Off Balance Sheet Financing, Variable Interest Entities, and Synthetic Leases

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Off Balance Sheet Financing, Variable Interest Entities, and Synthetic Leases

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Title: Off Balance Sheet Financing, Variable Interest Entities, and Synthetic Leases

1
Off Balance Sheet Financing, Variable Interest
Entities, and Synthetic Leases

And Enrons Collapse

Why do companies want to keep debt off the
balance sheet?

Leverage, debt/equity ratios, return on assets
(higher net income, smaller asset baseas we
leave off debt, we also leave off the related
asset)
And how are assets removed from the balance
sheet? As they become expenses in future periods

4
Who is using Off-Balance Sheet Financing?

Krispy Kreme, Continental Airlines, Cisco,
Pacific Gas and Electric, Goldman Sachs,
Microsoft, AOL Time Warner, Sears
In April, 2002, it was estimated that 10 - 20
billion of real estate is financed annually in
the US using synthetics

GE has about 56 billion worth of assets off its
books in SPEs, which represents 10 of GE total
assets.

Robert Willens, of Lehman Brothers states, Well
over half of American companies use some type of
off-balance sheet financing.

7
Three ways to keep debt off the Balance Sheet

leasing property or equipment instead of buying
it the equipment may be owned by a third party
or by a Variable Interest Entity, which is a form
of joint venture.
selling less valuable assets such as accounts
receivable instead of using them as collateral
creating a new joint venture (Special purpose
entity) to transfer both assets and liabilities.

8
So what is a Variable Interest Entity?

VIEs are business entities formed for the purpose
of conducting a well-specified activity, such as
the construction of a gas pipeline, collection of
a specific group of accounts receivable, etc.
Because VIEs are usually designated to conduct
just one pre-specified activity, the cash flows
and risk of the venture are normally clearly
specified.

By contrast, in a normal corporation the
corporate management can take on a variety of
transactions and activities the investor did not
expect.
What does this mean from an investors viewpoint?
Or a creditors viewpoint?

Despite the accounting questions raised by their
use, VIEs have been generally recognized as
legitimate financial tools.
They have played a vital role in helping
companies raise capital at a reasonable cost.
VIEs can generate great economic benefits.

OrVIEs can be used to manipulate a companys
financial reports to inflate assets, to
understate liabilities, to create false profits,
and to hide losses.
(VIEs are a lot like firethey can be used for
good or ill.)

12
Example

A company needs 1 billion to finance building
a gas pipeline in central Asia. Investors may
want their risk/reward exposure limited to the
pipeline. They might also want the pipeline to be
a self-supported, independent entity with no fear
that the sponsoring company would sell it. These
objectives can be achieved by forming a VIE with
a charter that specifies these limited operating
activities.

So the VIE could be a joint venture between a
sponsoring company and a group of investors. The
disposition of net cash flows from the venture
may be restricted to payments to the investors.

VIEs can be structured to preclude bankruptcy
filings. One way of doing this would be to
create 2 VIEs. The first would be the primary
investment vehicle to raise capital from outside
investors and would be designed to be completely
protected from bankruptcy filing. It might be an
all-equity entity (with no debt, it cant be
forced into bankruptcy)

The VIE doesnt have to be LARGE, so it might not
need a large equity investment to create the
initial VIE.

VIE1 would then invest in VIE2, which would buy
assets (either from a 3rd party or from the
sponsoring organization) hold the debt associated
with the purchase of those assets, and conduct
the specified activities of the project.
VIE1 would have to invest equity equal to 10 or
more of the assets of VIE2, which would equal
100 of the voting shares of VIE2.

The 2-part VIE also makes it easier to keep debt
off of the sponsoring corporations balance sheet
as it makes it easier to avoid consolidation.
Further, the transfer of assets to VIE2 by the
sponsoring company is considered a sale, and any
gain or loss on the transfer is recognized in
income.

Not only are corporations pleased with the
financial statement impact of using off-balance
sheet financing and VIEs, lenders might REQUIRE
the use this structure as they perceive that it
limits their risk and allows them to better
manage their risk.

As we will see, everyone attempts to limit their
risk exposure, and different parties in the
transaction may believe that their risk exposure
is essentially zero. However, there is not
adequate court precedent to validate this
belief(SOMEBODY has to be responsible for risk
of defaultdont they????)

20
Synthetic Leases

Leasing property or equipment instead of buying
it may involve the use of a synthetic lease. A
synthetic lease allows a company to have the
benefits of ownership without having to put the
asset or the liability on the balance sheet

(and how do assets get removed from the balance
sheet? When the are expensed to the income
statement.they have limited the expenses they
need to recognize on the income statement to just
the rent expense, no depreciation)

VIEs are the structure used to implement a
synthetic lease.

In a synthetic lease, the asset is held by the
VIE, and the VIE takes out loans to finance the
purchase of the asset. The asset is then leased
to the sponsoring corporation.

What do we remember about leases?
Capital leasethe value of the leased asset is
recognized, as is a liability equal to the
present value of the future lease payments.

In a capital lease, the asset and liability are
on the balance sheet, and the income statement
recognizes both the interest expense and
depreciation expense.

26
Capital Lease Criteria

Meeting any ONE of the following 4 criteria
causes the leasing corporation to recognize a
capital lease
PV of the lease payments 90 of FMV of asset
Lease life is 75 of total life
Title transfers at end of lease
Lease contains a bargain purchase option

Operating leaseno asset on the books, no
liability on the bookseach cash payment under
the lease is rent expense
If a lease can be structured as an operating
lease, the asset and related liability are kept
OFF the balance sheet.

