THE RAPID FINANCIAL COLLAPSE of Enron, driven in part by the company's use of off-balance-sheet, special-purpose entities (SPEs) and lack of financial disclosure, has wreaked havoc in the corporate real estate finance arena. Due to Enron's widespread use of such structures, the Financial Accounting Standards Board (FASB) has initiated a review of accounting and reporting guidelines related to SPEs and off-balance-sheet liabilities. The goal: improving the consistency and transparency of the financial reporting process.

As FASB's review process has unfolded, it has become evident that the impact of its proposed guideline changes on the real estate leasing market could be far-reaching. Because many real estate transactions are structured through special-purpose or single-purpose entities, virtually every real estate lease transaction could face scrutiny, raising concerns about potential limitations in the use of synthetic leases, bond leases and even traditional net leases.

Given the broad market uncertainty, we do not recommend the restructuring of existing transactions until FASB releases new guidelines, which is expected to take place in August. For transactions currently in progress, we recommend lease structures that meet the strictest demands of the proposed FASB changes or that could be restructured in a cost-effective manner to meet extreme compliance levels.

In order to assess the overall corporate impact of real estate finance structural changes, we recommend the development of a comprehensive portfolio strategy, especially for those firms with substantial exposure to SPE-related transaction structures.

Possible Changes

The current efforts of FASB, the Securities and Exchange Commission (SEC) and other regulatory bodies are aimed at curbing perceived SPE abuses. With respect to lease transactions, they are primarily focused on the shifting of risks and rewards of property ownership, and operations between lessees and lessors. Led by FASB, the review of SPE and off-balance-sheet guidelines is concentrating on the following issues:

  • Primary beneficiary — Under current FASB guidelines, as long as an independent lessor provides an equity investment of 3% or more, the lessee is not considered the transaction's primary beneficiary and does not have to consolidate the assets and liabilities of an SPE on its balance sheet. FASB is considering an increase in the equity requirement to a presumed minimum of 10% unless “clear and compelling evidence” exists that a smaller percentage is adequate under certain circumstances. The “clear and compelling evidence” language signals a possible movement away from a clear-cut economic test to a subjective auditor analysis of facts and circumstances.

  • Risks and rewards of ownership — While FASB has historically defined the party bearing substantially all the residual risks and enjoying substantially all the residual benefits as the primary beneficiary, interpretation and technical definitions have led to perceived abuses of independent lessors. With a renewed emphasis on sufficient independent economic substance for SPEs, FASB is expanding the risk/reward evaluation to include reviews of “fixed” equity returns, first-loss equity positions, residual value rights and lessee guarantees.

  • Disclosure — In January, the SEC issued an interpretive statement related to financial disclosure that was intended to clarify discussion of liquidity and capital resources, including off-balance-sheet transactions. FASB is likely to expand upon the SEC interpretation in pursuit of consistent corporate disclosure. Significant self-governance has already improved the reporting environment.

  • Timing — FASB has suggested that changes to SPE and off-balance-sheet reporting guidelines might apply to all transactions closed subsequent to the issuance of a final interpretation, and that all existing financial structures violating the new standards could be subject to consolidation.



James L. Koster II (top) and David F. Stringfield are managing directors of the financial services group of The Staubach Co., a Dallas-based real estate firm that provides solutions for companies seeking office, retail and industrial space.