Texas A&M University School of Law

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2007

Enron and the Special Purpose Entities - Use or

Abuse - The Real Problem - The Real Focus
Neal Newman
Texas A&M University School of Law, [email protected]

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Recommended Citation
Neal Newman, Enron and the Special Purpose Entities - Use or Abuse - The Real Problem - The Real Focus, 13 Law & Bus. Rev. Am. 97
(2007).
Available at: https://scholarship.law.tamu.edu/facscholar/143

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 ENRON AND THE SPECIAL PURPOSE
ENTITIES-USE OR ABUSE?-THE
REAL PROBLEM-THE REAL Focus

Neal Newman *

I. INTRODUCTION

N December of 2001, Enron Corporation, one of the nation's largest

energy and gas providers, filed for bankruptcy under chapter 11 of
the U.S. Bankruptcy Code, one of the largest corporate bankruptcy
filings at that time. 1 A myriad of scholarship, books, and articles have
been written on Enron's meteoric rise and fall. The failure in oversight
that permeated Enron's corporate gatekeepers, such as Enron's Board of
Directors and upper management, its public accountants Arthur Ander-
sen, the Securities and Exchange Commission (SEC), and other profes-
sionals who were tasked to navigate the Enron empire, was disturbing
and disconcerting on a number of levels-not the least of which being the
blow to investor confidence, the foundation that the capital markets are
built on.
On the heels of Enron's debacle came the Sarbanes-Oxley Act of 2002,
the far reaching legislative reform that was designed to shore-up the ac-
counting and corporate governance shortfalls that the legislature and the
2
investing public believed allowed Enron to do what it did unabated.
Supplementing the reforms set forth in the Sarbanes-Oxley Act are a
number of accounting rules, guidelines, and interpretations that are de-
signed to curtail the type of accounting fraud Enron perpetrated through
its use (or more accurately abuse) of what are referred to as special pur-
pose entities (SPEs). Although much has been written chronicling and
analyzing the various aspects of the Sarbanes-Oxley Act, little has been
written analyzing the accounting guidance related to SPEs.

• Associate Professor of law, Texas Wesleyan University School of law. This essay
benefited from the suggestions of professor Barbara Banoff from Florida State
University and professor Jeffrey J. Haas from the New York University School of
Law. Also thanks to Mr. Adam Burney and Cynthia Gustavson who both pro-
vided valuable help as research assistants. And finally, thanks to Texas Wesleyan
University School of Law who supported my work through the provision of a sum-
mer research grant.
1. Richard A. Oppel, Jr. & Andrew Ross Sorkin, Enron's Collapse: The Overview;
Enron Corp. Files Largest U.S. Claimfor Bankruptcy, N.Y. TIMES, Dec. 3, 2001, at
Al.
2. See Sarbanes-Oxley Act of 2002, 15 U.S.C.A. §§ 7201-02, 7211-19, 7231-34, 7241-
46, 7261-66 (West 2006).
98 LAW AND BUSINESS REVIEW OF THE AMERICAS [Vol. 13

Since the Enron debacle, a dark cloud has been cast over the SPE by
the investment and financial community. The line between SPE use and
abuse has been blurred to the point where the two are considered one in
the same, i.e., that SPEs by their very nature are these ominous, nefari-
ous, inherently evil entities whose only purpose is to defraud, obfuscate,
and manipulate financial statements. The purpose of this piece, among
other things, is to challenge this assumption and conclusion.
The focus for this paper is to take a look at both the new accounting
rules in the post-Enron era that have been enacted, in significant part,
due to what happened with Enron and its SPE use, as well as the account-
ing rules related to SPEs that were in effect during both the pre and post-
Enron eras. This article examines the accounting reforms and legislative
approaches currently being taken regarding the accounting for and disclo-
sures of SPEs. This piece questions whether or not those approaches are,
in fact, the correct ones.
The article will examine closely the method and manner that Enron
perpetrated such fraud, with the goal of demonstrating that it was not a
lack of accounting rules or deficient interpretive accounting guidance that
resulted in Enron's SPE improprieties. Instead, dishonest and fraudulent
behavior by Enron management was the real problem. The next part of
the piece will cite and critique current rules and some proposed account-
ing reforms being considered, analyzing their current and potential effec-
tiveness, with the goal of highlighting reasons why the proposed reforms
may not meet their desired or stated objectives. Finally, the piece will
explore and suggest some alternative approaches once the issue has been
reframed. In the alternative, this piece, in essence, suggests that enforce-
ment efforts should be focused on the SPE abusers instead of the SPEs
themselves.
The overall goal of this piece is to question whether we should be tak-
ing a different approach to financial fraud in the area of SPEs than the
path currently being taken; the end result being that we will ultimately be
making it more difficult and more costly for the myriad of legitimate SPE
use that may or may not be able to continue in light of the accounting and
disclosure requirements currently in place and that have been enacted to
a large degree in response to what occurred with Enron.

II. WHAT IS A SPE?

A. SPEs HISTORICALLY

To understand why or, more importantly, how, Enron perpetrated the

financial accounting fraud that it did, we must first understand from a
general standpoint what an SPE is and, more importantly, how it works.
SPEs are structures that have been around for years, only recently com-
ing into prominence primarily due to the manner that Enron abused the
SPE structure in connection with their financial reporting schemes. Since
that time, accountants and CPAs alike have tasked themselves to gaining
2007] ENRON AND THE SPECIAL PURPOSE ENTITIES 99
3
an understanding of these previously obscure entities.

B. WHAT ARE SPEs?-A LOOK AT THE VARIOUs FORMS

Though SPEs are considered to be complicated entities, the general

premise of an SPE is simple. An SPE is an entity formed for a discreet
and isolated purpose, to adhere to a specific business or economic objec-
tive; a simple premise or starting off point from which the concept builds.
The idea behind the SPE is to narrow the scope of risk to the assets and
liabilities placed in the SPE, such that potential investors' or equity hold-
ers' fortunes or misfortunes will be based entirely and exclusively on what
occurs with respect to the assets and liabilities placed within the SPE.
Note that this is the general idea, but there are a number of variations on
this single theme.
Generally, SPEs fall into three categories: (1) the joint venture, (2) the
synthetic lease, and (3) the asset securitization or off-balance sheet fi-
nancing. Granted, there can be a number of variations on these three
major themes, but the vast majority of SPE transactions fall in one of the
three. Each type will be discussed in turn.

1. The Joint Venture

The joint venture is perhaps the most basic and straight-forward SPE
type. In a joint venture, two or more parties come together and engage in
a venture that is separate and apart from their respective entities. 4 The
conduit that such ventures can occur through is the SPE. This conduit
can take any number of forms: a partnership, a corporation, a trust, an
LLC, etc. Understand that it's the entity's purpose, not its legal form,
that the SPE moniker is derived. An example of a typical joint venture
may be the construction of a gas pipeline to conduct off-shore oil drill-
ing. 5 In this instance, the entire scope of the venture will be transferred
to a separate and discreet business entity apart from the respective com-
panies. The SPE will own both the assets and liabilities associated with
the project. Because of the isolated nature of the project, such a circum-
stance creates an attractive situation for investors, as the risks and re-
wards of the project are now isolated within the SPE, rather than an
investor's success being subject to6 the fortunes or misfortunes of the re-
spective corporations as a whole.

3. Bob Jensen, What's Right and What's Wrong With (SPEs), SPVs, and VIEs, http://
www.trinity.edu/rjensen/theory/00overview/speOverview.htm (last visited Feb. 21,
2006).
4. See Cornell Law School Legal Information Institute, Joint Venture, http://
www.law.Cornell.edu/wex/index.php/Jointventure (last visited July 22, 2006) (giv-
ing an overview of a joint venture).
5. Bala G. Dharan, Financial Engineering with Special Purpose Entities, in ENRON
AND BEYOND: TECHNICAL ANALYSIS OF ACCOUNTING, CORPORATE GOVERN-
ANCE, AND SECURITIES ISSUES 103, 104 (Julia K. Brazelton & Janice L. Ammons
eds., 2002).
6. Id.
100 LAW AND BUSINESS REVIEW OF THE AMERICAS [Vol. 13

To insure that the SPE operates in the manner the venturing parties
contemplated, the chartering documents-such as the articles of incorpo-
ration, the partnership agreement, or the operating agreement, as appli-
cable-will narrow the SPE's scope to only those permitted activities.
There are several key things to observe with the SPE used in the joint
venture context. First, with the joint venture, the business purpose and
rationale for entering into such ventures are clear. The design and struc-
ture of such ventures and what they are trying to do and accomplish for
the most part make sense as well. Provided that proper formation occurs
and proper protocols are followed, the use of the SPE in the joint venture
context is a legitimate and non-controversial use of the SPE.

2. Synthetic Leases
a. The Typical Synthetic Lease Structure
The second category where SPEs are used as an integral part of a trans-
action is what is referred to as the synthetic lease. The following is a
typical synthetic lease example: ABC Company wants the use of a build-
ing for its corporate offices for the next twenty years. The land and build-
ing would cost $100 million to buy. Alternatively, ABC forms a separate
legal entity, an SPE, to purchase the building. The SPE in turn borrows
the necessary funds to acquire the building. The financial institution may
loan the SPE up to 90 percent of the fair market value of the real estate.
The loan is secured by the building. The remaining 10 percent of the cost
is put up by an outside equity investor. The outside investor owns 100
percent of the shareholder equity in the SPE, which results in all of the
outside equity being owned by someone other than the sponsoring
7
corporation.

b. Corporate Motivation Behind the Synthetic Lease

It is helpful to understand the underlying motivation for corporations
that use the synthetic lease structure. Transactions, especially of the mag-
nitude that are typically involved with synthetic lease transactions, will
have a significant impact on both the corporation's financial statements
and their tax returns. Accordingly, the goal is to structure the transaction
such that it will be as advantageous as possible for both financial and tax
reporting purposes.

c. Operating Versus Capital Lease-The Impact of One Versus the

Other
The two ways that the transaction can be structured from the lessor's
perspective is either as an operating lease or as a capital lease. 8 The re-
sulting characterization will have a significant impact on how the lease

7. Id. at 107.
8. STATEMENT OF FINANCIAL ACCOUNTING STANDARDS No. 13: ACCOUNTING FOR
LEASES 6(a) (1976) [hereinafter FAS 13].
2007] ENRON AND THE SPECIAL PURPOSE ENTITIES 101

transaction is accounted for. From a financial statement perspective, the

end user or lessee will want to characterize the lease as an operating
lease. Such characterization gives the lessee the more favorable treat-
ment from a financial reporting perspective. 9 When the lease transaction
is characterized as an operating lease, by implication the lessee is not ac-
quiring the asset but merely making use of it for a finite period of time
and then presumably returning it back to the lessor. Accordingly, from
an accounting standpoint, the lessee treats the transaction as an operating
expense, recognizing the lease payments as a lease or rental expense dur-
ing the lease term. 10
By contrast, the capital lease is the least favored between the two alter-
natives as far as the lessee is concerned. With capital leases, the lessee is
required to account for the transaction as if the lessee were acquiring the
asset.11 Accordingly, as opposed to merely expensing the periodic lease
payments as would be required for operating leases, the lessee must capi-
talize the asset and record it as such on its balance sheet. 12 The amount
the lessee records is the present value of the minimum lease payments as
calculated at the lease's inception. 13 Likewise, and more significantly, the
lessee is required to record a corresponding debt obligation for the same
amount. 14 Additionally, because the lessee is required to treat the asset
as if it is being acquired, the lessee must also record both the depreciation
expense to recognize the declining value of the asset and the interest ex-
pense to reflect the financing portion of the acquired asset over the term
15
of the lease.
Because of the required accounting treatment, the effect on the lessee's
financial statements is significant. As one would expect, publicly held
companies are sensitive to how lease transactions are classified. For ex-
ample, when a lessee is required to account for a lease transaction as a
capital lease, recording the corresponding debt obligation has' an adverse
effect on ratios such as the debt-to-equity ratio.16 Likewise, the added
burden of recording both depreciation and interest expense results in an
overall decrease in reported net income. Investors are sensitive to these
effects of a capital lease, which can have an adverse impact on a corpora-
tion's share price. Accordingly, as between the two alternatives, the
lessee will want the transaction structured as an operating lease to get a
more favorable accounting treatment.