Synthetic leases are structured so that the
sponsoring corporation accounts for them as
operating leases.
The lease term is less than 75 of the expected
useful life, and the payments are close to the
payments the SPE makes on the debt. At the end
of the lease term, the lessee usually has the
option to purchase the asset at its original
purchase price.

Instead of the company owning the asset, the VIE
owns the asset.
But the VIE is dependent on the sponsoring
company for cash flows, so has the sponsoring
company has not really given up control of the
asset?
The question of economic control, legal control,
and accounting control needs to be answered.

As long as the VIE does not have to be
consolidated with the financial statements of the
sponsoring corporation, the debt and asset are
both kept off the books.

31
Consolidations...

What do we know about consolidations?
The corporation must own 50 or LESS of the
voting interest of the SPE
At least one additional stockholder must own at
least 10 of the total assets of the VIE
(But remember, A-L OE, and OE may be very
small)

Also, for a VIE to remain unconsolidated, the
independent 3rd party owner(s) must possess the
substantive risks and rewards of the investment
in the VIE (FIN 46)--the owners investment and
return are at risk and not guaranteed by
another party (ENE).

The relation of the sponsoring company to the VIE
should be disclosed in the footnotes. This
should include guarantees or contingent
obligations. (The sponsoring corporation can
guarantee the debt of the VIE, but not the return
to the equity stockholders.)

The VIE is dependent on the sponsoring company
for its cash inflows, which are primarily the
rent charged for the asset.
These cash flows are then used to pay the debt
obligation.

Benefits of a synthetic lease include
Favorable interest ratesi.e.., 4 vs. 15
Favorable tax treatment. Congress passed a law
that allows depreciation expense as an expense on
the tax return even though the corporation does
not own the asset.
Stronger balance sheet, with lower leverage
ratios risk has been parceled out
Added protection from violating debt covenants
for sponsoring corporation.

Increased flexibility and lower cost of capital
And..the company is also directly benefiting
investors by conserving cash (taxes, interest)

37
Example

ABC Company wants the use of a building for its
corporate offices for he next 20 years. The land
and building would cost 100 million to buy.
A VIE is formed to buy the land and building. A
financial institution loans the VIE up to 90 of
the fmv of the real estate.
The loan is backed by the building.

The remaining 10 of the cost is put up by an
outside equity investor(s). The outside investor
owns 100 of the shareholder equity in the VIE
(Remember, Assets Liabilities Owners Equity.
This is what the 10 rule that is discussed is
all about.)

So, should the VIE be consolidated?
All of the outside equity is owned by someone
other than the sponsoring corporation.
(Normally, we consolidate when a corporation owns
more than 50 of the equity in a subsidiary.)

The VIE leases the land and building to ABC
Corporation at a lease cost adequate to cover the
lease payments.
At the end of the lease, the VIE sells the asset
at fmv (possibly to ABC) OR at original cost
(depending on the VIE terms and how the loan was
structured) and transfers any gain on sale to the
outside investors.

IF ABC had originally owned the building, they
could have sold it to the VIE, booked the gain on
sale, and leased it back.
They get the double benefit of booking the gain
on sale and of getting both the asset and the
liability off the balance sheet.

Estimates of the size of the synthetic lease
market vary (there is no required reporting for
the VIE as it is not publicly held) but some
claim that as much as 600 billion of real
estate, equipment, and other assets in the US may
be financed by synthetic leases.

GECC reports equipment leased to others of
36.5 billion, and an additional 29.4 billion in
direct financing leases

Example of dormitories on college campuses.

45
Risks...

Interest rate risk. The interest rate on the
debt acquired by the VIE is often a variable rate
debt, tied to a rate such as LIBOR (London
Interbank Offered Rate)
This risk can be managed with a derivative such
as an interest rate swap.

Residual Value Guarantees
At the end of the lease, the property is either
purchased by the company at its original cost (it
may have gone up or done since then), its fmv,
or rolled into a new lease, or sold to an
unrelated 3rd party to pay off the debt.
There is a danger that the property value will
decrease.

A rollover into a new lease may not be possible
if the lender has developed concerns about the
companys ability to payand if the company cant
pay, they may have to sell the asset to a third
party. If the asset is sold at a loss, the VIE
is liable for the difference, and that may have
to be paid by the sponsoring corporation as the
only source of VIE assets is the corporate rent
payment.

Synthetic leases are expensive in terms of legal,
tax accounting, securities registration, and
other similar costs.

Another major risk for VIE investor is that the
assets of the VIE, while seemingly completely
isolated from the transferor, may be rolled back
into the transferors balance sheet by a
bankruptcy judge. There is not adequate case
precedent to determine when this might happen.

The examples weve just seen consider the use of
VIEs to facilitate transactions with tangible
assetsreal estate, inventory, etc.
VIEs are also used for financial assets.

VIEs are used to increase liquidity by allowing a
company to bundle assets like accounts receivable
or mortgage-backed securities and to obtain cash
for these securities before the maturity date.

For example, Bank A might have loans with a face
value of 100 million. Because interest rates
have changed, the loans may have a fmv of 110
million. The Bank can transfer the loans to a
VIE. IF the transfer qualifies as a sale, the
bank may book a gain on sale immediately.

