Our friend and former colleague, Jennifer Walker Elrod, has been nominated to the Fifth Circuit Court of Appeals.  Jennifer is a 1988 graduate of Baylor University (Economics) and a 1992 graduate of Harvard Law School.  After her two-year clerkship with U.S. District Judge Sim Lake (of Enron fame), she was an associate at Baker Botts LLP in Houston.  She was appointed to the 190th District Court in Houston, Texas in March 2002 and was elected to a four-year term in November 2002.  Beyond that, Jennifer has been extremely active in the Houston community; according to a press release from Baylor when she was selected as a Distinguished Alumna, "Elrod served pro bono as the first General Counsel to Communities in School-Houston, and she was chair of the board of the Gulf Coast Legal Foundation. In 2004, The Houston Young Lawyers Association named Judge Elrod the Woodrow Seals Outstanding Young Lawyer of Houston, and [in 2006] she was honored as an Extraordinary Mother by the Cystic Fibrosis Foundation of Houston."

And even beyond that, Jennifer was a great role model to me when I became a working mother, having preceded me in that noble profession by a year or so.  To celebrate the other half of her life, I am posting two photos of her: her professional photo and a photo of her holding my son at 8 months.  (Wasn't he a bruiser?)

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I guess I'm a little slow this morning because Larry Ribstein and the Law Blog are all over this story about the SEC filing civil charges against two former in-house attorneys at Enron, Rex Rogers and Jordan Mintz for activities in 2000 and 2001.  Sigh.  The SEC is woefully underfunded an in a hiring freeze, but I'm glad the agency has its priorities straight here.

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Can corporate law save the world? Kent Greenfield says yes. I say no. We decided to write up our views, and you can find my side of the debate in a paper called "The Dystopian Potential of Corporate Law," which is now available for download from SSRN.

I have a strong preference for simple titles, and I normally don't use ten-dollar words like "Dystopia." In this instance, however, I invoked Edward Bellamy's famous utopian novel, Looking Backward, which was written in 1887. (If you teach corporate law and you haven't read Looking Backward, you should put it on your summer reading list. You can find it online here or here.) Looking Backward presents a horrifying vision:

Early in the last century the evolution was completed by the final consolidation of the entire capital of the nation. The industry and commerce of the country, ceasing to be conducted by a set of irresponsible corporations and syndicates of private persons at their caprice and for their profit, were entrusted to a single syndicate representing the people, to be conducted for the common interest for the common profit. The nation, that is to say, organized as the one great business corporation in which all other corporations were absorbed; it became the one capitalist in the place of all other capitalists, the sole employer, the final monopoly in which all previous and lesser monopolies were swallowed up, a monopoly in the profits and economies of which all citizens shared.

My argument is that Kent's proposals for reforms are motivated by the same impulses that motivated Bellamy, and the results of implementing those proposals ... well, I think you can see why I used the word "dystopian."

Kent and I had live debates on this subject at the University of Chicago and Boston College. You can see a write-up from the latter event here.

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CLEA has circulated its call for papers for the fall annual meeting.  The deadline for abstracts or papers is May 15th.  Details below the fold.

Here's the full text of the announcement.

You are invited to submit a paper for presentation at the next Annual Meeting of the Canadian Law and Economics Association on Friday and Saturday, September 28 and 29, 2007, at the Faculty of Law, University of Toronto. This call is being sent out by e-mail and will go out by post shortly. If your e-mail address has changed in the past year, please send your updated coordinates to Nadia Gulezko at:   n.gulezko@utoronto.ca.

Professor Michael Trebilcock, Chair in Law and Economics at the University of Toronto, Faculty of Law, will be the keynote speaker at this year’s conference.