9. See generally id. $$916-10.

10. Id. T 15.
11. Id. T110.
12. Id.
13. Id.
14. Id.
15. Id. 11.
16. The debt-to-equity ratio measures a corporation's debt in relation to its equity.
See DAVID R. HERWITZ & MATTHEW J. BARRETT, ACCOUNTING FOR LAWYERS
327 (3d ed. 2001).
102 LAW AND BUSINESS REVIEW OF THE AMERICAS [Vol. 13

d. Accounting Treatment for Synthetic Leases-Operating Versus

Capital-The Characterization Criteria Under Generally
Accepted Accounting Principles
As discussed earlier, because of the significant differences in account-
ing treatment for operating leases versus capital leases, the lessee will
want to characterize the lease as an operating lease if that alternative is a
viable option. Accordingly, the lessee has to make sure that the lease is
structured so that operating lease treatment is proper under Generally
Accepted Accounting Principles (GAAP). Statement of Financial Ac-
counting Standards No. 13 (SFAS 13) gives guidance relating to account-
ing for lease transactions. Under SFAS 13, the lease may not be
characterized as an operating lease if the lease meets any one of the fol-
lowing criteria: a.) "[t]he lease transfers ownership of the property to the
lessee by the end of the lease term";1 7 b.) "[t]he lease contains a bargain
purchase option" (i.e., "[a] provision allowing the lessee, at his option, to
purchase the leased property for a price which is sufficiently lower than
the expected fair value of the property)"; 18 c.) "[t]he lease term ... is
equal to 75 percent or more of the estimated economic life of the leased
property" (note, this criteria cannot be considered in classifying the lease,
if the lease's term begins during the last 25 percent of the asset's esti-
mated economic life); 19 and d.) the present value of the minimum lease
payments as calculated at the lease's inception is equal to 90 percent of
the fair value of the leased property (note, this criteria cannot be consid-
ered in classifying the lease if the lease's term begins during the last 25
20
percent of the asset's estimated economic life).
In looking at these four criteria, any one of which could trigger capital
lease treatment, it is evident that SFAS 13 requires capital lease treat-
ment when the economic substance of the transaction is such that the
lessee is acquiring the asset. Given this set of criteria, the trick is to struc-
ture the transaction such that the transaction does not fall under any of
the capital lease triggers mentioned above. Provided all of these criteria
can be avoided, then operating lease treatment will be appropriate.

e. When Consolidation is Required

The final hurdle related to synthetic leases and accounting for them is
the issue of whether or not the lessee has to report the lease obligation
owned by the SPE on a consolidated basis. This issue is significant be-
cause if the lessee is required to report the SPE on a consolidated basis
with the issuer, this would nullify any favorable accounting treatment that
the lessee would otherwise enjoy because the debt obligation would be
reported on the lessee's books on a consolidated basis regardless of how
the lessee characterized the lease initially. Again, the challenge in avoid-

17. FAS 13, supra note 8, 7(a).

18. Id. IT 7(b), 5(d).
19. Id. 7(c).
20. Id. I 7(d).
2007] ENRON AND THE SPECIAL PURPOSE ENTITIES 103

ing consolidation is to structure the lease and the SPE so that the lease
obligation is contained in such a way under GAAP that the lessee is not
required to report the SPE and the debt obligation contained in the SPE
on the issuer's books on a consolidated basis.
Accordingly, accounting guidelines have targeted leases that otherwise
qualify as operating leases and have enumerated specific instances where
those leases may still have to be accounted for on a consolidated basis on
the lessee's books. In that regard, those specific instances are any one of
the following: "1. [ljessee residual value guarantees and participations in
both risks and rewards associated with ownership of the leased prop-
erty[;] 2. [p]urchase options[;] 3. [s]pecial-purpose entity (SPE) lessor that
lacks economic substance[;] 4. [p]roperty constructed to lessee's specifica-
21
tions[; and] 5. [l]ease payments adjusted for final construction costs."
When the lease transaction contains any one of the characteristics
noted above, the issue is whether operating lease treatment is still appro-
priate. 22 Accordingly, lessees with any of the characteristics noted above
would have to report the SPE on a consolidated basis when all of the
following conditions exist: 23 "1. [s]ubstantially all of the activities of the
SPE involve assets that are to be leased to a single lessee."'2 4 This is al-
most always the case as, generally, the lessee sets up the SPE for the sole
purpose of taking ownership of that single asset and the corresponding
debt obligation.
2. The expected substantive residual risks and substantially all the
residual rewards of the leased asset(s) and the obligation im-
posed by the underlying debt of the SPE reside directly or indi-
rectly with the lessee through such means as:
a. The lease agreement
b. A residual value guarantee through, for example, the as-
sumption of first dollar of loss provisions...
c. A guarantee of the SPE's debt
d. An option granting the lessee a right to (1) purchase the
leased asset at a fixed price or at a defined price other than
fair value determined at the date of exercise or (2) receive
any of the
25
lessor's sales proceeds in excess of a stipulated
amount.
And "3. [t]he owner(s) of record of the SPE has not made an initial
substantive residual equity capital
'26
investment that is at risk during
the entire term of the lease."
Accordingly, the lessee has to structure the lease such that it fails at
least one of these three conditions. Lessees using the SPE structure for

21. EMERGING ISSUES TASK FORCE ISSUE No. 90-15: IMPACT OF NONSUBSTANTIVE
LESSORS, RESIDUAL VALUE GUARANTEES, AND OTHER PROVISIONS IN LEASING
TRANSACTIONS 1 (1991) [hereinafter EITF 90-15].
22. Id.
23. Id. at 2.
24. Id.
25. Id.
26. Id.
104 LAW AND BUSINESS REVIEW OF THE AMERICAS [Vol. 13

their synthetic lease transactions generally structure the lease such that it
fails the third criteria. The lessee accomplishes this by having a third
party investor as the equity owner of the SPE. By doing this, the third
party equity owners become the presumptive owners of the SPE by virtue
of their equity investment.
f. How Substantial Must the Equity Investment Be to Avoid
Consolidation?
The SEC weighed in on this issue and concluded that the appropriate
equity investment amount "should be comparable to that expected for a
substantive business involved in similar leasing transactions with similar
risks and rewards."'2 7 The SEC staff concluded that 3 percent would be
the minimum acceptable investment but further explained that a greater
investment would "be necessary depending on the facts and circum-
stances, including the credit risk associated with the lessee and the mar-
'2 8
ket risk factors associated with the leased property.
From the reading of Emerging Issues Task Force (EITF) Issue 90-15,
the inference that should have been drawn was that the 3 percent equity
investment was merely meant to be a guideline or a baseline minimum to
be increased when circumstances warranted. But what has happened in
practice is that the 3 percent rule has become the accepted practice and
the standard minimum equity investment amount required to pass SEC
muster. Accordingly, most entities that structure synthetic lease transac-
tions using SPEs have an equity investor investing at the 3 percent
minimum.
Given such liberal criteria for avoiding consolidation in the pre-Enron
debacle era, it would seem that issuers who wished to avoid consolidation
of their affiliated SPEs could do so without much effort. Accordingly,
had Enron followed these rules as prescribed, their case for innocence
would have been much stronger. But as we will explore in section III,
Enron's problems stemmed from departing from these rules (as liberal as
they were) as they existed, which subsequently prompted changes in the
criteria that a corporation must consolidate affiliated SPEs. This article
in later sections will examine what these changes entail.
g. Tax Treatment for Synthetic Leases
Interestingly, and not surprisingly, the last obstacle that the lease trans-
action must be navigated through is assessing the proper tax treatment
for the transaction. What makes the synthetic lease so appealing as a
financing structure is the fact that it can be accounted for differently for
financial reporting and tax purposes. The different treatment is afforded
for each because the characterization criteria for tax purposes are differ-
29
ent than the characterization criteria for financial accounting purposes.

27. Id. at 4.
28. Id.
29. See generally Rev. Rul. 55-540, 1955-2 C.B. 39.
2007] ENRON AND THE SPECIAL PURPOSE ENTITIES 105

Thus, if the transaction is structured properly, the lessee gets optimal ben-
efits from both a financial reporting and a tax perspective.
As discussed earlier, the lessee will want to characterize the lease as an
operating lease for financial reporting purposes to avoid having its in-
come statement weighted down with interest and depreciation expense
and its balance sheet burdened by recording the corresponding liability
from the financing obligation. For tax purposes, however, the lessee will
want to characterize the lease transaction as if the lessee is acquiring the
asset with the understanding that the investing public tracks what compa-
nies report for financial reporting purposes. But companies can report
different numbers to the Internal Revenue Service (IRS) due to the dif-
ferent reporting requirements mandated under the Internal Revenue
Code. 30 Likewise, the income reported for tax purposes has a real eco-
nomic impact on the corporation, as that number is the basis for their tax
liability to the Federal Government. Accordingly, the lessee corporation
will want to reduce taxable income as much as possible. One of the ways
this is done is through the corporation being afforded capital lease treat-
ment for tax purposes, thereby giving the lessee the right to record both
depreciation and interest expense for tax purposes on the leased transac-
tion, resulting in a reduction in taxable income. The key is structuring the
transaction properly to be afforded such treatment.

h. The Characterization Criteria for Tax Purposes-The Benefits

and Burdens Test
Unlike the bright-line tests used to characterize the lease transaction
for financial reporting purposes, the characterization criteria for tax pur-
poses use a different approach. In determining how the lease should be
characterized for tax reporting purposes, the determination is based on
the general principal that the transaction's economic substance coupled
with the intent of the parties comprising the transaction are the determin-
ing factors as to how the lease transaction will be characterized. 3 1 The
IRS and the courts have taken this general principle and have applied it
on a case-by-case basis to lease transactions of various types. 32 The IRS,
when determining who is the presumptive owner of a leased asset, looks
at a number of things, the first being the intent of the parties to the trans-
action in question 33. The court takes that intent and couples it with the
economic substance of the transaction, presumably looking for proper
balance between the two. 34 Essentially, the court looks at the transac-
tion's form as characterized by the parties, and then looks beyond the

30. For instance, a corporation may use different depreciation methods for financial
reporting purposes such as a straight-line depreciation method for financial report-
ing purposes and some accelerated depreciation method allowed for tax reporting
purposes. See HERWITZ & BARRETT, supra note 16, at 795.
31. See generally Rev. Rul. 55-540 § 4.
32. Id.
33. Id.
34. Frank Lyon Co. v. United States, 435 U.S. 561, 577 (1978).
106 LAW AND BUSINESS REVIEW OF THE AMERICAS [Vol. 13

documents to determine whether that form coincides with the economic

35
substance.
For example, in the case where the lessee wishes to treat the lease
transaction as a capital lease to enjoy the benefits of deducting deprecia-
tion and interest expense for tax purposes, the court will look to see
whether the lessee, by virtue of the transaction, is vested with the true
benefits and burdens of ownership. 36 If it is evident that the party seek-
ing to characterize the lease transaction as a capital lease is vested with
the true benefits and burdens of ownership, then the court will defer and
let the characterization stand.

i. The Argument for Harmonizing the Dual Treatment for Tax and
Accounting Purposes
Regarding synthetic leases and the dual treatment for tax and account-
ing purposes, there is sentiment in the field of academia that "this trans-
actional sleight-of-hand should not be permitted. '37 Admittedly, there is
a discordant paradox when you have a company that can take the very
same transaction and categorize it one way for financial accounting pur-
poses and another for tax purposes, even though the economic substance
of the transaction is the same. Some have advocated that the Financial
Accounting Standards Board (FASB), the governing body that sets ac-
counting standards, eliminate the bright-line tests used for financial re-
porting purposes and follow the "benefits and burdens" test that the IRS
follows; the argument being that the benefits and burdens test is based on
classifying the transaction on its economic substance versus an arbitrary
38
classification that conforms to bright-line tests of form.
Likewise, the SEC has noted similar issues in its assessment of the
bright-line tests set forth in determining capital versus operating treat-
ment for leases. The crux of the SEC's argument is that transactions that
are similar in terms of economic substance can have very different ac-
counting treatments based on slight variations in the transaction's actual
form. For example, the SEC notes, the difference between a lease that
commits an issuer to payments equaling 89 percent of an asset's fair value
versus 90 percent of an asset's fair value results in different accounting
treatment, one qualifying as an operating lease and the other relegated to
39
the less favored status of being accounted for as a capital lease.
In spite of some in the field of academia, as well as the SEC's recogni-
tion of the current problems with the existing rules, the SEC nonetheless

35. Id. at 576-77.

36. Id. at 577.
37. Donald J. Weidner, Synthetic Leases: StructuredFinance, FinancialAccounting and
Tax Ownership, 25 J. CORP. L. 445, 487 (2000).
38. Id. at 466.
39. SEC, REPORT AND RECOMMENDATIONS PURSUANT TO SECTION 401(c) OF THE
SARBANES-OXLEY ACT OF 2002 ON ARRANGEMENTS WITH OFF-BALANCE SHEET
IMPLICATIONS, SPECIAL PURPOSE ENTITIES, AND TRANSPARENCY OF FILINGS BY
ISSUERS 63 (2005) [hereinafter SEC REPORT 401(c)].
2007] ENRON AND THE SPECIAL PURPOSE ENTITIES 107

acknowledges that it would be difficult to change those rules given that

lease structuring based on the current accounting guidance is so preva-
lent. Such efforts to change would likely be met with strong resistance,
both from preparers who have become accustomed to designing leases
that achieve various reporting goals and from other parties that assist
40
those preparers.
To quantify that number, as of December 31, 2003,41 it is estimated that
63 percent of the total population of issuers reported having operating
leases as a part of their operations, and an estimated 22 percent reported
having capital leases. 42 In terms of the dollar amounts, an estimated $1.2
trillion are tied up in operating leases with another estimated $45 billion
tied up in capital leases. 4 3 With the prospect of all or a significant portion
of these operating leases being re-classified, resulting in debt recognition
on an issuer's balance sheet, it is clear why there would be resistance to
significant changes to the current accounting rules. In spite of these inter-
esting issues related to synthetic leases, such is not this article's focus. In
explaining SPEs in general, however, the piece would not be complete
without some discussion of synthetic lease transactions and the current
issues related to synthetic leases.
But this article focuses on SPE abuse, i.e. . a look at an issuer's failure
to follow existing accounting guidance, which does not appear to be prev-
alent in the synthetic lease context. The issues with the synthetic lease
transaction deal with whether the current accounting regime related to
synthetic lease transactions is appropriate even where the letter of the
law is followed explicitly. In sum, the synthetic lease discussion is here to
illustrate yet another common transaction that the SPE is used in and to
point out the fact that, in spite of some issues that are in flux, SPE use in
forming synthetic leases is nonetheless another legitimate use of the SPE
structure.