There have been questions about aggressive use of
the gain on sale accounting with respect to VIEs
of several financial institutions. For example,
Conseco, Inc. acquired a financing arm, Green
Tree Financial Corporation, in mid-1998. Prior
to the acquisition by Conseco, Green Tree had
made have use of gain-on-sale accounting for
several asset transfers.

The income recognized in these transactions had
to be later written down by Conseco when the
collections on receivables proved to be far less
than initially assumed. In early 2000, Conseco
took a 350 million write-off.

There is concern that VIEs can be motivated
either by a genuine business purpose, such as
risk sharing among investors and isolation of
project risk from company risk, or by a specific
financial disclosure goal, such as off-balance
sheet financing.

The financial accounting and disclosure effects
obtained by the use of VIEs differ substantially
in character and complexity from what we have
traditionally understood to be accounting
manipulations. Some refer to these effects as
financial engineering effects rather than
accounting manipulation.

VIE transactions are inherently complex,
requiring the formation of legal entities, and
the creation of financing arrangements between
the company, its lenders, and new outside
investors. These financial arrangements are
sometimes referred to as structured finance.

According to Dharan (Rice University, Houston),
an important characteristic of financial
engineering is an organizational commitment to
earnings management
Accounting manipulation, such as accrual and cost
allocation decisions, can be planned and executed
by individuals without full organizational
involvement.

By contrast, achieving the desired accounting
effects from the use of VIEs requires significant
legal planning, including the proper creation of
legal entities, as well as the use of investment
bankers for raising the necessary loans and
external capital.

Financial engineering thus also requires the
involvement of senior management and the company
board of directors in the decisions to create the
needed financial structures.

This means that a corporation where financial
engineering of financial statements is conducted
may well be characterized by a large-scale
break-down of internal controls to prevent
earnings management, as well as a general
corporate climate of accepting false performance
reports as representing reality...or that reality
doesnt matter...

The lack of disclosure transparency is another
characteristic of financial engineering decisions
and structured finance arrangements.
There are limited tools of financial analysis
available to senior managers and investors to
monitor the income effects of financial
engineering.

For instance, if debt is held off-balance sheet,
there is not much an investor or corporate
manager can do to predict when and whether the
debt will affect the reported financial
performance of the company. Further, off-balance
sheet debt may be able to be refinanced
indefinitely.

64
Hiding Debt

This seems to be a primary motivation for a
number of VIE controversies. The main purpose of
a VIE may be to let the VIE borrow funds and not
show the debt on the books of the sponsoring
corporation.

65
Gain on Sale Accounting

It may be possible to manipulate and misstate the
value at which the assets are transferred to the
VIE. It is potentially not an arms length
transaction.

66
Hiding Poor-Performing Assets

Companies may move underperforming assets to the
VIE, outside the view of investors of the
sponsoring corporation. For example, if
investment in a stock is transferred to the VIE,
subsequent declines in value would not appear on
the sponsoring corporations books (e.g., dot.com
investments)

67
Execution of transactions at fictitious prices
and on demand

By selling a portion of an investment to an VIE,
a market price is determined that may then be
used to value the retained asset to market. The
transfer of the asset can take place at the
discretion of management, and management
determines the transfer price.

And Enron has been accused of all of the above....

69
How Did This Happen???

The Enron story began with the merger of two gas
pipeline companies, Houston Natural Gas and
InterNorth. Its purpose was to be an interstate
natural gas pipeline company.

70
Deregulation

Deregulation in the utilities industries created
significant challenges for the new company.
Enron was losing its exclusive rights to
distribute its products.
Kenneth Lay, the first CEO, believed ENE needed
to develop a new business strategy to remain
competitive.

71
McKinsey Company

Lay hired McKinsey Company, management
consultants, to help develop a new business
strategy.
Jeffrey Skilling was one of the consultants who
began to work with Enron.
Skilling proposed a radical plan. Enron would
buy gas from suppliers and resell it to users,
charging a small fee for handling the
transactions.

Deregulation would allow ENE to take the roll of
middle man, matching supply and demand for gas.
Enron would buy gas from a network of suppliers,
sell it to a network of consumers, and
contractually guarantee both the supply and the
price. In doing so, ENE created a new product
and a new paradigm for the industrythe energy
derivative.

Skillings plan was successful, and Lay hired him
from McKinsey to work for Enron.
It is claimed that Skilling changed the corporate
culture at Enron.

74
Skilling

Skilling adopted an employee ranking system,
Performance Review Committee.
The PRC gained the reputation of having been the
harshest employee-ranking system in the country.
The Performance Review Committee ranked everyone
against their peers.

There was no limit on the bonuses paid to the top
performers.
Up to 15 of the bottom performers were fired
each year.
Fierce internal competition prevailed and
immediate gratification was prized above
long-term potential.
Secrecy became the order of the day.

The Performance Review process created incentives
to do the deal at all costs.

77
EnronOnline

Top executives became enamored with the new
economy, believing that they could duplicate the
success of the gas derivatives business with
electricity trading and eventually with any
product people were willing to tradeand even
some they were not!

In 1996, Jeffrey Skilling became Enrons
President and COO.

In August 1999. ENE essentially quite the oil and
gas production business, and in October 1999, ENE
began EnronOnline.

