special purpose entity enron

Both IFRS and US GAAP now require SPEs to be consolidated on the balance sheet because they could be hiding debt, risky assets, or contractual obligations that investors must know about. The combination of low returns and high growth likely induce a reliance on capital markets, which on the margin creates more risk to future cash flows. Perhaps the low returns demonstrated a company that is aggressively pushing growth at the expense of prudence. In the case of Enron, they were combining a portfolio of stable, low return energy businesses with high return trading businesses. Consequently, the combined business should have demonstrated high incremental returns. This is a red flag and was readily observable from public information over the 5 years preceding its collapse. Finally, Enron aggressively financed its SPEs by posting large amounts of Enron’s stock as collateral, which also remained undisclosed.

special purpose entity enron

To illustrate, a qualifying SPE is precluded from entering into written options that provide the holder with an opportunity to trigger a condition that enables the SPE to sell transferred assets under circumstances inconsistent with the requirements of paragraph 35 of Statement 140. Because the bright line should be drawn on the transfer of almost all risks, the Report states that if more than 5 percent of the risks involved with the real estate retains in the transferor, such real estate should not be derecognized from the balance sheet of the transferor. Reportedly, such “5 percent threshold” appears to have significant impact on real estate market. The question of whether a beneficial interest issued by a qualifying SPE is debt or equity is outside the scope of Statement 133. An investor must determine whether the beneficial interest issued by the qualifying SPE that it holds is debt or equity.

Morgan had $965 million in losses from payments due on oil and gas contracts with Enron. Morgan and Enron used fraudulent inducement to cause them to enter into the contracts. They used this as a defense against not making immediate payments under the terms of the surety bonds. The credit derivative would also have explicitly documented that the underlying revenues and credit risk was Enron’s, which would have made it difficult for Enron to disguise their liability and book the loan as revenue. I know of at least one hedge fund group that bought CDS as a way of betting against housing-sector stocks .

How Enron Pulled Off An Ethical

So Enron promised public markets growth of real underlying earnings, but was actually filling it desperately with one-time sale deals. An accounting entity is a clearly defined economic unit that isolates the accounting of certain transactions from other subdivisions or accounting entities. A financial asset securitization investment trust was a tool for securitizing non-mortgage debt with short maturities, such as car loans. If accounting loopholes are exploited, these vehicles can become a financially devastating way to hide company debt, as seen in 2001 in the Enron scandal. The various off-balance-sheet partnerships run by Andy Fastow and other Enron executives were purchasing such risky assets as power plants and communications infrastructure, and, in other cases, entering highly risky hedging transactions with Enron.

Synthetic lessees typically reserve the right to buy the property at the end of the lease, extend the lease, or sell the property and take any gain or loss in its value. Best of Both Worlds Instead, Cisco signed up for three deals in three years for $255 million in lease financing with Sumitomo Bank Leasing and Finance Inc. for several additions on its various sites for a total of about 2 million square feet. But that would crimp the Big Five’s clients — companies and Wall Street. In no way can the above reasoning be published as a justification for SPEs in the official literature. Hence, it is necessary to look to the official literature for justifications due to securitization and tax advantages. “Was this just bad luck, incompetence and greed, or were there some criminal or illegal actions, as has been suggested by the accounting firm that reviewed Enron’s books?” Dorgan said. Dorgan noted that Lay, Enron’s chairman and chief executive, has agreed to testify at a future hearing.

special purpose entity enron

It increased reported debt by $711 million in 1997, by $561 million in 1998, by $685 million in 1999, and by $628 million in 2000. Enron also revealed, for the first time, that it had learned that Fastow received more than $30 million from LJM1 and LJM2.

Cracks Start To Appear In The Special Purpose Entity Enron Scheme

Under FIN 46, investors holding a stake in a VIE need to determine whether or not they are the primary beneficiary (i.e., stand to absorb more than 50 percent of the loss or gain, or both). Since it was first issued in January 2003, FIN 46 has dramatically reduced the number of orphaned entities.

Consequently, the analysis presented below details the inner workings of two different SPE’s which are useful as models in understanding the nature of Enron’s scheme. With the help of their investment bankers during the 1990’s, airlines developed a new method to finance the purchase of airplanes – a leveraged lease held in an SPE. In this type of financing, the equity investors provide 20 percent of the funds needed to purchase the airplane, and the airline, typically by using funds borrowed from investors, provides the remaining 80 percent . The equity providers thus reduce their tax obligations by depreciating the airplane over a seven-year period.

