Special-Purpose Entities Are Often

A Clever Way to Raise Debt Levels

Often hidden behind the financial tables, special-purpose entities have recently become the subject of sharper scrutiny. Much of the Enron accounting issues revolved around special-purpose entities. And other companies, such as PNC Financial, have had to restate earnings because of alleged misuse of these special items.

But what the heck are they? These are items that make "financial engineers" grin from ear-to-ear. They provide clever -- though usually legitimate -- ways for companies to more efficiently raise debt, but they also make it tougher for investors to decipher a company's actual debt exposure.

To demystify these special items, think about mortgage applications. In order to get approved for a mortgage, it feels like you've got to go through a strip search. Mortgage companies need to know every gruesome detail of your financial life. They don't care that you make $100,000 and donate money to your church. They're much more interested in the high-flying balance on your credit card. And where did all those deposits come from while you were unemployed last year? Remember, your bookie would like to remain anonymous.

So wouldn't it be great if you could create a little mini-me and have him apply for the loan? Just give mini-me the $100,000 a year job. Nothing else. No credit debt, no strange bank balances. With a clean slate like that, the banks will be throwing money at mini-me.

Unfortunately, humans haven't mastered the art of cloning. But corporations have. A company can create a "mini-me" of its own, a special-purpose entity, and apply for cheap financing. It's actually one of the main reasons corporations use special-purpose entities.

SPE: Someone Please Explain

Let's assume a company needs financing for a new product. It could be anything -- building a new pipeline, constructing a new building. Because of the already existing debt on its balance sheet, the banks may loan the money at a hypothetical interest rate of, say, 8%. That interest rate makes the chief financial officer flinch. So, instead of applying for the loan itself, the company sets up a special-purpose entity (sometimes referred to as special-purpose vehicles or the securitization of assets.)

Think of the SPE as a trust. (So don't bother trying to call it -- no one will answer!) To establish this trust, the company must sell the SPE an asset -- any of the ones listed on its balance sheet will do. In this case, it sells its receivable balance and therefore must remove it from the balance sheet. The SPE pays the company for the receivables with the money it collects from these new investors and the company gets to beef up the cash section of its balance sheet.

So the SPE has one big asset on its books. It now can hit the pavement and go find some money for its new project. It is essentially using the receivable as a security to peddle to the market, hence the moniker -- the securitization of assets.

With only one asset on its books, investors won't be hard to find. Even better, they're willing to accept a lower interest rate because it appears that the repayment of their loan is a pretty sure thing since the SPE has no other debt.

Assuming the parent company has not offered a guarantee on the loan (we'll get to that shortly), the company no longer has connections to the SPE. And in turn, the SPE's creditors now only have claim to the assets of the SPE, says Ed Ketz, associate accounting professor at Penn State University.

So everyone is happy, right? The firm just got a lower interest rate for the money it needs to finance a new project and the new investors locked into a reasonably safe loan.

Well don't forget about the company's creditors. They aren't all that thrilled with the fact that the company sold off one of its assets, especially if it did so at a loss. Now how are they going to get paid?

And of course, anyone who spends a second looking at financial statements may be a little perturbed by this arrangement as well. In many instances, we'd like to see that debt reported on the company's balance sheet. But as long as the company is not liable for the SPE's debt, FASB allows the transaction to be reported off-balance sheet, says Tim Lucas, the Financial Accounting Standards Board's research director. To be more specific, some wacko accounting rule says that at least one SPE investor needs to put up at least 3% of the SPE's equity. The company can contribute the rest and still qualify for off-balance-sheet treatment.

In some instances though, the company offers to guarantee the SPE's loan. Enron guaranteed some of its SPEs debt with its own shares. But even in that case, the accounting rules still do not require the company to report that on its balance sheet. It just needs to disclose that guarantee in the footnotes, says Ketz. But doesn't following accounting rules seem to defy the economic reality of the situation?

This is the where the abuse comes in. Some companies use these entities purposely to keep debt off its balance sheet.

SPEs and the Shady Side

Are SPEs only for Crooks? Hardly. Just about every major company uses them -- especially to get cheap financing, and, in some instances, there are tax perks to using these things as well. Even more alluring, SPEs can be a legitimate way to remove risk from the balance sheet. So if a company is embarking on a precarious project, setting it up in a SPE can shelter the entire company from the threat of it failing.

And SPEs have been around for years, stuffed away in some footnote. We can thank Enron for bringing them to our daily dinner conversation. And, in turn, fault Enron for putting SPEs under a microscope. Perhaps PNC Bank is blaming Enron for the $155 million earning hit it was forced to take because the SEC forced it to include three SPEs on its balance sheet, rather barely giving them a mention in the footnotes.

But that's not to say that everyone uses them incorrectly. Of its $500 billion in assets, General Electric has around $55 billion in SPEs. And that SPE debt appears justifiable.

"Special-purpose entities can be completely legitimate way for a company to segregate from its core operations a certain activity and remove risk of that activity from ongoing operations," say Michael Young, a Willkie Farr & Gallagher securities law and financial reporting partner and author of Accounting Irregularities and Financial Fraud.

Unfortunately, in Enron's case, it appears that many of the SPEs were created strictly for the benefit of a select few members of top management.

But all this attention to SPEs is a good thing. FASB has been wrestling with what should be on or off the balance sheet for years now, and the Enron debacle will likely force it to issue official guidelines. It began deliberations last week and hopes to put out a draft on the consolidation of SPEs by April, with finalized rules coming by year-end.

Until that happens, be on the lookout for this off-balance sheet financing. Here's a tip: When searching the footnotes to the financial statements, use the "Find" function. That's CTRL F. Then put in any of those words -- "special," "entity," "securitize," "off-balance sheet." If the word exists, your screen will hop to it. It's a much quicker way to locate these things.

This saga is not going away for a long while. Maybe by the time it's over, our scientists will have perfected human cloning. Then we can each have a mini-me of our own, right along with Corporate America.

It seems only fair.

Write to Tracy Byrnes at tracy_byrnes@yahoo.com

Updated February 21, 2002 6:04 p.m. EST