80
EnronOnline

In 2000, EnronOnline handled 355 billion in
trades.
Key to the volume of trades was financing the
transactions.
To maintain a strong credit rating, ENE began the
widespread use of Special Purpose Entities (now
called Variable Interest Entities) and
partnerships.

81
Andrew Fastow

Fastow was a protégé of Skilling, and it fell to
him to develop the financing that was required to
allow EnronOnline to function.
Fastow was under intense pressure to produce more
and more financing.

Enron used accepted practices for reducing risk,
including transference of high risk assets off
its books. The company also transferred debt to
separate entities, off its books.
This improved the balance sheet and ENEs
apparent return on investments.

83
ENRON

Testimony of Frank Partnoy, Professor of Law,
University of San Diego School of Law, Hearings
before the United States Senate Committee On
Governmental Affairs, January 24, 2002
www.senate.gov/gov)affairs/0212402partnoy.htm

Enron was at its core a derivatives trading firm.
Many people didnt understand that, thinking that
ENE was primarily an energy company.
But it had transformed into a new economy
company with a primary business of trading in
derivative securities.

From numbers in ENEs 2000 Income Statement,
using the assumption that other revenues is a
gain or loss from derivatives transactions
2000 1999 1998
Non derivatives revenue 93,557 34,744
27,215
Non derivatives expenses 94,517 34,761
26,381
Non derivatives gross margin (960)
13 834
Gain (loss) from derivatives 7,232
5,338 4,045
Other Expenses 4,319 4,549 3,501
Operating Income 1,953 802 1,378

The increase in non-derivatives revenue was
offset by an increase in non-derivatives
expenses.
ENEs non-derivatives businesses were not
performing well in 1998 and were deteriorating
through 2000, as indicated by the negative trend
in gross margin.
ENEs positive operating income was primarily
from gains from derivatives.

There appear to be two answers to the question of
why ENE collapsed. One relates to the use of
derivatives outside ENE, in transactions with
some no-infamous Special Purpose Entities.
The other relates to the use of derivatives
inside ENE.

Derivatives can be traded two ways on regulated
exchanges or in unregulated OTC markets. ENEs
activities involved the OTC derivatives markets.

The size of derivatives markets typically is
measured in terms of the notional values of
contracts. Recent estimates of the size of the
exchange-traded derivatives market are in the
range of 13 to 14 trillion in notional amount.
By contrast, the estimated notional amount of
outstanding OTC derivatives as of year-end 2002
was 95.2 trillion.

The OTC derivatives markets, which for the most
part did not exist twenty (or in some cases 10)
years ago, now comprise about 90 percent of the
aggregate derivatives market. By those measures,
OTC derivatives markets are bigger than the
markets for U.S. stocks.

By 2000, ENE had become a full-blown OTC
derivatives trading firm. Its OTC
derivatives-related assets and liabilities
increased more than five-fold during 2000 alone.

92
Derivatives outside ENE

ENE had over 3,000 off-balance sheet subsidiaries
and partnerships.

ENE entered into derivatives transactions with
these entities to shield volatile assets from
quarterly financial reporting and to inflate
artificially the value of certain ENE assets.

ENE used derivatives and SPEs to manipulate
its financial statements in three ways
It hid losses it suffered on technology stocks
It hid huge debts incurred to finance
unprofitable new businesses
It inflated the value of other troubled
businesses.

95
Using Derivatives to Hide Losses on Technology
Stocks

ENE invested hundreds of millions of dollars in
speculative technology stocks. As the market
began to deteriorate, they hid the losses.
An oft-cited example is Rhythms Net Connections,
a start-up telecommunications company.

A subsidiary of ENE (along with other investors
including MSFT and Stanford University) invested
a relatively small amount of venture capital (on
the order of 10 million) in Rhythms Net
Connections.

Rhythms went public on April 6, 1999. ENEs
stake was suddenly worth hundreds of millions of
dollars. (And this was only one of ENEs tech
investments..)

ENE was prohibited from selling its stock for 6
months after the IPO.

ENE entered into a series of transactions with an
SPE, in this case, Raptor, which was owned by
another SPE, LJM1.
ENE gave Raptor the shares of stock in exchange
for a loan.
Raptor issued its own securities to investors and
use the cash from this stock transaction to lend
money to ENE.

100

ENE entered into a price swap derivative
contract with Raptor. ENE committed to give ENE
stock to Raptor if Raptors assets declined in
value. In other words, as long as Rhythms Net
Connections stock price remained high, ENE had
no problems. And as long as ENE stock price
remained high, problems would be relatively minor.

101

ENE had committed to maintain Raptors value at
1.2 billion. If ENE stock price declined in
value, ENE would need to give Raptor more shares
to maintain this value.
This ENE transaction carried the risk of diluting
the ownership of ENE stockholders if either ENE
stock or the stock Raptor held declined in value.

102
Using Derivatives to Hide Debt

Because the securities Raptor issued were backed
by ENEs promise to deliver more ENE shares,
investors in Raptor essentially were buying ENE
debt, not the stock of Rhythms Net Connections.
In fact, the performance of Rhythms Net
Connections was irrelevant to investors in
Raptor.

103

Essentially, ENE was using stock as collateral
for debt, disguised as share ownership.

104

ENE recognized the gain on the technology stocks
and avoided recognizing, at least on an interim
basis, any future losses on the technology stocks
they owned.