3. Asset Securitizations-[Off-BalanceSheet Financing]

a. How Asset Securitizations Work
Asset securitizations have been around for some time and constitute an
important tool in the capital-raising component for corporations who
need to be creative and innovative in their capital-raising efforts. 44 In a
typical securitization, the corporation, referred to as the originator, will
transfer a select group of assets into an SPE. 45 The assets transferred are
usually account receivables. 4 6 But in theory, the assets can be any type of

40. Id.
41. Id. at 29.
42. Id. at 64.
43. Id.
44. For example, the first structured financings identified as such took place in the
early 1970s. See STEVEN L. SCHWARCZ, STRUCTURED FINANCE: A GUIDE TO THE
PRINCIPLES OF ASSET SECURITIZATION § 1:2, at 1-7 (3d ed. 2002).
45. Id. § 1:1, at 1-3.
46. Id. § 1:1, at 1-4.
108 LAW AND BUSINESS REVIEW OF THE AMERICAS [Vol. 13

asset that will have a potential future payment stream. 47

The SPE in turn issues some type of security in exchange for cash.
The security can be either in the form of debt or equity issued to third
parties who are willing to invest. The securities are backed by the assets
that have been transferred to the SPE. 48 The SPE in turn transfers the
money received from the investors on to the originator.4 9 The price the
investors are willing to pay depends on the creditworthiness of the trans-
ferred assets that are backing the security.50 If the receivables, for exam-
ple, are of a high quality, i.e., the likelihood of collection is fairly certain,
then investors are willing to pay more for the securities because the risk
of default is low. 5 1. The debtors who have an outstanding receivables
balance owed to the originator are then informed that their balance has
been transferred and are therefore instructed to send payment to the SPE
instead of the originator. When the SPE receives the payments, the col-
lected cash is transferred to the investing security holders.
If the transaction works according to plan, it can be win-win for all
parties involved. The originator benefits because the securitization al-
lows the originator to realize the receivables in the form of cash at a date
sooner than they otherwise might if they waited to receive payment from
the debtors at maturity. For example, an originator may receive $9,000
today on a securitized account receivable whose face value is $10,000.
The originator is giving up the right to receive $10,000 at a future date in
exchange for receiving $9,000 at an earlier point in time. This is a circum-
stance that is win-win for an originator who may have an immediate and
pressing need for cash.
The transaction is likewise beneficial to the investor. The investor pre-
sumably is not concerned with immediate access to cash. So the investor
is willing to pay $9,000 for the security in exchange for the right to receive
the $10,000 receivable face value when the balance comes due and is
paid. Accordingly, all parties benefit from the transaction. Additionally,
there are other benefits that come with using asset securitizations as a
capital raising tool, namely the accounting and financial reporting aspects
related to securitizations. Those benefits will be discussed next.

b. The Financial Reporting Benefits Related to Asset

Securitizations
As was discussed in the section on synthetic leases, the same issues
regarding how different financing options will effect a company's finan-
cial reporting and perceived financial health are present in the asset
securitization arena as well. As we saw with synthetic leases, the goal of
the transaction was for the lessee to be afforded operating lease treat-

47. Id. § 1:1, at 1-5.

48. Id.
49. Id.
50. Id.
51. Id. § 1:3, at 1-10.
2007] ENRON AND THE SPECIAL PURPOSE ENTITIES 109

ment and the more favorable accounting that comes with such treatment.
Likewise, with asset securitizations, similar issues of balance sheet sensi-
tivity exist, although with slightly different issues related to financial
reporting.
Companies benefit from asset securitizations in two ways. First, if the
transaction is structured properly and most efficiently, the discount rate
that investors are willing to pay is better than the cost of borrowing that52
an originator might otherwise incur in a typical financing transaction.
Second, because of the off-balance sheet nature of the transaction, the
originator is absolved from having to recognize a debt obligation, and
therefore financial ratios such as the debt-to-equity ratio are improved as
a result. 53 The debt-to-equity ratio, for example, is a ratio that may be
pegged to loan covenants or is otherwise tracked by financial analysts
who use such ratios to assess the overall financial health of a corporation.
Accordingly, keeping this ratio low through alternative means of capital
rising can be important.
Regarding the first issue, this idea is similar to what was observed with
the joint venture scenario discussed earlier. When a selected group of
assets is isolated and transferred to an SPE, the investor's investment de-
cision is based solely on those assets isolated and segregated in the SPE
versus being based on the creditworthiness of the originator as a whole.
Accordingly, instead of the investor's fortunes being tied to the origina-
tor, they are now based exclusively on the creditworthiness of the assets
isolated in the SPE.54 As a result, the investor is willing to pay more for
these assets than he otherwise might if his investment 55decision were
based on the fortunes of the originator taken as a whole.

c. The Key Issue with Isolating the Assets-Bankruptcy

Remoteness

One of the key aspects, however, in the securitization process is that

the SPE that the assets are transferred in to must be "bankruptcy re-
mote," meaning that the assets transferred must legally be beyond the
originator's reach in the event that the originator, for instance, files for
bankruptcy, and the issue of using the transferred assets to settle any
claims comes into question. 56 The nuances of and the particulars of how
a bankruptcy remote SPE is established is beyond the scope of this arti-
cle. But in general, the SPE achieves bankruptcy remoteness through
proper drafting of its chartering or incorporating documents and through
57
its corporate governance structure.
Accordingly, the chartering documents will be drafted in such a way

52. Id. § 1:1, at 1-5.

53. Id. § 1:1, at 1-6.
54. Id. § 1:1, at 1-5.
55. Id.
56. Id. § 3:1, at 3-1.
57. Id. § 3:2.1, at 3-3.
110 LAW AND BUSINESS REVIEW OF THE AMERICAS [Vol. 13

that the entity's ability to declare bankruptcy is limited. 58 Understand

that typically the originator in many instances may be the sole share-
holder or majority shareholder in the SPE. Accordingly, to satisfy third
party investors or creditors and to induce their investment, the SPE will
have independent directors presiding on the SPE's board;5 9 independent
in this context being defined as a person who is not a director, officer, or
5 percent or more shareholder of the originator. 60 Through the charter-
ing documents, the independent directors will be the ones vested with the
exclusive authority to declare bankruptcy; the implication being that, be-
cause of their independent status, their bankruptcy decision will not be
influenced by the originator's circumstances but by what is in the best
61
interest of the SPE.
The second issue is using securitizations to minimize the impact on the
liability side of a corporation's balance sheet. In a typical financing situa-
tion, the corporation borrows the needed capital from a third party
lender. From a financial reporting standpoint, what happens is the corpo-
ration takes the cash and records it as an asset. But because the funds are
borrowed, the corporation must also record the corresponding liability on
its balance sheet. 6 2 The additional debt obligation has an adverse affect
on the debt-to-equity ratio as a result. But when the corporation raises
capital through the securitization process, the SPE is the entity that bears
any debt obligation through, for example, the issuance of debt securities,
where the investor/creditor is buying the right to the full face value of the
receivables when those receivables are paid. Because the transaction is
off-balance sheet, the originator is not required to record any debt obliga-
tions in exchange for the corresponding cash received in the transaction.
As a result, the originator's financial portrait is painted in a more
favorable light.

d. The Controversial Side of Asset Securitizations-Sale Treatment

When No Sale Occurs
Regarding asset securitizations, although they are or can be legitimate
techniques that companies can employ to raise capital, there are aspects
of the transaction that inherently can lend themselves to abuse. For ex-
ample, the issue arises at the juncture where the asset is transferred from
the originator to the SPE. The issue is what the proper accounting treat-
ment for the originator is in relation to the asset transfers. The available
options are either: (1) treating the transferred assets as sales and recog-
nizing the difference between the assets' carrying value and the actual

58. Id.
59. Id.
60. Id.
61. The issue of bankruptcy remoteness and when the SPE's directors can or may be
required to declare bankruptcy can become more involved and more complicated
in certain contexts. For a more detailed discussion on this issue, see id. § 3:2.1, at
3-3-3-13.
62. This accounting treatment is a general concept under the GAAP.
2007] ENRON AND THE SPECIAL PURPOSE ENTITIES 111

cash received as a gain on sale or (2) reflecting the transaction as a se-

cured financing. What can be tempting for some originators in their
quest for presenting the financial health of their company in the best light
possible is recording the asset transfers as sales when the true economic
substance of the transaction calls for secured financing treatment instead.
The motivation for and temptation to account for these transactions as
such is apparent; higher reported income numbers from recording the
transfer as a gain-on-sale and lower reported debt obligations due to the
transaction being off-balance sheet. The details of when and under what
circumstances sale treatment for the asset transfer is proper will be dis-
cussed next. At the outset, however, it is important to appreciate that
this is an area that can inherently lend itself to abuse. But again, it is also
important to appreciate that it is not the accounting rules that are the
root of the problem but the decision to follow or not to follow those ac-
counting rules as they currently exist.

e. Financial Accounting Standard 140-Sales Recognition-A Sale

or a Secured Financing?

As will always be the case, the threshold question that arises when an
originator transfers assets in connection with a securitization is the appro-
priate accounting treatment at the juncture where the asset is transferred
from the originator to the SPE. The two alternatives are: (1) recording
the asset transfer as a sale or (2) recording the asset transfer as a secured
financing. Again, to understand the competing tensions, if the asset
transfer qualifies for sales recognition, then the sponsor can record the
proceeds from the transfer as revenue, which in turn increases net in-
come, an overall financial statement enhancement.
On the other hand, if the asset transfer does not qualify for sales recog-
nition, the transaction is then a secured financing. Under this scenario,
proper accounting treatment would be to record the proceeds received in
exchange for the transferred assets as a debt obligation on its balance
sheet. Also, the originator would be required to record those proceeds as
proceeds from financing activities on the originator's cash flow
63
statement.

f. Sales Treatment versus Secured Financing

What determines sales versus secured financing treatment are the

terms that the asset transfer occurs under. Under Financial Accounting
Standard (FAS) 140, sales treatment versus secured financing is premised
upon control, i.e., who acquires or retains control of the transferring as-

63. This is a concept under GAAP, which requires that proceeds from financing activi-
ties be recorded as such in the company's Statement of Cash Flows. See, DONALD
E. KIESO ET AL., INTERMEDIATE ACCOUNTING 1275 (John Wiley & Sons, Inc. New
York, 7th ed. 1992).
112 LAW AND BUSINESS REVIEW OF THE AMERICAS [Vol. 13

set.6 4 If the originator retains some form of control over the transferred
asset, then sales treatment is not proper. 65 The idea is that the ties be-
tween the originator and the assets must be severed before sale treatment
is proper.
Under this set of accounting rules, the potential for abuse is evident.
The originator is looking to reduce his financing costs by isolating a dis-
creet set of assets. The third party lender is looking for a profitable in-
vestment by purchasing assets at a relative discount and realizing the
profit once collection on the transferred assets occurs and is realized.
When structured as designed, everything works well. The originator en-
joys an infusion of needed capital, and the investor enjoys a profit when
the revenues from the transferred assets are realized.
But what happens when the motivation for such transactions change?
What happens when the motivation for such transactions is merely to
achieve accounting results versus real business objectives? What happens
when the transferred assets aren't credit worthy at all, but the transferor
still wants to conduct such transactions to enhance financial statement
presentation through improper sales and revenue recognition? What
would induce a lender into financing an SPE based on assets whose real-
izations were questionable? This is the backdrop that sets the stage in
exploring Enron's SPE abuse.

