Off-balance sheet financing, or external funding not recognized on the issuing company’s financial statements, has garnered its fair share of attention recently, primarily due to the collapse of the Enron Corporation. Enron’s management extensively utilized a specific form of off-balance sheet financing, the creation of Special Purpose Entities (SPEs). Evidence suggests that the intent of these was to hide extensive corporate liabilities from creditors, investors, and regulators. So complete was the deception that even knowledgeable investment analysts found it difficult to ascertain the true operating condition of the company.
Since Enron’s Chapter 11 bankruptcy filing, many companies utilizing other than straight forward, visible external financing structures have seen their publicly traded securities deeply discounted. Market participants have questioned management’s intentions and the quality of corporate reporting. Even General Electric, once admired for its ability to deliver consistent operating results, has been taken to task for perceived accounting irregularities–the same accounting treatments the company has traditionally used to produce consistent performance.
Now that time has passed since the Enron debacle and other world events have replaced it in the daily headlines, it is time to take another look at Special Purpose Entities to see if they provide an economic service, or are just a vehicle for corporate and managerial malfeasance.
What Is an SPE and Why All the Fuss?
An SPE is a separate legal structure created by a firm to provide liquidity and/or obtain favorable external funding. Assets are isolated within the new entity, and securities issued by the entity are backed by these assets as collateral. An SPE can take various forms, including partnerships and trusts, and typically does not feature independent, third-party or “public” equity holders. Additionally, the securities issued by the SPE may contain “credit enhancements” or guarantees that reduce risk to the purchasers and therefore, further reduce the cost of funding. A problem may arise when a firm pledges equity as a credit enhancement. If market conditions cause the value of the equity to decline, the firm will be required to pledge additional shares. As additional shares are pledged, shareholders–fearing dilution and bankruptcy–may sell their shares, thus resulting in greater volatility and requirements for additional guarantees.
What caused the problems? One factor was the ability of a firm to own up to 97 percent of an SPE without reflecting either its assets or liabilities on the firm’s balance sheet. This was accomplished by using a loophole in American accounting practices that allowed an SPE to skirt the rules of consolidation. Prior to January 2003, firms were required to include in their consolidated financial statements subsidiaries in which they had a “controlling financial interest.” Controlling financial interest was defined as a majority voting interest. Without majority voting interest, a firm was not required to consolidate the SPE even if it was the primary beneficiary of the SPEs activities.
How Do Firms Use SPEs?
SPEs are used to securitize, acquire, and lease assets. Securitization was popularized first by mortgage markets. That is, an entity (sometimes an SPE) purchases mortgages from an initiator (often the creator of the SPE), pools them, and issues securities to investors backed by the mortgages. Firms now securitize many other financial assets, including accounts receivables, credit card balances, and commercial loans. Firms benefit from securitization in two ways. First, selling the assets provides an influx of cash and liquidity. Second, because the securities sold by the SPE are backed by assets (called asset-backed securities), the cost of debt may be reduced. The market for securities backed by assets other than mortgages has grown tremendously and now is estimated at $746 billion dollars per year.
In early 2002, Ford Motor Company used securitization when faced with liquidity problems. A ratings downgrade on its debt required the company to substantially reduce its outstanding commercial paper. Ford needed an alternative source of external financing. Debt was available, but at a cost. The market was pricing Ford’s existing intermediate maturity debt at Libor plus 221 basis points. Ford turned to Ford Motor Credit, which, through an SPE, issued bonds backed by a diverse pool of consumer and dealer loans at Libor plus 15 basis points.
While securitization is an important use, SPEs are also used to acquire assets. Krispy Kreme decided in early 2002 to use a synthetic lease to finance a $35 million factory in Illinois. In a synthetic lease, a firm sets up an SPE to hold a property’s title and then leases the property back at rates below those of a traditional lease. Synthetic leases were popularized in the late 1990’s by technology companies such as Cisco Systems and are used frequently by retailers and others who require large investments in real estate. However, because of Enron, 2002 was not the time to use a synthetic lease. The New York Post used Krispy Kreme as an example of off-balance sheet financing in a full-page article and referred to the arrangement as making “an entire doughnut factory disappear.” The impact of the article on Krispy Kreme’s securities was immediate, and its management announced they were restructuring the financing to more traditional on-balance sheet loans. Why did management take this action that increased their financing costs? They stated they feared “misperception” of the reason for the choice of a synthetic lease.
What Has Changed?
After Enron filed for bankruptcy, both the Securities and Exchange Commission (SEC) and the Financial Accounting Standard Board (FASB) increased their scrutiny of SPEs. The SEC is currently debating proposed changes, and FASB recently issued a ruling. FASB adopted Financial Accounting Interpretation (FIN) 46, effective January 31, 2003, for newly created entities. More importantly, existing entities were not grandfathered and must comply with the ruling.
FIN 46 divides legal entities into two groups: those consolidated through “voting interests” (the original definition) and those consolidated by “variable interests.” The acknowledgement of variable interest entities (VIEs) expands the requirement for consolidation. The firm that benefits from residual returns and covers expected losses is required to consolidate the entity on its financial statements. In addition, the required outside equity increased from 3 percent to 10 percent.