105

According to Sherron Watkins, ENE recognized over
550 million of fair value gains on stocks via
swaps with Raptor. Yet much of the stock
declined significantlyAvici by 98 from 178
million to 5 million, New Power Company by 80
percent from 40 per share to 6 per share.

106

Enron had to issue stock to offset these losses.
In all, ENE had derivative instruments of 54.9
million shares of ENE common stock at an average
price of 57.92, or about 3.7 billion. At the
start of these deals, over 7 of ENE shares were
potentially committed, and the number rose as the
value of the shares declined.

107

Further, because the SPEs were not consolidated,
the decline in value was not reflected on the
quarterly financial statements.

108

This appears to be the type of guarantee that
Andersen claims was not disclosed to them in
their audit of ENE.
Either Andersen did not know, or they determined
that the guarantee did not constitute control
which would require consolidation.

109

Other commonly cited example here involves JEDI
and Chewco SPEs.

110

The form of the transactions between ENE, JEDI,
and Chewco were similar to the transactions with
Raptor, guaranteeing repayment to Chewcos
outside investor.

111

From 1993 through 1996, ENE and the California
Public Employees Retirement System (CalPERS)
were partners in a 500 million joint venture
investment partnership called JEDI.

112

Because ENE and CalPERS had joint control of the
partnership, ENE did not consolidate JEDI. ENE
would therefore record its contractual share of
gains and losses from JEDI on its income
statement and would disclose the gain or loss
separately in its financial footnotes, but would
NOT show JEDIs debt on its balance sheet.

113

In November, 1997, ENE wanted CalPERs to invest
in another, larger partnership. CalPERS was
willing, but only if their interest in JEDI was
bought out first.
ENE needed to find a new partner for JEDI to
avoid consolidation of its financial statements.

114

Chewco was formed to purchase CalPERs interest.
They needed to find an independent investor to
put up 3 of the total assets in Chewco as an
equity investment.
They were unable to do so.

115

Notwithstanding the shortfall in required equity
capital, ENE did not consolidate Chewco (or JEDI)
into its consolidated financial statements.
When ENE and Andersen reviewed the transaction
closely in 2001, they concluded that Chewco did
not satisfy the SPE accounting rules.

116

Because JEDIs non-consolidation depended on
Chewcos statusneither did JEDI.
In November 2001, ENE announced that it would
consolidate Chewco and JEDO retroactive to 1997.
This retroactive consolidation resulted in a
massive reduction in ENEs reported net income
and a massive increase in its reported debt.

117

For entities do not have to be consolidated, they
are considered related parties, and under FAS 57,
companies have to disclose the nature of the
relationship with related parties. It is
debatable whether ENEs impenetrable footnotes
met the requirements.

118

In 2000, ENE disclosed about 2.1 billion of such
derivative transactions with related entities,
and recognized gains of about 500 million
related to those transactions. This was
disclosed in footnote 16, page 48, of the Enron
2000 Annual Report...

119
Using Derivatives to Inflate the Value of
Troubled Businesses

It appears that Enron inflated the value of
certain assets it held by selling a small portion
of those assets to a special purpose entity at an
inflated price, and then revaluing the remaining
assets held on their balance sheet at the new
inflated price.

120

From the 2000 annual report, page 49 In 2000,
Enron sold a portion of its dark fiber inventory
to the Related Party in exchange for 30 million
cash and 70 million note receivable that was
subsequently repaid. Enron recognized gross
margin of 67 million on the sale.

121

The related party was LJM2, an SPE run by Andrew
Fastow, the CFO of Enron.
Enron sold fiber with a cost bases of 33 million
for three times that value. LJM2 issued
securities to investors to obtain the cash to pay
the note receivable. The investor was willing to
buy the stock because if the dark fiber
declined in value, ENE would make the investor
whole.

122

So Enron retained the economic risk associated
with the dark fiber. And even as the value of
the dark fiber plunged during 2000, Enron
recorded a significant gain on the sale, and
avoided recognizing any losses on assets held by
LJM2.

123

Enrons sale of dark fiber to LJM2 magically
generated an inflated price which Enron then
could use in valuing any remaining dark fiber it
held.
According to testimony, the letter from Sherron
Watkins indicated this is exactly what happened.

124
Derivatives Inside Enron

Enron changed from an energy business to a
derivatives trading company.
AS the shift occurred, it appears that some
employees began lying systematically about the
profits and losses of the trading operation. In
good times, they established prudency reserves
that they then dipped into when times were bad.
Essentially, they established cookie jar
reserves

125
Mismarking Forward Curves

A forward curve is a list of forward rates for a
range of maturities for derivative contracts.
For example, natural gas contracts trade on the
New York Mercantile Exchange. A trader can
commit to buy a particular type of natural gas to
be delivered in weeks, months, or years.

126

The rate at which a trader can buy natural gas
today with in payment and delivery in one year is
the one year forward rate. The forward curve for
a particular natural gas contract is simply the
list of forward rates for all maturities.

127

Forward curves are used to determine the value of
a derivatives contract today, and are used to
mark the contract to market as required by GAAP
for derivatives contracts (as financial assets,
they are revalued to market at the financial
statement date.)

128

It appears that traders would deliberately
mismark their forward curves to create artificial
values for contracts (and artificial income as
well.)
A trader can also develop valuation models for
complex contracts that arent routinely traded.
Tweaking the assumptions can change the value
significantly.

