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The market's distaste for complex financing could raise your company's cost of capital, even if you comply with new reporting rules.
Tim Reason, CFO Magazine
October 1, 2002
Must structured finance be obscure, or even misleading, to be effective? It certainly was misleading at Enron — and, until the transactions involved were made less obscure, quite effective. Citigroup and J.P. Morgan Chase & Co. lent more than $8 billion to Enron between 1992 and 2001, but set the financing up to look like a series of gas trades that could be recorded as revenue. So Enron's debt of $10 billion in 2000, for example, was understated by $4 billion, while its cash flow from operations of $3.2 billion was overstated by almost 50 percent — which kept its credit rating higher than it should have been, too.
The banks disavow any responsibility for the fact that these transactions ultimately helped bankrupt the energy company. But the only purpose of the deals was to mask debt as cash from trading operations. That wasn't immediately apparent in testimony before a Senate committee, where executives of both banks spent much of their time erecting a general defense of structured finance instead of explaining the objectives of their deals for Enron. "Structured financings have been used over the past several decades by virtually all sophisticated companies as a way of raising money," testified Rick Caplan, a Citigroup managing director.
Whether that way of raising money is legitimate is another question. For that to be so, the deals have to serve some purpose other than hiding the debt they create. That applies to all kinds of deals, not just those Enron employed. And the current backlash against such financing will make it incumbent upon corporate finance executives to make that purpose clear.
Those who use asset securitizations, synthetic leases, or other common structured financing techniques surely would prefer not to hear them equated with Enron's transactions. But the scandals have cast a pall over this entire sector of the capital markets, and are provoking major changes. For starters, the Financial Accounting Standards Board (FASB) plans to finalize tight new rules for special-purpose entities (SPEs) — the vehicles typically used to engineer the deals by taking the assets and debt involved off companies' balance sheets — by year's end. And the recently passed Sarbanes-Oxley Act of 2002 calls for a Securities and Exchange Commission study of off-balance-sheet disclosures in a year's time. Even the banks are deflecting the bad publicity by demanding specific public disclosures from their corporate clients. All this will make it much tougher to justify — or even find — structured finance deals.
The Chicken or the Egg?
Most such deals raise capital in spite of constraints posed by credit ratings or financial covenants. But it's impossible to separate structured finance from the accounting methods corporations use to achieve it. That raises the chicken-or-egg question underscored by recent scandals: Can the deal stand on its economic merits or does it depend on favorable accounting?
"The fundamental rationale for structured financing is the value it creates" by unlocking otherwise inaccessible capital, argues Andrew T. Feldstein, head of structured financing products at JPMorgan Chase. "The vast majority of structured finance transactions were done for good economic reasons. The anecdotes you hear about are the ones that were done badly."
But what is the economic purpose of structured finance deals that are done well — those, that is, that meet the rules for off-balance-sheet treatment? Some critics find little. Richard Thevenet, treasurer of MasterCard Inc., contends that accounting, not economics, all too often drives common structured finance transactions such as synthetic leases. That's apparent, says Thevenet, when one examines how they actually reduce a company's cost of capital. In fact, he contends that any such reduction is artificial. All things being equal, he says, "it's much cheaper to put [an asset] on the balance sheet," because "you're paying extra to have the appearance of it being off-balance-sheet." As for the cost savings, he adds, synthetic leases increase net income and operating cash flow because assets are depreciated for tax purposes, but not for accounting purposes. However, they lower total cash flow because the financing costs are so much higher. "So you've reduced cash flow and flexibility, increased costs, and for what reason? Window dressing, so you can move assets off reported books," says Thevenet.
No question, structured finance allows companies to obtain more capital than they would get as straightforward equity or debt. And even critics acknowledge that can sometimes be a good thing. "Structured finance allows people to raise money they may not otherwise be able to raise, and that access to capital contributes to productivity," says Lynn Turner, former chief accountant at the SEC and now an accounting professor at Colorado State University.
The problem is, investors need to know whether that capital can be profitably used. And they often can't when it's not on the balance sheet. Sure, proponents argue that proper deals meet accounting rules that require the terms to be disclosed in footnotes, but the fact is that such disclosures are sketchy at best. And unless the terms are sufficiently clear to be accounted for, the true cost and risk of such financing are not apparent.
"Regardless of how you structure them," says Turner, "the economics of the transactions need to end up in the financials. If that impacts the costs, then so be it; we need to make decisions based on real economics, not hidden gimmicks."