FIN 46 is broad enough and SPE structures are complex enough that it will take some time before accounting professionals fully understand the implications of the ruling. However, it is clear that all parties involved with entities, including those without any nominal equity interest or voting rights, will need to analyze their relationships to the SPE to determine if they must now consolidate.
Why an SPE?
There are many reasons given to explain the use of an SPE. We will look at three in detail:
- Reduce the cost of borrowing
- Shift risk to another party
- Transfer tax advantages to another party
Why are borrowing costs reduced?
In corporate finance, two general classes of external financing are recognized, equity and debt. Equity is more risky to an investor than debt and therefore, requires a return premium. Consequently, equity is more costly to the firm than debt. But equity provides flexibility – no returns are promised, and dividends are paid at the discretion of management. Alternatively, firms may reduce their cost of external funding by issuing debt. But debt has a fixed cost, and payments to debt holders must be made, or the company can face legal action. However, the IRS provides an added bonus. Firms expense interest payments for tax purposes, thereby further reducing the cost to issuers.
An ideal financing instrument would combine the tax benefits of debt with the flexibility or “no promises” of equity. An SPE can be structured to create such a hybrid security. A firm can create an SPE and fund it with subordinated debt. The SPE then issues preferred stock, stock that allows dividends to be skipped without repercussions. Normally, subordinated debt would carry a cost reflective of its subordinated position, but given the debt is issued to a captured entity, the issuing firm only need establish a coupon high enough to meet preferred dividend requirements. The end result is a flexible financing structure in which debt is raised at a reasonable cost, yet the firm has the flexibility of deferring payment without legal recourse.
How is risk shifted?
An SPE can be used to shift risk from one firm to another willing to accept it. For example, Dell Computers has a joint venture, Dell Financial Services (DFS), with Tyco International Ltd. Dell, which owns 70 percent of DFS, sells its accounts receivables or the loans it makes to customers who buy Dell computers on credit, to DFS. This allows Dell to reduce its collection period and cost. However, Dell does not control DFS and therefore, does not include it on consolidated financial statements. Tyco’s management states that it considers the customer, not Dell, responsible for payment and consolidates DFS. Therefore, Dell shifts the risk of bad debt to Tyco.
How are tax advantages transferred?
With the help of their investment bankers during the 1990’s, airlines developed a new method to finance the purchase of airplanes – a leveraged lease held in an SPE. In this type of financing, the equity investors provide 20 percent of the funds needed to purchase the airplane, and the airline, typically by using funds borrowed from investors, provides the remaining 80 percent (the debt portion). The equity providers thus reduce their tax obligations by depreciating the airplane over a seven-year period.
A particularly popular form of the leveraged lease is the “enhanced equipment trust certificate,” or EETC. The EETC is typically issued against a pool of airplanes. Notes are then issued in groups (or tranches) with different maturities and expected returns. EETCs have been used by Continental Airlines to finance 75 percent of its airplanes, by America West to finance virtually all its airplanes, and by US Airways to finance almost 100 percent of its purchases since 1995.
However, equity providers did not seem to recognize that risk was also shifted. After September 11, airline travel decreased, and airlines cut their flight schedules. Thousands of unneeded airplanes were parked in the desert, and the value of airplanes decreased 20 to 40 percent. Airlines sought or threatened to seek bankruptcy protection. They negotiated tough new terms with their creditors, including EETC equity providers. As expected, firms such as Boeing and General Electric, both of which have large airplane financing units, suffered losses on their investments. However, other losses came as a surprise. Disney announced in late 2002 that it was taking a non-cash charge of $114 million to write down losses on an equity position in an EETC. Bank of New York, Morgan Stanley, Pitney Bowes, and others announced similar losses. The final impact on corporate America and airplane financing is still to be seen.
Should We Throw Out the Baby?
There are legitimate economic reasons to use SPEs. They can reduce the cost of borrowing, shift risk to another party, and transfer tax advantages to those who can use them. However, all transactions must be obvious to all impacted parties, and all parties must understand the risk implications. Consequently, how to increase transparency is the aim of SEC proposals now being discussed. However, if a firm uses an SPE or any other practice to hide liabilities, fraud or manipulation, then the question is can any number of rules and regulations stop such actions? Does throwing the baby out with the bath water solve these problems?
Matthew Goldstein, “Is ‘Structured Finance’ Still Shady?” TheStreet.com, April 7, 2003.
Kathryn Tully, “Asset-backed Comes into Its Own,” Euromoney, Issue 398 (June 2002), p. 96-101.
Britt Tunick, “Many Worries for Synthetic Leases: Loans may be disguised, but even bankruptcy can’t avoid them,” The Investment Dealers’ Digest, March 18, 2002, p. 11-12.
Nick Evans and Antony Currie, “Enronitis, Witch-hunts and Financial Hypochondria,” Euromoney, Issue 395 (March 2002), p. 42-47.
Mindy Berman, “A Closer Look at Financial Accounting Interpretation No. 46,” Securities Data Publishing Asset Securitization Report, January 27, 2003.
David Henry with Heather Timmons, Steve Rosenbush, and Michael Arndt, “Who Else Is Hiding Debt?” BusinessWeek, Issue 3767 (January 28, 2002), p. 36-37.
J. Lynn Lunsford and Susan Carey, “Jet-Finance Deals May Suffer From Continued Airline Woes,” The Wall Street Journal Online, January 14, 2003.