Business Law Prof Blog

Taxes and Takeovers

Before Congress charges into new taxes on hedge funds and private equity funds it ought to pause and consider its record on special taxes aimed at takeovers.  Beginning in 1969 with section 279 and continuing to 1989 with section 163, Congress has attempted to discourage takeovers with various tax provisions aimed at debt financing.  We also have special rules for golden parachutes and pension plan cash-outs and special rules for the carry-over (and carry-back) of tax attributes.  All the rules need careful re-examination; most of them are either easily avoided and/or have consequences in deal structuring that are counterproductive.  Now we have Congress ready to impose special rules on partnerships in which a managing partner (the hedge fund firm or private equity firm) earns a portion of the profits (the "carry") to attack another form of an equity acquisition or takeover.  Once again the results will be the same.  Deal structures will change to meet the new rules and the new structures will cost more to create, but deals will still happen and tax collections will increase only marginally once the clever planners take over.  More rules and new regulations will be needed to stop the new deal forms or, as is usually the case, we just resign ourselves to the new forms. 

The new proposals themselves confuse reporters (and the public).  One reads commonly in the press, for example, that one bill pending in Congress seeks to have publicly-traded master limited partnerships (now taxed at 15%) "taxed like corporations" (at 35%).  Publicly traded limited partnerships are now taxed as separate entities and are now taxed at 35% on ordinary income; like corporations, such partnerships are taxed at 15% on long term capital gains (the business of equity based investment funds).  If a hedge fund was a corporation it would pay 15% on investment gains.  And, by the way, most corporations have an effective tax rate, even on ordinary income, at closer to 18%.   In essence, some in Congress want special rules for managing partners in partnerships.  Congress wants managing partners to pay ordinary income taxes on their investment gains, now taxed at capital gains rates.  Corporate managers who receive at-the-money options in lieu in all corporate investments (the equivalent of a "carry") would be better off under such a rule.  Publicly traded hedge funds will incorporate on the IPO.  There is no substitute for scraping the double tax system and designing a flow through tax system for all business entities.  It would stop all the games and enable Congress to level whatever rates it wants on business income at the individual level.                

Supreme Court and Business

It was inevitable -- the Supreme Court is under attack by the popular press.  The Court's decisions on social issues has upset the fair minded.  One of the attacks is interesting; separate the Court from its political base by labeling it pro-business and anti-shareholder.  Even conservatives are pro-shareholder.  The attack is transparent.  Shareholders as well as businesses are better off when frivolous litigation is harder to bring.  The balance between legitimate and illegitimate lawsuits is important to shareholder value.  The court, by adjusting the balance, if it is correct, is not anti-shareholder; it is pro-shareholder. There is no evidence that the Court is biased toward or corrupted by big business; such challenges after the public legitimacy of the court and should not be lightly made, especially to serve other social purposes.  We have come through an era when many have come to believe that the court, like a kindly grandfather, is the repository of whatever is fair.  Jurisdiction, separation and balance of powers, executive or legislative prerogative, federalism, and limited judicial factfinding are concepts for wimps; the court should declare what is just and fair and tell everybody else to stuff it.  If the Court does not do what you think is fair (long statutes of limitation for discrimination actions), scream about it and impugn the integrity of the justices who do not do what you want.  That's the ticket. 

The Roberts court has a better sense of what the Court is and should be; now we need the press to educate the public not to mislead them.

Bell Canada Buyout

The 51.7 billion (Canadian $$) buyout for Canada's largest company is another one that smells.  The primary buyout group includes the Ontario Teacher's Pension Plan.  First, their involvement meets the 47% cap on foreign ownership under Canadian law that limits other United States buyout groups from actively bidding.  In other words, they are getting it cheap and if the Canadian Parliament lifts the cap they can immediately resell for a profit.  Second, the what is a teacher's pension plan doing with so much money in one deal?  Using teachers pension money to speculate on a buyout makes sense only in very small amounts.  Third, the bidding process was very secretive and led to speculation about a broad that favored a bidder that would protect existing management.  The Teacher's Pension Plan managers have been publicly very complimentary of existing managers.  It does not take much in an action to favor one bidder over another, managers have advisers that know the tricks; a secretive auction makes the temptation overwhelming.  We need to get better control over the conflicted role of existing management in buyouts, Canadian and American. 

