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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

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
  • And how are assets removed from the balance
    sheet? As they become expenses in future periods

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

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

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.

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

  • By contrast, in a normal corporation the
    corporate management can take on a variety of
    transactions and activities the investor did not
  • 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.)

  • 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

  • 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

  • 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????)

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.

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
  • 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.

  • 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

  • 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

  • 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)

  • 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.

  • 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

  • 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

  • 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

  • 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

  • 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

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

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

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.,

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....

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.

  • 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

McKinsey Company
  • Lay hired McKinsey Company, management
    consultants, to help develop a new business
  • 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

  • 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

  • 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.

  • 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
  • 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.

  • 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.

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

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.

  • 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

  • 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
  • Non derivatives expenses 94,517 34,761
  • 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
  • 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.

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

Using Derivatives to Hide Losses on Technology
  • 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

  • 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

  • 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.

  • 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.

  • 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.

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

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

  • 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.

  • 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.

  • 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.

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

  • 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.

  • Other commonly cited example here involves JEDI
    and Chewco SPEs.

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

  • 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.

  • 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.

  • 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.

  • 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.

  • 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.

  • 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.

  • 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.

  • 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...

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.

  • 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.

  • 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

  • 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

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

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

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.

  • 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.

  • 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.)

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

  • 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.

  • 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.

  • 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.

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

  • 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.

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.

So where are we with
  • Special Purpose Entities
  • Variable Interest Entities

  • 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.

  • 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).

  • 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

  • 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

  • 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

  • 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.

  • 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

  • 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.

  • 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.

  • 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.

  • 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.

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

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.

  • 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.

  • 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.

  • 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.

  • 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

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

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.

  • 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.

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

  • 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.

  • 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.

  • 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.

  • 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?

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.

  • 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

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

  • 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.

  • 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.

  • 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

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

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

  • 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

  • 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

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

  • 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

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.

  • 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

  • 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.

  • 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.

  • 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.

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

  • 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.

  • 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

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.

  • 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,

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

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
  • Adopt measures to ensure outside auditor

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.

  • 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

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

FEI Survey of Corporate Governance Best Practices
  • May, 2002
  • 328 responses 101 from NASDAQ-listed companies
    the rest from NYSE, AMEX, other

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.

  • 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.

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

  • 10 have a separate code for financial

Board of Directors
  • 62 say that their Board has an independent
    nominating committee.

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

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

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

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

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

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

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

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

  • 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

  • Listed companies must have a majority of outside
  • 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.

  • 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

  • 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.

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

  • 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

Nominating/Corporate Governance Committee
  • Listed companies must have a nominating/corporate
    governance committee composed entirely of
    independent directors.

  • 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

  • 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

Compensation Committee
  • Listed companies must have a compensation
    committee composed entirely of independent
  • 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,

  • 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.

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

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

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

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.

  • 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

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

  • 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

  • At least annually obtain and review a