Doc Enron Scandal Summary Of Its Use And Abuse Of Special Purpose Entities Spe

enron special purpose entities

The 53-count, 65-page indictment covers a broad range of financial crimes, including bank fraud, making false statements to banks and auditors, securities fraud, wire fraud, money laundering, conspiracy, and insider trading. United States District Judge Sim Lake had previously denied motions by the defendants to have separate trials and to relocate the case out of Houston, where the defendants argued the negative publicity concerning Enron’s demise would make it impossible to get a fair trial. On May 25, 2006, the jury in the Lay and Skilling trial returned its verdicts. Skilling was convicted of 19 of 28 counts of securities fraud and wire fraud and acquitted on the remaining nine, including charges of insider trading. In 2013 the United States Department of Justice reached a deal with Skilling, which resulted in ten years being cut from his sentence. Two days later, on November 21, Wall Street expressed serious doubts that Dynegy would proceed with its deal at all, or would seek to radically renegotiate. Furthermore, Enron revealed in a 10-Q filing that almost all the money it had recently borrowed for purposes including buying its commercial paper, or about $5 billion, had been exhausted in just 50 days.

A parent company has numerous reasons that it may choose to create an SPV. Special Purpose Vehicles are subsidiary company’s that are used to perform a particular business purpose. Though this severe misuse of SPVs was far from Enron’s only odd and harmful accounting practice, however likely more than any other factor, it contributed to the company’s sudden collapse. These sudden payouts caused further issues contributing to Enron’s sudden and disastrous decline. When Enron’s own stock prices declined, this led to a collapse in the value of these SPVs, causing these guarantees to trigger.

enron special purpose entities

If Enron’s share price did not drop by more than $10 per share by October, the put option would expire and Talon could pocket a $41 million gain, a 273% annualized return on investment. The difference in yields — nearly half a percentage point — was large enough to signify that the market places a very high value on sponsors’ implicit backing of SPVs, Gorton says. People were stunned by that.” The study also found that sponsors with a higher risk of bankruptcy were more likely to use SPVs for financing, since they stood to benefit more from the lower financing cost produced by SPV bankruptcy insulation. Paragraph 46 of Statement 140 is limited to consolidation by the ? Since the third party is neither the transferor nor one of its affiliates, consolidation policy standards and guidance, including the guidance in Issue and Topic D-14, should be used to determine whether consolidation is appropriate. The conditions for sale accounting in paragraph 9 are irrelevant to determining whether a transferee is a qualifying SPE and whether it should be consolidated. Derivative instruments that preclude the transferor from achieving legal isolation under paragraph 9 Derivative instruments through which the transferor retains effective control over the transferred assets under paragraph 9.

He said that notwithstanding Pitt’s prior legal representation “of a substantial segment of the accounting profession,” he expects a thorough SEC investigation of the Enron matter–as well as “any and all other matters involving your former clients.” Of course there are other scenarios that are less extreme, but it would seem that passions run too high in the Enron scandal. The Enron collapse ruined the lives of too many people for Harvey Pitt to avoid ending up on the floor of Heartbreak Hotel. Of course this will greatly please Osama Levitt and Omar Turner in the Heartbreak Hotel.

For purposes of the above examples, assume that the investor does not consolidate the qualifying SPE. This Statement replaces FASB Statement No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. It revises the standards for accounting for securitizations and other transfers of financial assets and collateral and requires certain disclosures, but it carries over most of Statement 125’s provisions without reconsideration. One of the most controversial issues at that time was the non-consolidation of finance and leasing subsidiaries on the basis that their operations were so different from the manufacturing or other operations of the parent that consolidation would not be meaningful. During my first year at the FASB , we finalized Statement 94, which required consolidation of all majority-owned subsidiaries such as those just mentioned. In that Statement the Board said that it felt that consolidation based on control was the most appropriate approach but it hadn’t yet been able to agree on what that meant so Statement 94 was intended to be an interim step while the Board worked to refine the notion of control. Derrick contacted V&E to determine whether it could, under the legal ethics rules, handle the investigation.

Iv Enron, Jp Morgan, And Sureties: Recent Abuse

In a synthetic lease, a firm sets up an SPE to hold a property’s title and then leases the property back at rates below those of a traditional lease. Synthetic leases were popularized in the late 1990’s by technology companies such as Cisco Systems and are used frequently by retailers and others who require large investments in real estate. However, because of Enron, 2002 was not the time to use a synthetic lease. Why did management take this action that increased their financing costs? They stated they feared “misperception” of the reason for the choice of a synthetic lease.

