In recent months the rules regarding special purpose entitles have come under great scrutiny. Special purpose entities allow firms to raise debt while at the same time making it almost impossible for investors to determine the actual amount of debt exposure. ("Special Purpose Entities are Often a Clever Way to Raise Debt Levels") Thus was the case with Enron, which collapsed in 2001 when their fraudulent accounting practice were exposed. The purpose of this discussion is to investigate which accounting practices were violated as it relates to the SEC rules on Special Purpose Entities and full disclosure. We will also discuss the ethical issues that the company made regarding the firms' accounting practices.
Special Purpose Entities and the SEC Rules that Enron Broke
Special Purpose Entities are also called the securitization of debt. They are totally legal and most companies use them for legitimate reasons such as sheltering a new sector of a firm for the rest of the firm in case the new sector of the firm does not succeed. However, in the case of Enron the entities were used to hide the extent of the firms' debt from shareholders. The SPE is used as a trust,
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." ("Special Purpose Entities are Often a Clever Way to Raise Debt Levels")
The SEC rules for SPE's require that the company actually have a special purpose for creating the entity. As stated earlier when a company legitimately creates a SPE it is actually for the purpose of accessing capital or hedging risk. This was what the SEC had in mind when it created the Special Purpose Entity rules. The rules were not created to simply hide a firm's debt from investors. However, according to The Journal of Accountancy, Enron used SPE's to do just that by using the entities to hide troubled assets that were losing value. The Enron Corporation was run using thousands of SPE's. These entities included foreign energy facilities and the broadband operation that the company had created. "Transferring these assets to SPE's meant their losses would be kept off Enron's books." (Thomas)
The most questionable SPE was called LJM Cayman LP and LJM2 Co-Investment LP, which operated from 1999 until 2001. (Thomas) This particular SPE was managed by Andrew Fastow and reportedly paid him a salary in excess of $30 million which was more than he was paid by the Enron Corporation. (Thomas)
According to The Journal of Accountancy Enron used the entity in the following way, the LJM partnerships invested in another group of SPEs, known as the Raptor vehicles, which were designed in part to hedge an Enron investment in a bankrupt broadband company, Rhythm NetConnections. As part of the capitalization of the Raptor entities, Enron issued common stock in exchange for a note receivable of $1.2 billion. Enron increased notes receivable and shareholders' equity to reflect this transaction, which appears to violate generally accepted accounting principles." (Thomas)
Ultimately officials began to questions the convoluted footnotes that accompanied Enron's 2000 financial reports. The company was found out and had to fully explain the way they used SPE's.
At the time of the Enron collapse the SEC's rules were that companies had to provide investors with full disclosure of financial dealings. Enron disclosed financial information but did so in ways that were deceitful and convoluted which made them impossible for investors to decipher. This lack of transparency on Enron's part proved to be its undoing. The purpose of the SEC's regulations is to ensure that investors are provided with the financial information that is needed to make an intelligent decision on whether or not to invest or continue investing in the company.
I believe that full disclosure means full disclosure. Investors need to know the true amount of debt that a…