III. ENRON AND ITS SPE ABUSE-PAINTING A (FALSE)

FINANCIAL PORTRAIT WITH THE SPE BRUSH
Almost overnight, the fall of Enron wiped out $70 billion of share-
holder value and resulted in default on tens of billions of dollars of
66
debt.

A. How DID THIS HAPPEN? THEIR CORPORATE CULTURE-A

CLIMATE FOR PUSHING THE ENVELOPE

The Enron story began with the merger of two gas pipeline companies,
Houston Natural Gas and InterNorth. Its purpose was to be an interstate
natural gas pipeline company. 6 7 Deregulation in the utilities industries
created significant challenges for the new company. Enron was losing its
exclusive rights to distribute its products. Kenneth Lay, the first CEO,
believed Enron needed to develop a new business strategy to remain

64. SUMMARY OF STATEMENT No. 140: ACCOUNTING FOR TRANSFERS AND SERVICING
OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES-A REPLACEMENT
OF FASB STATEMENT No. 125 (2000), availableat http://www.fasb.org/st/summary/
stsum140.shtml (last visited Feb. 23, 2006) [hereinafter STATEMENT 140].
65. Id.
66. Charles J. Tabb, The Enron Bankruptcy, in ENRON: CORPORATE FIASCOS AND
THEIR IMPLICATIONS 303 (Nancy B. Rapoport & Bala G. Dharan eds., 2004).
67. Enron Timeline, Hous. CHRON., Dec. 13, 2005, available at http://www.chron.com/
cs/cda/printstay.mpl/special/Enron/timeline/2342585.html.
2007] ENRON AND THE SPECIAL PURPOSE ENTITIES 113

competitive. 68 Lay hired McKinsey & Company, management consul-

tants, to help develop a new business strategy. Jeffrey Skilling was one of
the consultants who began to work with Enron. 69 Skilling proposed a
radical plan. Enron would buy gas from suppliers and resell it to users,
charging a small fee for handling the transactions. Deregulation would
allow Enron to take the role of middleman, matching supply and demand
for gas. 70 Enron would buy gas from a network of suppliers, sell it to a
network of consumers, and contractually guarantee both the supply and
the price. In doing so, Enron created a new product and a new paradigm
for the industry: the energy derivative. 71 Skilling's plan was successful,
and Lay hired him from McKinsey to work for Enron. It is claimed that
Skilling changed the corporate culture at Enron. Skilling adopted an em- 72
ployee ranking system, the Performance Review Committee (PRC).
The PRC gained the reputation of being the harshest employee-ranking
system in the country. 73 They ranked everyone against their peers.
There was no limit on the bonuses paid to the top performers. But up to
15 percent of the bottom performers were fired each year. 74 Fierce inter-
nal competition prevailed, and immediate gratification was prized above
long-term potential. Secrecy became the order of the day. The perform-
ance review process created incentives to do the deal at all costs. 75 Enron
had a mandate. That mandate was to make sure that Enron's stock price
continued to rise by ensuring that key financial ratios remained on a
steady climb. Such was the corporate culture. The breeding ground that
spawned the innovative and creative use of the SPE, that was later re-
vealed to be mere fraud, only exacted at a very high level and was done in
a manner that no one had seen before.

B. How THE ENRON SPEs WERE STRUCTURED, HIGHLIGHTING

WHERE ENRON DEPARTED FROM GAAP

By this point, those who are even remotely interested in what hap-
pened with Enron have read the well documented accounts of the LJM1
and LJM2 partnerships, Chewco, Raptors, etc. These are the SPEs that
made the headlines and were the entities that the casual observer is most

68. Jeffrey D. Van Niel, Enron-The Primer, in ENRON: CORPORATE FIASCOS AND
THEIR IMPLICATIONS 3, 11 (Nancy B. Rapoport & Bala G. Dharan eds., 2004).
69. Jeffrey K. Skilling Timeline, Hous. CHRON., Feb. 20, 2004, available at www.chron.
com/cs/cda/printstay.mpl/special/enron/2412024.
70. Van Niel, supra note 68, at 11.
71. Lynne L. Dallas, Enron and Ethical CorporateClimates, in ENRON: CORPORATE
FIASCOS AND THEIR IMPLICATIONS 187, 196 (Nancy B. Rapoport & Bala G.
Dharan eds., 2004).
72. Id.
73. Anastasia Kurdina, The Collapse of Enron: Managerial Aspect, http://www.per-
sonal-writer.com/enron/ (last visited July 25, 2006).
74. Dallas, supra note 71, at 196.
75. Id.
114 LAW AND BUSINESS REVIEW OF THE AMERICAS [Vol. 13

familiar. 76 But those SPEs merely scratched the surface. Enron's SPE
abuse was pervasive, covering a period from approximately 1999 through
2001 where Enron consummated hundreds of SPE transactions of various
forms and sizes, which accounted for a significant portion of their re-
ported revenue during that same
77
period, right up until Enron filed for
bankruptcy in December 2001.

1. The FAS 140 Transaction in General

This part of the piece examines a specific SPE transaction type that
Enron used repeatedly, which, in the year 2000, "(i) increased its re-
ported net income by $351.6 million (36% of its total reported net in-
come); (ii) increased its reported funds flow from operations by $1.2
billion (38% of its total reported funds flow from operations); and (iii)
[improperly] kept $1.4 billion of debt off its balance sheet."' 78 This trans-
action type was referred to as the FAS 140 transaction, patterned after
and designed to comply with FAS 140, which sets forth the accounting
guidelines related to asset transfers in connection with structured
79
financings.
In sum, the FAS 140 technique involved Enron's purported sale of an
asset to an SPE that was not consolidated in Enron's financial statements.
"In most cases, the SPE financed its acquisition of the asset by borrowing
97% of the purchase price and issuing equity for the remaining 3%" (thus
attempting to comply with the 3 percent equity investment rule discussed
earlier). 80 "Enron obligated itself to repay the loan through [what is re-
ferred to as] a Total Return Swap." 81 "Through the Total Return Swap
and the other agreements employed in this technique, Enron retained
substantially all of the economic benefits and risks of [asset ownership],
notwithstanding the purported sale to the SPE. ' '82 In the following sec-
tion, the FAS 140 transaction will be dissected in detail, highlighting
where Enron's accounting treatment departed from GAAP.

2. The Structure of a Typical FAS 140 Transaction Dissected

"A typical Enron FAS 140 Transaction began with the contribution by

76. See generally REPORT OF INVESTIGATION BY THE SPECIAL INVESTIGATIVE COM-

MITTrEE OF THE BOARD OF DIRECTORS OF ENRON CORP. (2002), availableat http://
news.findlaw.com/hdocs/docs/enron/sicreport.
77. See Second Interim Report of Neal Batson, Court-Appointed Examiner at 48-49,
In re Enron Corp., No. 01-16034 (AJG) (Bankr. S.D.N.Y. Jan. 21, 2003), available
at http://www.enron.com/corp/por/pdfs/examiner2/InterimReport2ofExaminer.pdf
[hereinafter Batson II]. For example, the chart shows a 96 percent downward net
income adjustment for the year 2000 once the inflated effects of the SPE transac-
tions are deducted from net income. Id. at 49.
78. Id. at 39.
79. Id. at 38.
80. Id. at 40.
81. Id. at 40, n.100.
82. Id. at 40.
2007] ENRON AND THE SPECIAL PURPOSE ENTITIES 115

the [s]ponsor 83 of an asset to an Asset LLC. '' 84 The Asset LLC would
then issue two classes of stock: Class A and Class B. The Class A stock
represented the Asset LLC's voting interests, whereas the Class B shares
represented the economic interest in the LLC. 85 The Class A interests
would be issued to the Enron subsidiary that the asset was transferred
from, and the Class B economic interests would usually be issued to an
SPE, generally a Share Trust (the Trust), which Enron would also have a
hand in forming. 86 The Class B interests sold to the Trust were entitled to
no voting rights but were entitled to substantially all of the economic in-
terests in the Asset LLC. In exchange, a payment in the amount of the 87
special distribution was to be made by the Asset LLC to the sponsor.
The Trust financed the purchase price of the Class B [i]nterest by
selling an equity interest in itself to a third party, often an affiliate of
one of its [1Ienders, and by borrowing under a [c]redit [f]acility pro-
vided by those [l]enders. The equity was generally entitled to be re-
paid the amount of its investment plus an annual rate of return.
Generally, the amount of the equity was equal to at least 3% of the
purchase price for the Class B [i]nterest, plus the amount of fees due
to the [1]enders. The right of the equityholder to receive payment
with respect to its equity was subordinated to the right of the
[1]enders to receive [the] payment [that was advanced] under the
[c]redit [f]acility.... [T]he amounts due88to the equityholder were not
supported by the Total Return Swaps.
At the closing of the FAS 140 transaction, upon the Trust's payment to
the Asset LLC of the purchase price for the Class B interests, "the Asset
LLC would typically use those funds to make the special distribution to
the [s]ponsor, thus immediately conveying the full proceeds of the trans-
action to the [s]ponsor." 89 A diagram detailing the typical FAS 140 trans-
action is set forth in Appendix A.
In looking at the transaction as a whole, perhaps the most important
part of the equation is the movement of money from the lenders through
the conduits of the Trust and the Asset LLC on through to Enron or an
Enron subsidiary. And even more interesting is how Enron accounted
for and disclosed that movement in its financial statements. On the other
end of these FAS 140 transactions were the lenders. Typical participants
loaning money in these FAS 140 transactions were institutions such as
Canadian Imperial Bank of Commerce, JP Morgan Chase & Co., Ci-

83. The terms sponsor and originator mean the same thing in this context and thus can
be used interchangeably.
84. First Interim Report of Neal Batson, Court-Appointed Examiner at 59, In re En-
ron Corp., No. 01-16034 (AJG) (Bankr. S.D.N.Y. Sept. 21, 2002), availableat http:/
/www.enron.com/corp/por/pdfs/InterimReportlofExaminer.pdf [hereinafter Bat-
son I].
85. Id. at 59-60.
86. Id. at 60.
87. Id.
88. Id. at 60-61.
89. Id. at 61.
116 LAW AND BUSINESS REVIEW OF THE AMERICAS [Vol. 13

tiGroup, and Morgan Stanley (Lenders). 90

The Lenders would transfer money into the Enron-formed Trusts, who
would in turn transfer the proceeds from the Trust to the Asset LLC, who
would in turn transfer the money and the Class A interest in the Asset
LLC in exchange for the transferred asset (again see diagram at Appen-
dix A). 91

3. Forensics of the FAS 140-Keeping the Lenders Comfortable

It is at this juncture where we stop and do a forensic analysis of the
FAS 140 transaction. In a typical FAS 140 transaction, the values that
Enron would assess these transferred assets at would be anywhere from
$10 million to $500 million. 92 Accordingly, with these FAS 140 transac-
tions exists a situation where you have a financial institution loaning an
Enron-formed Trust up to $500 million based on the strength or
creditworthiness of a transferred asset whose realization is doubtful at
best.
The logical inquiry that follows is what would then induce a financial
institution to lend money to an Enron-formed Trust under these circum-
stances? The answer is in the final piece of the FAS 140 puzzle, the Total
Return Swap. The Total Return Swap in this context is, in essence, a
guarantee. With the FAS 140 transactions, Enron would guarantee, on
behalf of the Trust, the payments the Trust was obligated to pay the
Lenders. Thus, whatever short-fall stemmed from the transferred asset,
which was not generating the requisite cash to service the debt obligation,
Enron, through the Total Return Swap, guaranteed those payments to the
Lenders. 93 In even the most general of terms, under GAAP, where one
party obligates itself to a debt obligation, GAAP requires that the obligor
record and disclose that financial obligation. With Enron, in most of the
transactions structured in this manner, they did not.

