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