Special purpose entity
Encyclopedia
A special purpose entity (SPE; or, especially in Europe, special purpose vehicle/SPV, or, in certain cases in each EU jurisdiction – FVC financial vehicle corporation) is a legal entity (usually a limited company of some type or, sometimes, a limited partnership
) created to fulfill narrow, specific or temporary objectives. SPEs are typically used by companies to isolate the firm from financial risk. They are also commonly used to hide debt (inflating profits), hide ownership, and obscure relationships between different entities which are in fact related to each other (see Enron
). Normally a company will transfer assets to the SPE for management or use the SPE to finance a large project thereby achieving a narrow set of goals without putting the entire firm at risk. SPEs are also commonly used in complex financings to separate different layers of equity infusion. Commonly created and registered in tax havens, SPE's allow tax avoidance strategies unavailable in the home district. Round-tripping
is one such strategy. In addition, they are commonly used to own a single asset and associated permits and contract rights (such as an apartment building or a power plant), to allow for easier transfer of that asset. They are an integral part of public private partnerships common throughout Europe which rely on a project finance type structure.
A special purpose entity may be owned by one or more other entities and certain jurisdictions may require ownership by certain parties in specific percentages. Often it is important that the SPE not be owned by the entity on whose behalf the SPE is being set up (the sponsor). For example, in the context of a loan securitization
, if the SPE securitisation vehicle were owned or controlled by the bank whose loans were to be secured, the SPE would be consolidated with the rest of the bank's group for regulatory, accounting, and bankruptcy purposes, which would defeat the point of the securitisation. Therefore many SPEs are set up as 'orphan' companies
with their shares settled on charitable trust
and with professional directors
provided by an administration company to ensure that there is no connection with the sponsor.
A good SPE should be able to stand on its feet, independent of the sponsoring company. Unfortunately, this does not always happen in practice. One of the reasons for the collapse of the Enron SPE was that it became a vehicle for furthering the ends of the parent company in violation of the prudential norms of corporate financing and accounting.
, in order to hide losses and fabricate earnings, resulting in the Enron scandal of 2001
.
They were also used to hide losses and overstate earnings by executives at Tower Financial, which declared bankruptcy in 1994. Several executives of the company were found guilty of securities fraud, served prison sentences, and paid fines.
, a number of accounting standards apply to SPEs, most notably FIN46R that sets out the consolidation treatment of these entities. There are a number of other standards that apply to different transactions with SPEs.
Under International Financial Reporting Standards
(IFRS), the relevant standard is IAS 27 in connection with the interpretation of SIC12 (Consolidation—Special Purpose Entities). For periods beginning on or after 1 January 2013, IFRS 10 Consolidated Financial Statements supersedes IAS 27 and SIC 12.
Limited partnership
A limited partnership is a form of partnership similar to a general partnership, except that in addition to one or more general partners , there are one or more limited partners . It is a partnership in which only one partner is required to be a general partner.The GPs are, in all major respects,...
) created to fulfill narrow, specific or temporary objectives. SPEs are typically used by companies to isolate the firm from financial risk. They are also commonly used to hide debt (inflating profits), hide ownership, and obscure relationships between different entities which are in fact related to each other (see Enron
Enron
Enron Corporation was an American energy, commodities, and services company based in Houston, Texas. Before its bankruptcy on December 2, 2001, Enron employed approximately 22,000 staff and was one of the world's leading electricity, natural gas, communications, and pulp and paper companies, with...
). Normally a company will transfer assets to the SPE for management or use the SPE to finance a large project thereby achieving a narrow set of goals without putting the entire firm at risk. SPEs are also commonly used in complex financings to separate different layers of equity infusion. Commonly created and registered in tax havens, SPE's allow tax avoidance strategies unavailable in the home district. Round-tripping
Round-tripping
Round-tripping, also known as round-trip transactions or "Lazy Susans", is defined by The Wall Street Journal, as a form of barter that involves a company selling "an unused asset to another company while at the same time agreeing to buy back the same or similar assets at about the same price."...
is one such strategy. In addition, they are commonly used to own a single asset and associated permits and contract rights (such as an apartment building or a power plant), to allow for easier transfer of that asset. They are an integral part of public private partnerships common throughout Europe which rely on a project finance type structure.
A special purpose entity may be owned by one or more other entities and certain jurisdictions may require ownership by certain parties in specific percentages. Often it is important that the SPE not be owned by the entity on whose behalf the SPE is being set up (the sponsor). For example, in the context of a loan securitization
Securitization
Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation , to...
, if the SPE securitisation vehicle were owned or controlled by the bank whose loans were to be secured, the SPE would be consolidated with the rest of the bank's group for regulatory, accounting, and bankruptcy purposes, which would defeat the point of the securitisation. Therefore many SPEs are set up as 'orphan' companies
Orphan structure
An orphan structure is a financing term referring to a company whose shares are held by a trustee on a charitable purpose trust. The company is said to be an "orphan" as it is not beneficially owned by anyone....
with their shares settled on charitable trust
Charitable trust
A charitable trust is an irrevocable trust established for charitable purposes, and is a more specific term than "charitable organization".-United States:...
and with professional directors
Board of directors
A board of directors is a body of elected or appointed members who jointly oversee the activities of a company or organization. Other names include board of governors, board of managers, board of regents, board of trustees, and board of visitors...
provided by an administration company to ensure that there is no connection with the sponsor.
