"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."
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