Post-Enron Changes May Scrap 3% Rule on Partnerships
By Rob Urban
Bloomberg
New York, Jan. 31 (Bloomberg) -- U.S. accounting rulemakers may scrap a standard that allowed Enron Corp. to shift debt off its books through partnerships with investors who took as little as 3 percent of the risk.
Enron used the so-called 3 percent rule to keep $2.6 billion in debt from three partnerships off its balance sheet, then was forced to consolidate the debt and wipe out $502 million in profits back to 1997. The rule permits companies to shed debts or assets onto affiliated partnerships if independent investors contribute at least 3 percent of the partnerships' funding.
The Financial Accounting Standards Board plans to propose measures by June addressing how much outside capital an affiliate must have to be treated as an independent entity. A test like the 3 percent rule encourages financial engineering and should be replaced by a standard that looks at whether outsiders control the partnership and bear the risks, accounting experts said.
``The issue is control,'' said Jack Murray, vice president and special counsel for First American Title Insurance Co., an expert on off-balance-sheet financing. ``If you set up an entity as a pass-through vehicle, and all it can do is what you tell it to do, you should have to put it on your balance sheet.''
Broader Review
The scrutiny of the 3 percent rule is part of a wider review by FASB of the standards governing ``special purpose entities.'' Many U.S. companies use such vehicles. Some airlines create trusts to finance their planes, and financial companies use them to fund credit card debts. In most cases, the partnerships are controlled, and majority owned, by outsiders, experts said.
Enron took SPEs to a new level, creating more than 3,000 affiliated partnerships and subsidiaries that collapsed in the largest bankruptcy in U.S. history, accounting experts and lawyers say.
Ray Simpson, project manager for FASB, said the accounting group has two priorities for rules it hopes to propose in the second quarter: guidelines to guard against entities with ``insufficient independent economic substance'' and standards to prevent use of a ``straw man'' as the third-party investor. FASB's decisions determine what meets ``generally accepted accounting principles.''
`Skin in the Game'
Initially proposed by the Securities and Exchange Commission in 1990 as a minimum to ensure outsiders had some ``skin in the game,'' in the words of former SEC Chief Accountant Lynn Turner, the 3 percent rule has evolved into the primary test for when companies can avoid consolidating the results of special purpose entities they sponsor.
The point of SPEs is to avoid consolidation, allowing the sponsoring company keep the debts and assets of the SPE off its books while recording gains and losses from transactions with the affiliate.
To meet the standards for off-balance sheet treatment, an SPE's assets must be legally isolated from the parent company and an independent third party must have a substantive investment at risk. Many accounting experts argue FASB's new standards should avoid setting a specific level of investment, such as 3 percent, that is sufficient for an outside investor.
`Bright Lines'
``If you try to build a system or a process that eliminates judgment to the maximum extent, the auditor can go to the client and point at the rule and say, `This is what you can do,''' said Michael Sutton, who was the SEC's chief accountant between 1995 and 1998. ``It's inevitable you are going to have these financial engineers that find ways to work around those rules.''
The 3 percent rule highlights a broader debate in accounting between advocates of ``principles-based'' rules that require auditors to look at the economic substance of a transaction and those who argue for ``bright lines'' that clearly define what a company can and cannot do.
Adopting a more principles-based approach will be difficult because without specific rules ``companies are going to say, `Where does it say I can't do it?'' said Jim Harrington, head of accounting and SEC technical services for PricewaterhouseCoopers LLC, the biggest accounting firm. Still, he said he thinks accounting should shift in that direction because ``it does away with the financial engineering.''
FASB officials said their goal is to approve the first revisions of rules on SPEs by the end of the year.
FASB Priorities
``We're going to approach this issue in a fairly narrow way in an effort to get some answers that are particularly relevant to special purpose entities approved quickly,'' said FASB President Edmund Jenkins.
Drawing the line on what constitutes a ``straw man'' in an SPE may be difficult. Regulators will try to address cases where ``a relative, a former or current employee, or somebody else who has a de facto agency relationship'' with the sponsoring company may not be truly independent, Simpson said.
Once FASB deals with the first revisions of rules on SPEs, the group plans to address two more areas: treatment of convertible securities or derivatives that might change the distribution of equity in the affiliate, and treatment of different types of shareholder rights that define who is in control, Simpson said.
Enron's use of two partnerships, Chewco and JEDI, illustrates the kind of ``aggressive accounting'' described by Enron's auditor, Arthur Andersen LLP, in internal documents subpoenaed by Congress. Enron employees set up Chewco in 1997 when the California Public Employees' Retirement System, the largest U.S. pension fund, wanted to exit the JEDI joint venture it had with Enron.
Chewco Case Study
Calpers' JEDI stake was valued at $383 million, and Enron needed a new investor. Enron made a loan of $132 million to Chewco, and guaranteed another loan for $240 million, putting the company on the hook for exactly 97 percent of Chewco's total funding, which was used to buy out Calpers from JEDI. Michael J. Kopper, an Enron employee, was manager of the Chewco general partner at the time.
In testimony to Congress, Andersen Chief Executive Joseph Berardino said the auditor was told the rest, $11.4 million, came from a ``large financial institution.'' Andersen said last year it learned that half of that $11.4 million actually came, indirectly, from Enron.
Calls for Change
That meant Chewco wasn't independent, and therefore JEDI wasn't either. So because of a $6 million difference in the outside funding for Chewco, Enron erased $399 million in profits over four and a half years and added back $2.6 billion in debt that had been inappropriately kept off the books. A similar violation of the 3 percent rule with another partnership, LJM1, erased another $103 million in previously reported profits.
The restatements, coming on top of revelations that Enron's former chief financial officer, Andrew Fastow, had made $30 million from other Enron partnerships, increased concern about Enron's accounting and helped spark the final collapse.
``What little we know about Enron to date suggests that the 3 percent rule is inadequate and certainly seems to have been the cover under which some pretty egregious things went on,'' said Damon Silvers, associate general counsel at the AFL-CIO, which has more than $400 million invested in member benefit funds. ``The potential that this had to essentially warp a company's balance sheet was not something we were aware of until Enron.''
`Mind-Boggling'
Previous efforts to tighten regulations on off-balance-sheet financing met faced resistance from accounting firms and companies who said the proposals were impractical. Now Andersen is being sued by shareholders and creditors and investigated by Congress and the Justice Department for its role in Enron's collapse.
``Contingent liability risk got the accounting firms' attention,'' said Glenn Reynolds, chief executive officer of Creditsights, an independent credit-research company. ``There's a mind-boggling amount of stuff that FASB has been debating and it's clear there are vested interests all over the place, but now the accounting firms are all worried about getting sued so they'll get behind the change.''
SEC Chairman Harvey Pitt, who met recently with FASB President Jenkins to discuss the issue, said the commission will tighten rules on disclosure of special purpose entities. SEC regulators tell companies what to report in public filings, while FASB controls the accounting rules. President George W. Bush on Monday said corporations must be required to make ``full disclosure of liabilities'' to prevent another Enron. |