As in past years, we are soliciting papers in all areas of Law and Economics. In addition, there will be a number of sessions focusing on specific themes.  The provisional list of these sessions follows:

1. Corporate Governance (Poonam Puri - ppuri@osgoode.yorku.ca)
2. Corporate Law (Poonam Puri  - ppuri@osgoode.yorku.ca)
3. Bankruptcy (Stephanie Ben-Ishai - SBenIshai@osgoode.yorku.ca)
4. Teaching Law and Economics (Stephanie Ben-Ishai - SBenIshai@osgoode.yorku.ca)
5. Securities Law (Anita Anand anita.anand@utoronto.ca )
6. Family Law and Economics  (Margaret Brinig - margaret-brinig@uiowa.edu)
7. Normative Law and Economics (Shuba Ghosh sghosh@mail.smu.edu)
8. Behavioural Law and Economics  (Claire Hill - hillx445@umn.edu)
9. Norms  (Claire Hill -hillx445@umn.edu)
10. Bioeconomics and Neuroeconomics (Janet Landa jlanda@yorku.ca)
11. Competition Policy (Edward Iacobucci Edward.iacobucci@utoronto.ca)
12. Regulation of the Legal Profession  (Norman Siebrasse  - siebrass@unb.ca)
13. Taxation (Ben Alarie - ben.alarie@utoronto.ca)
14. Environmental Law and Economics (Andrew Green  - a.green@utoronto.ca)
15. Intellectual Property (Ariel Katz  ariel.katz@utoronto.ca)
16. Crime (Phil Curry pcurry@sfu.ca)

**Anyone wishing to present at the conference should send an abstract, paper or Internet link to submissions@canlecon.org by May 15, 2007.   Please indicate whether your submission fits into a particular theme.

You may wish to communicate directly with the coordinators listed above if you have questions or suggestions regarding the themes, but please submit to submissions@canlecon.org .  The draft programme will be decided upon by July 1, 2007. Completed papers (or, preferably, Internet links to the papers) will be due by August 15, 2007. Panel moderators will be indicated on the programme. Accepted papers will be posted on SSRN with the authors’ approval.

Registration information will be sent to all participants in due course. Please note that the registration fee for the 2007 CLEA Annual Conference is $200.00 CDN/$160.00 US.  For students this fee is 30.00 CDN / 25.00 U.S.  This covers all conference materials and meals, including the dinner on Friday evening. Spouses or partners are welcome to attend the Friday evening dinner, for a fee of $20.00.   Please send your cheque, made out to the University of Toronto to Nadia Gulezko, Faculty of Law, University of Toronto, 84 Queen’s Park, Toronto, ON M5S 2C5.  Please note that members will not be permitted to present if their registration fee is not paid.   Please visit the CLEA web site for inforrmation on accommodations.

Poonam Puri (ppuri@osgoode.yorku.ca)
President

The Association web site can be found at: www.canlecon.org

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Yesterday, the Supreme Grant decided to consider a case posing questions about aider and abettor liability under Section 10(b) during OT 2007.  The case, Stoneridge Investment Partners LLC v. Scientific-Atlanta, Inc., presents the following question presented:

Whether the Court's decision in Central Bank, N.A. v. First Interstate Bank, N.A., 511 U.S. 164 (1994), forecloses claims for deceptive conduct under 10(b) of the Securities Exchange Act of 1934. . . ., where Respondents engaged in transactions with a public corporation with no legitimiate business or economic purpose except to inflate artifically the public corporation's financial statements, but where Respondents themsleves made no public statements concerning these transactions.

In the case below, In re Charter Communications, Inc. Securities Litigation, 443 F.3d 987 (8th Cir. 2006)shareholders of Charter, a cable television provider that sold cable service through TV-top boxes provided by vendors Scientific-Atlanta and Motorola, alleged securities fraud by the two vendors for entering into sham transactions with Charter amounting to $17 million to inflate the stock price. Obviously, neither Motorola or Scientific-Atlanta prepared disclosure documents for Charter shareholders with false statements or were under a duty to speak to them but kept silent. However, shareholders alleged that the defendants were otherwise primary violators because they were necessary to the sham under 10b-5(a) and (c). Neither the district court nor the Eighth Circuit agreed with them (the appellate opinion is a brisk 7 pages, with headnotes.)

So, the Supreme Court will hear this case next term.  Law.com mentions that the Ninth Circuit has held that an "aider and abettor" can be liable under some circumstances, such as "creating a false appearance of fact."  The district court in the Southern District of Texas in the Enron litigation had also held that many stereotypical "aiders and abettors" such as outside banks, a law firm and an accounting firm, could be held liable under Section 10(b), although that ruling was muddied by the Fifth Circuit's refusal of class certification last week due to the fact that the defendants were mere aiders and abettors.  So, lots of people will be watching this case, including law firms, accounting firms, and commercial and investment banks.  Of course, the case could do several things:  (1) keep the status quo; (2) broaden the definition of primary violator to include a broader range of persons; or (3) reverse Central Bank (the least likely scenario, I would think).

