Beyond Enron

The fate of Andrew Fastow and company casts a harsh light on off-balance-sheet financing.

The change in heart isn’t limited to Enron’s competitors within the energy industry. Technology companies such as EDS and PeopleSoft now find themselves trying to reassure investors about activities that have been disclosed merely in footnotes to their annual reports. Electronic Data Systems, for instance, has instead decided to report each quarter the full extent of the debts of off-balance-sheet entities designed to finance the purchase of computer systems from customers. PeopleSoft, meanwhile, is under pressure to bring back onto its balance sheet a research-and-development subsidiary that it spun off roughly three years ago but effectively controls.

How different are such activities from Enron’s? Night and day, insist finance executives at EDS and PeopleSoft, and some analysts agree. But investors are punishing their stocks regardless out of fear that such arrangements hide costs.

Yet when PeopleSoft first decided to spin off its R&D subsidiary, Ronald Codd, PeopleSoft’s CFO at the time, insisted that he could convince analysts (and the market along with them) that the subsidiary’s costs should be separated from PeopleSoft’s even if accounting rules were changed to require their consolidation. As it turned out, FASB did change the rules — but exempted PeopleSoft because it had acted beforehand.

Today, however, PeopleSoft finds itself hard-pressed to distinguish its off-balance-sheet maneuvers from Enron’s. To be sure, Codd’s successor, Kevin Parker, contends that “it’s simplistic” to compare the two companies’ activities: the PeopleSoft subsidiary’s costs are fully disclosed, he says, and “we’ve talked very deliberately and very publicly” about the company’s relations with its subsidiary. Parker adds that any decision to reacquire and consolidate the R&D subsidiary would have “very little” to do with investor concerns about PeopleSoft’s accounting practices.

Now You See It…

Beyond investigations and litigation, a key question in the wake of Enron’s collapse is what benefit can be derived from such off-balance-sheet activities if all information concerning them is disclosed. After all, the fundamental purpose of off-balance-sheet financing is to convince the marketplace to dismiss, if not ignore, the risks associated with it. Yet if those risks belong entirely to another party, as total dismissal would require, it stands to reason that their benefits must, too. And if Enron was trying to deny that financial reality, how different was it from that of other financial engineers? Not that much, when you consider what Fastow himself had to say about the subject.

As he explained to CFO back in 1999, the key to Enron’s energy-trading business was the fact that “the counterparties who enter into these contracts with Enron have to be able to take Enron counterparty credit risk.” That meant that Enron needed to be “a strong investment-grade credit.” But Fastow chose to achieve this not through the old-fashioned means of issuing equity (which dilutes existing shares) or selling assets outright (cash doesn’t earn much), but by shifting debt off the balance sheet through special-purpose entities and other unconsolidated affiliates. “We’ve had to be very creative,” said Fastow, who was also careful to emphasize that “we’re very conservative in our accounting approach.”

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