129

Certain derivative contracts are more susceptible
to mismarking than othersfor example it is
difficult to mismark contracts that were publicly
traded. However, the NYMEX forward curve has a
maturity of only six years a trader could
mismark a ten-year natural gas forward rate.

130

Because many of Enrons derivatives had long
maturities..up to 29 yearsthere were often not
prices from liquid markets to use as benchmarks.
It is possible that some contracts were valued
based on transfer rates between different
nonconsolidated SPEs.

131

Enron Online was founded in the fall of 1999.
During 2000, Enrons derivatives-related assets
increased from 2.2 billion to 12 billion, and
Enrons derivatives-related liabilities increased
from 1.8 billion to 10.5 billion.

132

Much of this change was related to EnronOnline.
But EnronOnlines assets and revenues were
qualitatively different from Enrons other
derivatives trading.

133

Whereas Enrons derivatives operations included
speculative positions in various contracts,
EnronOnlines operations simply matched buyers
and sellers. The revenues associated with
EnronOnline arguably do not belong in Enrons
financial statements.

134
Risk Management At Enron

Enrons risk management manual stated, Reported
earnings follow the rules and principles of
accounting. The results do not always create
measures consistent with the underlying
economics. However, corporate managements
performance is generally measured by accounting
income, not underlying economics. Risk management
strategies are therefore directed at accounting
rather than economic performance.

135
So where are we with

Special Purpose Entities
Variable Interest Entities

136

In 1990, the EITF, with the implicit concurrence
of the SEC, issued guidance in EITF 90-15. This
guidance and the related EITF publication called
Topic D-14, Transactions Involving Special
Purpose Entities, were the primary sources for
the acceptance of the infamous three percent rule
for SPE non-consolidation.

137

The 3 rule stated that an SPE need not be
consolidated if at least three percent of the
total assets was owned by the outside equity
holders who bear ownership risk.
The rule was formalized in FAS 125 (June 1996)
which was replaced with FAS 140 (September 2000).

138

Motivation for the EITF is found in the SEC
Observer cited in D-14
The SEC staff is becoming increasingly concerned
about certain receivables, leasing, and other
transactions involving SPEs. Certain
characteristics of those transactions raise
questions about whether SPEs should be
consolidated, notwithstanding lack of majority

139

ownership, and whether transfers of assets to the
SPE should be recognized as sales. Generally the
SEC staff believes that for nonconsolidation and
sales recognition by the sponsor to be
appropriate, the majority owner(s) of the SPE
must be an independent third party who has made a
substantive capital investment in the SPE, and
has control

140

of the SPE, and has substantive risks and rewards
of ownership of the assets of the SPE, including
substantive risks and rewards of ownership of the
assets of the SPE (including residuals).
Conversely, the SEC staff believes that
nonconsolidation and sales recognition are not
appropriate by the sponsor when the majority
owner of the SPE makes only a nominal capital
investment,

141

the activities of the SPE are virtually all on
the sponsors behalf, and the substantive risks
and rewards of the assets or the debt of the SPE
rest directly or indirectly with the sponsor.

142

In EITF 90-15 discussion, however, the following
statement was made
The initial substantive residual equity
investment should be comparable to that expected
for a substantive business involved in similar
leasing transactions with similar risks and
rewards. The SEC staff understands from
discussions with the Working Group members that
those

143

members believe that the 3 percent is the minimum
acceptable investment. The SEC staff believes a
greater investment may be necessary depending on
the facts and circumstances.

144

It appears that the 3 rule was an ad hoc
solution to a specific issue faced by the EITF
and was intended as guidance.
Somehow that guidance became the industry
standardand professional judgment about fair
presentation was been left behind.

145

Further, the rule was a significant easing of the
normal consolidation rule that normally requires
control, regardless of percent ownership, be the
standard for determining consolidation vs.
nonconsolidation.

146

The charter that limits the sponsoring companies
activities with respect to the SPE has been used
to justify the claim that the sponsoring
corporation does not have control.

147
FIN 46

Because of the problems with SPEs brought to
light with ENE, the FASB issued Interpretation
46, Consolidation of Variable Interest Entities.

148
FIN 46

In general, a variable interest entity is a
corporation, partnership, trust, or any other
legal structure used for business purposes that
either (a) does not have equity investors with
voting rights or (b) has equity investors that do
not provide sufficient financial resources for
the entity to support its activities.

149

Fin 46 increases the minimum outside equity
investment in a VIE to 10 from 3. Those that
fail the new standard can no longer be kept off a
balance sheet. Companies have until the end of
the third quarter to either comply with the new
10 requirement, or to consolidate the VIE.

150

A variable interest entity often holds financial
assets, including loans or receivables, real
estate or other property. A variable interest
entity may be essentially passive or it may
engage in research and development or other
activities on behalf of another company.

151

Until FIN 46 was released, one company generally
has included another entity in its consolidated
financial statements only if it controlled the
entity through voting interests.

152

Interpretation 46 changes that by requiring a
variable interest entity to be consolidated by a
company if that company is subject to a majority
of the risk of loss from the variable interest
entitys activities or entitled to receive a
majority of the entity's residual returns or
both.

153

A company that consolidates a variable interest
entity is called the primary beneficiary of that
entity.

154
FIN 46

In contrast to the original exposure draft, which
applied only to special-purpose entities (any
entity that did not meet the accounting
definition of a business), the final
Interpretation is far broader in scope and
potentially applies to any legal entity, such as
real estate partnerships and joint ventures.

