Business Law Prof Blog

Rise of Unincorporated Business Entities Linked to Regulation and Ethical Issues

According to the latest issue of the University of Illinois Law Review, the rapid expansion of non-incorporated businesses entities, such as limited liability companies (LLCs) and limited liability partnerships (LLPs), raises questions ranging from government regulation to professional ethics.

The use of unincorporated business entities has allowed people to create entities that are more loosely structured than your typical shareholder "C-corp" corporation. 

Some of the advantages of these unincorporated business entities include: flexibility to contract directly with clients than through the corporation, limited liability in both tort actions and contract actions, and the elimination of "so-called" double taxation.  This double taxation occurs because a standard corporation is taxed on its income again when profits are distributed to the stockholders.  Unincorporated business entities, such as the LLC or LLP, are not taxed at the corporate level, but instead the owners pay personal taxes based on their share of the enterprise (unless the owners agree otherwise).

These unincorporated business have also begun to replace the traditional partnership, limited partnership, and close corporation (S-corp).  And with current regulatory schemes, such as Sarbanes-Oxley and SEC reporting and filing requirements, there is a good chance that some public companies will de-list and change their structure from a traditional C-corps to unincorporated entities.  The change will likely occur because LLCs and LLPs are currently only bound under the SEC fraud provisions.  However, Saul Levmore, a law professor at the University of Chicago, predicts that these unincorporated entities will come under federal regulation "following a shocking scandal" and as a result "the distance between corporate and uncorporate law (will) narrow."

Finally, it is worth noting that these unincorporated entities pose ethical issues to lawyers who represent them.  The case law on whether the lawyer is retained by the LLP is representing the individual partners or the LLP itself is very confusing.  As a result, many LLPs and other unincorporated entities are advised to create explicit written agreements at the outset of representation which sets forth the relationship between the parties and the lawyer.

For more, check out the Illinois College of Law symposium issue called "Uncorporation: A New Age?"

Back Door Erosion of Double Tax at State Level?

  The news that Goldman Sachs will recieve close to $150 million in New York tax subsidies to build its new headquarters in Lower Manhattan has raised some eyebrows.  In addition the state has promised Goldman the use of low interest money through the sale of Liberty Bonds.  Goldman, one the country's most successful investment banks, does not need the money.   The now ubiquitious practice of local governments bidding for firms with tax breaks is an erosion of the double tax for corporations at the state level.  [The double tax is a tax on earnings at the firm level followed by a tax on distributions to owners at the shareholder level.]  Competition among states has, in essence led to a significant reduction of the double tax burden for relocating companies.  It is an odd and random method of eliminating what should be eliminated directly.

Six Flags Response: We're For Sale

Today, Six Flags, Inc. (NYSE: PKS) announced that its Board of Directors has unanimously determined to seek proposals from third parties regarding a possible sale of the company, and will invite Red Zone LLC to participate in the purchase of the company.  (A copy of the Press Release can be found here.)

This move by the Board of Directors is in response to Dan Snyder's Red Zone LLC and its solicitation for a partial tender offer of Six Flags shares.  (Previous post regarding the tender offer can be found here).

The Board also unanimously determined to oppose Red Zone's attempt to gain effective control of Six Flags through its tender offer.

Michael Gellert, the presiding independent director of Six Flags' Board, stated that pursuing a sale is "the best way to deliver full and fair value to all Six Flags stockholders. . . ."  Gellert also stated that he hopes that Red Zone does not "take any action which would impede our ability to maximize value for all stockholders."

The company noted, and some analysts agree (Reuters report here), that there can be no assurance that any sale or other transaction will result from the sale effort.  Reuters is reports that Matthew Harrigan, an analyst with Janco Partners Inc, said that "potential buyers would be few and far between" and he ruled out Walt Disney Co. (NYSE: DIS).

Lehman Brothers and Allen & Company LLC are serving as finanical advisors and Weil, Gotshal & Manges LLP is serving as legal advisor to Six Flags.  Skadden, Arps, Slate, Meagher & Flom LLP is serving as legal advisor to Six Flags' independent board.

As a result of the report, Six Flags shares are up 66 cents a share or nearly 10% to 7.20, which is 70 cents higher than the tender offer from Snyder's Red Zone LLC.  The response of Six Flags to an unwanted offer from Red Zone -- to put the company up for auction -- is responsible and reflects a new approach from the 80s and 90s when an all-out defense would have been the likely approach.

Hedge Funds

    Hedge funds take advantage of markets that have not cleared to a market price equilibrium. They took advantage of the market readjustment period after the collapse of the stock market bubble of 2000.  They made money on the short side as many in the market resisted the correction.  They also made money on the artificially low short term interest rates set by the federal reserve.  For a while it was an easy game. The low hanging fruit has been picked.  As the market gets more stable, the hedge funds loose their opportunity to make the profits that justify their huge cut and fees.  The marginal funds will lose investors and some will venture into more extreme trading strategies (credito derivatives??).  The best funds will survive.  With a new market shock, marginal funds will reappear and again take advantage of the market adjustment. 

