The main aim of business units is to maximize profitability in the market while ensuring that risks are low as possible. An organization can’t run without exposing itself to potential risks. When not taken care of, risks can have devastating consequences on a business unit. It is for this reason that many organizations have been trying to find the best way through which they can manage risks, as well as other eventualities. One of the best ways through which most business executives prefer managing their risk is the utilization of the special purpose entities, especially when sourcing for funds to finance a major project. Fox (78) defines special purpose entities as legal entities that are usually limited companies of some type or sometimes a limited partnership created to fulfill a narrow, specific, or temporary objective. Based on this definition, it comes out clearly that a special purpose entity is only available to firms, which are limited liability companies or partnerships, but also to other firms aspiring to strengthen their financial muscles in the industry. A number of organizations prefer the use of special purpose entities to isolate financial risks from the firm. Special purpose entities have been very popular in Europe since they are used as one of the ways through which firms can acquire external financing without transferring the debt to their balance sheet.
According to Ali (76), special purpose entities have helped firms lower their financial risks on various fronts. Firms use special purpose entities to secure loans, especially if it is a huge loan needed for a short time to help solve an imminent financial crisis. Some firms use it to share risks when dealing with high-risk assets or projects by allowing other investors to share the risk. Other firms use special purpose entities to transfer assets without the need to sign new permits. Through this, special purpose entities help in maintaining intellectual property since it is considered one of the ways of staying ahead as far as market competition is concerned. There are numerous other benefits of special purpose entities, making it an important tool in the successful running of the organization. It is a fact that some business executives would try using some legal means to hide their mischievous deeds to fulfill their selfish interests. Despite the obvious advantages stated above, it is worrying that some firms abuse special purpose entities to meet their own selfish interests. One such firm was Enron. According to Fox (56), Enron was considered one of the most successful firms in the energy sector in the years preceding 2001.
After being named America’s most innovative company by Forbes for six years consecutively, most of the investors had a lot of trust in the company, always considering it one of the most secure firms financially. Within these six years, its shares of stock in the market were constantly on the rise, a fact that convinced other investors that any form of partnership with this firm was bound to bring lots of benefits after a short while. The top executives of Enron however, abused this trust they had struggled to build for years by concealing the true position of the firm financially.
The top management of Enron realized that it needed some cash in order to keep the firm on its foot. However, they were not willing to borrow this money from the capital market for fear of the costs they will be charged. They were also keen on avoiding the transfer of debt to the balance sheet of the firm. The transfer of debt to the balance sheet of the firm would reveal to the investors the true financial state of this firm, which at that time, was not attractive at all. The management resorted to special purpose entities as a way of getting this finance. As Ali (89) observes, the trust that Enron had built in the market made it easy to get the much-needed finance within a very short time. So lucrative was the strategy that the management did not consider some of the possible consequences of a fall in the stock prices. According to Fox (41), the management set up different types of special purpose entities to cover the billion-dollar asset and hid its losses and fabricated earnings by vague and confusing explanations, and hedged its investment on its balance sheet by silently transferring its own stock to special purpose entities in exchange for the note. The management considered this a perfect solution to the problem that Enron had been experiencing. Finally, Enron was considered America’s most innovative firm, and this problem could be solved in an innovative way. They knew that with the constant rise in their stock prices, this debt would easily be paid without the knowledge of the firm’s investors because the debt would not be reflected on the balance sheet of the firm.
Ali (112) blames the management for the trouble that Enron finally found itself in. this scholar says that there was a conflict of interest on the side of the top management of this firm. On one side, they were in charge of protecting this firm by making decisions that would help it prosper. On the other side, they were able to get personal benefits by using special purpose entities to get loans without this amount having to be reflected on the balance sheet of the firm. This appeared so attractive that the management forgot its allegiance to the firm. They knew that with the sound position of the firm, their deeds could be concealed easily once the firm is able to pay back the investors within a short while. This greed was taken off-limits as the corrupt officials considered special purpose entities sources of income where they would go for finances whenever they felt necessary. The trust Enron had built in the market acted as a perfect disguise for any investor who would need an assurance of the security of their investment.
However, it reached a moment where this firm could not hold any longer. It was apparent that management had used a special purpose entity to solicit too much money than the firm could pay. Most of these funds ended up in the pockets of individuals at the management. The revelation came when the stock of this firm started falling. The investor came demanding their money, and when this got to the public, the stock price of this firm even deepened further as the investors rushed to dispose of their shares in the firm before it would fall. However, the harm was already done and Enron- a firm once admired as an innovative and successful American firm- was finally declared bankrupt in November 2004.
References
Ali, Paul. Securitisation of Derivatives and Alternative Asset Classes: Yearbook 2005. The Hague: Kluwer Law International, 2005. Print.
Fox, Loren. Enron: The Rise and fall. Hoboken: John Wiley & Sons, 2002. Print.