To do so, it sells its receivables to a special purpose entity, which issues securities based on the cash flows represented by the receivables. These securities are considered by investors to be low risk, since the creditors of the initiating business cannot access the receivables now owned by the special purpose entity. An SPE is a separate legal structure created by a firm to provide liquidity and/or obtain favorable external funding. Assets are isolated within the new entity, and securities issued by the entity are backed by these assets as collateral. An SPE can take various forms, including partnerships and trusts, and typically does not feature independent, third-party or “public” equity holders. Additionally, the securities issued by the SPE may contain “credit enhancements” or guarantees that reduce risk to the purchasers and therefore, further reduce the cost of funding.

Special Purpose Vehicle Spv

In any event, after Statement 94 was issued, the Board continued to debate consolidation and did so for the rest of my ten years as Chairman. An exposure draft was eventually issued that would have required consolidation based on control and would have adopted the reporting entity concept so that consolidation procedures would have been dramatically revised.

  • Disclosure about variable interest entities in which an enterprise has a significant variable interest but does not consolidate will help financial statement users assess the enterprise’s risk.
  • An SPV is secured even if the parent company faces huge liabilities and financial risks.
  • The assets are sold to the SPE and could include trade accounts receivable, equity securities, notes receivable, etc.
  • The problem surfaced in December 2002 during congressional hearings on the extensive role that certain banks—including Citigroup, J.P. Morgan Chase & Co., and Merrill Lynch & Co.—played in deceptive transactions involving Enron SPEs.
  • After Enron filed for bankruptcy, both the Securities and Exchange Commission and the Financial Accounting Standard Board increased their scrutiny of SPEs.

One piece of legislation, the Sarbanes–Oxley Act, increased penalties for destroying, altering, or fabricating records in federal investigations or for attempting to defraud shareholders. The act also increased the accountability of auditing firms to remain unbiased and independent of their clients. Many executives at Enron were indicted for a variety of charges normal balance and some were later sentenced to prison, including Lay and Skilling. Arthur Andersen was found guilty of illegally destroying documents relevant to the SEC investigation, which voided its license to audit public companies and effectively closed the firm. Supreme Court, Arthur Andersen had lost the majority of its customers and had ceased operating.

What Are Special Purpose Vehicles Used For?

As illustrated by the convoluted Chewco deal, Enron was clearly using off-balance sheet vehicles with the explicit intent of hiding assets and debt and thereby creating a picture of a company that was performing much better than it actually was. This time, Enron was staring at a potential trading loss from Borget of $1 billion, which would force the company into bankruptcy. Enron executive Mike Muckleroy stepped in, however, to finesse the trades and ultimately worked the losses down from $1 billion to $140 million.

Use Of Special

SPVs are commonly utilized in certain structured finance applications, such as asset securitization, joint ventures, property deals, or to isolate parent company assets, operations, or risks. While there are many legitimate uses for establishing SPVs, they have also played a role in several financial and accounting scandals. Enron’s stock was rising rapidly, and the company transferred much of the stock to a special purpose vehicle, taking cash or a note in return.

S recording an obligation to pass through the cash flows from those transferred assets to the qualifying SPE. The JICPA Accounting Standards Committee Report 15 establishes accounting rules for securitizations of real estates. The Report adopts the “risk-and-reward approach” to transfers of real estates, rather than “financial component approach,” which was adopted in Accounting Standards for Financial Instruments. Under the “risk-and-reward approach,” if transferors transfer almost all risks and rewards of the real estates to transferees, such transfer should be accounted for as a sale of the real estate, otherwise it should be accounted for as a borrowing transaction. For example, if the transferor assumes repurchase obligation of the real estate, it should not derecognize the real estate because almost all risks and rewards are not transferred to the transferee. If the sponsor is the transferor of the financial assets and the SPE meets the ‘qualifying criteria,’ the sponsor can still avoid consolidation, even if the EITF Topic D-14 and related guidelines are not met.