4. Improper Revenue Recognition

Next is Enron's accounting treatment in connection with the trans-
ferred asset. With its FAS 140 transactions, Enron would record these
asset transfers as sales, thereby improperly inflating revenue on its in-
come statement. 94 Also, depending upon the assets involved, Enron
would recognize cash flow from these activities as cash flows from operat-
ing activities. 9 5 With structured financings, for such accounting treatment
to be proper and in accordance with FAS 140, the transferring entity must

90. BNA, Inc., CIBC to Pay $2.4 Billion to Settle Enron Stockholder Suit, http://
pubs.bna.com/ip/BNA/srlr.nsf/is/aOble4xOz4 (last visited Feb. 24, 2006).
91. Batson I, supra note 84, at 59-60.
92. For example, in a FAS 140 transaction referred to as the Cerberus Transaction,
Enron transferred a block of stock it owned of EOG Resources, Inc. worth ap-
proximately $500 million. Id. at 67.
93. Id. at 64-65.
94. Id. at 53.
95. Id.
2007] ENRON AND THE SPECIAL PURPOSE ENTITIES 117

completely relinquish itself of any rights to profits that could be realized

from the transferred asset once the presumptive sale occurs. Likewise,
the transaction must be structured in a way such that the sponsoring en-
tity is absolved from any potential liability if the SPE fails to realize the
96
payments from the transferred assets.
A look at a conventional structured finance will illustrate this point. In
the conventional structured finance, once the transferring entity sells the
account receivables, for example, to the SPE, it is only proper for the
sponsor to record the transfer as a sale if and only if the SPE has no
recourse against the sponsor related to the transferred assets. If a struc-
tured finance is designed in this manner, the sponsor may record the asset
transfer as a sale and likewise record the cash proceeds from that sale as
either cash received from operations (depending on whether this was
something they did in the normal course of its operations) or cash pro-
ceeds received from investing activities. Only where the transferring en-
tity has relinquished both the risks and rewards of ownership is
accounting for the transferred assets in this manner proper.
But in Enron's case, accounting for the asset transfers as sales was not
proper for several reasons. First, Enron maintained control of the trans-
ferred asset through its ownership of the Class A voting membership in-
terests in the LLC, which the asset was transferred to. Second, Enron
guaranteed payment through the Total Return Swaps in the (likely) event
the payment streams from the transferred assets were insufficient to re-
pay the Lenders. The underlying point here again being that the rules
were clear, and Enron merely chose to depart from those rules to report
the financial results they desired, despite the fact that their reported re-
sults veered significantly from what was actually occurring.

5. (Improper) Valuation of the Transferred Assets

Another aspect of Enron's accounting treatment related to its FAS 140
transactions is the questionable circumstances surrounding some of En-
ron's valuation of the transferred assets. Enron's asset valuations were
designed to maximize the gain on sale accounting treatment for those
transferred assets. As was discussed earlier, in many instances, the assets
Enron transferred were atypical for use in a structured financing, as these
were assets not normally traded on any open market where a fair market
value for those assets could be derived, nor were they your garden variety
trade or account receivables where the time line for payment and valua-
tions are discernible. 97 Accordingly, Enron would make its own valua-
tion and attach that Enron-assessed value to those transferred assets.
Upon the asset's transfer, Enron would take the difference between the

96. See STATEMENT 140, supra note 64.

97. For example, typical asset types used in these FAS 140 transactions were common
stock warrants, partnership interests, membership interests in limited liability com-
panies, or interests in trusts formed in connection with other financial transactions
undertaken by Enron. Batson II, supra note 77, at 110-11.
118 LAW AND BUSINESS REVIEW OF THE AMERICAS [Vol. 13

Enron-assessed value and the actual proceeds from the asset and record
the difference as a gain on sale. 98 Therefore, through improper asset val-
uations coupled with improper revenue recognition, Enron was able to
paint a picture of steady earnings and cash flow in operations that did not
reflect the true financial position of its operations.

C. COMPLICIT FRAUD RATHER THAN AMBIGUOUS

ACCOUNTING RULES

With these transactions viewed through a transparent lens, the conclu-

sion one arrives at is that Enron's improper SPE reporting had little to do
with ambiguity or lack of accounting literature and guidance in the area.
The improper accounting treatment was intentional, and the SPE abuse
was merely the method of choice.
Enron tried to structure and conform these transactions to justify its
desired accounting treatment. But their desired accounting treatment
didn't reconcile with the true economic substance of these transactions.
Sale treatment and revenue recognition were inappropriate because En-
ron still maintained both control of and residual obligations for the trans-
ferred assets by virtue of Enron's ownership of the Class A voting
interests and the Total Return Swaps. But the Total Return Swap guaran-
tees were the only way that the Lenders would be convinced to loan
money to the Trusts due to the poor quality of the assets involved in the
transfers.
In concluding this portion of the piece, the overarching point to appre-
ciate is that Enron's mis-accounting had nothing to do with ambiguities in
the accounting literature and everything to do with the complicit and co-
ordinated efforts of Enron and those involved with its financial reporting
process to achieve the accounting results that were a departure from the
true economic substance of the underlying transactions that Enron's fi-
nancial reporting purported to reflect.

IV. THE ACCOUNTING AND LEGISLATIVE RESPONSE-

TREATING THE SYMPTOM VERSUS TACKLING
THE PROBLEM
The accounting and interpretive guidance that has been enacted in the
post-Enron era are rules that merely treat the symptoms of SPE abuse
but fail to address the actual problem. There have been a number of
significant events related to financial accounting and disclosure since the
passage of the Sarbanes-Oxley Act. The two most relevant pieces of ac-
counting guidance that address these issues are (1) FAS 140, Accounting
for Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities, which gives guidance on when a transaction may be recog-
nized as a sale versus a secured borrowing or financing; 99 and (2) Consoli-

98. Batson I, supra note 84, at 53.

99. STATEMENT 140, supra note 64.
2007] ENRON AND THE SPECIAL PURPOSE ENTITIES 119

dation of Variable Interest Entities (revised December 2003)-an

interpretation of Accounting Research Bulletin No. 51 (FASB Interpreta-
tions (FIN) 46(R)), which requires a risks and rewards approach to con-
solidation of variable interest entities (VIEs) as opposed to an approach
based on control by ownership of legal authority. 10 0 FIN 46(R) was de-
signed to address, among other things, some of the concerns with the fail-
ure of issuers under earlier guidance to consolidate certain SPEs.
This portion of the piece will focus on these two bodies of accounting
literature and interpretive guidance. First, it will explain how FAS 140
and FIN 46(R) work and then highlight the goals these two pieces of
accounting guidance are trying to achieve. Finally, it will show that, in
spite of their intentions, these two pieces of accounting guidance, which
in theory seem well meaning and hopefully effective, still fail to address
the core problem that is at the root of Enron and similar SPE abuse cases
that have been or will be perpetrated.

A. FAS 140
As alluded to earlier, FAS 140 deals with that situation where a corpo-
ration (the originator or sponsor) transfers assets to an SPE. The key
issue to resolve is whether the transfer can be treated as a sale, which
bolsters financial reporting, or as a secured financing, which would pre-
vent the originator from not only recording the asset transfer as a sale but
also requiring the originator to recognize a debt obligation as well.' 0 a In
essence, in accordance with FAS 140, the originator may record the asset
transfer as a sale if and only if all the following conditions are met:
a The transferred assets have been isolated from the transferor-put
presumptively beyond the reach of the transferor and its creditors, even
in bankruptcy or other receivership.
b Each transferee . . . has the right to pledge or exchange the as-
sets ... it receive[s], and no condition both constrains the transferee...
from taking advantage of its right to pledge or exchange and provides
more than a trivial benefit to the transferor.
c The transferor does not maintain effective control over the trans-
ferred assets through either (1) an agreement that both entitles and obli-
gates the transferor to repurchase or redeem them before their maturity
or (2) the ability to unilaterally cause the holder to return specific
02
assets.'
Cutting through the accounting verbiage, the key question to deter-
mine is whether or not the originator has relinquished both the risks and
rewards of ownership of the transferred assets. Only when the bond be-

100. STATUS OF INTERPRETATION No. 46: CONSOLIDATION OF VARIABLE INTEREST EN-

TITIES-AN INTERPRETATION OF ARB No. 51 (2003), available at http://
www.fasb.org/st/status/statpg-fin46.shtml (last visited Feb. 24, 2006) [hereinafter
INTERPRETATION 46].
101. STATEMENT 140, supra note 64.
102. Id.
120 LAW AND BUSINESS REVIEW OF THE AMERICAS [Vol. 13

tween the assets and the originator has been severed is it proper for the
originator to recognize such transfers as sales. When using these account-
ing principles as the backdrop for assessing a representative Enron trans-
action, what results is accounting guidance that is clear as to its criteria
and a corporation, irrespective of such clarity, recording transactions in
direct contravention of such guidance and clarity.
As discussed at length in the previous section, Enron transferred assets
to the Asset LLC and improperly recorded such assets as sales, in spite of
the fact that Enron failed to relinquish both the risks and rewards of own-
ership in two ways. First, Enron guaranteed the Trust's payment obliga-
tions to its Lenders through the Total Return Swaps entered into in
connection with these transactions, 10 3 and second, Enron maintained vot-
10 4
ing control through its ownership of the Class A membership interests.
Where the originator of the transferred asset guarantees payment against
the collection or realization of the transferred assets, the risks and re-
wards of ownership have not been relinquished, and recording the trans-
action as a sale is not proper. Again, the key point to emphasize here is
that the problems with the transactions had nothing to do with ambigui-
ties or gaps in the accounting literature and everything to do with Enron
management being narrowly focused on distorting its financial picture.

B. FIN 46(R)-THE NEW CONSOLIDATION CRITERIA-CHANGES IN

THE FINANCIAL REPORTING REGIME SINCE THE PASSAGE OF THE
SARBANES-OXLEY ACT-AN ATTEMPT TO CLOSE THE 3 PERCENT
LOOPHOLE AND REQUIRE CONSOLIDATION BASED ON ECONOMIC
SUBSTANCE VERSUS LEGAL FORM

FIN 46(R) in essence deals with the situation where Company A has a
financial interest in Company B. FIN 46(R) outlines when and under
what circumstances the relationship between Company A and Company
B is such that GAAP would require the two to be reported on a consoli-
dated basis. The usual investment that we are most familiar with would
be Company A's investment in Company B through stock ownership.
Prior to guidance that was developed in the SPE arena, entities would be
required to consolidate only in the instance where Company A had ma-
jority ownership in Company B through A's ownership of B's stock. This
test was generally treated as a bright-line test where consolidation would
be required only at the point where Company A was a majority owner of
10 5
Company B's stock (i.e., greater than 50 percent).
As a result of this bright-line test, corporations would avoid the consol-
idation requirement by controlling the entity through some means other
than stock ownership and would avoid consolidation, thereby keeping
both the assets and, more importantly, any underlying liabilities off Cor-

103. Batson II, supra note 77, at 38.

104. Batson I, supra note 84, at 59.
105. HERWITZ & BARRETr, supra note 16, at 521.
2007] ENRON AND THE SPECIAL PURPOSE ENTITIES 121

poration A's books. 10 6 As discussed earlier, with respect to SPEs, the

consolidation criteria was loosened further with EITF Issue 90-15, where
the sponsoring corporation could avoid consolidation if the SPE equity
owner made an initial substantive residual capital investment that is at
risk during the entire term of the lease. 10 7 FIN 46(R), among other
things, is aimed at closing this loophole.
VIEs include SPEs and can be generally described as entities where the
equity investment at risk does not provide its holders with the character-
istics of a controlling financial interest or is insufficient for the entity to
finance its activities without additional subordinated financial support. 10 8
These characteristics are meant to identify arrangements where control of
the entity would not be achieved through voting stock ownership but
through some other method. 0 9 FIN 46(R) requires consolidation of a
VIE by a party that has a majority of the risks and rewards associated
with the entity." 0 FIN 46(R) also establishes a methodology for deter-
mining what party associated with a VIE should consolidate the VIE. Es-
sentially, the requirement is that the party exposed to a majority of the
variation in the outcome of the performance of a VIE, both positive and
negative, should consolidate the VIE because such exposure is likely to
be indicative of control.' 1 ' FIN 46(R) refers to such a party as the pri-
112
mary beneficiary of the VIE.
An issuer's involvement or interest in a VIE can manifest itself in debt
instruments, guarantees, service contracts, written put options, Total Re-
turn Swaps, or other instruments.1 1 3 These arrangements with a VIE can
put the issuer in a position akin to an equity holder in that the issuer
bears the same risks and rewards of the VIE as an equity holder would.
For example, consider an issuer that owns 49 percent of the voting stock
of another entity and is the sole guarantor of debt of the entity. Before
FIN 46(R), such an issuer may not have been required to consolidate the
other entity based upon voting control. But subsequent to the promulga-
tion of FIN 46(R), if this same entity is deemed to be a VIE, then the
issuer would likely be required to consolidate due to the issuer's addi-
114
tional risk of loss from the outstanding guarantee.

