Off Balance Sheet Financing

¶ … Balance Sheet Financing

The SEC's definition of "off-balance sheet arrangement" includes any contractual arrangement to which an unconsolidated entity is a party under which the registrant has any obligation under certain guarantee contracts, a retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement that serves as credit, liquidity or market risk support to that entity for such assets; any obligation under certain derivative instruments; any obligation under a material variable interest held by the registrant in an unconsolidated entity that provides financing, liquidity, market risk or credit risk support to the registrant, or engages in leasing, hedging or research and development services with the registrant. [footnoteRef:1] [1: http://www.sec.gov/rules/final/33-8182.htm]

PROBLEM, JUSTIFICATION, LEGALITIES and ETHICS:

Although off balance sheet financing is legal, several technicalities may be exploited, substantial liabilities may be removed from the balance sheet and certain obligations may not be disclosed at all. This may create a materially misleading picture of the company's finances. Such unchecked practices may prove to be severely detrimental to the company's financial health as demonstrated in the following examples. However companies often use off-balance-sheet financing to keep their debt to equity and leverage ratios low leading to a lower cost of capital, especially if the inclusion of a large expenditure would break negative debt covenants. It may also be used to offset lowered asset values. Off-balance sheet financing is attractive from a risk and asset- liability management standpoint. When assets and liabilities are moved from one balance sheet to another, the risks associated with those assets and liabilities go with them. SPVs can also be used in tax avoidance. Thus the parent can finance the new venture without diluting existing shareholders or adding to the parent's debt burden.

EXAMPLES: ENRON and LEHMAN BROTHERS

The sudden collapse of energy-trading giant Enron Corporation is attributed in large part to the firm's off-balance-sheet financing and hidden debt through multiple partnerships. Enron's financial arrangements involved transferring overvalued assets to partnerships such as LJM, Chewco, Whitewing, Osprey, JEDI and Raptor in which Enron had a controlling interest but was not required to include on its balance sheet. It had hedged downside risk in its own illiquid investments using special purpose entities that were actually using the company's own stock and financial guarantees to finance these hedges.

Lehman Brothers employed off-balance sheet devices, known within Lehman as "Repo 105" and "Repo 108" transactions, to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to create a materially misleading picture of the firm's financial condition in late 2007 and 2008. Repo 105 transactions were nearly identical to standard repo transactions except that Lehman accounted for Repo 105 transactions as "sales" instead of financing transactions, thus removing the inventory from its balance sheet. Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet. Lehman used the cash from Repo 105 transactions to pay down other liabilities, thereby reducing both the total liabilities and the total assets reported on its balance sheet and lowering its leverage ratios. A few days after the new quarter began, Lehman would borrow the necessary funds to repay the cash borrowing plus interest, repurchase the securities, and restore the assets to its balance sheet. Lehman never publicly disclosed its use of Repo 105 transactions, its accounting treatment for these transactions, the considerable escalation of its total Repo 105 usage in late 2007 and into 2008, or the material impact these transactions had on the firm's publicly reported net leverage ratio.[footnoteRef:2] [2: http://www.zerohedge.com/article/repo-105-scam-how-lehman-fooled-everyone-including-allegedly-dick-fuld-and-how-other-banks-a]

PRINCIPLES of OFF BALANCE SHEET FINANCING