Enron’s Collapse Uncovers Pitfalls of Hidden Debt

Billions of dollars of corporate debt remains hidden from investors in partnerships and ventures similar to those that contributed to the crash of Houston-based energy trader Enron Corp., financial experts say.

Studios use this type of financing to fund films, airlines use it to purchase jetliners, manufacturing concerns use it to build factories and technology firms use it to finance computer sales--all with varying degrees of risk.

Typically, these loans carry only minimal disclosure, often in complex footnotes buried deep within financial documents companies file with the Securities and Exchange Commission. In most cases, they are designed to make the financial statements of companies look better to investors.

The rapid meltdown at Enron, which ranks as the largest bankruptcy in U.S. history, underscores the risks buried in these partnerships and ventures, which can obscure a company’s financial condition from even the most sophisticated analysts.

The effects of Enron’s implosion have reached far and wide--even where partnership deals are part of normal business practice. Hollywood studios are finding investors cautious about ponying up money for partnerships used to finance films, said Bill Mechanic, former head of 20th Century Fox who recently started an independent production company at Walt Disney Co.

Meanwhile, Wall Street has pummeled companies suspected of harboring time bombs such as Enron’s, including rival energy companies Dynegy Inc., based in Houston, and San Jose-based Calpine Corp.

Another repercussion of Enron’s collapse is the demand for reforms that would require more disclosure from corporations and changes in accounting rules that would prevent companies from keeping debt off their balance sheet.

“My prediction is that given what happened with Enron there will be a considerable cry to get all this debt swept up into a consolidated balance sheet,” said Randolph Beatty, dean of USC’s Leventhal School of Accounting.

Partnerships and other special purpose entities have evolved into a potent force in some sectors of corporate America without a parallel change in how accountants and auditors look at them.

The accounting industry acknowledged as much after Enron’s insolvency, when the chief executives of the nation’s five largest accounting firms issued a joint statement saying “the process of accounting standard-setting is too cumbersome and slow in today’s economy.”

“Accounting rules associated with disclosing partnerships and joint ventures are very murky,” Beatty said.

But demanding wholesale changes in the accounting and reporting of partnerships may present new problems for corporate accounting with unpredictable results.

If credit-rating agencies decide company balance sheets look riskier with the extra debt of partnerships and other ventures, they could lower corporate debt rating and cause a subsequent increase in the cost of borrowing money.

Still, tighter rules would not affect all or even most businesses, Beatty said. For example, General Motors Corp. did not suffer any backlash when it started including the debt of its financing arm on its balance sheet in the late 1980s.

“People might have to do a better job explaining what’s gong on,” Beatty said. “It is the businesses at the margin where it will make a difference.”

The credit-rating agencies already attempt to learn as much as they can about off-balance-sheet financing when evaluating a company.

Several credit analysts said they get more information than the average investor. But since Enron, credit-rating agencies are taking a tougher stance.

“We are in the process of talking to the firms to make sure we know all about any obligations that are out there,” said A.J. Sabatelle, an analyst at Moody’s Investors Service.

Many businesses that use this tool to buff their balance sheets are in little danger of an Enron-style collapse. For example, leasing arrangements used by airlines are well known to Wall Street.

But the ubiquitous use of these partnerships and special purpose entities poses troubling questions for investors striving to understand the financial structure and health of a company, said Lynn Turner, the SEC’s former chief accountant who now heads the Center for Quality Financial Reporting at Colorado State University.

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A Way to Manage Risk

Some experts at investment banks, accounting firms, law firms and financial institutions have become adept at structuring these partnerships to the advantage of their clients.

Though they have a variety of uses, the partnerships often are intended to make companies look better by showing less debt, said Robert Willens, an accounting expert at Lehman Bros.

Off-balance-sheet partnerships are one of the most common ways to manage risk and extend the reach at major Hollywood studios and independent film companies.

More than 50% of films involve some kind of outside financing arrangement and many are partnerships, said Chris McGurk, vice chairman of MGM Studios, noting that the industry has relied on outside financing for decades. “Our film slate looks like an investment portfolio.”