Bausch & Lomb: A Sorry Tale

Bausch & Lomb, a 154 year old company, is selling to a private equity firm, Warburg Pincus for $65 a share.  The company is struggling and its stock price is well down from highs of $80 a share two years ago.  The CEO responsible for the company's recent setbacks is Ronald L. Zarella.  Zarella will receive a golden parachute payout of $40 million and have an equity stake in the privatized company.  If the company turns around, he will rake it more millions.  There are three things seriously wrong with this story:  First, Zarella is profiting from his own weak managing record (there were accounting problems while he led the company).  Second, Zarella is conflicted in the buyout both by the overly generous golden parachute and by his participation in the purchaser. And third, the purchaser will undoubtedly do the cookie cutter "Peltz thing" to print money -- sell under-producing assets, sell undervalued assets, leverage and distribute money to shareholders (an extraordinary dividend or buyback).   This is not rocket science; it is pathetically simple. If this is a viable strategy for the private company it is surely a viable strategy for a public company; Zarella should have done the Peltz thing as CEO of the public company.  The entire deal smells.  At some point, we are going to have to come to grip with the fact them many of the private buyouts are a huge reward for those who should not be rewarded and this reward may itself be a primary reason for the buyout.  Buyout groups look for companies with poor managers and fat golden parachute agreements; convince the manager to sell, cash the agreement, and come abroad the buyout team which can use his knowledge and contacts (and inside information) and tell him how to behave. We need a decent judicial opinion on one of these deals that lays out more protections for shareholders.    

The Tribune Takeover

With Congress worrying so much about in imposing a surrogate double tax on investment fund managers, perhaps they should look at ESOPS.  Zell is using an ESOP/Sub S structure to unwind a double tax on the Tribune Company and use the tax proceeds to fund his takeover.  No a murmur in Congress. The structure enables Zell buy the company with extreme leverage and little downside risk. The risk is borne by the employees.  If Zell cannot turn around a company that is hemorrhaging money (and he has never run a newspaper), the employees lose big and he loses $250 m (a pittance).  If he succeeds, he hits big, will make a fortune, and the employees will show modest or comfortable gains.  The lesson, long ignored, is that we need a tax system that is more neutral on business incentives.

Taxing Fund Managers

The Wrangle, Levin, et AL. bill, introduced yesterday, would double the tax paid by money fund managers on their "carry" in investment partnerships.  They currently pay 15% (the long term capital gains rate); under the bill they would pay 35% (the ordinary income tax rate for entities).  In political terms, fund managers made money too much too fast, were too public about their new wealth, and were late to fund political cover (contributions of politicians).  The story of the tremendous new wealth of the founders of Blackstone, splashed all over the newspapers due to their IPSO yesterday, was the last straw.  A tax the rich battle cry in a 2008 Presidential election and a new public identification of a new way to be rich produced the inevitable -- a proposal to double the tax on fund managers.  At issue is whether such a tax can be put into the context of current tax rules.  If so, the tax is a political and policy question; if not, the tax is a discriminatory, discretionary wealth tax on those who have recently acquired wealth (like a tax on anyone whose last name is "Buffet" or a tax on speaker fees of ex-Presidents that accumulate to over, say, $5 million ).   To me it looks like the latter form of tax.  The fund manager tax is a product of two other tax based distinctions that are interrelated:  First, the double tax on "corporate entities" (a tax at the entity level and the investor level on distributed entity earnings) and the single tax on "partnership" like entities;  Second, the distinction between income and capital gain (salary and investment returns).  The new proposal, in essence, expands on the Backus/Crassly bill (that taxes the returns of all publicly-traded fund managers differently than privately held fund managers) and re-institutes a surrogate double tax on fund managers in partnerships by calling their returns income (instead of capital gains).  The problem is, of course, that we, as most other developed nations, should not have a double tax at all.  Entity returns, in all forms of entities, should be attributed to investors and taxed once.  An argument for "taxing the rich" would appear in more progressive rates on individual returns.  This indirect double tax by re-characterizing capital gains as income will have problematic consequences.  In the simplest form of the argument, the tax penalizes that who contribute purely labor (those without capital) in partnerships (involving capital investments) in exchange for a split of the profits and leaves alone those who contribute pure capital.  As an example, Ms. Operator, with no money, finds an under-priced commercial property, and solicits Mr. Moneybags to invest cash in a partnership, both to take an even split of the resale of the commercial property one year later (after renovation and marketing). Ms. Operator will do all the work.  The tax bill hits Operator for a 35% tax and Moneybags pays only a 15% tax.  At most, Operator should pay a 35% tax on foregone salary, and a 15% tax on the investment of the foregone salary.  Taxing her on the total investment return as income makes no sense; she has the same investment risk as Moneybags. Penalizing pure labor, the clever, innovative folks with no money, has never been a good move -- aren't these the folks we want to encourage??  Moreove, those that can pay tax lawyers will work around the new tax.  For example, Moneybags, as part of the original investment, "loans" money to Operator without recourse (this part will get fancy) and Operator invests the loaned money in the project.  There will be many, many variations on this.  The small partnerships who cannot pay the tax lawyers will be stuck.  We have a "perfect storm" here;  distrust of hedge funds, tax the rich progressives, new wealth in new patterns, concern over "private" ownership of large companies; a political campaign for control of the White House; a tax deficit with calls for new social spending programs (health care) -- and we are going to sink something, something of value.               