Synthetic Leases Expire
James Kent, vice president and treasurer of Chiron Corp., in Emeryville, California, says that in general, "financing alternatives priced on our creditworthiness have always been more attractive than a structured product." Kent says that in 1996, however, the biotech firm found that a synthetic lease on a new research facility "compared very favorably to a credit-based borrowing."
Six years later, the landscape has changed. Kent has made no decision about what to do when the lease comes up for renewal next July. Uncertainty as he waits for FASB to "clarify the ground rules" makes it impossible to evaluate costs, he says. More important, he adds, "we recognize that this is an area of significant current scrutiny." Wary of the "taint" of off-balance-sheet treatment, Kent notes that Chiron has plenty of alternatives, including $1.2 billion in cash — more than enough to buy back its less than $200 million research facility.
In fact, synthetic leases are likely to be all but wiped out by FASB's proposed revision of the SPE rules, which was released for comment this past summer. Expected to be final by year-end, the rules could be in effect as soon as second-quarter 2003. As proposed, they raise the outside equity ownership stake required to define an SPE as independent from 3 percent to a "rebuttable presumption" of 10 percent. The rules also are intended to ensure that the outside capital comes from a truly independent source that is truly at risk for that capital.
Where majority voting rights are difficult to determine, the rules create a complex set of criteria for establishing the "primary beneficiary" of the SPE. In most synthetic leases, companies set up an SPE to own a property and lease it back to them, with the lessee the primary beneficiary of the lessor SPE. So the rules would require the lessee to consolidate the lessor onto its balance sheet. There are exceptions if another party holds the majority voting rights or if the SPE is consolidated by a substantive business enterprise, but in general the proposed rules would nullify most synthetic leases.
Also potentially affected by FASB's proposal are asset-backed securitizations. Bradley Schwartz, a managing director at JPMorgan, says asset-backed securitizations are being used even by investment-grade companies to supplement or supplant traditional backup credit lines, particularly since they are shielded from corporate-event risk. Now, however, asset-backed paper issuance is declining as well, both because companies might have authorized more than they needed and because of the uncertainty generated by FASB's rulemaking. Ultimately, says Joanne W. Rose, executive managing director of global structured finance rating at Standard & Poor's, "I expect there will be more transparency and more disclosure around securitization and its effect on the balance sheet. That is positive for everybody."
Unless you badly need credit. A big potential drawback is the possibility that the enormous commercial paper (CP) conduits run by the banks themselves could be among the SPEs forced back on balance sheet. These conduits purchase the securitized assets from qualified SPEs. While the latter aren't subject to the provisions of the proposed rule, consolidation of CP conduits could severely curtail the ability of banks to lend. "If you apply the provisions to CP conduits, you could absolutely conclude that the banks should consolidate," says Michael Joseph, a partner with Ernst & Young. In that event, it's hard to see any result other than a credit crunch. "If the banks have to consolidate their CP conduits, that's going to be huge," says Joseph.
Guarding the Hen House
Banks are already requiring more from their corporate customers in terms of reporting, and that may make other capital costly, simply because the details of structured finance, and the debt it often masks, may become more apparent to ratings agencies, analysts, and investors. While banks insist they bore no responsibility for policing Enron's accounting, the damage it did has given them reason to take a renewed interest. "People are assailing our reputation," declares Feldstein. JPMorgan Chase and Citigroup — along with six other banks — also have been named as defendants in class-action lawsuits for their role in Enron's collapse.
In August, chairman and CEO Sandy Weill announced that Citigroup would no longer perform material structured financings for clients that won't record them on their balance sheet unless the clients agree to publicly disclose the impact to investors. Citigroup will require "prompt disclosure of the details of the transaction, including management's analysis of the net effect the transaction has on the financial condition of the company, the nature and amount of the obligations, and a description of events that may cause an obligation to arise, increase, or be accelerated." The bank also will require its clients to provide a complete set of transaction documents to the client's chief legal officer, independent auditors, and, oddly, the CFO.
JPMorgan Chase chairman and CEO Bill Harrison followed suit five days later, creating a policy review office that, among other responsibilities, "will help ensure that we do not participate in transactions that are not properly disclosed by our clients."
Both proposals are vague — effectively, the banks are doing no more than insisting that companies follow existing SEC regulations and Sarbanes-Oxley. But even that is a dramatic change from their heated protestations during the Enron hearings that they are blind to their clients' accounting decisions. Indeed, JPMorgan Chase's Feldstein still obliquely suggests that rival Citigroup may have gone too far, noting that for a bank to require disclosure or review it with auditors "is impractical, not our expertise, and presumes a sort of paternalistic relationship which is entirely inappropriate and I would think would anger our clients."