Uses
Some of the reasons for creating special purpose entities are:- Securitization: SPEs are commonly used to securitiseSecuritizationSecuritization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation , to...
loans (or other receivables). For example, a bank may wish to issue a mortgage-backed securityMortgage-backed securityA mortgage-backed security is an asset-backed security that represents a claim on the cash flows from mortgage loans through a process known as securitization.-Securitization:...
whose payments come from a pool of loans. However, to ensure that the holders of the mortgage-back securities have the first priority right to receive payments on the loans, these loans need to be legally separated from the other obligations of the bank. This is done by creating an SPE, and then transferring the loans from the bank to the SPE. - Risk sharing: Corporates may use SPEs to legally isolate a high risk project/asset from the parent company and to allow other investors to take a share of the risk.
- Finance: Multi-tiered SPEs allow multiple tiers of investment and debt.
- Asset transfer: Many permits required to operate certain assets (such as power plants) are either non-transferable or difficult to transfer. By having an SPE own the asset and all the permits, the SPE can be sold as a self-contained package, rather than attempting to assign over numerous permits.
- For competitive reasons: For example, when Intel and Hewlett-PackardHewlett-PackardHewlett-Packard Company or HP is an American multinational information technology corporation headquartered in Palo Alto, California, USA that provides products, technologies, softwares, solutions and services to consumers, small- and medium-sized businesses and large enterprises, including...
started developing IA-64 (Itanium) processor architecture, they created a special purpose entity which owned the intellectual technology behind the processor. This was done to prevent competitors like AMD accessing the technology through pre-existing licensing deals. - Financial engineering: SPEs are often used in financial engineering schemes which have, as their main goal, the avoidance of tax or the manipulation of financial statements. The EnronEnronEnron Corporation was an American energy, commodities, and services company based in Houston, Texas. Before its bankruptcy on December 2, 2001, Enron employed approximately 22,000 staff and was one of the world's leading electricity, natural gas, communications, and pulp and paper companies, with...
case is possibly the most famous example of a company using SPEs to achieve the latter goal. - Regulatory reasons: A special purpose entity can sometimes be set up within an orphan structure to circumvent regulatory restrictions, such as regulations relating to nationality of ownership of specific assets.
- Property investing: Some countries have different tax rates for capital gains and gains from property sales. For tax reasons, letting each property be owned by a separate company can be a good thing. These companies can then be sold and bought instead of the actual properties, effectively converting property sale gains into capital gains for tax purposes.
Establishment of a SPE
Like a company, an SPE must have promoter(s) or sponsor(s). Usually, a sponsoring corporation hives off assets or activities from the rest of the company into an SPE. This isolation of assets is important for providing comfort to investors. The assets or activities are distanced from the parent company, hence the performance of the new entity will not be affected by the ups and downs of the originating entity. The SPE will be subject to fewer risks and thus provide greater comfort to the lenders. What is important here is the distance between the sponsoring company and the SPE. In the absence of adequate distance between the sponsor and the new entity, the latter will not be an SPE but only a subsidiary company.A good SPE should be able to stand on its feet, independent of the sponsoring company. Unfortunately, this does not always happen in practice. One of the reasons for the collapse of the Enron SPE was that it became a vehicle for furthering the ends of the parent company in violation of the prudential norms of corporate financing and accounting.
Abuses
Special purpose entities were one of the main tools used by executives at EnronEnron
Enron Corporation was an American energy, commodities, and services company based in Houston, Texas. Before its bankruptcy on December 2, 2001, Enron employed approximately 22,000 staff and was one of the world's leading electricity, natural gas, communications, and pulp and paper companies, with...
, in order to hide losses and fabricate earnings, resulting in the Enron scandal of 2001
Enron scandal
The Enron scandal, revealed in October 2001, eventually led to the bankruptcy of the Enron Corporation, an American energy company based in Houston, Texas, and the dissolution of Arthur Andersen, which was one of the five largest audit and accountancy partnerships in the world...
.
They were also used to hide losses and overstate earnings by executives at Tower Financial, which declared bankruptcy in 1994. Several executives of the company were found guilty of securities fraud, served prison sentences, and paid fines.
Accounting guidance
Under US GAAPGaap
In demonology, Gaap is a mighty Prince and Great President of Hell, commanding sixty-six legions of demons. He is, according to The Lesser Key of Solomon, the king and prince of the southern region of Hell and Earth, and according to the Pseudomonarchia Daemonum the king of the western region and...
, a number of accounting standards apply to SPEs, most notably FIN46R that sets out the consolidation treatment of these entities. There are a number of other standards that apply to different transactions with SPEs.
Under International Financial Reporting Standards
International Financial Reporting Standards
International Financial Reporting Standards are principles-based standards, interpretations and the framework adopted by the International Accounting Standards Board ....
(IFRS), the relevant standard is IAS 27 in connection with the interpretation of SIC12 (Consolidation—Special Purpose Entities). For periods beginning on or after 1 January 2013, IFRS 10 Consolidated Financial Statements supersedes IAS 27 and SIC 12.
See also
- FIN 46FIN 46FIN 46, revised and replaced in its entirety by FIN 46R, is a statement for the purposes of United States Generally Accepted Accounting Principles published by the US Financial Accounting Standards Board which requires a reporting enterprise to consolidate a variable interest entity if it is the...
(FASB ruling on consolidation of variable interest entities) - Off-Balance-Sheet EntitiesOff-balance-sheetOff-balance sheet usually means an asset or debt or financing activity not on the company's balance sheet.Some companies may have significant amounts of off-balance sheet assets and liabilities. For example, financial institutions often offer asset management or brokerage services to their clients...
- Variable Interest EntityVariable Interest EntityVariable interest entity is a term used by the United States Financial Accounting Standards Board in FIN 46 to refer to an entity in which the investor holds a controlling interest that is not based on the majority of voting rights. It is closely related to the concept of a special purpose entity...
(VIE) - Orphan structureOrphan structureAn orphan structure is a financing term referring to a company whose shares are held by a trustee on a charitable purpose trust. The company is said to be an "orphan" as it is not beneficially owned by anyone....