155

FIN 46 is complex. Judgment is called for in
analyzing entities with which a company has
business arrangements to determine if those
entities are Variable Interest Entities (VIEs)
and, if so, whether consolidation is required.

156

In applying FIN 46, an enterprise and its related
parties must first determine whether they have a
variable interest in another entity.

157

If the enterprise and its related parties have a
variable interest in an entity, they next need to
determine if the entity is a VIE. An entity is a
VIE if
the equity in the entity is not sufficient to
absorb the entitys expected losses
the equity investors do not have the ability to
control the activities of the entity or
the investors are not obligated to absorb losses,
if they occur, or receive the entitys residual
returns, if they occur.

158

If an entity is a VIE, the enterprise and its
related parties need to determine if they or
another investor are exposed to a majority of
the entitys expected losses. If so, that party
is required to consolidate the VIE.

159

If no investor is exposed to a majority of
expected losses, then the enterprise and its
related parties would need to determine if they
are entitled to a majority of the entitys
residual rewards. If so, they would be required
to consolidate the entity.

160

So the three main accounting issues are
Whether or not the VIE should be consolidated
(FIN 46)
When the transfer of assets to a VIE should be
treated as a sale
How the related-party transactions are defined
and reported. Can transfers of assets to related
parties be reported as revenue?

161
Consolidating VIEs

Consolidation rules for VIEs have been
controversial and can be traced back to the
initial statements that set conditions for
capital and operating leases.

162

Out of the ashes of the Enron debacle, corporate
reputation is reemerging as a significant
economic value.
Companies are facing a newly energized
shareholder community - especially big pension
funds, foundations and social activists...
Harvey Pitt, March, 2002, in written testimony to
Congress

163
Harvey Pitt

Corporate governance needs to be improved. Recent
events underscore the need to craft responsible
guidance for directors and senior officers to
follow.

164

There are a number of ways current corporate
governance standards can be improved to
strengthen the resolve of honest managers and
the directors who oversee management's actions
and make them more responsive to the public's
expectations and interests.

165

We think the best way to do that is a two-fold
approach first, make certain that officers and
directors have a clear understanding of what
their roles are, and second, apply serious
consequences to those who do not live up to their
fiduciary obligations.

166

Corporate governance should establish policies
and procedures that encourage corporate leaders
be faithful to the interests of shareholders and
act with both ability and integrity. The most
important challenge to corporate governance today
is to restore the preeminence of these values

167
Business Roundtable on Corporate Governance

Principles
Select CEO AND oversee the SEE and other senior
management in the competent and ethical
operations of the company on a day to day basis.
Management has the responsibility to act in an
effective and ethical manner to produce value for
the stockholders

168

Management has the responsibility to produce
fair financial statements and timely disclosure

169

The BOD and audit committee are responsible to
hire the auditor, and the BOD and AC must be
vigilant to ensure that the company or its
employees do not compromise the independence of
the auditor

170

Effective directors are diligent monitors,but not
managers, of business operations.
Stockholders have little say in the day-to-day
operations but have the right to elect
representatives (directors) to look out for their
interests

171

Good governance structure is a system for
principled goal setting, effective decision
making and monitoring of compliance and
performance.

172

Audit committee, compensation committee, and
governance committee functions are CENTRAL to
effective governance.
The Audit Committee should be comprised of
independent directors
Audit committee members must understand the
business and risk profile, be financially
literate, and have at least one financial expert

173
Greenspan, 3/26/02

In a further endeavor to align boards of
directors with shareholders, rather than
management, considerable attention has been
placed on filling board seats with so-called
independent directors.

174

However, in my experience, few directors in
modern times have seen their interests as
separate from those of the CEO, who effectively
appointed them and, presumably, could remove them
from future slates of directors submitted to
shareholders.

175

After considerable soul-searching and many
congressional hearings, the current CEO-dominant
paradigm, with all its faults, will likely
continue to be viewed as the most viable form of
corporate governance for todays world.

176

The only credible alternative is for
large--primarily institutional--shareholders to
exert far more control over corporate affairs
than they appear to be willing to exercise.

177

Fortunately, it seems clear that, if the CEO
chooses to govern in the interests of
shareholders, he or she can, by example and
through oversight, induce corporate colleagues
and outside auditors to behave in ways that
produce de facto governance that matches the de
jure shareholder-led model.

178

Such CEO leadership is critical for achieving the
optimum allocation of the nations corporate
capital

179

I do not deny that laws could be passed to force
selection of slates of directors who are patently
independent of CEO influence and thereby
significantly diminish the role of the CEO.

180

I suspect, however, that such an initiative,
while ensuring independent directors, would
create competing power centers within a
corporation, and thus dilute coherent control and
impair effective governance

181
Audit Committee

Pitt In an environment where the quality of
financial information is more critical than ever
before, the audit committee stands to protect and
preserve the integrity of Americas financial
reporting process.

182

Given their importance, there is no reason why
every public company in America shouldnt have an
audit committee made up of the right people,doing
the right things, and asking the right questions
an audit committee that meets several times a
year where every member has a understanding of
the basic principles of financial reporting,

183

Where there are no personal ties to the company
where, ultimately, the investor interest is being
served.