106. For example, the sponsoring company may control the SPE by narrowly defining
the scope of the SPE's permitted activities and placing such limitations in the
SPE's chartering documents, such as its Articles of Incorporation.
107. EITF 90-15, supra note 21. Although not stated specifically in EITF 90-15, indus-
try practice had evolved to the point where 3 percent equity investment was suffi-
cient at-risk equity investment to avoid consolidation.
108. INTERPRETATION 46, supra note 100, at 4.
109. See id. at 5.
110. Id. at 13.
111. See id.
112. See id. at 8.
113. See id. at 12.
114. See id. at 13.
122 LAW AND BUSINESS REVIEW OF THE AMERICAS [Vol. 13

C. MOVING FORWARD WITH THE NEW ACCOUNTING-LACK OF

ACCOUNTING RULES WERE NOT THE PROBLEM

Having set the salient accounting guidance out in some detail, an as-
sessment can now be made as to how effective such new guidance would
have been or will be in preventing Enron-like SPE abuse. The crux of
FIN 46(R) is a redefining of the criteria where an entity should be re-
ported on a consolidated basis. FIN 46(R) switches the criteria from re-
quiring consolidation only when the SPE in question did not have at least
a 3 percent equity investment from an outside third party to now requir-
ing the entity that has the majority of risk or rewards related to that SPE
115
to report that SPE on a consolidated basis.
In theory, such a change has merit. Arguably, with a broadened set of
criteria where consolidation would be required, financial reporting in this
area would be more transparent as entities that would have avoided con-
solidation prior to FIN 46(R) would now be pulled onto the balance sheet
on a consolidated basis, thereby resulting in a more transparent and accu-
rate representation of a corporation's true financial picture. In practice,
however, there is evidence suggesting that such measures as expanding
the consolidation criteria would be an exercise in futility.
First, Enron's failure to consolidate or otherwise disclose its obligations
had nothing to do with any ambiguity or shortcomings in the accounting
literature. What Enron did with most of the SPEs it used was simple
fraud. 116 For example, as shown by the FAS 140 example discussed ear-
lier, Enron violated the then existing accounting guidance on a number of
fronts. Contrary to FAS 140, Enron recorded the asset transfers as sales
even though Enron retained control of the transferred assets through
their Class A voting membership interests. Moreover, Enron failed on
several occasions to record the debt obligations related to the FAS 140
transactions, which was in fact Enron's obligation. Again, the failure to
disclose had nothing to do with shortfalls in the accounting literature but
more so with Enron's intent on obfuscation and omission. The Total Re-
turn Swaps that Enron entered into in connection with these transactions
were Enron's unequivocal guarantee to repay the debt in the event the
cash value of the monetized assets was not realized. The major point to
emphasize here is that no accounting guidance is going to counteract the
deliberate intent to obfuscate and defraud.
Further, there is evidence to suggest that new accounting guidance will
only cause issuers to restructure their transactions to avoid the new ac-
counting criteria. 117 In anticipation of FIN 46(R) being implemented, a
number of entities restructured their arrangements with potential VIEs

115. Id. at 11, J 9 (explaining that, at a minimum, the equity investment must be at least
10%, instead of the previous 3%).
116. For example, for the year 2000, 96 percent of Enron's reported net income was due
to improper reporting of funds channeled to Enron through SPEs. Batson II,
supra note 77, at 47.
117. SEC REPORT 401(c), supra note 39, at 94.
2007] ENRON AND THE SPECIAL PURPOSE ENTITIES 123

such that they would not require consolidation. 11 8 The SEC notes anec-
dotally that many arrangements with potential VIEs were restructured
such that the entity either would not be considered a VIE or such that no
party would be required to consolidate the VIE. The effect of such
changes is difficult to measure. But in some cases, it appears that the
changes made involved substantive changes to the economics of the vari-
able interests or to the decision-making capabilities of the investors, while
in other cases, the changes may have been less substantive. 119

D. IMPLEMENTATION COSTS

Although FIN 46(R) arguably constitutes an improvement over the

previously existing consolidation guidance, a number of interpretive
questions remain. Many users of FIN 46(R) find it theoretically and prac-
tically challenging to apply.1 2° In fact, the actual application of FIN
46(R) is complicated and time-consuming to implement. Further, the cal-
culations under FIN 46(R) have to be recalculated each reporting period
as one's variable interests in an entity may change between financial re-
porting periods. 12 1 Currently, the FASB is considering ways to resolve an
issue originally discussed by the EITF in Issue 04-07, determining
whether an interest is a variable interest in a potential variable interest
entity. A consensus on this EITF Issue may change how some issuers
apply FIN 46(R). 122 But in its current form, properly applying FIN 46(R)
will be a winding maze that issuers are now being forced to navigate
through.
The resulting situation is that company resources will be diverted to-
ward making sure their VIE transactions are in compliance with FIN
46(R). Although not quantified in this piece, the added burden upon a
corporation's internal accounting functions in calculating and accounting
for its VIEs already exists. Likewise, the issuer will incur additional costs
to be paid to the issuer's public accountants as they will require addi-
tional man hours to sort through and determine whether the issuer's VIE
disclosures are proper.
It is understood that proper financial reporting should not be compro-
mised or sacrificed just because additional costs will be incurred. The
additional costs would be justified, however, if the additional burdens
were focused on the identified problem. But here, it is arguable whether
FIN 46(R) is or will effectively address the problem of SPE abuse.

V. A STEP BACK-A TIME TO ASSESS

When we find something that we perceive as broken, it is human na-
ture to utilize the most expedient measures at our disposal to fix the

118. Id.
119. Id. at 92.
120. Id.
121. INTERPRETATION 46, supra note 100.
122. SEC REPORT 401(c), supra note 39, at 92.
124 LAW AND BUSINESS REVIEW OF THE AMERICAS [Vol. 13

problem. Here is no exception. But what happens when the focus of the
problem has been redirected from the weapon (meaning the SPE) to the
entities pulling the trigger? Quite naturally, what should come from a
refocusing of the problem is a refocusing of the means as to that problem
should be addressed.
It is understandable that during the rising tide of public outcry in the
wake of the Enron debacle there was a collective call for action to be
taken. Congress and the relevant standard-setters in the accounting
world, in their quest to stem that tide and restore investor confidence in
our public markets, reacted quickly with the passing of the Sarbanes-
Oxley Act. Likewise, the FASB followed suit by revamping its rules on
consolidation with the issuance of FIN 46(R). But now that the investing
public's collective memory of the Enron sting has faded, we have the lux-
ury of taking a thoughtful look at what is really happening in cases like
Enron and, accordingly, can take a more focused approach at trying to
prevent future Enrons from occurring.

A. SCOPE OF THE PROBLEM

First and foremost, the standard-setters need to make a more focused

assessment of the problem. Is Enron-like SPE abuse widespread and
prevalent, or was Enron a unique and isolated set of circumstances? How
widespread is SPE use in its various forms? And, more importantly, how
widespread is the abuse of SPEs? Narrower still, is anyone, other than
Enron, engaging in the type of deliberate, contrived, prevalent, proprie-
tary, and abusive use of SPEs that Enron used to misrepresent its finan-
cial position? Answers to these questions would go a long way in crafting
a more pointed and tailored response to curtailing SPE abuse. Research
reveals that there are some instances of SPE abuse occurring in the post-
Enron era but nothing as widespread, complex, and contrived as what
123
occurred with Enron.

123. For example, an online LexisNexis search for companies engaging in SPE abuse
yielded the following:
PNC Financial, a leading U.S. bank .... agreed to pay [$115 million] in
penalties and restitution to spare itself from prosecution over its efforts
to hide hundreds of millions of dollars in non-performing assets.

[The] agreement mark[s] the SEC's first enforcement action involving

the misuse of special-purpose vehicles.
Joshua Chaffin & Gary Silverman, PNC Pays Fine to Escape Threat of Prosecution,
FIN. TIMES (USA), June 3, 2003, at 18.
T[he] world's largest insurance company, American International Group,
[was] facing a criminal investigation by the US Justice Department into
allegations that it helped a major banking client move bad loans off its
books.

[The allegations were that] PNC . . . avoided consolidating $762 mil-

lion ... in bad loans on to its balance sheet, effectively inflating its profit
by $155 million.
2007] ENRON AND THE SPECIAL PURPOSE ENTITIES 125

B. THE SEC ATTEMPTS TO ADDRESS THE PROBLEM

To its credit, the SEC set out to do something along these lines in an
attempt to quantify the extent that public companies are utilizing SPEs.
But their research did not take it as far as trying to determine SPE abuse.
In 2005, the SEC issued a report (the Report) that addressed two primary
questions: (1) the extent of off-balance sheet arrangements, including the
use of SPEs and (2) whether current financial statements of issuers trans-
parently reflect the economics of off-balance sheet arrangements. 124 The
Report was informative and insightful and shed light on a number of dif-
ferent and important aspects as they relate to SPEs and how they are
being disclosed amongst the approximately 10,100 publicly-held compa-
125
nies in the United States.
Regarding the first question, the mandate was to assess the extent that
public companies were using off-balance sheet arrangements, and more
to the point, SPEs. The idea being, if the use was widespread and perva-
sive versus narrow and hardly used, that assessment would drive, to some
extent, the necessary approach to effectively enforce the use of, account-
ing for, and disclosures of SPEs. The SEC did a number of empirical
studies, collecting data through looking at a stratified sample of publicly-
held companies and then publishing the results of those empirical studies
126
in their Report.
It was hoped that the Report would uncover the types of off-balance
SPEs being structured by public issuers. In other words, the hope and
expectation was that the Report would convey either yes, there are a
myriad of corporations that are using SPEs in a fraudulent and abusive
manner similar to Enron or no, the abuse of the SPE structure is not
widespread such that we need not be alarmed nor enact more legislation
to address the problem. But the Report, not surprisingly, did not yield
such clear results or conclusions.
Instead, the Report was broader in nature. Data on these issues were
reported in a number of different ways, which different conclusions could
be drawn from. But before discussing and analyzing the data itself, it is
important to point out that at the point in time that the study was done,
FIN 46(R) was still in its fledgling stages. Therefore, a number of the
studies' participants at the time they were picked as part of the sample

[The allegation was that] AIG sold PNC on the idea of creating special-
purpose entities for these bad loans.

PNC... agreed ... to pay $90 million to compensate shareholders and

$25 million in penalties to settle related charges after the Justice Depart-
ment said that the special purpose entities in question did not qualify for
nonconsolidation and therefore should have been included in its financial
statements.
Charlie Gibson, AIG Facing Criminal Probe Over Loan Deal, EVENING STAN-
DARD (LONDON), Sept. 30, 2004, at A40.
124. SEC REPORT 401(c), supra note 39, at 27.
125. Id. at 32.
126. See generally id. at 27.
126 LAW AND BUSINESS REVIEW OF THE AMERICAS [Vol. 13

may not have fully matriculated the mandates of FIN 46(R) into their
financial reporting. That notwithstanding, the Report itself gives us some
interesting information.
One of the first empirical studies outlined in the Report was the "An-
ticipated Effects of Adoption of Interpretation No 46 Presented in An-
nual 10-K Filings."'1 27 The Report took a stratified sample of large and
small issuers. Of the stratified sample comprised of 200 large and small
issuers, the study revealed that 38 percent of those sampled reported that
the effect of adopting FIN 46(R) was not material or not expected to be
material. 128 The study also revealed that less than 4 percent of the 200
issuer sample reported that the impact of adopting Interpretation No.
46(R) was not material or not expected to be material. 12 9 An extrapola-
tion of the findings from the sample to the approximate population of
active U.S. issuers suggests that less than 1 percent of the issuers in the
130
population would expect the effect of FIN 46(R) to be material.
Statistical data can often be interpreted in a number of different ways.
The data revealed in the Report is no exception. As stated earlier,
roughly 38 percent of the 200 issuers sampled stated that the impact of
FIN 46(R) was either not material or not expected to be material. Only
3.5 percent of the sample reported that the impact of adopting FIN 46(R)
13 1
was material or was expected to be material for any VIEs.
Among other things, a few possible inferences can be drawn. First is
the distinct possibility that improper corporate use of SPEs is not perva-
sive, especially to the point where revamping the criteria for consolidat-
ing such entities is required. Second, and perhaps the more plausible
explanation, is the fact that FIN 46(R) will just be another accounting
guideline that corporations will structure their transactions around to
achieve their desired results, those being either consolidation or non-con-
solidation. The new accounting guidance related to consolidating VIEs is
a continuation of the cycle that has brought us to this juncture in the first
place. The SEC and the FASB enacts accounting guidance and interpre-
tations to shore up perceived weaknesses or shortfalls in financial report-
ing, and then corporations in response merely restructure their
transactions to circumnavigate the matter. A better mousetrap is built
followed by a better mouse to avoid the trap.
From such a pattern, the inferential leap would not be so large to sug-
gest that public companies will react the same way to FIN 46(R). Cor-
roborating this assertion are sentiments the SEC expressed in its Report.
The Report suggests that some of the low numbers related to corporate
consolidations in response to FIN 46(R) are attributed to issuers being
preemptive in their financial reporting and restructuring their off-balance

