What is a Sham Sale?

A sham sale is a transaction in which a company sells assets to third parties controlled by the shareholders at prices well below the market values of the assets. Once these assets have been stripped away from the company, the entity enters bankruptcy, leaving little of value for creditors to recover.

Characteristics of a Sham Sale

There are several characteristics of a transaction that indicate the presence of a sham sale. They are as follows:

Unchanged asset control. After the purported transaction, control over the asset remains with the original owner. This is the case when the original owner continues to benefit from the use of the asset.
No payment. The purported buyer is not making a substantive payment to the seller.
No intent to sell. The parties to the purported deal have no intent to actually shift ownership of the asset to the buyer.

The three preceding characteristics can be used to identify sham sales. In addition, the parties to these agreements might have entered into a hidden agreement, under which they intend to reverse the sale at some point in the future. These agreements may not become apparent until years later, when the sale is reversed.

Example of a Sham Sale

In the Enron case, the company engaged in sham sales as part of its financial manipulation. Enron used special purpose entities (SPEs) to create the illusion of revenue and profits by conducting fake transactions. To do this, Enron set up numerous subsidiary companies that it technically controlled but kept off its balance sheet. Enron "sold" assets, such as energy contracts or physical properties, to these SPEs at inflated prices. However, the transactions were structured in a way that Enron still retained control over the assets, and the "buyers" (the SPEs) did not actually provide payment or take on real risk. Enron recorded these "sales" as revenue, misleading investors and creditors about the company’s true financial health.

As a result Enron boosted its profits, hid debt from creditors and regulators, and inflated its stock price by presenting an inflated and healthy-looking financial outlook. The fraud was eventually exposed, leading to Enron’s bankruptcy, significant financial losses for shareholders and employees, and criminal charges against executives.

How to Avoid Sham Sales

There are several ways for creditors to combat sham sales. They are as follows:

Mandate a loan covenant. Creditors can force the company to agree to a loan covenant, so that it cannot engage in the sale of assets without the permission of the lender.
Repayment guarantees. Creditors can require personal repayment guarantees by the owners of the business.
Security interest. Creditors can take a security interest in the company's assets and perfect the lien. The lien attaches to the assets even if they are sold to a third party, so the assets can still be seized even after a sham sale.