Interestingly, Chief Justice Roberts and Justice Breyer took no part in the review or granting of cert, almost certainly due to their personal stock holdings.  However, Roberts divested himself of certain stock holdings to be able to participate in the Credit Suisse case today, and those in the know (not me) predict that he will do the same in order to ensure that this case, with its potential for wide-ranging consequences for several industries, will not be heard by only seven justices.

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The antitrust IPO case, Credit Suisse First Boston Ltd. v. Billing, was argued in front of the Supreme Court this morning.  The transcript is here.  According to the Houston Chronicle, the justices seemed skeptical that securities laws should not preempt antitrust laws in this arena.  (The district court had held that the securities laws did preempt antitrust laws, but the Second Circuit had reversed.)  I guess we'll have to read and decide for ourselves.

C

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Twitter. Twitter Blog.

Kottke on Twitter.

Kedrosky on Twitter.

Twittermap. Twittervision. (Wow!)

Twitter explained. (Maybe you should start here.)

Twitter's on the front page of Financial Times?

What am I doing? Registering with Twitter.

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Related Posts: Blackstone IPO: The Tax Analysis, Blackstone IPO: Regulatory Arbitrage

Blackstone's IPO structure is a nifty piece of tax engineering.  Under current law, it will probably qualify as a publicly-traded partnership, which will allow it to maintain two key tax advantages:  (1) the capital gains preference on carried interest distributions, which I address in Two and Twenty, and (2) the ability to pass income through to investors without incurring an entity-level tax.  Blackstone's impressive IRRs depend, in part, on the availability of these tax preferences.

Although I think Blackstone's structure probably works under current law, there's a significant political tax risk.  These rules aren't set in stone, and the Blackstone deal is the kind of deal that could stir Congress to act. 

Taxing Carry as Ordinary Income?  One possibility is that Congress could change the partnership tax rules.  A couple of weeks ago, before Blackstone filed, the news from Capitol Hill was that the Senate Finance Committee was interested in revisiting the tax treatment of carried interest distributions.   The Private Equity Council, a newly-formed private equity lobbying group, has taken up this issue.

The revenue implications are significant.  The tax writing committees are looking for revenue offsets to free up space for other tax policy reforms, like easing the burden of the AMT on the middle class.  It could find a large revenue bump from treating carry as ordinary income, taxing it at 35% rates instead of 15% long-term capital gains rates.  Congress could also raise revenue by treating all income to fund managers, including carry, as employment income.  Treating carry as employment income would subject that income to another 3% or so in state and federal payroll taxes.  (Social security payroll taxes are capped at $90,000 of income, but Medicare taxes aren't capped.)  If there's, say, a trillion dollars of capital in private equity, generating a 15% annual return ($150 billion), and fund managers get 20% of that return ($30 billion), raising the rates by 20% would produce $6 Billion in additional tax revenue.  Over ten years, and discounting to present value, that could generate about $42 billion.  Not trivial.  I also think I'm underestimating the carry; Blackstone alone earned $2 billion last year, much of that in the form of carried interest distributions.

(This estimate also doesn't count hedge funds.  Because many hedge funds generate ordinary income and short term capital gains, the revenue implications are much smaller.  To the extent that hedge funds are acting more like private equity funds and taking strategic positions in companies which they hold for more than a year, however, there is certainly some revenue potential.)

Cost of Capital Method.  In Two and Twenty, I introduce a "cost-of-capital" method of taxing carry that would represent a compromise between treating carry as a return on human capital (labor income) and a return on investment capital (reflecting the sweat equity investment of fund managers).  Under that approach, the basic 20% carry structure would be treated as a non-recourse, zero interest rate loan of 20% of the capital of the fund, which fund managers then invest in the fund.  The fund managers would then recognize, as ordinary income, an annual charge on the forgiveness of the imputed interest on the imputed loan; further appreciation of the fund investment would retain its character as capital gain.  If there's a trillion dollars of capital in private equity, you'd have $200 billion of imputed loans to fund managers, times a 6% interest rate, times 35%, or $4 Billion a year in additional tax revenue.  Over ten years, would mean about $28 billion present value in revenue. 