Established trading operations, such as the major investment banks (Goldman Sachs, Morgan Stanley, JP Morgan, etc.) didn’t endure years and years of investment without harvest. Nor did the major investment banks suffer limited harvests during the period that Enron had. Nor did that make sense given the nature of Enron’s trading operations. Many Wall Street firms provided both strategic and financial advice to Enron during the lead-up to Enron’s demise. Merrill Lynch, JP Morgan, Credit Suisse First Boston, Citigroup, and others were intimately involved in the financing of Enron’s SPEs. Unlike Daedalus, these firms were all too happy to encourage Enron to fly near the sun.

Restructuring Losses And Sec Investigation

In fact, the new rules may exclude some beneficial structures by throwing into question whether reserve accounts built up from residual cash flows in synthetic deals will cause the CDO to be treated as a variable interest entity . In addition to changing the accounting rules, IFRS also strengthened the definition of control to include many special purpose entities, with an evaluation required to determine the purpose, design, and risks. This way, companies like Enron won’t be able to avoid the requirements. And if the SPE meets these requirements, then it must be consolidated. 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. Statement of Financial Accounting Standards 140 details these criteria. SFAS 94 provides primary guidance regarding consolidation principles and focuses on control of the entity.

Since Enron’s Chapter 11 bankruptcy filing, many companies utilizing other than straight forward, visible external financing structures have seen their publicly traded securities deeply discounted. Market participants have questioned management’s intentions and the quality of corporate reporting. Even General Electric, once admired for its ability to deliver consistent operating results, has been taken to task for perceived accounting irregularities–the same accounting treatments the company has traditionally used to produce consistent performance. On the heels of Enron’s debacle came the Sarbanes-Oxley Act of 2002, the far reaching legislative reform that was designed to shore-up the accounting and corporate governance shortfalls that the legislature and the investing public believed allowed Enron to do what it did unabated. Supplementing the reforms set forth in the Sarbanes-Oxley Act are a number of accounting rules, guidelines, and interpretations that are designed to curtail the type of accounting fraud Enron perpetrated through its use of what are referred to as special purpose entities . Although much has been written chronicling and analyzing the various aspects of the Sarbanes-Oxley Act, little has been written analyzing the accounting guidance related to SPEs.

  • Notably, should the servicer fail to perform as required in the legal documents, the trustee will be required to substitute another servicer so as to preserve the security holder’s interests in the deal.
  • As the company establishes a foothold in its markets, perhaps the harvesting of returns will soon begin to offset large capital outlays.
  • First, at least some of them involved Enron selling assets to the SPE and recording significant profits.
  • After opening a criminal investigation into the scandal, Attorney General John Ashcroft recused himself and his chief of staff from the case when Democratic Congressman Henry Waxman accused Ashcroft of receiving $25,000 from Enron for his failed reelection campaign to the Senate in 2000.
  • Michael W. Krautz, a former Enron accountant, was among the accused who was acquitted of charges related to the scandal.

However, I think the above does point out that this is an extremely difficult topic and reasonable people can disagree. In fact, one of my principal reservations about the control approach to consolidation is that two parties can read the same “guidance” and reach the opposite conclusion as to whether consolidation is required.

For example, Enron’s investment in Rhythms NetConnections had increased from $10 million in March 1998 to $300 million in May 1999. Managers wanted to lock in the $290 million gain, even though the company was prohibited from selling its shares before December 1999. In June 1999, an Enron SPE, LJM Swap Sub LLP, controlled by Enron CFO Andrew Fastow, issued a put option on the Rhythms shares in exchange for a cache of restricted Enron stock and various notes. This put option would entitle Enron to recover any loss in the value of the Rhythms shares.

Organizational Culture And How Enron Did It Wrong

To illustrate the application of a principles-based consolidation standard to a situation contemplated by the ED, consider the case of a synthetic lease. A company sets up an SPE to purchase and finance assets on its behalf, and the assets are then leased to the company via an operating lease. The company-lessee typically does not have an equity position in the SPE, but effectively bears the risk and benefits of ownership of the leased assets through residual value guarantees. Moreover, the company’s use of the assets and the residual value guarantees provide direct evidence of the company’s effective economic control over the SPE. Accordingly, the company should consolidate the SPE under the Committee’s approach to consolidation. And they agreed, in effect, to cease and desist from doing other structured-finance deals that mislead investors.

