June 23, 2007
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.
June 22, 2007
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.
[New post] In response to Judge Chidester's comment, I should note I agree with the potential unfairness of press accounts of judge's actions but occasionally judges do deserve a barb or two, especially when based on the judge's own language in an opinion or in open court that smacks of a loss of judicial temperament. Here Judge Walton was very, very preachy in open court, suggesting he was riding his own horse in this notable case. You have to be a judge to judge a judge?? Hardly.
June 21, 2007
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.
The SEC and Global Uniformity
I am consistently buffaloed by the SEC's strategy on global integration of our legal standards. We are told by the SEC that the Sarbanes Oxley Act of 2002 will put American markets ahead of other markets, give us a competitive advantage, because our markets will have more integrity due to stronger rules against fraud. Then, in the next breath, we are told that we will accept international accounting rules rather than use our own so we can integrate with the global disclosure standards. Should not, using the SEC's logic on SOX, our rules be better or stronger?? Accounting rules are at the core of the disclosure system; if we brag about having the best regulatory system to differential ourselves from other world markets should not our accounting rules be unique and better. Pick a strategy or explain why SOX (on accounting rules, by the way) is different than FASBs (v IFRA).
Tellabs: Not a Victory for Defendants
The Tellabs opinion is out and the court reversed the Seventh Circuit in a 8-1 decision. The majority opinion held that the Seventh Circuit had used the wrong standard to assess the pleadings under a motion to dismiss stage. The majority opted for a "at least as likely" standard for assessing pleadings of scienter (an inference of scienter must be at least as likely as competing plausible inferences); the plaintiffs get the benefit of all reasonable factual inferences and the standard applies to the complaint as a whole, not each factual pleading or each fact pled with "particularity." Two concurring judges favored a "more likely than not" standard (an inference of scienter must be more likely than any competing plausible inference of no scienter) and a dissenting judge favored a "probable cause" standard (competing inferences could b, but do not necessarily have to be considered). The majority standard is not what the defense bar wanted; they wanted the standard of the concurring judges, which the court rejected. This is not a defense bar victory; it is a draw at best. Reporters will fail to get this correct and rack with up as another victory for corporate American; it is not. The majority held, importantly, that the pleading standard was not higher that the standard of proof required at trial; the defense bar argued that Congress so intended it to be higher. This is a big difference. Reporters, do not overstate the true meaning of this case.