Changing the publicly-traded partnership rules?  The Blackstone IPO raises the stakes by threatening the integrity of the corporate tax base.  If Blackstone's structure works, then other financial intermediaries may be tempted to adopt the structure as well as an alternative to going public as a corporations.  And firms like Goldman Sachs, which went public as a corporation, may be tempted to split-off portions of their business as publicly-traded partnerships.   Congress has been willing, to some extent, to extend pass-through treatment to the real estate, mutual fund, and oil and gas industries, but extending this treatment to active, strategic investors is new territory.  Changing the rules (both with respect to carry and PTPs) may be necessary not just to raise revenue, but just to preserve the current tax base.

The Wall Street Rule.  Ironically, if the private equity industry moves aggressively enough in adopting the publicly-traded partnership structure, tax reform becomes more difficult.  The Wall Street Rule, a rule of thumb used in the taxation of securities context, holds that after enough investors have developed expectations of a given tax treatment (say, that a given security will be treated as debt and not equity), the IRS will not upset those expectations, even in the absence of published guidance.  The IRS, of course, disclaims the legitimacy of the Wall Street Rule, as it must.  Given its institutional constraints, the IRS can't be expected to act quickly on every new deal structure that comes along.  But there is also little doubt that it becomes politcally more difficult to act as more and more investors act in reliance on the tax treatment promised in the prospectus.  This shouldn't come as a surprise; at the moment, there are only a few thousand professionals with a direct financial interest in maintaining the status quo method of treating carry as capital gain.  As more companies go public, all of their investors attain a financial interest in the status quo.   It's much easier to raise taxes on a few thousand super-rich investment professionals than hundreds of thousands of investors.

Related Post: Blackstone IPO: The Tax Analysis

Related Post: Blackstone IPO: Regulatory Arbitrage

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Today's New York Times had an interesting article discussing extremely nasty claims settlement practices by long term care insurers. The article discusses, for example, the curious variation in consumer complaint ratios, against the major players in this field. Conseco got one complaint per 383 policy holders. Genworth Financial received 1 complaint per 12,434 policy holders. Some of the allegations are pretty darned scary, the sort of misconduct I thought John Grisham had only fantasized about in his book The Rainmaker. It's hard to know how to assess the allegations, however, since the Times report finds few instances in which judges or jurors passed on the entire case. Instead, it appears that most of these matters, like an awful lot of civil litigation today, were resolved by confidential settlements in which records of the proceedings were sealed.

I think it's time we think longer and harder about the propriety of using public resources to fund litigation and then denying the public the results of that subsidized dispute resolution mechanism. There's an excellent and sophisticated article up on on SSRN about this subject by Professor Scott Moss from Marquette. If I might be permitted some speculation, it seems that basically what we've done is to create the equivalent of intellectual property rights in information about alleged wrongdoing. The parties generate information from use of the discovery process and generate further information by arriving on a settlement amount. While the parties pay much of the cost of this endeavor, taxpayers rather than litigants are amortizing the fixed costs of the civil justice apparatus or some of the marginal costs of dedicating the court system to their particular dispute. If the parties are able to bargain over the privacy of this information, they can extract from each other -- usually the plaintiff extracting from the defendant -- some portion of any expected increase in liability in other lawsuits that would result from publication of the information. Although perhaps this ability to bargain doesn't greatly alter the total amount paid by the defendant for the wrongdoing, at a minimum it would seem to reallocate compensation among plaintiffs in a way that may have little to do with the merits of the claims.

Anyway, I'd hate for this structural issue about modern litigation or my back-of-the-envelope musings on the subject to drown out what appears to be a compelling argument for nourishing that duty of good faith and fair dealing. But there that structural issue was, lurking not too far in the background in this and much other litigation about alleged corporate wrongdoing. So, I brought it up.

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Omar explains.

Kieran Healy checks in with a link to this interesting working paper.