SEC Charges Former KMart CEO and CFO For Failure to Disclose Liquidity Problems

In a 37 page complaint filed in the United States District Court For The Eastern District of Michigan, the SEC charges former Kmart CEO Charles Conaway and ex-CFO John McDonald for allegedly misleading investorys about the retailer's financial strength before it declared bankruptcy in 2002. (SEC complaint can be found here.)

The Complaint alleges that former officers withheld from investors and analysts covering the company that the buildup of inventory towards the end of 2001 was actually from unnecessary purchases of nearly $850M in excess inventory.  Conaway and McDonald reported to investors and analysts that the excess inventory was from seasonal inventory fluctuations.

After Conaway noticed that the company overbought more inventory that he originally thought, KMart began a project, approved and authorized by Conaway and McDonald, to withhold payments from vendors in order to hide its cash flow problems.  The SEC claims that this project and problem was noticed by then-CFO Jeffrey Boyer, who recommended discussing the problems at an upcoming board meeting.  The Complaint states that Boyer was terminated the next day and McDonald took over his position.

The SEC seeks civil penalties from both McDonald and Conaway and other penalties.  The SEC is specifically going to go after a $2.5M retention loan plus interest, that KMart gave to McDonald.  KMart emerged from bankruptcy in 2003 and later acquired Sears, Roebuck and Co.  The combined company is currently called Sears Holding Corp and is traded on the NASDAQ (SHLD).

The claims remind us that trouble is most frequent in our publicly traded companies when profits sour.  Executives lie, hoping to hold things together,  and just get in deeper and deeper.  For lawyers and their clients, when things go south, tell the truth, save your reputation, and try again somewhere else.

Rachesky Buys 7.3% of Lions Gate Entertainment Corp

According to SEC Filings, Dr. Mark Rachesky has purchased a 7.3% stake in Lion's Gate Entertainment Corp (NYSE: LGF).  Dr. Rachesky, who beneficially owns 7,425,000 shares, made no comment in the SEC filing with regards to taking over the company or a change in control.

Dr. Rachesky is the founder and President of MHR Fund Management LLC and affiliates, and from 1990 through June 1996, Dr. Rachesky was employed by Carl Icahn.  Dr. Rachesky stated as a senior investment officer and for the last three years as sole Managing Director of Icahn Holding Corp and acting chief investment officer.

Comparing what Rachesky is doing with Lion's Gate to what his mentor Carl Icahn is doing with Time Warner (NYSE: TWX), Rachesky may be playing the old takeover game rather than the new demand the incumbant board do a restructuring game. Lion's Gate is a smaller company (about $1B vs. TWX's S83.6B).  Are Rachesky and Icahn are looking to broker a corporate marriage between Time Warner and independently owned movie producer Lion's Gate?

Is OSI Pharmaceuticals Paying Too Much for Eyetech Pharma?

Today, OSI Pharmaceuticals (NASDAQ: OSIP) announced that it would be purchasing Eyetech Pharmaceuticals (NASDAQ: EYET) for $935M in cash and stock. (AP report can be found here, Reuters commentary here.).

The deal has sent the stocks in opposite directions which can be expected in such deals.  Eyetech, which is being valued at $20 a share, was up 4 points to 18 and change, or nearly 30%.  OSI was down nearly 9 points to 32 and change, or about 21%.

Eyetech, who develops drugs and treatments for diseases affecting the back of the eye, agreed to be purchased at a 43% premium to Friday's close.  Analysts believe that OSI is paying too high of a premium for Eyetech and is expanding into an area where it has no expertise.  Eyetech's main drug, Macugen, is expected to lose market share when rival Genentech Inc. (NYSE: DNA) is expected to release Lucentis.  Lucentis is a competing eye-disease drug, which has had better results than Macugen.

OSI backed the move in order to broaden the scope of the company beyond its main stay cancer and diabetes market.  OSI's CEO stated that OSI will benefit through accelerated profitablity, cost savings and improved research and development efforts.

As a result of the Eyetech deal, Morgan Stanley cut its price target on OSI from $74 to $60, stating that the deal was a surprise and did not see any benefits from the deal. 

Also, analysts questioned Eyetech accepting an offer which was $1 lower than its IPO price in January 2004.

Another item worth interest is Jim Cramer was bearish on Eyetech last month.  Thestreet.com's article on Mad Money Recap can be found here (the bearish call is on page 3).  Cramer also continues to toot his own horn about Genetech and their prospects compared to OSI Pharma and it will be interesting to see what his comments are tonight on this deal.

The OSI announcement and the stock market reaction leads to several thoughts:  First, this is an usually harsh reaction to a cash deal (it is more characteristic of a stock deal).  Second, the markets have really wised up to acquisitions and are much more skeptical of the CEO spin on these deals.  Third, the hedge funds may get in -- buy OSI stock (and short Eyetech??), block the deal, and sell the stock (cover the short on Eyetech??).

Ernst v Merck

   Reports from interviews with the jurors in the Ernst trial reveal that the vote was 10 to 2 against Merck.  Several of the jurors believed that Merck was "covering up" bad news and were willing to use the case to express their displeasure.  They ran through the causation problems in the case (Did Ernst die from a blood clot caused by Vioxx??) so as to discipline Merck.