent third party. In the leasing business, the 3 percent threshold is enough to ensure that SPEs won’t be manipulated by the sponsoring companies. That’s because the sponsors won’t make enough money to guarantee the 3 percent investment and thereby gain the ability to manipulate the SPE. For SPEs that house more lucrative and volatile assets, however, the 3 percent threshold may not be enough. According to the Enron-board-appointed Powers Committee, which investigated the company’s off-balance-sheet partnerships, Enron had agreed in advance to protect outside investors in the LJM partnerships against losses. That essentially gave the company free rein with the entities.
Early discussions at FASB suggest that board members will try to deter such manipulation by raising the outside investment threshold to as much as 10 percent. “Given present practice, a 3 percent minimum threshold doesn’t seem to be doing the job,” says Ray Simpson, manager of FASB’s SPE project.
Much of the estimated $2 trillion in assets residing in SPEs is in the form of receivables, loans, or mortgages that serve as collateral to issue mortgage- and asset-backed securities. By isolating assets in an SPE, companies can, in many cases, improve their access to the capital markets and lower their overall cost of capital. Many of the SPEs used for securitization purposes are “qualifying” special-purpose entities (QSPEs) that often issue securities rated by credit-rating agencies.
As long as the entities meet the criteria set out in FAS 140, they don’t have to be consolidated and don’t require a third-party investment. Essentially, a QSPE has to stick closely to its special purpose. It can engage only in the activities it was set up to perform; that is, buy assets from the sponsoring company (usually with the proceeds of commercial paper), package them into securities, and sell them to investors. GE Capital, for example, can establish a QSPE that issues securities backed by equipment leases and other receivables acquired from GE Capital, transferring most of the risk to institutional investors.
“A QSPE just holds assets and does what it’s told,” says Stephen G. Ryan, an associate professor of accounting at New York University’s Stern School of Business. “It’s like a watch: you wind it up and let it run.” The one controversial issue is how to value the residual risk that most companies retain from the securitization transactions. FASB is not expected to change the rules regarding QSPE accounting.
Many SPEs, however, don’t run like clockwork. For example, collateralized mortgage, debt, and bond obligations (CMOs, CDOs, and CBOs), which are usually set up as SPEs by commercial or investment banks, typically have an asset manager who actively trades the underlying collateral. They don’t qualify for the exemption, because QSPEs can trade assets only under very restricted circumstances. CMOs, CDOs, and their kin therefore require an outside owner to stay off-balance-sheet.
“FAS 140 rules remove the discretion that an asset manager has,” explains Jeff Allen, a senior manager with PricewaterhouseCoopers. “In some cases, it’s impossible to accept the constraints.” And if the threshold for outside investment is raised to 10 percent, the economic viability of these investment entities could be undermined.
At the same time, scores of different companies will find it more difficult to keep nonqualifying SPEs off their books. “It’s pretty clear the rules will be tightened,” says Jim Palmer, president of Boeing Capital Corp. The finance subsidiary of the aircraft manufacturer may have to bring some $1.2 billion in debt back on its books. “Our SPE structures currently meet existing rules, but if FASB moves to 10 percent, they’ll probably have to come on the balance sheet.” Palmer doesn’t expect that will limit his company’s growth going forward. But others may find that the added debt on their balance sheets will affect credit ratings — even loan covenants with commercial banks.
Consolidation Sans Control
The post-Enron fear of investors and FASB is that nonqualified SPEs provide a means for executives to manage their company’s earnings and, worse, commit fraud, as it appears Enron executives did. Simpson says that the purpose of new rules is not to stop the use of SPEs, but to reflect the risks they pose to sponsoring companies. “Just because a company has an SPE doesn’t mean it’s doing something wrong,” says Simpson. “Our objective is not to limit the use of SPEs, but to consolidate them where appropriate.”
When is consolidation appropriate? The threshold is not the salient consideration, says Simpson. FASB’s aim is to ensure that nonqualified SPEs have “sufficient independent economic substance.” In layman’s terms: that the SPEs are not controlled and cannot be manipulated by sponsoring companies.
The various off-balance-sheet partnerships run by Andy Fastow and other Enron executives were purchasing such risky assets as power plants and communications infrastructure, and, in other cases, entering highly risky hedging transactions with Enron. Clearly, some of the asset sales and repurchases, as well as the hedging transactions that Enron executed with the LJM partnerships and other furry friends like Chewco, Jedi, and Raptor, could never have been done with truly independent third parties. “The company was willing to give away 3 percent to Fastow not to consolidate the SPEs,” says NYU’s Ryan.
The upshot is that companies that use SPEs for legitimate reasons will likely be paying for the sins of others. If the 10 percent threshold is applied across the board by FASB, off-balance-sheet leasing transactions could soon be a thing of the past. “SPE owners will be taking on more risk and they’ll want more return,” says Willens. “It may no longer make economic sense for companies to lease through an SPE.” Given that existing off-balance-sheet structures are not likely to be grandfathered, companies with SPEs will either have to consolidate the entities, which in many cases would defeat their purpose, or restructure them to qualify under FAS 140 rules. The third option is to find new investors to take on the higher 10 percent stake. “Everyone will be working on ways to find outside investors,” says Boeing Capital’s Palmer.
But given the fear and loathing that SPEs are generating in the marketplace, that won’t be easy.
A Better Solution?
Although new rules for special-purpose entities (SPEs) aren’t expected until September, it’s probably too much to hope that the Financial Accounting Standards Board will merely reinforce Securities and Exchange Commission disclosure requirements rather than change the rules concerning consolidation. “I don’t think the accounting model is broken,” says Jeff Allen, a senior manager with Pricewaterhouse-Coopers. “We just need better disclosure.”
Public companies are already required to disclose contingent liabilities, recourse obligations, and guarantees that arise from their relationships with SPEs. The information, however, is typically buried in the notes to financial statements and is difficult to understand. “It’s usually a dump of contractual terms that no one can process,” says Stephen G. Ryan, associate professor of accounting at New York University’s Stern School of Business. FASB seems to be leaning toward forcing off-balance-sheet assets and debt back onto the books. “Consolidation is a simplistic approach,” says Ryan. “In the best of all worlds, companies would account for all the contractual rights and obligations in SPEs and then tie the risks associated with them to items in the financial statements.”
The problem is that the best of all worlds involves a lot of accounting legwork and judgment. FASB already has a separate project dealing with accounting and disclosure for financial guarantees. Other gnarly issues include determining when off-balance-sheet contingencies are probable enough to become actual liabilities that require recognition in the financial statements. In the wake of the Enron scandal, FASB may be less inclined to leave matters of judgment to corporate finance departments and their auditors. —A.O.