Enron has given off-balance sheet financing a bad name. However, such financing is legitimate and can often be quite effective, argue Yogesh Bhattarai and Sandeep Farias

Special Purpose Vehicles (SPVs) and off-balance sheet financing have come into considerable disrepute and are being questioned after the collapse of the energy giant Enron, one of the most shocking failures in US corporate history. With the Enron backdrop, off- balance sheet financing has conjured up images of fabricated accounts and fake transactions. However, the practice is generally legal and respectable and often quite effective. This article addresses the challenge before the legal system to balance legitimate off- balance sheet transactions and cases where it has been used to defraud investors. 

There are a number of reasons for off-balance sheet transactions, some of which are: Off-balance-sheet companies are created to help finance new ventures. These separate companies are used to transfer and `limit the risk of the new venture business' from the parent company to a separate company as a way to finance. The new venture/ business, consequently, is able to raise finance, without diluting existing shareholders of the parent or adding to the parent's debt burden. 

Sometimes, separate companies were created to pursue a business project that was a part of the parent's main line of business, for instance, a company involved in a manufacturing business may start a related business of marketing and distribution in a separate company. Sometimes, separate legal entities are created to contain a business that was significantly different from the parents' core business like a company involved in construction may float a separate company to carry on the business of manufacture. Companies usually obtain funds in joint ventures by combining their know-how or product with a partner's money. The company may contribute its know-how to a joint venture funded by another party and receive royalties as the joint venture succeeds. Perhaps, one of the most important areas where special purpose vehicles are used is in a asset securitisation transaction where a company (originator) sells its trade receivables to an entity created specially for this purpose (special purpose vehicle or an SPV). The SPV then refinances this purchase by selling the receivables to investors. The essential premise of securitisation is that the transfer by the originator to the SPV is "bankruptcy-remote", that is, the receivables are insulated from the bankruptcy risk of the originator. In order to ensure that the assets actually achieve the "bankruptcy remoteness", it is essential to move them out of the balance sheet of the originator and park them with another independent entity. Such a structure provides comfort to the investor that as they are investing in a pool of assets that is held on their behalf only by the SPV and is not subject to any subsequent deterioration in the credit quality of the originator. securitisation affords additional liquidity; a new source of capital, finance for companies' ongoing business. 

SPVs and off-balance sheet transactions: SPVs are used in transactions to reduce taxes, specifically, in case of foreign direct investment where an investor may incorporate an SPV in a tax neutral jurisdiction which enables an investor to save capital gains or dividend tax on sale of shares or assets, reduce tax burden, whether on account of capital gains or otherwise. On the other hand, balance sheets are supposed to reflect the true and fair financial position of the company. If innovative transactions are entered into for avoidance of prudential capital requirements or where the transactions are not truly off-balance sheet (for instance, a transaction may be with recourse to the originator), information of the off-balance sheet exposure published may be insufficient to give shareholders, creditors and regulatory authorities a reasonable picture of a company's activities as this information relates to assets which have been transferred to an off-balance sheet entity. 

While Enron has demonstrated that there is a requirement for tightening accounting standards and adequate reporting systems to ensure that all major off-balance sheet activities are adequately captured, reports presented to shareholders and regulatory authorities and general dissemination of information, an alarmist approach is adopted which stifles or curtails the use of special purpose vehicles for legitimate financing and off-balance sheet transactions. For instance, securitisation is in a very nascent stage of development. The concept of a special purpose vehicle is clearly recognised in the securitisation report of the Reserve Bank and the draft Securitisation Bill. The challenge before the legal system and the regulators is to strike a balance between encouraging and promoting commerce and regulating and preventing illegalities or transactions intended to defraud people. Traditionally, the legal system has responded to these challenges by the use of judicially developed tools like the `doctrine of lifting the corporate veil'. Legally, there is a way to regulate off-balance sheet transactions by a process commonly described to as `lifting the veil'. The principle laid down in the Salomon case more than a century ago in 1897 by the House of Lords is that the company is a legal entity distinct from its members. By lifting the veil, the law either goes behind the corporate personality to the individual members or ignores the separate personality of each company in favour of the economic entity constituted by a group of associated companies. 

This is more readily done under American law. To know the real state of affairs behind the fagade of the principle of the corporate personality, the courts have pierced the veil of incorporation. This course is adopted when it is found that the principles of corporate personality is flagrantly opposed to justice, convenience or interest of the revenue. 

Where, therefore, the corporate character is employed for the purpose of committing illegality or for defrauding others, the court would ignore the corporate character and will look at the reality behind the corporate veil so as to enable it to pass appropriate orders to do justice between the parties concerned (Subhra Mukherjee vs Bharat Coking Coal (2000) 3 SCC 312, DDA vs Skipper Construction (1996) 4 SCC 622). 

In the case of State of UP vs Renusagar Power Co (1988) (4 SCC 59), the company was incorporated by Hindalco in order to fulfil the condition of industrial license of Hindalco through production of aluminium. This model of setting up a power station through Renusagar was adopted, to avoid complications in cases of takeover of the power station by the state or the electricity board. It was observed by the SC that Renusagar can be said to be a wholly owned subsidiary of Hindalco and completely controlled by Hindalco. The profits of Renusagar were treated as the profits of Hindalco. It was therefore held that Renusagar had in reality no separate existence, apart from and independent of Hindalco. It was held by the court that the persons generating and consuming energy were the same and thus lifted the corporate veil and treated them as one for the purpose of payment of duty. In conclusion, it may not require a complete revamp of the current regulatory framework to regulate the use of off balance sheet transations by the use of special purpose vehicles but the application of the traditional rules to new areas of commerce