Introduction
Since the landmark case of Enron Corporation controversy in 2001 involving the company’s bankruptcy, the public’s view of structured finance and derivatives has been tainted with suspicion of unethical exploitation. Although the legalities involving the abuse of structured finance by market participants for economic gains is still being explored, recommendations are necessary in order to minimize the impact of a market meltdown.
Defining Structured Finance and Derivatives
The term structured finance is rarely defined, but to give an example, a structured financial transaction often uses an SPE or a special purposes entity. A larger corporation uses an SPE as a subsidiary in order to isolate the risks by dedicating it in the financing and acquisition of assets. However, the use of an SPE to hide the company’s debts to make the financial statements looks better is a subject of criticism in terms of unethical business conduct (Jobst). In addition, the use of SPE shields the parent company from consequences of its financial decisions by allowing the SPE to absorb all the risk associated with an acquired asset, hence, this practice is regarded as an abuse of the structured finance and derivatives (Kavanagh). It is noted in cases where the use of SPEs is in question; the parent company frees itself from the implications of market risks.
How Structured Finance is abused
A good example of a market participant abusing the structured finance where the company transferred its stocks to its SPE and in effect, the SPE hedge some Enron’s investments. When the stock price of both Enron and its SPE, the latter can no longer perform its hedge and rising debt forced the SPE to breach the independent equity requirement for non-consolidation (Schwarcz). In addition, the conflict of interest by the company’s executives caused the further company to collapse. The abuses done to structured finance gave rise to several accounting issues highlighting the implications of hedging in transferring economic risks. Since the benefits of SPE is attributed to the off-balance sheet of the parent company, its private nature, and bankruptcy remote, the SPE is often used for both legitimate and illegitimate purposes.
In the case of Enron, its SPEs became the sacrificial pawns to the imminent market meltdown as observed in its falling stock price. Cases of abuse of structured finance as observed in Enron, the complex transactions were created to achieve accounting results rather from operational means. The motivation behind such unethical accounting practice is to minimize the effect of losses in cases where the market and economic conditions are not at its best, avoid indications of debt in the financial statement, and at the same time to increase profit.
Conclusion
Although the use of structured finance has its legal basis, its unethical application in the corporate practice encompasses the abuse of the benefits. It is both a legal business practice exploited in illegal purposes. In addition, the unethical nature of abuse of structured finance is rooted from conflicts of interest surrounding the use of SPEs.
References
Jobst, Andreas A. "A Primer On Structured Finance". J deriv hedge funds 13.3 (2007): 199-213. Web. 6 May 2016.
Kavanagh, Barabara. The Uses And Abuses Of Structured Finance. Cato Project on Good Governance, Audit, and Tax Reform, 2003. Web. 6 May 2016. Policy Analysis.
Schwarcz, Steven. "Enron And The Use And Abuse Of Special Purpose Entities In Corporate Structures". University of Cincinnati Law Review 70.4 (2002): 1309-1318. Web. 6 May 2016.