127. Id. at 93.

128. Id.
129. Id.
130. Id.
131. Id.
2007] ENRON AND THE SPECIAL PURPOSE ENTITIES 127

sheet or VIE transactions to avoid reporting such entities on a consoli-

dated basis. 132 Although the report does note that if issuers are changing
the way their SPEs are structured such that they no longer control the
SPE or are not the primary beneficiary of the expected returns or losses,
FIN 46(R) will have improved financial reporting even if there is not a
significant increase in the frequency of consolidation of SPE
33
consolidation.1
These are just possible inferences that the data might suggest and not
definitive conclusions. But what is certain is that the Report did not re-
veal, and purposely did not try to reveal, the extent that potential SPE
abuse similar to Enron was being practiced by other issuers. Understand-
ably and arguably, this would be hard information to ferret. Now, how-
ever, finding such information should be much easier given that we now
know what to look for.
Bringing the analysis full circle, the question is begged-does such leg-
islation move the ball any further down the field in addressing the type of
SPE abuse similar to Enron? Though unclear, the answer is likely to be
no. As stated earlier, what we saw with Enron was not a situation where
accounting guidelines were written such that Enron could follow the let-
ter of the law while breaking the spirit of the law. Enron made inten-
tional efforts to circumnavigate the accounting rules then in existence
with the specific intent of achieving accounting results while obfuscating
the true underlying substance of those transactions. Accordingly, the
main point to emphasize here is that in Enron's case, accounting guidance
or lack thereof was not the problem. It is therefore counterintuitive to
think that additional accounting guidance would then be the solution.
Arguably, those persons set on breaking the prior rules will break any
new legislation or guidance as well if that is in fact their intent.
Of course, the counter-argument would then be that revised accounting
guidelines now make it more difficult to perpetrate the accounting fraud
that Enron perpetrated because the criteria and circumstances that con-
solidation is required are much broader with higher thresholds for non-
consolidation, which means a lot less wiggle-room. One may speculate
how the use of SPEs under FIN 46(R) will work. More than likely, those
corporations that are in the grey area with respect to SPEs may err on the
side of caution and decide either to comply with the rule or not do the
transaction at all. On the other hand, it is not a stretch to conclude that
those corporations that are intent on committing financial fraud will do
so, regardless of what the rules are. Once the intent to circumnavigate
the rule is there, the how is merely a formality.

132. Id. at 92.

133. Id.
128 LAW AND BUSINESS REVIEW OF THE AMERICAS [Vol. 13

VI. SEC INITIATIVES TO IMPROVE FINANCIAL REPORTING

TRANSPARENCY-A CRITIQUE-BETTER
MOUSETRAP, BETTER MOUSE
The difficulties in improving financial reporting related to SPEs not-
withstanding, merely because the task or problem at hand is formidable
does not mean that attempts should not be made to fix them. Instead, it
is quite the contrary. In fact, in the later part of the Report cites a num-
ber of proposed and current initiatives aimed at improving accuracy and
transparency in financial reporting. Whether or not such attempts will
meet their desired objectives remains to be seen. But evidence suggests
that while these efforts may enjoy success in the short run, the long-term
prospects for success may be minimal if any. This section looks at some
of the proposed initiatives and will critique their likelihood of success,
pointing out some of the challenges that the proposed effort will face.

A. SEC RECOMMENDATION: ELIMINATE OR AT LEAST REDUCE

ACCOUNTING-MOTIVATED STRUCTURED TRANSACTIONS

The Report's first suggestion is to eliminate or reduce accounting-moti-

vated structured transactions. Accounting-motivated structured transac-
tions normally involve transactions that are structured in an attempt to
achieve accounting results that do not mirror the underlying economics of
the transaction. 134 The very glaring example is the accounting-motivated
transactions Enron structured to boost its earnings and cash-flow num-
bers but that were quite different in economic substance. The Report
discusses the need to eliminate or at least reduce the extent that issuers
are engaging in accounting-motivated transactions.
The goal of eliminating accounting-motivated transactions is, in theory,
a sound one. Recording accounting results that are contrary to their true
economic substance threatens one of the foundational bricks that the cap-
ital markets are built upon. So, in theory, the extent that such practices
could be reduced, if not eliminated altogether, is a step in the right direc-
tion. But in practice, eliminating or even reducing accounting-motivated
transactions is a difficult task in part due to the reasons discussed below.
One of the big obstacles to fair financial reporting that either seems to
be underappreciated, merely accepted as a given, or perhaps not consid-
ered at all, is the discordant incentives between management that is
tasked to report accurate financial information within material respects
and the potentially adverse consequences that management may suffer
personally or individually as a result of reporting such adverse financial
information.
When we look at the compensation structure of upper-level manage-
ment at many large publicly-held companies, we see some recurring
themes. Most of these upper-level managers receive a large part of their
compensation in the form of bonuses based on the company's profitabil-

134. Id. at 99.

2007] ENRON AND THE SPECIAL PURPOSE ENTITIES 129

ity or the performance of its stock. 135 The stock awarded may be incen-
tive based, performance based, or on another basis.13 6 Also, bonuses
and, more importantly, continued employment can be tied to the earnings
13 7
numbers their respective companies report.
Given such a dynamic, we can see the competing tensions being put on
the financial reporting process. The resulting situation is one where you
have management dealing with the difficult situation of disclosing adverse
financial information that could have a direct adverse impact on their
own personal situations. In an ideal world, we would like to think that
these officers, in adhering to their fiduciary duties of care and loyalty,
would not let such possible personal consequences compromise their pro-
fessional integrity. But the reality of the situation is that it can and often
does. 13 8 With this dynamic present each and every reporting period, we
see the inherent vulnerability in the reporting process, which was likely
integral to some of the incredibly large-scale accounting scandals that
have occurred to date.
It is these divergent incentives that create the competing tensions be-
tween standard- setters looking for more transparency in financial report-
ing and management that is sensitive to how such transparent
information, when such information is negative, will affect the company's
share price in general and, more specifically, the impact that such nega-
tive information will have on their own personal financial situations, as
they relate to the corporations that they preside as fiduciaries over.
As long as these tensions exists, standard-setters will in large part be
relying on management to do the right thing even in those instances
where doing the right thing could have an adverse effect on them person-
ally. Granted, we would like to think that one's commitment to one's
fiduciary duties as an officer or director, one's personal and professional
integrity, or even one's moral compass would place the requisite checks
and balances on doing the right thing. But a cursory glance at the Wall
Street Journal and the inundation of corporate scandals tells us other-
wise. 139 Until this dynamic of divergent incentives is remedied, it is logi-
cal to conclude that accounting-motivated transactions will continue.

135. Id.
136. A look at the executive compensation of any publicly-held company will likely
have some incentive-based form of compensation tied to the company's stock per-
formance or earnings per share. See, e.g., Home Depot, Proxy Statement and No-
tice of 2006 Annual Meeting of Stockholders 33 (2006), http://ir.homedepot.com/
downloads/hd2006proxy.pdf. Bonuses and additional payouts to executives were
contingent on the company meeting certain specified levels of average diluted
earnings per share. See id.
137. Id.
138. For example, the Houston Chronicle printed an article that summarized some of
the more recent and high-profile scandals. Listed among them were Adelphia
Communications Corporation, WorldCom Inc., Tyco International Ltd., and
HealthSouth Corp. Enron Began a Wave of Scandals: Collapses Changed the Way
that Companies do Business, Hous. CHRON., Jan. 27, 2006, available at http://
www.chron.com/cs/cda/printstory.mpl/special/enron/3616142.
139. Id.
130 LAW AND BUSINESS REVIEW OF THE AMERICAS [Vol. 13

B. SEC RECOMMENDATION: IMPROVE COMMUNICATION Focus IN

FINANCIAL REPORTING

The SEC also calls for a paradigm shift in the whole idea behind com-
municating through financial reporting. The Report notes that the cur-
rent climate is replete with a large volume of complex financial reporting
requirements. As a consequence, accountants and lawyers are less con-
cerned with communicating effectively to investors through their finan-
cial reports, as long as they are technically compliant with the disclosure
rules. 140 The Report further notes that if somehow reporting companies
were able to make a shift in this paradigm away from focusing on mere
technical compliance and move toward the principled objective of effec-
tive communication to investors, then significant improvements in finan-
cial reporting would occur even if few or none of the recommendations
outlined in the Report were adopted. 14I Conversely, the Report notes
that without this paradigm shift, the onus or burden of effective commu-
nication will remain with the standard-setters, where case improvements
in financial reporting will only stretch to the cross-roads where the laws
outlining financial reporting and lawyer/accountant interpretation
meet. 142 In other words, a continued formula where the investor will re-
main saddled with the burden of deciphering cryptically drafted
143
reports.
Technical compliance versus clear, concise, and meaningful communi-
cations is the crux of the matter when talking about improved communi-
cation in financial reporting:
Full and fair disclosure is one of the cornerstones of investor protec-
tion under the federal securities laws. If a prospectus fails to com-
municate information clearly, investors do not receive that basic
protection.. .A major challenge facing the securities industry and its
regulators is assuring that financial and business information
144
reaches
investors in a form they can read and understand.
But again, the dynamics involved make this proposition for financial
reporting a difficult one. Take, for instance, the following example.
Something of an adverse nature occurs within a corporation. Depending
on the gravity of the event, a meeting is called and the CEO, the CFO,
the Board of Directors (if they are available), corporate counsel, the com-
pany's outside counsel, as well as their public accountants, have assem-
bled in the company's war room to discuss how such news should be
handled. The securities laws mandate that material information related
to the corporation must be disclosed. In any number of these meetings
that occur across the country with publicly-held companies, the discussion
can be interesting. What goes on is a sort of verbal ballet, where the very

140. SEC REPORT 401(c), supra note 39, at 103.

141. Id. at 104.
142. Id.
143. Id.
144. Id. at 103-04.
2007] ENRON AND THE SPECIAL PURPOSE ENTITIES 131

smart lawyers, CEOs, and other attendees try to determine ways to dis-
close the information without really disclosing the information. The end
result of these meetings and deliberations are tepidly worded phrases,
buoyed by mitigating facts, and whitewashed in superfluous verbiage.
The goal is to meet the technical disclosure requirements, while at the
same time burying the essence of such information in tersely worded
phrases or dispersing the information throughout the filing, such that
while the information may technically be there, effective communication
of what is actually occurring is not.
As alluded to earlier, the practice of obfuscation through lack of clarity
stems from the competing dynamics. Management understands that they
have to comply with the disclosure rules under the federal securities laws.
But at the same time, management is aware of the possible adverse af-
fects such information may have on the corporation's stock price and the
implications this may have on them personally once the news is dissemi-
nated. The competing incentives create the tension that results in techni-
cal compliance versus real true meaningful communication.
Once again, this dynamic puts tension on the free flow of material in-
formation. It is understood that there are disclosure laws in place and
new legislation, such as the Sarbanes-Oxley Act, that stiffens penalties for
violators, resulting in jail time for offenders.' 45 Not to mention the fidu-
ciary duties for directors and officers and, finally, the mere moral and
ethical obligations about simply doing the right thing. In theory, all these
layers of legal protections, inhibitors, and moral obligations should insu-
late financial reporting from the problems that have occurred. But more
than likely, the problems that we are seeing with financial reporting are
likely to continue as human decision-making is not always based on the
unyielding obligation to follow both the letter and the spirit of the law but
on a more deeply rooted desire for self-preservation. The emotional re-
action to self-preservation is akin to how we handled matters in our youth
when we did something we weren't supposed to do. If we didn't tell our
parents what we did, then we wouldn't get in trouble.
But just as our parents eventually became aware of the offending con-
duct then, such is the case now as adults. And just as the consequences
were exacerbated then by our attempt at a cover-up, so too is the case as
adults when the truth eventually comes to light. In hindsight, almost in-
evitably, upfront disclosure likely would have been the better choice for
self-preservation both as children and as adults. But again, the emotional
response of self-preservation is to cover up the truth and hope nobody
(ever) finds out about it.
Sometimes, both as children and as adults, the truth stays buried indefi-
nitely, and the consequences are avoided. From a self-preservation
standpoint, the choice of non-disclosure makes most sense where the of-
fense is non-recurring, i.e., a one-time instance. But where the offenses

145. White-Collar Crime Penalty Enhancement Act of 2002, 18 U.S.C.A § 1341 (West
2006) (part of the Sarbanes-Oxley Act).
132 LAW AND BUSINESS REVIEW OF THE AMERICAS [Vol. 13

are recurring or ongoing, such as Enron's fraudulent reporting that oc-

curred on both a quarterly and an annual basis, it would seem like the
long-term goal of self-preservation would be to confess and accept the
consequences that hopefully would be mitigated by the forthright behav-
ior. All of this makes sense from a hindsight, logical, and unemotional
perspective. But putting one's self in the shoes of an Enron executive,
the pressure put upon them by their constituencies, the ramifications of
reduced shareholder value, and other pressures, the gut reaction pre-
vailed, and the obfuscation continued until it snowballed so large that
discovery of their improprieties was inevitable.
The overall point to understand here is that as long as the current dy-
namic of leaving the responsibility of financial reporting in the hands of
those who may be adversely affected personally remains, the competing
tensions of discordant incentives will continue to put pressure on clear
and meaningful financial reporting and the issues of fraud, obfuscation,
and omission of material financial information are likely to continue until
this misalignment is somehow rectified.