184
Blue Ribbon Panel on Best Practices

Audit Committees oversee both internal and
external audits
Ensure independent communications with auditors
Engage in robust, candid and probing discussions
about the quality of the companys financial
reporting
Adopt measures to ensure outside auditor
objectivity

185
OMalley Panel

Audit Committees should obtain annual reports
from management assessing the companys internal
controls, and should pre-approve non-audit
services provided by the independent auditor.

186

By asking audit committees to consider the
quality--not just the acceptability--of a
companys financial statements, we recognize the
systemic importance of justifying decisions that
directly affect a companys financial reporting
process.

187

This seems intended to encourage the Audit
Committee and the auditor to discuss gray areas
of accounting.

188
FEI Survey of Corporate Governance Best Practices

May, 2002
328 responses 101 from NASDAQ-listed companies
the rest from NYSE, AMEX, other

189
Code of Conduct

83 have a Code of Conduct and 69 of those
companies ask employees to sign a Code of
Conduct. For those that do have a Code of
Conduct, 85 had their Code approved by their
Board of Directors.

190

For those that do have a Code of Conduct, 80
have a formal process for employees to report
violations to the code, and 72 have established
a process so that violations of the Code are
reported to the Board of Directors.

191

96 say that their Code addresses conflicts of
interest
97 say that their Code addresses compliance with
all applicable laws.

192

10 have a separate code for financial
officers/managers

193
Board of Directors

62 say that their Board has an independent
nominating committee.

194

70 do NOT have a Lead Outside Director
57 do NOT have a designated officer in charge of
corporate governance

195

All publicly traded companies are required to
have at least one financial expert as aboard
member, serving on the audit committee.

196

39 of companies describe their financial
expert as a current or former CEO
32 say it is a current or former CFO

197

The average number of directors on a BOD is 10.
The number that qualify as independent is 7.

198

The average number of directors on a BOD is 10.
The number that qualify as independent is 7.

199

86 do NOT provide a program for educating board
members on a continuing basis

200
The Audit Committee

When asked whether the audit committee must
authorize all non-audit services provided to the
company by the independent auditors, 60 said no.
However, 62 said that the Audit Committee was
required to approve the overall level of nonaudit
services.

201

Statement It is hard to find qualified and
interested members to serve on the audit
committee
Strongly agree 12
Agree 28
No opinion 35
Disagree 20
Strongly disagree 5

202

Question Does the internal audit function
report directly, or jointly with another officer,
to the audit committee?
28 Direct
49 Joint
23 Does not report to the audit committee

203
NYSE

Listed companies must have a majority of outside
directors.
No director qualifies as independent unless the
BOD affirmatively determines that the director
has no material relationship with the listed
company (either directly or as a shareholder,
partner, or officer of an organization that has a
relationship with the company. Companies must
disclose this determination.

204

No director who is a former employee can be
independent until 5 years after their
employment ended
No director who is, or in the past 5 has been,
affiliated with or employed by a present or
former auditor of the company or an affiliate of
the company can be independent until 5 years
after the end of the affiliation or the auditing
relationship.

205

No director can be independent if in the last 5
years he or she is or has been part of an
interlocking directorate in which an executive
officer of the listed company serves on the
compensation committee of another company that
concurrently employs the director.

206

Directors with immediate family members in the
foregoing categories are likewise subject to the
5-year cooling off period for purposes of
determining independence.

207

To empower nonmanagement directors to serve as a
more effective check on management, the
nonmanagement directors of each company must meet
at regularly scheduled executive sessions without
management.

208
Nominating/Corporate Governance Committee

Listed companies must have a nominating/corporate
governance committee composed entirely of
independent directors.

209

The nominating/corporate governance committee
must have a written charter that addresses
The committees purpose, which must at the
minimum be to identify individuals qualified to
be board members, and to select, or to recommend
that the board select, the director nominees for
the next annual meeting of shareholders, and
recommend to the board a set of corporate
governance principles

210

The committees goals and responsibilities which
must reflect, at a minimum, the boards criteria
for selecting new directors and oversight of the
evaluation of the board and management
And an annual performance evaluation of the
committee

211
Compensation Committee

Listed companies must have a compensation
committee composed entirely of independent
directors.
The compensation committee must have a charter
that addresses the committees purpose, which
must, at the minimum, be to discharge the boards
responsibilities with regard to compensation of
the companys executives, and to include an
annual report on executive compensation to be
included in the companys proxy statement,

212

Detail the committees responsibilities and
duties, which at a minimum must be to review and
approve corporate goals and objectives relevant
to CEO compensation, evaluate the CEOs
performance in light of these goals and
objectives, and set the CEOs compensation level
based on this evaluation.

213

And to make recommendations to the board with
respect to incentive-based compensation plans and
equity-based plans

214

Further, they must complete an annual performance
review of the committee.

215

Directors fees are the only compensation that a
member of the audit committee may receive from
the corporation.

216
Audit Committee

The audit committee has the sole authority to
hire or fire the auditor, and to approve any
significant nonaudit relationship with the
independent auditor.

217

The audit committee must have a written charter
that addresses the committees purpose, which at
a minimum must be to assist board oversight of
the integrity of the companys financial
statements, the companys compliance with legal
and regulatory requirements, the independent
auditors qualifications and independence, and
performance of the companys internal audit
function and independent auditors, and

218

Prepare the report that SEC rules require be
included in the companys annual proxy statement.

219

The duties and responsibilities of the audit
committee which must include, at the minimum,
Retain and terminate the companys independent
auditors (stockholder ratification may also be
required)