VideoGot 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.
Qualifying SPEs
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.
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