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What is a Special Purpose Entity?
What’s important to know about it?
In this article, I will break down the meaning of Special Purpose Entity so you know all there is to know about it!
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What Is A Special Purpose Entity
A special purpose entity, or SPE, refers to a company formed for a very specific purpose such as holding a pool of assets, passing the financial risk to others, getting a tax benefit, or creating liquidity for an entity.
In other words, a special purpose entity is not created to run a business in its normal course but to achieve a particular purpose.
Typically, special purpose entities are formed as part of a complex chain of interrelated companies and have little or no physical presence or operations.
For example, a special purpose entity can be formed to allow investors to pool their capital to invest in a startup or a project.
In this context, the special purpose entity is used for investment purposes.
You can also have a special purpose entity used to shield another company from liability or risk.
For example, a company may want to enter into a joint venture with another entity without exposing itself to liability.
As a result, it will form a special purpose entity to enter into the joint venture in such a way that the parent company is shielded from liability and risk.
Keep reading as I will further explain to you what a special purpose entity means and how it works.
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Why Special Purpose Entities Are Used
There are many reasons why special-purpose entities are used.
One of the most important reasons a special purpose entity may be formed is to isolate financial risk.
Since a special purpose entity has its own balance sheet, it can be used to either take risk away from another entity or shield assets.
For instance, a parent company can form a subsidiary for the sole purpose of holding a pool of assets free from financial risk.
Alternatively, a special purpose entity can be formed by a parent company to engage in risky transactions.
This way, any negative impact of the transaction will only affect the special purpose entity without harming the parent company.
You can also have special purpose entities used for the securitization of debt, to consolidate capital to invest in a startup or a particular project, or to take advantage of a certain tax break.
On the flip side, special-purpose entities have also been misused to perpetrate financial fraud resulting in major losses to investors.
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How Does A Special Purpose Entity Work
The special purpose entity can be used for many reasons such as to undertake a risky project, shield assets from financial risk, or create liquidity.
Let’s assume that a company is looking to undertake a risky project and does not want to compromise the assets on its balance sheet.
Company A, which is the company in operations, will form Company B to undertake the risky project.
Company B will enter into a joint venture with another company to get into a new market.
If the project is successful, then Company A reaps the benefit of the joint venture.
However, if the project is not successful, Company B will go bankrupt without impacting Company A’s assets.
A company can form a special purpose entity by forming a corporation, limited liability company, partnership, trust, or any other type of entity that can be created in the given jurisdiction.
What’s important is that the special purpose entity provides limited liability protection to the company forming it.
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Special Purpose Entity Risks
Although special purpose entities can be highly effective and useful in business, it is possible that companies use them to perpetrate illegal operations or scam investors.
For instance, special-purpose entities have been used to mask financial information from investors.
This can be done by having the special purpose entity issue its own financial statements without having the parent company report the activities of the special purpose entity on its own balance sheet.
This means that a parent company can use a special purpose entity to hide liabilities in such a way that investors will not be able to truly assess the parent company’s true risk profile.
The most notable example of misuse of special purpose entities came to light with the collapse of Enron Corp. in 2001.
Although Enron appeared to be a highly successful energy company, its true financial position was hidden through the extensive use of special purpose entities, among other tactics.
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Special Purpose Entity Example
The use of special purpose entities has become notorious with Enron’s major financial scandal.
In 2001, Enron’s financial collapse exposed to the market the misuse of special purpose entities and accounting tricks to defraud investors.
To cook its books, Enron created special-purpose entities and transferred stock to it in exchange for cash or promissory notes.
The special purpose entity then used the stock for hedging assets that were ultimately reported on the company’s balance sheet.
Even though Enron had reported the special purpose entities on its balance sheet, investors did not realize that the company was involved in such a large-scale fraudulent activity.
Eventually, as Enron’s stock price started to drop, the scam was uncovered.
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Special Purpose Entity FAQ
What are special purpose entities used for?
Special purpose entities are used for many reasons, such as:
- Securitization of debt
- Risk sharing
- Financing purposes
- Asset transfer
- Holding intellectual property
- Financial engineering
- For regulatory purposes
- To acquire assets
How are special purpose entities established?
A special purpose entity can be established as a trust, limited liability company, corporation, partnership, or another form of legal entity.
Typically, you have a company acting as a sponsor where it provides assets or capital to the special purpose entity.
The special purpose entity will either shield the assets from the sponsor’s operations or engage in risky projects shielding the sponsor.
It’s important for the sponsor to keep enough distance from the special purpose entity to avoid getting qualified as a subsidiary.
Can special purpose entities be used for illegal purposes?
Unfortunately, special-purpose entities can be used by some to perpetrate fraud or financial scams.
In the 2001 Enron scandal, it appeared that special purpose entities were used by the Enron executives to hide losses and create paper earnings.
Investors should carefully assess a company’s financial statements and business operations before investing to avoid unwanted surprises.
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So there you have it folks!
What does a special purpose entity mean?
In a nutshell, a special purpose entity is a type of company that is formed for a specific purpose, such as isolating financial risk, taking advantage of a tax benefit, creating liquidity for another entity, or others.
In many cases, a special purpose entity is formed to take risks away from another entity.
For example, a company may incorporate a subsidiary with the specific intention of having the subsidiary own assets and hold capital without exposure to important risk.
This way, in the worst-case scenario, the parent company may file for bankruptcy without impact on the special purpose entity that was created.
Now that you know what special purpose entities are all about and how they work, good luck with your research!
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