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Related post:  The Blackstone IPO: Regulatory Arbitrage

Blackstone's S-1 describes an intriguing tax structure, and it promises a tax opinion from Simpson Thacher.  It looks like it probably "works."  Given the current DC political climate and hunger for revenue offsets, however, and the likelihood that Congress will take a hard look at the taxation of private equity funds, the tax risk is significant.  Analysis follows after the jump.

As I discussed last week, Blackstone's IPO structure takes an aggressive tax stance. 

Background.  By operating in partnership form, private equity funds take advantage of a quirk in the tax law that allows fund managers to receive compensation in the form of equity taxed at long term capital gains rates (15%) instead of ordinary income rates (35%).   The partnership form also allows the asset management aspect of the operation to take place without incurring an entity-level corporate tax.  Private equity funds also want to avoid operating as RICs (regulated investment companies), which get pass-through taxation but subject the firm to the restrictive regulation of the Investment Company Act of 1940.  Publicly-traded entities are normally taxed as corporations; accessing the liquidity of the public equity markets usually requires paying a steep toll charge in the form of an entity-level tax.

The tax issue.  Blackstone elegantly finesses this tax problem by trying to qualify to an exception to the publicly-traded partnership rules (section 7704) for entities that earn "passive-type income."  Normally, publicly-traded partnerships are taxed as corporations, regardless of how they are organized under state law.  Section 7704 carves out exceptions for partnerships with "passive-type income," which include interest, dividends, real property rents, certain oil and gas activities, and gain from the sale or disposition of most capital assets.  The exception thus distinguishes passive investment activities, for which pass-through treatment is appropriate, from the operation of an active trade or business, for which it's not appropriate.

What's at stake.  Failing to qualify for pass-through treatment wouldn't be fatal to Blackstone's future.  But it would hurt.  A lot.  It would lose two key tax advantages:  (1) the capital gains preference on carried interest distributions, which I address in Two and Twenty, and (2) the ability to pass income through to investors without incurring an entity-level tax.  Blackstone's impressive IRRs depend, in part, on the availability of these tax preferences. 

Suppose a Blackstone fund buys a portfolio company for $100 million and sells it five years later for $200 million.  It's 20% carry is worth $20 million.  If it's a partnership, then investors pay tax on a pro rata share on that $20 million at 15% capital gain rate, and collectively take home $17 million.  If it's a corporation, the corporation first pays tax on that $20 million at 35%, leaving $13 million; shareholders then pay another 15% tax on the dividend distribution, leaving about $11 million.  $6 million goes to the government instead of investors ... that's a huge difference.

Does it look like a duck?  Drawing the line between corporations and partnerships has always been a challenge.  In the old days, entity classification depended on a four-factor test of limited liability, continuity of life, centralized management, and free transferability.  (Under the old test, then, it's obvious that a publicly-traded Blackstone would be treated as a corporation.)  Under the check-the-box regs, however, unincorporated entities may elect whether to be taxed as a corporation or a partnership.   Section 7704, however, serves as a backstop to the check-the-box regs, ensuring that  publicly-traded active businesses can't elect out of corporate taxation.  The normative justification for taxing some entities like corporations but not others is pretty fuzzy.  All we have as a guiding principle is the "corporate resemblance" test derived from an old 1935 Supreme Court case, Morrissey vs. Commissioner.  In colloquial terms, if it walks like a duck and quacks like a duck, it should be taxed like a duck.  (Although Minnesota tax prof Gregg Polsky has raised concerns about the validity of the check-the-box regs for failing to faithfully apply the resemblance test, my own view is that the regs are valid as a matter of institutional deference to a reasonable agency interpretation of the Code.)  In any event, a publicly traded Blackstone sure quacks like a duck, so a careful reading of 7704 is in order.

Passive-type income.  To retain its partnership tax status, Blackstone will have to avoid classification as a publicly-traded partnership under section 7704.  Section 7704(c) makes an exception for publicly-traded partnerships with at least 90% passive-type income, which includes interest, dividends, and gain from the sale or disposition of a capital asset.  Most of Blackstone's income comes from carried interest distributions.  These distributions, in turn, are generated by the sale of portfolio companies held by the underlying Blackstone funds.  Do these distributions qualify as passive income?  It appears so.  Section 7704(d)(1) lists the different types of qualifying income, including 7704(d)(1)(B), dividends.  Portfolio companies generate dividends.  Under the plain language of 7704(d)(1)(F), then, carried interest distributions would appear to be "gain from the sale or disposition of a capital asset ... held for the production of income described in any of the foregoing subparagraphs or this paragraph ...."