C. SEC AGENDA ITEM: CONTINUE WORK ON

CONSOLIDATION POLICY

As was discussed earlier, the consolidation decision is typically based

on whether or not control exists, with the determination of control gener-
ally based on legal ability to control the entity. But it is possible to effec-
tively control an entity without having legal control. An issuer that owns
49 percent of the voting shares of an entity whose shares are otherwise
widely distributed would almost certainly be able to set policy for that
other entity but currently would not be deemed to control that other en-
146
tity for accounting purposes.
While the FASB discontinued its broad project on effective control,
FIN 46(R) is an attempt to deal with SPEs by creating a consolidation
test for those entities that is meant to identify what entity has the major-
ity of the exposure to variations in performance and, in turn, effective
control. But because that test is so different from the test used to deter-
mine consolidation of other entities, a new series of structures that strad-
dle the lines between consolidation approaches has sprung up, and
various structures have been designed to work around the guidance in
FIN 46(R). The EITF and FASB staff believes that more time should be
taken to evaluate the results of FIN 46(R) and to allow the development
of interpretive guidance that may assist in its application. Several
projects currently being undertaken by the EITF and the FASB staff may
14 7
provide such guidance.
The current consolidation guidance is complicated, despite the consis-
tent objective of requiring consolidation when an investor controls an-

146. SEC REPORT 401(c), supra note 39, at 109.

147. Id.
2007] ENRON AND THE SPECIAL PURPOSE ENTITIES 133

other entity. The SEC believes additional standard-setting efforts related

to consolidation should be focused on whether there are ways to achieve
the objectives with less complex guidance. In addition, once the ques-
tions regarding FIN 46(R) have been more fully addressed, the FASB
may also wish to consider whether it should again explore the use of ef-
fective, rather than legal, control to guide all consolidation decisions. Fi-
nally, additional work holds the promise of promoting further
convergence between consolidation guidance in the U.S. GAAP and the
consolidation guidance in the International Accounting Standards
148
Board's standards.
It is without question that the more changes the standard-setters make,
which causes issuers to account for their off-balance sheet transactions in
such a way that the form of those transactions reflects the structure's eco-
nomic substance, the better off theoretically we will be. Such efforts are
to be applauded as they are well-intentioned and could lead to better and
more accurate financial reporting in the future.
But at the same time, we must not let such changes create a sense of
false euphoria and lull us into thinking that those efforts will be the pan-
acea to the issues related to SPE abuse. Within the depths of all of this
empirical data and intellectual discussion surrounding the issues related
to SPEs, what seems to get only minimal attention is the fact that the SPE
abuse Enron perpetrated was simply fraud with the SPE being the entity
of choice, in part due to its inherently complex nature. But in spite of
their complexity, if the true economic substance and nature of these enti-
ties had been disclosed properly and in accordance with GAAP, analysts,
investors, and shareholders alike all would likely have seen that such
transactions were problematic, and investors could have reacted and al-
tered their investment decisions accordingly. Again, lack of sufficient ac-
counting guidance was not the problem.

VII. SUGGESTIONS FOR AN ALTERNATIVE APPROACH-

HOW TO PREVENT ANOTHER ENRON
How to prevent another Enron is quite literally the billion dollar ques-
tion. Before a discourse even commences on this subject, we must first
acknowledge that any efforts to prevent another Enron would be just
that, an effort. When we weigh the resources of the SEC against the
some 10,000 plus publicly-held companies out there, abuses such as this
and others will continue to happen.
One maxim that we as an investing public have had is the notion that
we can legislate people into doing the right thing, when the fact of the
matter is that it is difficult, if not impossible, to do so. No matter what
type of law, regulation, or statute that is put in place, if an individual or a
group of people are intent on breaking that law, they will. When we look
at Enron and examine in detail what was going on with its use of SPEs,

148. Id.
134 LAW AND BUSINESS REVIEW OF THE AMERICAS [Vol. 13

the problem had nothing to do with ambiguities in the accounting or stat-

utory literature. The problem was with unethical and criminal behavior.
The problem was that you had people in positions of power and public
trust that made deliberate decisions to abuse that power and violate that
trust. At the time, those people knew quite well what the law was and
what it was they needed to do to comply with that law. Lack of clarity in
the law was not the problem.
If we take the above assessment and analysis as true, the natural in-
quiry then is what should be done or what should we have done in re-
sponse to the Enrons, Adelphias, and WorldComs of the world? How
could they have been prevented? And how do we make sure that an-
other Enron, WorldCom, or Adelphia doesn't occur again? Well, that is
the question that lawmakers have been contemplating for the better part
of four and a half years as they carefully examine Sarbanes-Oxley's effec-
tiveness with its provisions taking a foot-hold and matriculating them-
selves into corporate America's collective culture. Observations from
high-ranking officials involved with standard-setting and regulation sug-
gest that Sarbanes-Oxley's provisions have been effective in improving
financial statement disclosure, corporate governance, and auditor
49
independence.
The response to this empirical data though is whether financial state-
ment disclosure, corporate governance, and auditor independence im-
proved because of Sarbanes-Oxley or in spite of Sarbanes-Oxley? The
argument here could go either way. Some would say that Sarbanes-
Oxley's provisions were instrumental in bringing about much-needed re-
form in corporate governance, auditor independence, and financial state-
ment disclosure. On the other hand, others contend that the
improvement in these areas were merely due to the fact that issuers are
now operating in the post-Enron environment of heightened scrutiny.
The only real response to either school of thought is that time will tell.
It is at this juncture that we can acknowledge that the efforts that the
standard-setters are making may prevent those issuers who may be
tempted to straddle the financial reporting fence from actually doing so.
In the post-Enron climate where we find ourselves, everyone for the most
part seems to be minding their Ps and Qs. That alone may be enough to
keep issuers from even coming close to the line. But eventually, the
bright lights of public scrutiny will dim. The memory of Enron will likely
be there for some time, but the pain from its sting will eventually subside.
And, when the bright lights do dim and the climate again reverts back to
one where issuers for the most part will be left to their own recognizance,
what decisions will be made then? As we have seen, when smart people
wish to circumnavigate the rules, they will find a way to do so. Money

149. See generally William H. Donaldson, SEC Chairman, Testimony Concerning the
Impact of the Sarbanes-Oxley Act, Before the House Committee on Financial Ser-
vices (Apr. 21, 2005), availableat www.sec.gov/news/testimony/ts042105 whd.htm.
2007] ENRON AND THE SPECIAL PURPOSE ENTITIES 135

and power are opiates proven to succeed in clouding judgment and erod-
ing the core values and ethical judgment of otherwise law-abiding people.
There is no set of accounting guidance and literature out there that will
prevent this type of occurrence from happening, and this is the very type
of accounting abuse that we do want to avoid and prevent. But as much
as we want to convince ourselves otherwise, the making of better mouse-
traps likely will not do that. All better mousetraps will likely do is cause
the evolution of better mice that will be genetically improved to avoid
such traps. As the SEC has already noted, there is evidence that many
issuers were preemptive with respect to FIN 46(R) and already com-
menced to restructuring their off-balance sheet transactions to avoid con-
150
solidation under the new guidance.
If there is any good that came from a situation like Enron, it's that
collectively as an investing public, we are better versed on accounting
fraud of this nature. The financial markets, the analysts, the SEC, and the
public accountants have all by now absorbed many of the intricacies of
SPE abuse. In short, we now know what to look for, and efforts can be
focused accordingly.
So, how do we prevent another Enron from happening again? The
standard-setters and the gatekeepers, in spite of all the accounting and
disclosure reform, need to appreciate what they are dealing with. A defi-
ciency or a perceived deficiency in the accounting rules is not the prob-
lem. The problem is persons that seek to obfuscate, omit, and
fraudulently report financial information. Accordingly, focus on ferreting
out SPE abuse should be primarily placed on the abusers themselves, not
on the SPEs formed to perpetrate such abuse. Widespread legislation
and accounting reform merely casts a broad net with the hopes that the
abusers will get snared along with the rest of the fish. But, in the
meantime, those fish are burdened with the added cost of complex and
complicated compliance when they weren't doing anything wrong under
the old regime nor had problems complying under the old regime.
So what is the alternative? The forefront of the approach should be a
narrow and isolated focus on SPE abusers. Although the matter has not
been completely resolved, the evidence suggests that actual SPE abusers
represent a small pool of companies relative to the total population of
public companies. A resolution could be achieved by the SEC and/or
other related gatekeepers taking a risk-based approach toward the prob-
lem. First, the gatekeepers should narrow their scope by first focusing on
those companies or industries that lend themselves or could potentially
lend themselves toward SPE abuse. Those industries that tend to deal
heavily in derivatives and intangible assets, such as the buying and selling
of futures contracts, etc. would be good places to start. Additionally,
there are those industries or companies that stand to come under earn-
ings pressure-having trouble reaching financial forecasts or earnings

150. SEC REPORT 401(c), supra note 39, at 92.

136 LAW AND BUSINESS REVIEW OF THE AMERICAS [Vol. 13

targets or seem to be engaging in creative ways at maintaining earnings

and revenue growth.
The overarching idea is that since we have seen it before (ala Enron),
the accumulated knowledge is taken and applied going forward. It could
very well be possible that in terms of SPE abuse, the proprietary abuse
that Enron perpetrated was a local and isolated event. The SEC Report,
though useful in the information it contained, did little to address the
question of whether or not there is widespread SPE and off-balance sheet
abuse. The Report merely focused on SPE and off-balance sheet use,
which is helpful but doesn't tell the whole story or tell the most important
part of the story.
With all of this collective knowledge and insight as to the accounting
fraud that Enron perpetrated, it is reasonable to conclude that the SEC
could derive some sort of search criteria or corporate profiling of either
industries or particular companies that show indicia for potential SPE
abuse. Those companies could then be targeted and special attention and
focus could be placed on those companies. Understand that the initial
stages of such action would be non-intrusive. The initial stages of the
focus would merely involve a close and scrutinizing look at those compa-
nies' annual and periodic reports for evidence of SPE abuse or any other
type of financial reporting irregularities. If such scrutiny raises red flags,
then the SEC could then perform an escalated inquiry into the matter.
If the escalated inquiry yields problematic accounting, then the next
step would be for the SEC to initiate a more aggressive fact-finding in-
quiry. If accounting irregularities are found, the indictment, prosecution,
and ultimate conviction should be a high-profile event. Then a clear and
unequivocal message would be sent to other similarly-situated offenders
to make the proper adjustments in their financial reporting or face the
same fate.

VIII. CONCLUSION
The issues dealt with in this paper are complex, and trying to resolve
these issues poses an even greater challenge. But before real effective
change can be achieved, we must first be able to target the root of the
problem. Complex problems tend to involve complex solutions. The
band-aid of legislation, more guidance, or clearer guidance will more than
likely result in nothing more than the tug and pull between standard-
setters and issuers to continue along this move-countermove approach
that has gotten us to where we are today. Until we are able to focus more
narrowly on the problem and deal with it from that more directed ap-
proach, we'll probably be seeing more of the same. Better mousetrap,
better mouse.
2007] ENRON AND THE SPECIAL PURPOSE ENTITIES 137

APPENDIX A

Total Return
\ Swap

Class B Interest Equity

(99.99 percent of Investment
Economics) $
138 LAW AND BUSINESS REVIEW OF THE AMERICAS [Vol. 13