In Enron’s case, India ultimately objected to the high forward prices negotiated by an official who received many valuable personal perks from Enron. The SEC is the accounting standard setter that first allowed SPE accounting off the books.

This Statement addresses the potential impacts on the provisions and application of Interpretation 46 as a result of the elimination of the qualifying special-purpose entity concept in Statement 166. Ultimately, the two Boards will seek to issue a converged standard that addresses consolidation of all entities.

Enrons Energy Origins

The judge, Jed Rakoff ruled that a senior J.P.Morgan official’s e-mail describing the transactions as “disguised loans” could be used in the trial. Morgan’s special purpose corporations also engaged in a sham gas trade with the same vehicles. One leg of the sham gas transaction allowed Enron to receive the upfront payment of the loan monies. Another leg of the sham gas transaction allowed Enron to repay enron special purpose entities the loan. If we choose a venue such as the Cayman Islands that does not have tax treaties in place with most jurisdictions, there is no mechanism for reclaiming tax withheld on the underlying asset income from the country of origination. The SPE will purchase assets that are not subject to withholding at the country of the assets’ origination so that investors will not suffer a reduced return.

enron special purpose entities

The industry’s roots go back several decades to the “securitization” of mortgage debt by Fannie Mae and Freddie Mac, the government-sponsored mortgage providers. In this process, a large number of mortgages are bundled together and sold to investors in the form of bonds. The investors then receive the interest and principal payments made by the homeowners.

Other Accounting Issues

Bankruptcy Code, one of the largest corporate bankruptcy filings at that time. A myriad of scholarship, books, and articles have been written on Enron’s meteoric rise and fall. By mid-November, Enron announced it was planning to sell about $8 billion worth of underperforming assets, along with a general plan to reduce its scale for the sake of financial stability. On November 19 Enron disclosed to the public further evidence of its critical state of affairs.

So the transaction itself was neutral to Enron’s balance sheet assets at the initiation of the hedge…from an accounting standpoint. In the Chewco transaction, it is not entirely clear what the participating banks knew about Enron at the time. Presuming that they were not directly colluding with Enron, it appears that they suffered from a micro-macro bias (i.e., missing the forest for the trees). By looking at the limited scope of an individual transaction, it’s conceivable that they may have neglected the overall picture of Enron’s desirability as a trading partner, ethics and financial health. In fact, if they had just achieved an understanding of the entirety of the very deal in which they were instrumental in financing (i.e., Chewco), then both ethics and prudence would demand refraining from doing business with Enron. Alternatively, these banks may well have been aiding and abetting Enron, but such inquiry was outside the scope of this investigation. Whatever the case, the Chewco deal, and others like it, enabled Enron to hide debt.

Several structures lend themselves to money laundering, disguising loans as revenue to misstate earnings, concealment of losses, embezzlement, and other accounting improprieties. Even when used legitimately, the way the issuance of SPEs is represented is sometimes ethically marginal. Instead of making changes or coming clean, the company used mark to market accounting to hide its losses. Under this method, a company can record its assets on a company’s balance sheet at their fair market value instead of the book value. Profits could also listed as projections rather than their actual numbers. Brent Clark explains that special purpose entities/vehicles are not inherently evil but are a prevalent and potentially useful tool in modern corporate finance.

Enron Lesson No 2: Special Purpose Entities

Lay had retired in February, turning over the CEO position to Skilling. In August 2001, Skilling resigned as CEO, citing personal reasons. Around the same time, analysts began to downgrade their rating for Enron’s stock, and the stock descended to a 52-week low of $39.95.


Corporations will be obliged to report swaps, other derivatives, contingent liabilities, and the activity of offshore SPEs, so potential hidden risks are fully disclosed. In other words, the financial reports should tell the entire story, and tell it accurately. The assets are pre-funded from proceeds of an EMTN issued by the SPE and underwritten or sold by the bank arranger’s (bank sponsor’s) capital markets group. The SPE pays the asset cash flows to the bank arrangers swap desk as one leg of a swap payment. The bank arranger provides the structured coupons due to the investors under the EMTN issue. As Enron increased its portfolio of equity investments, company managers found that mark-to-market losses were having an increasingly adverse effect on net income. Accordingly, they began to design SPE transactions to offset these losses.

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