Still, Blackstone may not be home free.  First of all, the tax status depends on not being treated as a regulated investment company, which in turn relies on a delicate 40 Act interpretation.  Second, there's a pretty strong argument that it's violating the spirit of the rules, and non-textual arguments have special force in the tax context. 

Legislative History.  The House explanation in the legislative history explains that the purpose is to distinguish "those partnerships that are engaged in activities commonly considered as essentially no more than investments" and "those activities more typically conducted in corporate form that are in the nature of active business activities."  Passthrough treatment is appropriate if the partners could "independently acquire such investments."  Public investors, of course, can't normally independently acquire an investment in Blackstone. 

The House report goes on to explain, in the context of interest and rents, that amounts contingent on profits are not intended to be included as passive income.  Interest that's contingent on profits "involves a greater degree of risk, and also a greater potential for economic gain," than fixed or market-indexed interest rates, "and thus is properly regarded as from an underlying business activity."  Carried interest distributions are obviously contingent on profits -- the profits of the underlying fund.  But they are a step removed from the underlying business activity of the portfolio companies, so it's not clear that this is improper. 

More to the point, perhaps, the House report then explains that interest isn't passive if it's derived in the conduct of a financial or insurance business, such as an active banking business.  The key question, then, is whether the management of the underlying funds is an active business. 

What about those management fees?  Fund managers derive income not just from carry, but also from management fees, advisory fees, break-up fees, and other streams of income that would be difficult to characterize as passive.  Regulation 1.7704-3(a)(2) explains that qualifying income does not include income derived in the ordinary course of a trade or business.  "For purposes of the preceding sentence, income derived from an asset with respect to which the partnership is a broker, market maker, or dealer is income derived in the ordinary course of a trade or business; income derived from an asset with respect to which the taxpayer is a trader or investor is not income derived in the ordinary course of a trade or business."

A private equity fund manager isn't a broker or a dealer ... but neither is it a trader or investor, at least in the usual sense.  What is it?  It's an active financial intermediary, for which we have no established tax classification.  The receipt of management fees and other fees that don't depend on the profitability of the underlying portfolio companies is pretty clearly active income.  The receipt of carry is something closer to investment income.

To solve this problem and slip into the 90% qualifying income exception, Blackstone will siphon off its "bad" income (management fees, etc.) into a separate entity that elects to be taxed as a corporation.  The blocker entity pays tax on the ordinary income.  That entity will then pay dividends to the master partnership.  The master partnership then has two primary sources of income:  (1) dividends from the blocker entities, and (2) capital gains from carried interest distributions from the underlying funds.  Since dividends are qualifying income, and since carry is income derived from the sale of a capital asset, all is well. 

Or is it?  Blackstone, like many businesses, derives income from a mix of ordinary income and capital gains.  In the aggregate, it's difficult to characterize what Blackstone does as pure passive investing.  Blackstone finesses the tax treatment by paying corporate tax only on the ordinary income, and passing through the rest of the income without paying an entity-level tax.  This creates a significant competitive advantage compared to investment banks like Goldman Sachs and Morgan Stanley, which are structured as corporations and pay an entity-level tax on all of their income.

I'm not sure, as a matter of tax policy, that we should allow complex tax structuring to provide this sort of competitive advantage.  As I explain in Two and Twenty, most funds are pretty aggressive about converting management fees into special allocations of carry.  Moreover, even if some "bad" income is siphoned off, that doesn't change the essential character of what fund managers do.  And that's pretty difficult to characterize as passive investing. 

Think about it this way.  Pass-through treatment is appropriate for passive investment vehicles where fund managers are just sourcing and screening investments.  Most mutual fund managers don't try to take an active role in the governance of the underlying company that their investors put money in.  At most, they apply indirect pressure on management.  But private equity fund managers do much more than that - they create alpha.  They sit on boards, restructure portfolio companies, fire managers, spin-off divisions, streamline operations, create new jobs --- this is not passive investing.  Investors would be crazy to pay the kind of fees that fund managers earn if all they were doing was picking stocks.

