Beyond Enron

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

Enron’s future, ironically enough, thus depends on the relatively few hard assets it saw fit to keep on its balance sheet. Fastow himself obviously thought it made sense to minimize them. “Most oil and gas companies are just funded on-balance-sheet,” he told CFO in 1999. Therefore, the off-balance-sheet activity Enron engaged in gave it “a structural cost advantage,” insisted Fastow.

Most analysts, consultants, academics, and journalists thought so, too, and held up Enron as an example to follow (including CFO, which gave Fastow an Excellence Award in 1999). Not only did many of Enron’s competitors eventually do so, but so did companies in other industries, though some observers would claim that a few were even better at this game, or at least earlier practitioners.

Among skeptics of this kind of financial engineering is Stephen Wright, a finance professor at the University of London and co-author of Valuing Wall Street, a 2000 book devoted to the then-unfashionable notion of Tobin’s Q, which holds that a company’s market value ultimately equals the replacement cost of its tangible assets. Says Wright: “Not everybody can shift assets off their balance sheet, and when everybody is claiming that they should, clearly there are grounds for suspicion of that claim.”

Having assets on the balance sheet is a much bigger issue now than it was just a year ago, and not just for energy companies. Consider the rise in asset-based lending, which requires assets to be used as collateral. While such lending has long been a source of capital for troubled companies, even investment-grade borrowers are going this route. “Demand is extremely robust,” says an investment banker whose firm specializes in such lending and has had dealings with Enron.

Bank Run

Now, in fact, the rating agencies promise to take a much harder look at off-balance-sheet arrangements. And the additional scrutiny won’t stop there, as Enron’s meltdown is beginning to spark intensive congressional scrutiny of the regulation of the financial and commodity markets (not to mention the adequacy of federal protection of 401(k) plan assets). At a minimum, new standards for disclosure of off-balance-sheet liabilities seem in order. FASB seems to recognize this, as a spokeswoman reports that the accounting body has placed its long-waylaid Consolidations Project back near the top of its agenda. Its key proposal would tighten FASB’s definition of control, and with it the conditions under which the results of a company’s subsidiaries and other affiliates needn’t be consolidated in its own financial statements.

For its part, the SEC says it plans to close certain loopholes in its disclosure requirements. The most relevant one may involve the definition of what constitutes material information, since Enron’s auditor, Arthur Andersen LLP, accepted the company’s claims that much of its off-balance-sheet activities needn’t be disclosed, because the amounts at stake were sufficiently small to be considered immaterial. What more the commission should do here is open to question, however, since it issued guidelines some three years ago that made it clear that size alone wasn’t an appropriate measure of materiality. Indeed, many suggest that a more effective move would be to ban accounting firms from providing consulting services to clients they audit. (Andersen billed Enron $27 million for consulting services in 2000, versus $25 million for auditing work.) Such a ban was proposed by former SEC chairman Arthur Levitt, but was abandoned in the face of industry opposition.

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