Who Else Is Hiding Debt

Moving financial obligations into off-book vehicles is now a common ploy

When energy trader Enron Corp. (ENE ) admitted to hiding billions of dollars of liabilities in mysterious off-book entities, it trotted out the lame excuse of scoundrels: Everyone does it. And this time, it was the gospel truth.

Hundreds of respected U.S. companies are ferreting away trillions of dollars in debt in off-balance-sheet subsidiaries, partnerships, and assorted obligations, including leases, pension plans, and take-or-pay contracts with suppliers. Potentially bankrupting contracts are mentioned vaguely in footnotes to company accounts, at best. The goal is to skirt the rules of consolidation, the bedrock of the American financial reporting system and the source of much its credibility. These rules, set clear in 1959, aim to make public companies give a full and fair picture of their business--including all the assets and liabilities of any subsidiaries. But accountants, lawyers, and bankers have learned to drive a coach and horses through them.

Because of a gaping loophole in accounting practice, companies create arcane legal structures, often called special-purpose entities (SPEs). Then, the parent can bankroll up to 97% of the initial investment in an SPE without having to consolidate it into its own accounts. Normally, once a company owns 50% or more of another, it must consolidate it under the 1959 rules. The controversial exception that outsiders need invest only 3% of an SPE's capital for it to be independent and off the balance sheet came about through fumbles by the Securities & Exchange Commission and the Financial Accounting Standards Board. In 1990, accounting firms asked the SEC to endorse the 3% rule that had become a common, though unofficial, practice in the '80s. The SEC didn't like the idea, but it didn't stomp on it, either. It asked the FASB to set tighter rules to force consolidation of entities that were effectively controlled by companies. FASB drafted two overhauls of the rules but never finished the job, and the SEC is still waiting.

It's not just the energy industry that exploits the loophole and stashes major liabilities in the never-never land of SPEs. Increasingly, companies of all stripes routinely use them to offload potential balance-sheet bombshells such as loan guarantees or the financing of sales of their own products. For example, the accounts of data processor Electronic Data Systems Corp. (EDS ) don't show $500 million--half of last year's earnings--that it would owe if its customers were to cancel their contracts and leave it holding the bag for loans on their computer equipment. The arrangement is acknowledged only in a footnote. An EDS spokesman says the tactic is common in the industry and does not put the company at undue risk.

Airlines keep appearances aloft by shunting billions worth of airplane financing into off-balance-sheet vehicles, says credit analyst Philip Baggaley of Standard & Poor's Corp. United Airlines Inc. parent UAL Corp.'s (UAL ) published balance sheet for 2000 shows $5 billion of long-term debt. But only a footnote describes the bulk of its lease payments, which Baggaley estimates have a present value of $12.7 billion, due over 26 years on 233 airplanes. AMR Corp., parent of American Airlines Inc., is on the hook for $7.9 billion in lease payments not on its balance sheet. "Everyone who's involved in the industry knows that the true leverage is higher" than what's shown on the balance sheet, says Baggaley. UAL and AMR declined to comment.

Banks arrange many of the devices and are big users themselves. J.P. Morgan Chase & Co. (JPM ), for example, has revealed in the Enron bankruptcy that it has nearly $1 billion in potential liabilities stemming from a single 49%-owned Channel Islands entity called Mahonia that traded with Enron. The liabilities bring the bank's total Enron exposure to $2.6 billion. And J.P. Morgan is not alone. A suit filed earlier this month shows that many U.S. finance companies are among 52 partners in LJM2, an Enron off-balance-sheet entity with over $300 million in assets. The partners, including Citigroup, Wachovia, and American International Group, may all have to takes losses on it.

The banks' participation in SPEs is attracting scrutiny of federal regulators. A Federal Reserve spokesman said it is "concerned about" off-balance-sheet exposures and hopes new accounting rules will be put in place. How many more Mahonia or LJM2-like entities are there? The Channel Islands tax haven boasts more than 350 SPEs and similar entities, though it is impossible to know how many should really be consolidated on balance sheets of U.S. companies. Assets in the entities total more than $635 billion, according to Fitzrovia International PLC, a London-based research firm. The Cayman Islands, which has been competing for the business since the 1980s, claims another 600 trusts and banks, most of which have SPE expertise.

With some of the vehicles, it is impossible for investors to know from financial reports who could be responsible for what. For example, Dell Computer Corp. (DELL ) has a joint venture with Tyco International Ltd. (TYC ) called Dell Financial Services that last year originated $2.5 billion in customer financing, according to a footnote to Dell's accounts. According to the note, Dell owns 70% of DFS, but does not control it and therefore keeps DFS debts off its own balance sheet. What if DFS has trouble from customers not paying? Dell spokesman T.R. Reid says any obligations of DFS are Tyco's responsibility and Tyco agrees. Jeffrey D. Simon, president of the global vendor financing business at Tyco Capital, says Tyco would look to Dell's customers to pay and not to Dell. Tyco's balance sheet reflects borrowing to finance Dell's customers.

Companies argue that off-balance-sheet vehicles benefit investors because they enable management to tap extra sources of financing and hedge trading risks that could roil earnings. Maybe so, but they sure make the companies, and their executives, look good: Return on capital looks better than it is because balance sheets understate the amount employed. And investors and regulators don't freak out as corporate debt balloons. But critics charge that the widespread use of off-balance-sheet schemes encourages contempt for accounting rules in the executive suite and spreads confusion among investors. "The nonprofessional has no idea of the extent of the real liabilities," says J. Edward Ketz, accounting professor at Pennsylvania State University. "Professionals can be easily fooled, too."

Worse yet, many SPEs have provisions that can throw their users into a full-blown financial crisis. To get assets off its books, a company typically sells them to an SPE, funding the purchase by borrowing cash from institutional investors. As a sweetener to protect investors, many SPEs incorporate triggers that require the parent to repay loans or give them new securities if its stock falls below a certain price or credit-rating agencies downgrade its debt. It was just such triggers in its notorious off-balance-sheet partnerships that sent Enron into a death spiral. And triggers fueled the crises last year at Pacific Gas & Electric (PCG ), Southern California Edison, and Xerox (XRX ), according to Moody's Investors Service. "All of this hidden debt and these triggers could make the next economic downturn a lot worse than it would otherwise be," says Lynn Turner, who was chief accountant at the Securities & Exchange Commission until July.

Despite the risks, SPEs remain very appealing to companies. And any attempt to curb them or abolish the 3% rule will run into furious opposition. Since the early '90s, an army of accountants, lawyers, and bankers built a huge industry to concoct ever more creative ways to evade consolidated reporting. So reform won't come easily. "It will be a phenomenal fight," says Turner.

Maybe so, but Enron's demise shows how quickly a tiny loophole can tear the country's economic fabric. And there may never be a better time to close it.

By David Henry, with Heather Timmons and Steve Rosenbush in New York and Michael Arndt in Chicago

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