The SEC is currently debating proposed changes, and FASB recently issued a ruling. FASB adopted Financial Accounting Interpretation 46, effective January 31, 2003, for newly created entities. More importantly, existing entities were not grandfathered and must comply with the ruling. Now that time has passed since the Enron debacle and other world events have replaced it in the daily headlines, it is time to take another look at Special Purpose Entities to see if they provide an economic service, or are just a vehicle for corporate and managerial malfeasance.

If a transfer of financial assets in exchange for cash or other consideration does not meet the criteria for a sale in paragraph 9, the transferor and transferee shall account for the transfer as a secured borrowing with pledge of collateral . Predetermination of the ongoing activities of an SPE by an enterprise would not represent the type of restrictions referred to in the statement on consolidated financial statements and accounting for investments in subsidiaries which preclude certain subsidiaries from being consolidated.

The Most Typical Holding In A Special Purpose Vehicle

This article explains the basic components of structured finance transactions and the sound reasons for their undertaking from both an investor and originator perspective, and will also provide the reader with examples of different common structures. Section II of this document describes the basic mechanics and players inherent in nearly all securitizations and structured transactions; the remaining sections of this document will discuss examples of different types of structures. Section III discusses asset backed special purpose entity enron commercial paper vehicles and the important reasons for their evolution. Section IV will dissect a project finance securitization, generally undertaken to specifically fund the project in question. Section V will discuss catastrophe linked bonds , or “cats”, as an example of a means of shifting a risk concentration away from the originator and towards investors in need of portfolio diversification. They see them as a cheaper alternative to leasing, purchasing or developing property with traditional loans.

In examining the issue further, Lay discovered that the two had doctored the bank statements when presenting their income summary side of the story. But the oil trading unit had posted profits of $10 million in 1985 and $28 million in 1986.

During his tenure at Enron, Fastow “earned” $37 million just from these off-balance-sheet financing deals, separate and distinct from his compensation as CFO. Because these transactions were not arm’s length, such self-dealing was clearly unethical and also violated securities laws and numerous regulations. In footnotes to Enron’s fiscal year 2000 financial statements, one note refers to a related-party transaction with a senior executive, although the note does not cite Fastow by name. By the third quarter of 2001, the Raptors had a combined deficiency of over $500 million.

A transferors or servicers having discretion to select which loans to remove to reposition a portfolio is beyond those powers set forth in paragraph 35 of Statement 140. Sale accounting would also be precluded under the provisions of paragraphs 9, 54, and 86 of Statement 140 because such a power gives the transferor the unilateral right to reclaim specific assets from the qualifying SPE. Caveat to FAS 140 will say it’s okay for qualified special purpose entity to write a conditional call option. Now such leases are widely available from specialized leasing companies. Filling a Basic Need Cisco turned to synthetic leases because it needed more space but didn’t like the traditional options. When the company grew to $382 million back in fiscal 1992, management knew it wouldn’t be long before the firm would run out of room.

SIC 12 addresses when a special purpose entity should be consolidated by a reporting enterprise under the consolidation principles in IAS 27. The SIC agreed that an enterprise should consolidate a special purpose entity (“SPE”) when, in substance, the enterprise controls the SPE. Examples of SPEs include entities set up to effect a lease, a securitisation of financial assets, or R&D activities. The concept of control used in IAS 27 requires having the ability to direct or dominate decision making accompanied by the objective of obtaining benefits from the SPE’s activities. The Interpretation provides example indications of when control may exist in the context of an SPE.

However, sale accounting is precluded by paragraph 9 only if the transfer involves an agreement that both entitles and obligates the transferor to repurchase or redeem the assets before maturity and all of the requirements of paragraphs are met. For transfers of existing securities under a dollar-roll repurchase agreement, the transferee must be committed to return substantially-the-same securities to the transferor to fail the condition in paragraph 9 that would preclude sale accounting. bookkeeping The asset to be returned may be TBA at the time of the transfer because the transferor would have no way of knowing whether the transferee held the security to be returned. That is, the transferor is only required to obtain a commitment from the transferee to return substantially-the-same securities and is not required to determine that the transferee holds the securities that it has committed to return. For paragraph 9 to preclude sale accounting, pursuant to paragraph 47, ?

That same day, Enron stock closed at $67.19 meaning that the put Swap Sub received was “in the money” by $12.8 million. Enron’s Chief Accounting Officer Richard Causey testified to the Powers Committee that the put was given to Swap Sub to freeze the economics while the negotiating of the unwind could be finalized.