Jack Murray on Synthetic Leases and Enron fallout in general
Synthetic lease transactions, as a classic form of
off-balance-sheet financing, have been absorbing a public-relations beating as
a result of the Enron Corp. scandal.
Interestingly, many of the media conglomerates whose magazines,
newspapers, newsletters and journals have published articles criticizing or
condemning off-balance-sheet financing in general and synthetic leasing in
particular (with descriptions such as "contortion of reality,"
"accounting gimmick," and "off-balance-sheet trick"), are
themselves users and beneficiaries of synthetic lease financing. The fact is
that more than $100 billion in synthetic leasing transactions has been
consummated in the past ten years, and more than 2000 publicly traded U.S. corporations
utilize some form of off-balance-sheet financing (including synthetic leases).
As I pointed out in a previous posting, unlike the Enron
off-balance-sheet shenanigans synthetic-lease financing has not been
characterized by violations or abuses of either the letter or the spirit of the
accounting and tax rules and regulations that govern such transactions. As one
commentator has pointed out, "In real estate you have bricks, sticks and
mortar. Appraising it is fairly easy to do. This was not true in the
partnerships Enron established."
Furthermore, credit-rating agencies such as Standard &
Poor's, Moody's, and Fitch already take synthetic-lease obligations into
account when assessing a corporation's creditworthiness. For example, on March
7, 2002, Fitch issued a report on synthetic leasing. According to this report,
"When rating companies that use synthetic leases, Fitch Ratings will
effectively add the financing back to the balance sheet and income statement by
adjusting leverage and other key credit ratios. In addition, Fitch may assign a
rating to the lease debt, based on the credit rating of the lessee and/or the
value of the underlying asset(s)."
Nonetheless, synthetic leases are being painted with the
"Enronitis" brush, and the new FASB accounting Interpretations
affecting the use of SPEs (with respect to guarantees and consolidation,
respectively), as well as the negative public perception of any form of
off-balance-sheet financing, will severely restrict -- but not eliminate --
this form of corporate financing of real estate. Unfortunately, as a result of
the negative p.r. fallout from the Enron fiasco, corporations are
understandably wary of entering into synthetic lease transactions, even when it
might otherwise make economic sense to do so.
Earlier this year, Krispy Kreme (the highly successful doughnut maker)
saw its stock plunge 10 percent after it first announced its plans to utilize a
synthetic lease, in connection with the construction of a $35 million
manufacturing and mixing facility in Illinois. The stock price recovered only
when the company's management announced that it was abandoning the synthetic
lease structure and would instead use conventional mortgage financing. Also,
due to investor concerns about accounting procedures and a stated determination
to increase transparency and decrease shareholder concern, Cisco Systems (the
world's largest maker of computer-networking equipment) announced in May 2002
that it would pay approximately $1.9 billion to terminate existing synthetic
leases by buying back the properties, thereby discontinuing all but one of its
synthetic lease transactions.
The new accounting rules regarding disclosure and
consolidation promulgated by FASB likely will have a profound effect on the use
of SPEs in off-balance-sheet financing transactions, particularly with respect
to synthetic leases. The Interpretation regarding consolidation (which is
currently in the "comment" period and is expected to be finalized in
the fourth quarter of 2002) is intended to provide guidance on the consolidation
of certain SPEs that lack independent economic substance, and will require that
at least 10 percent (as opposed to the current "bright line" test of
three percent under current rules) of the total capitalization for the SPE
(both debt and equity) must be equity "at risk" to conclude that a
substantive equity investment has been made in the SPE. The implementation of
the Interpretation will require a large number of publicly traded U.S. companies
to add synthetic lease liabilities to their balance sheets by (most likely) the
end of the first quarter of 2003. Many companies (including lessees in
synthetic leasing transactions) that have used special-purpose-entity lessors
will be required to bring assets and liabilities on the balance sheet with
negative effects on their debt-to-equity ratios, return on assets, operating
and profitability margins, and cost of financing. This could lead to downgraded credit ratings, regulatory
concerns, and debt-covenant violations of loan agreements. It will likely be
very difficult for many existing SPEs to be restructured in order to meet the
new FASB criteria. Many corporations
will be forced to revise structures used for many years as efficient sources of
financing, and capital costs will increase as the result of having to seek less
attractive and more expensive alternative sources of financing.
There is, no doubt, a need for more accurate and complete
disclosure of synthetic-leasing and other off-balance-sheet transactions.
Companies seeking synthetic lease financing that are not rated "investment
grade" by rating agencies such as Moody's, Standard & Poor's, or
Fitch, are commonly required to post collateral (which can be in an amount equal to 75-100 percent of the project
cost) with the financing source in the form of an escrow or defeasance account,
letter of credit, surety bond, first deficiency guarantee, or some other form
of credit enhancement. This obligation
often will be described on the company's balance sheet as "restricted
cash," "long-term asset," or included within the category of
"total cash, and cash equivalents, restricted cash and short-term
investments." However, this
segregated cash is not in fact available to fund the company's business
operations, and may be used only to fund the company's obligations under the
synthetic lease.
Investors and analysts are increasingly suspicious of these
types of "disclosures." As a
direct result of the Enron debacle, the Securities and Exchange Commission
issued, on January 22, 2002, a statement (Release Nos.
33-8056; 34-45321; FR-61; ("SEC Statement")
clarifying its views and providing immediate guidance with respect to
"material off-balance-sheet activities." This statement applies to
financial disclosures by public companies for the calendar year 2001, and
provides interpretive guidance for companies with respect to liquidity and
capital resources (including off-balance-sheet transactions). The SEC Statement is designed to provide
more "transparent" disclosures in the wake of the Enron failure, and
encourages companies to provide more specific and understandable information.
The SEC believes that this information should go beyond the minimum technical
legal requirements (or "boilerplate"), and should be tailored to the
company's individual circumstances. The SEC Statement stresses the need for a
narrative explanation of financial statements as opposed to numerical
presentation and brief accompanying footnotes. The SEC Statement also
emphasizes that the information provided should be "useful and
understandable," and available in a single location rather than in a
fragmented manner throughout the company's financial statements.
The Sarbanes-Oxley Act of 2002, enacted on July 30, requires
that, not later than 180 days after such enactment, the SEC issue final rules
requiring each annual and quarterly financial report filed with the SEC to
disclose all material off-balance-sheet obligations (including contingent
obligations) that may have a material effect on, among other things, financial
condition, results of operations, liquidity, capital resources, or significant
components of revenues or expenses. Within one year of the new Act's effective
date, the SEC is required to complete a study of filings by companies to
determine the extent of off-balance-sheet transactions and special purpose
entities.
Jack Murray
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