Difficult Federal Judges

The description of Judge Reggie Walton comments in the court room during the trial of Scooter Libby were not flattering.  Multiple times he made comments from the bench that are more correctly described as speeches; several of the comments were petulant.  His conduct reminds me of the Judge in the KPMG tax case.  A lack of judicial humility on the bench is not new but it seems to be growing in frequency, particularly in the newsworthy cases.  New data on the selection of federal judges illustrates a selection bias against main-line practicing attorneys and in favor of academics, public officials, and those who practice public law.  Are the two related?  Judges with a cause would seem to be more likely to be peevish to those with whom they disagree.

Credit Suisse Case on the IPO Market

The Supreme Court held In Credit Suisse Securities v Billing, consistent with its past history, that securities laws cede jurisdiction over market structure of the securities markets to the SEC, pre-empting the federal antitrust laws.  The ruling was not a surprise.  I agree with the holding but not he SEC use of its power; the SEC has favored antifraud enforcement over competitive concerns and, in my view, overly micro-structured the securities markets to limit otherwise healthy competition.  Justice Stevens concurring opinion reminds me that judges, when they step out from making jurisdictional decisions and decide to comment on market forces, are often, well, just out of their league.  Justice Stevens pronouncement that underwriting syndicates cannot fix prices and the suggestion that they can is "frivolous" is a laugher.  The market for underwriting has very few players (there are five or six large investment banks) and underwriting fees for stock are an amazingly stable 7% across time, across types of companies, across size of offerings.  To say that the few underwriters, participating in each others offerings, have informally or formally colluded to fix a 7% rate is not frivolous; it is plausible, even probable.  Then there is the "underpricing problem."  Watch the Blackstone IPO on its first day.  Why do American IPOs average, 15% or more underpricing on the first day?  There are competing theories, some are market based and some are not (they are based on the market power of investment banks).  Stevens is way out of his league in his pronouncements in his concurrence and he was sanctimonious in tone when he wrote them.  Why make such statements without an adequate record or investigation?  Put on the robe and some judges get instant smarts.       

Taxing Hedge Funds

Congress, tempting by Victor Fleischer's argument, is considering taxing the "carry" of hedge funds at ordinary income tax rates.  Hedge funds create investment pools and take 20% of the returns, if any, as compensation for their management duties.  Investors willing agree because their 80% return for a 100% investment still often shows a total return of 20% or more. 

The tax proposal is a mistake, of course, because it is not based on a general principle that makes economic sense.   There are numerous reasons to do it that do not make economic sense:  1) We should tax anyone who make large amounts of money fast at higher rates just because they are making boatloads of money or 2) We should threaten to tax those who make money and do not contribute to political campaigns to get political cover to induce them to ante up (ask Bill Gates about this).  Reason 1) is pure economic redistribution, a discretionary progressive tax system, and 2) is political extortion.

Partnerships in everything from local laundries to complex multi-national ventures have long had two types of investors, Moneybags (a passive investor who puts up the cash for a portion of the profits) and Operator (who invests labor and no cash and takes no salary but takes a portion of the profits).  Both Moneybags and Operator are taxed the same on the profits; if the profits are ordinary income both pay income tax -- if the profits are capital gains (long or short), both pay capital gains tax.  Fleischer would have the partners taxed differently on capital investments.  Operator would pay income tax and Moneybags would pay a capital gains tax. There is no theory to support this: Operator is investing foregone salary but the returns are not in any sense salary, they are speculative returns based on an investment of the foregone salary. The best one could do is tax the estimated foregone salary at ordinary income rates perhaps, and deduct it as return of capital before the capital gains rate is applied to the rest of the profits, but this is administratively difficult for little gain.  The investment return of the Operator is not salary in any traditional sense. 

The Blackstone IPO

The Blackstone IPO is way oversubscribed.  The underpricing tomorrow will be horrific.  Priced at 29 to 31, watch the run by the end of the day to double that.  Others have noted the ironies in this IPO:  1) a company that takes others private is going public, 2) small investors can buy stock in a firm that puts investments together for only the sophisticated and wealthy, 3) knowledgeable insiders are exiting, in part, a mature market in buyouts and inviting the noise traders, who know nothing of the state of the buyout market, to get in.  I focus on the nature of the offering itself.  It reminds me of Google.  A company worth $32 billion is selling a small fraction of itself, $4.8 billion, and over half, $2.6,  is going directly into the pockets of the founders not into the company.  Moreover, the new shareholders will have no management power at all.  In other words the company does not need the money and is not conceding any manager rights to the new shareholders (other than the right to sue for breach of fiduciary duties perhaps).  This is a pure liquidity play for the exclusive benefit of existing insiders; the insiders want to be able to sell shares in a public market and the markets are content to play along, assuming a speculative gain in a roller coaster stock.