Hollywood borrowed the partnership idea from the oil and gas industry, said Nigel Sinclair, co-chairman of Intermedia Films, a film financing company that made “Nurse Betty.” “In the movie business, you have to manage huge capital outlays ... in a series of one-off relationships, single-project deals....Every film we do is off-balance-sheet. Some are partnerships.”

Airlines also are big users of off-balance-sheet accounting.

At UAL Corp.’s United Airlines, “operating leases” that don’t appear on its balance sheet cover most of the roughly 300 leased jets the company flies.

United provides some information in financial footnotes, listing total operating-lease payments due over the next several years at $24 billion, 10 times the amount of capital-lease obligations listed on its balance sheet.

Though the use of these operating-lease financing arrangements in the airline industry are comparatively well disclosed, analysts say, the details of deals in other industries are often sparse.

Dell Computer Corp. teamed with an outside company in 1998 to form Dell Financial Services, a partnership that finances the leasing and purchase of Dell computers. The partnership did $2.5 billion in business in the latest fiscal year, Dell said in an SEC filing.

However, Dell did not reveal how DFS finances its operations or whether it borrows money to do so.

When asked whether DFS raises debt to finance itself, a Dell spokesman said the company does not divulge that information.

“We don’t disclose that publicly,” Mike Maher said. “We don’t get into that level of detail as a matter of course.”

However, he said the partnership presents minimal financial risk for the computer company.

The structure of Enron’s partnerships was especially troubling, accounting experts say. The company had created dozens of companies largely hidden from investors who were purchasing Enron’s shares, and in some cases from the credit-rating agencies that passed judgment on the company’s financial health.

In some instances, top Enron executives were managing the partnerships--which made investments in energy companies, water facilities, telecommunications and other ventures--and collecting millions of dollars in payments.

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Disclosure Unclear

As details of the partnerships became public in October and November, Enron was forced to factor their losses and debt into its own balance sheet. That contributed to a decline in the company’s credit status and its rapid slide into bankruptcy.

The Enron model for using partnerships is not unique. They often have only tiny investments by outsiders and are mostly controlled by the parent corporation, Turner said.

The accounting industry has argued that the standard outside investment in such a partnership needs to be only 3% for a company to exclude the venture from its financial statement. For example, an airline could buy a $100-million jetliner under a partnership and keep the whole transaction off its balance sheet if it could find an outside investor to put up $3 million of the purchase price, Turner said.

But much remains unclear about how to report these partnerships and in what instances they should be fully disclosed to investors.

Despite the common use of the 3% test by accountants, the SEC guidelines for these partnerships don’t provide minimum outside investment figures.

Instead, the SEC requires the outside investment to be “substantive” or similar to the amount of cash third-party companies would use to establish a venture in the same business, Turner said.

Nonetheless, that 3% figure was the threshold used in some Enron transactions, Joseph Berardino, chief executive of Enron’s auditor, the Arthur Andersen accounting firm, said at a congressional hearing this month.

The question of whether to include the results of such a partnership in a balance sheet arises over the issue of who is in control of the venture.

If three chemical companies build a plant together, it wouldn’t make sense for them to consolidate the operations of a venture in which they own only one-third, said Tim Lucas, chief staff member of the Financial Accounting Standards Board.

Some ventures should appear in a company’s financial statements and others, such as the chemical plant, should not, Lucas said.

“The problem is that there are a whole bunch in the middle that we would argue over,” Lucas said.

The accounting standards board has debated the partnership issue for decades. The subject was the focus of a board meeting as recently as Nov. 21, when Enron was unraveling.

“The problem is that as soon as we draw a line, the people who design these things will figure out how to structure them to be on the side of the line they want to be on, and often that’s just barely outside of having to consolidate the numbers,” Lucas said.

But regardless of the reason, Turner said, “We need to make sure that accountants aren’t helping the investment banks and underwriters set up SPEs [special purpose entities] to get around the rules. It is simple, the rule should be that all SPEs should be consolidated when whoever sponsored them has the majority of the economic upside or downside.

“As auditors we are supposed to be working for investors rather than the management team,” Turner said.

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Times staff writers Walter Hamilton, James F. Peltz and Corie Brown contributed to this report.