Perhaps Feldstein should be more worried about investor anger. With Andersen out of business and Enron bankrupt, the banks' deep pockets guarantee they will be vigorously sued for their alleged role in propping up Enron's finances. "These top banks were involved in Enron's day-to-day business operations," says William S. Lerach, of Milberg Weiss Bershad Hynes & Lerach, who is leading the class-action securities-fraud litigation against Enron. "They helped them structure these SPE transactions that were used to falsify the financial results."
Some observers say the banks are extremely vulnerable. "The banks are going to see claims like they've never seen before. The evidence from the congressional investigation is so compelling that it raises a significant risk that these firms will face humongous settlements," warns Turner, who thinks the evidence compiled by Senate investigators will force the banks to settle rather than face a jury. "If they go to trial, the jury will hang them before the trial starts," he says.
The End of the Beginning
Scrutiny of a company's actual debt — not just what's reflected on the balance sheet — will not end when FASB issues its new SPE rules. The Sarbanes-Oxley Act orders the SEC to issue rules requiring disclosure of "all material off-balance-sheet transactions... and other relationships of the issuer with unconsolidated entities." Within the next year, the SEC will study the extent of off-balance-sheet transactions and the use of SPEs, and report "whether generally accepted accounting rules result in financial statements of issuers reflecting the economics of such off-balance-sheet transactions to investors in transparent fashion."
In other words, companies will no longer be able to use off-balance-sheet treatment of debt to make it look as if they're less leveraged than they really are. "For the first time ever, we are going to find out about how much people are really hiding," says Turner of the impending SEC report, "and I think the world is going to be shocked when they see that. It is going to be a clarion call for action." If he's right, the changes that CFOs have recently seen in structured finance will be only the beginning.
Tim Reason is a staff writer at CFO.
Cash Not in the Bank
While it is far too early to estimate the cost that investor lawsuits against Citigroup and J.P. Morgan Chase & Co. might exact on corporate finance, the immediate fallout of the banks' deals with Enron is all too apparent. Enron's prepaid gas and oil swaps were far from typical structured finance transactions, but coupled with WorldCom's manipulations, they have already resulted in heightened scrutiny of cash-flow statements. "Although the statement of cash flows is much less susceptible to accounting manipulations than the income statement, recent developments have shown that it is far from sacrosanct," wrote Standard & Poor's analyst Scott Sprinzen in a recent report on financial reporting transparency.
The SEC has said it would like FASB to revisit the cash flow reporting rules laid out by FAS 95. That, too, could have significant implications for the cost of capital, since the primary concern of bond investors as well as commercial lenders is whether a firm's cash flow is sufficient to cover interest payments. (Citigroup and JPMorgan Chase, of course, are now at the front of the creditors' line because Enron's cash flow wasn't what it appeared to be.) —T.R.
Waiving the Red Flag
One of the more interesting defenses of structured finance raised by banks is that Enron essentially "overdosed" on it. Enron conducted $8.5 billion in prepaid forward swaps with Citigroup and J.P. Morgan Chase & Co. and at least $1 billion with six other banks.
Since those deals helped Enron conceal the loans as cash flow from gas trades, the banks could claim that they had no way of knowing how much Enron was also borrowing from their rivals — or whether it could handle the growing load. "We don't do due diligence," says Andrew T. Feldstein, head of JPMorgan Chase's structured financing products. "If our client is advised by capable counsel and capable accounting firms, we assume our client is providing factual information to those constituents as well as to its regulators."
But Arthur Andersen's approval of Enron's accounting depended on the independence of each party to the gas trades — including Mahonia, the special-purpose entity created by JPMorgan Chase. A taped phone call obtained by Senate investigators records JPMorgan Chase and Enron employees crafting a response after Andersen demanded a letter confirming that Mahonia met the criteria. "You also want to make sure that Mahonia seems independent," says one of the voices on the tape.
Accounting issues aside, the banks' own deal books should have been enough to raise red flags. Using its inside knowledge of Enron's prepaid swaps with Citigroup, Salomon Smith Barney concluded in November 1999 that Enron's financial statements underreported its debt by 38 percent. By April 2001, Salomon estimated Enron's debt to be 57 percent to 92 percent higher than reported. Nonetheless, Citigroup sold bonds based on Enron's reported debt to the public in 2000 and 2001.
Indeed, Enron's allure seems to have overpowered red flags. Internal E-mails suggest JPMorgan Chase officials were shocked to learn in October 2001 just how much Enron had outstanding. "$5B in prepays!!!!!!!!!" wrote one employee. The response was: "shutup and delete this email." —T.R.