And Blackstone doesn't help its case by arguing, in the context of the 40 Act, that it is indeed an active business.  As I noted in my last post,  Blackstone argues in the context of the 40 Act that the "primary source of income from each of our businesses is properly characterized as income earned in exchange for the performance of services."  Service income, not investment income.  Active income, not passive income.  Now, it's certainly plausible that Congress intended active financial intermediaries to be treated as active for purposes of the 40 Act and passive for purposes of the tax code.  The tax code tolerates a fairly high degree of planning, such as when REITs siphon off "bad" income into a blocker entity.  But when this sort of regulatory arbitrage promises to significantly diminish corporate tax revenues, Congress is likely to revisit how the rules are written. 

At the end of the day, I think Blackstone is violating the spirit of the rules.  I'd be surprised if Congress didn't agree.  Still, since carried interest distributions are income derived from the gain derived from the sale of a capital asset, the language of the existing statute may be enough to carry the day, for now.   It's certainly appears to be enough to justify the S-1 filing and the tax opinion from Simpson that will accompany it. 

In sum, under current law there's some tax risk that the IRS will challenge Blackstone's claim to the "passive-type income" exception to the publicly-traded partnership rules.  The greater risk, I think, is that Congress may change the rules.  Tomorrow:  The politics of taxing Blackstone. 

Previous post:  The Blackstone IPO: Regulatory Arbitrage

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It's somewhat risky to blog in an area in which one does not specialize and that has been written about imensely by very smart people. But, on the assumptions that no one will bring all of this up at my confirmation hearings and that risk is what blogs are for, could I venture some grave doubts this weekend about the weak form of the Efficient Capital Market hypothesis. That's the still-prominent, still-taught concept that says that investors can not expect (except by luck whose success goes to zero asymptotically) to profit by technical trading strategies, i.e. those that look solely at the time series of returns on a security. (Good discussions here and here). My doubts are strong enough that I am willing to cast aside any empirical studies purporting to find successful technical strading strategies and to assume for the sake of argument that all legitimate studies heretofore conducted have not found a successful strategy.

The basic problems are that the search space is infinite and what we see in the market are the coarse features of what is likely a much more finely grained and difficult-to-observe process. Suppose, for example, it were true that the market could be predicted extremely well as a function of the past 10 market returns. Could one find the right model or would one end up saying that no successful investing strategy could be found? One might try some sort of linear or polynomial multiple regression. But even if one confined oneself to models in which each variable appeared only once and the only interactions among the variables took the form of multiplication and addition (simple, arithmetic models), there would still be 115,975 models to examine. (The number of models is equal to the Bell Number of 10). To be sure, a modern computer could chomp through all that without ill effects, but once we relax the unreasonable assumption that all interactions amongst the variables are multiplicative or additive, the search space expands geometrically. Moreover, if there were 20 pieces of data rather than 10 that one wished to examine, there would be 51724158235372 simple arithmetic models that one would need to examine. Even Deep Blue might not enjoy that work flow. To be sure, there are sophisticated ways such as genetic programming of cutting through that large a search space to find pretty good models, but even these sophisticated methodologies may end up foundering as the variety of arithmetic operations permitted increases or one relaxes the one-use-per-variable constraint. (Has anyone actually tried this methodology on stock data?)

So even assuming researchers did not find an algorithm that correctly predicted investment return movements, that does not prove that no such algorithm exists but simply that it is difficult to find. And while, at the limit, the distinction between non-existence and unfindability may evaporate, it does not strike me as impossible that someone dedicated to finding a good algorithm for a particular investment or collection of investments might succeed through diligence and industry where academic researchers had failed. And, if they did, if they were not particularly altruistic, they might keep that information private and trade at a low enough level to prevent piggybacking on their strategies.

And now, to really cause trouble, the whole debate on the subject reminds me of efforts to prove or disprove the existence of alien life on the presence or absence of intelligible signals from space. To begin with, negative results from searches of portions of space over a short period of time provies little either way. Moreover, the space of signals that might be "intelligently" generated is likely infinite and I doubt we could eliminate bias in our efforts to focus on the sort of signals that would "most likely" be generated.

The question I end up with is what legal rules or practices change if we become less confident in the truth of the weak form of the Efficient Capital Market Hypothesis?

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I've been following the Elizabeth Edwards story very closely because I'm a great admirer of hers.  Perhaps I feel an affinity toward her -- an attorney, a mother, even once a legal writing instructor.  At the end of the 2004 campaign, as we know now, she was diagnosed with fairly advanced breast cancer.  And, as we learned on Thursday, that cancer has now metastacized, at least to her rib, creating an incurable condition with an uncertain prognosis.  Yet, John and Elizabeth Edwards announced on Thursday that the John Edwards for President campaign will go on; and now, the critics come out to proclaim this brave and noble or selfish and misguided.

Here is my take on their decision.  What would you do if you were told that on average, you might have 4-5 years to live, but on one side of the tail you could have far less and on the other possibly 10?  Many of us would drop everything, liquidate assets and travel the world.  The Edwards family has had unlimited resources for quite awhile.  If it is Elizabeth Edwards' dream to travel the world, she would have done so already, and she may already have.  She grew up in a military family and lived in different parts of Asia, so foreign travel may not be a lingering desire.  We might want to quit our jobs to spend every single second with our children, especially small ones like Jack (6) and Emma Claire (8).  But how long can you snuggle with them, hunkered down waiting?  A few years?  What about 5?  What could you give them that would last after you were gone?

I believe that Ms. Edwards, who grew up in a military family, has always had a sense of public life and a sense that some things are bigger than her, whether her father's missions, one of John Edwards' class action cases or his senatorial duties.  She went to law school, and her daughter is in law school now.  She enjoys public speaking, and she enjoys meeting people and talking to them about what is troubling them.  I can imagine that she asked herself, if she is only going to be here for 4-5 years, what would she like to do, and I think the answer was campaign for and be First Lady of the United States.  Write my children's names into the history books and help my husband accomplish a long-term goal of making a difference.  Sure, whenever someone runs for high office, there is an element of selfish ambition, but there's also a sense of contribution and service.  I'm sure both these elements contribute to the final decision, but I like to think that the main motivation is a sense of calling. 

I think many of us would want to spend the remainder of our lives, however short, fulfilling our calling.  I think Elizabeth Edwards deserves to try to do the same. 

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Earlier this week, this video of Jim Cramer started making the rounds on YouTube. (The video has been removed from YouTube, but it is still available at TheStreet.com.) The New York Post got to the story on Tuesday, with followups here and here. In the video, Cramer candidly describes various means of illegal manipulation of stock prices, noting "the Securities and Exchange Commission doesn't get it" and asking "Who cares about the fundamentals?"

In an attempt to mitigate the damage, Cramer called Don Imus and said, "I learned a big lesson here: you got to be a little more clear . . . you can't be as glib, because people will interpret this as being that you're a bad guy."

Henry Blodget (remember him?) speculates that Cramer may have committed "professional suicide." Hmm. I doubt it. The video was originally broadcast on TheStreet.com on Dec. 22, 2006. Cramer comes off looking like a self-important blowhard -- which is consistent with his public persona -- but it doesn't look like a confession of wrongdoing.

Thanks to Greg Call for the tip.

UPDATE: This just in from the lemonade-from-lemons department (aka, The Department of Fat Chances):

"I'm delighted if someone who understands how this works is truly on a reforming bent," says Michael Josephson, an ethics expert at the Josephson Institute of Ethics. He says Cramer should brief regulators on how to stop the practice. "It's not enough to rant on this."

UPDATE2: This story has not hit the big time. No mention in the W$J or NYT.

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I am sitting in the 21st Annual Coming Together of Peoples Conference, listening to Lance Morgan, CEO of Ho-Chunk, Inc. Morgan is telling the story of his company, and he begins by fingering tribal trust land as the source of economic development problems among Native Americans. Under the most charitable view of history, trust land was initiated as a way to protect Native Americans from expropriation, but even if it began for good reasons, trust land now stands in the way of economic development. The problem is that trust land cannot be used as collateral.

Enter gambling, which has provided the capital for further community development in Thurston County, Nebraska. Much of that development is now being financed through grants and tax credits, but the ultimate goal, according to Morgan, is to create an economically viable community, which does not exist now.

By the way, Morgan graduated from Harvard Law School.

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