The following letter was sent to SEC Chair Mary Schapiro and IRS Commissioner Doug Shulman on “tax day” with the hope they will jointly work at restoring the integrity of cash flow statements, without question the most important analytical tool for investment advisors like myself. It is simply astonishing, given their material nature, that listed companies are not fully disclosing purchased and accumulated net operating losses nor the impact of complying with the “fractions rule” in the case of private equity partnerships.
Parish & Company
10260 S.W. Greenburg Rd., Suite 400
Portland, OR 97223
April 15, 2011
Office of the Chairman
Securities and Exchange Commission
Mail Stop 1070
100 F Street NE
Washington, D.C. 20549
cc: Elise B. Walter – SEC Commissioner
Troy A. Parades – SEC Commissioner
Robert Khuzami – SEC Director
Doug Shulman – IRS Commissioner
Heather Maloy – IRS Commissioner Large Business Division
Walter Harris – IRS Director Financial Services
Elise Bean – Congressional Oversight Committee
Dear Chair Schapiro,
In 15 years as an investment advisor I have always done my best to support the SEC’s work, having led many key corporate governance related initiatives. Past Chairs Levitt, Pitt and Donaldson are all familiar with my work, which has also been reported in front page stories in leading publications including Bloomberg, the New York Times, Barrons and USA Today.
The purpose of this letter today is to alert you directly to an alarming trend with respect to the rapidly eroding integrity of cash flow statements filed with the commission. The culprit is non-disclosure of important tax related transactions involving material net operating losses, in addition to compensation and related expense allocations subject to the “fractions rule”and NOL loss limitation rules that are material to past, present and future cash flows involving publicly traded partnerships, such as Blackstone, in which tax exempt investors participate. The NOL related limitation issues are also a significant issue in mergers and buyouts of public companies.
Back in late 1999 when I provided original research to Gretchen Morgenson, David Cay Johnston and Floyd Norris of the NY Times regarding how Microsoft paid no federal income tax I was told that this was ridiculous. You discredit your excellent work by saying such a thing, Morgenson added. Six months later she did a front page story outlining the scheme involving the issuance of NQ stock options. Similarly Bob Herdman, Chief Operating Officer at the Commission, thought the idea ridiculous at first.
While everyone was focused on the future dilution of options, my focus was instead on the historic tax based cash flow impact of options. What made this original research possible was a cash flow statement that analyzed cash flow and, in conjunction with footnotes, provided a good general idea of tax related impacts.
More recently, since last summer, I have tried to get the NY Times to do a story on how major private equity and hedge funds may indeed be escaping taxation completely via gaming carried interest deductions in violation of two key IRS reforms established by former President Reagan, the “fractions rule”and limitations on purchased NOLs.
The Times chose to focus on publicly traded GE and in their story never fully highlighted how GE is using NOLs. How could the Times put their reputation on the line based upon my work without adequate SEC disclosure? Also interesting to note is that at one time over the last two years, one private equity firm, Harbinger, owned more than 10 percent of the NY Times. Similarly, per Yahoo finance, JP Morgan owns almost 10 percent of Gannett, parent to USA today.
Media consolidation and outright ownership of media by major financial institutions, including private equity and hedge funds that have bitterly fought to undermine both the SEC’s and IRS efforts, has complicated this task. Perhaps now is a good time for the SEC and IRS to be more vigilant and oriented at making news aimed at solving fundamental problems before they accumulate and lead to major market problems. While leading attorneys at major law firms representing the private equity crowd enjoy great access with top officials via conferences and other venues, independent advisors like myself with a distinguished record can barely get a phone call returned.
GE was low hanging “media fruit” so to speak. Clearly the much bigger issue is that involving the takeover of public companies by private equity and hedge funds, effectively converting these formerly tax paying entities to the equivalent of tax exempts using NQ option and carried interest schemes resulting in an NOL pyramid scheme. Again, the bulk of these NOLs were never cash expenses but simply NQ options and carried interest.
If these private equity and hedge funds were indeed catering only to affluent investors that would be fine yet today many of these organizations receive most of their funding from public pensions. I have written about this extensively over the last 5-7 years and pushed hard to get the concept behind carry fees fully understood and disclosed. Again, numerous examples of this work appear in major publications.
One of the big lessons of the dot.com era was the need for the SEC to collaborate more with the Federal Reserve and see the economic impact of accounting irregularities. Most notable of course back then were merger and stock option accounting related issues. Former San Francisco Fed President Robert Parry told me, look Bill, “accounting issues were not in the fed’s purview” in late 1999. This was when the market was more focused upon whether Alan Greenspan took a bath before a meeting of the Federal Reserve.
The key lesson in the recent crisis involving mortgage financing and related derivatives was of course that conflicts of interest with key regulators and rating agencies can lead to similarly disastrous results. If Moody’s had done their job, we would have had no crisis. Also germane was the impact of top government officials such as Robert Rubin moving to industry and aggressively attacking important safeguards, Glass-Steagall in his case.
The reason I have copied your former colleague at FINRA, current IRS Commissioner Doug Shulman, is that to date there has been almost no discussion regarding how tax policy played a major role in both crises and in my opinion, with the proposed repeal of the fractions rule, could ignite the next. My work in this area goes back to 1999.
My hope is that you will work together to restore integrity in what is clearly the most important disclosure of all for any public company, the cash flow statement and related footnotes. Doing so will also greatly enhance overall tax equity, in my judgement. The notion that major tax related impacts not be disclosed is a significant fraud upon all statement users and puts the whole system at risk.
More specifically, someone at the Treasury has proposed repealing the fractions rule in the 2012 revenue guidelines. To that, I only have the following thoughts: Robert Rubin/Glass-Steagall; Wendy Graham/Derivatives Deregulation. It is absolutely ridiculous when it was such an important reform and there has been almost no enforcement of it for years, perhaps not unlike mortgage underwriting standards. The industry failed in Congress and failed to get an American Bar Association sponsored revenue ruling ,yet now it the Treasury itself advocating the repeal of the fractions rule.
While some companies will argue rightfully that tax returns are private and not required to be disclosed, such material NOL and “fractions rule” related information must be disclosed when public firms are taken private or in the event of significant sales or mergers. This is fundamental accounting 101. Some would add that failure to do so is the very essence of fraud because it fuels the notion that investing is an insider’s game. What it also does is allow problems to accumulate and ultimately exacerbate major problems in the market.
These cash flow based disclosures are vital information to an SEC Registered advisor like myself, and other investors. And for the last couple of years I have found increasing frustration in dealing with leading journalists because they are simply not getting the mandatory public disclosure required to corroborate my research findings and forward key corporate governance initiatives.
A good recent example is the General Electric sale of NBC to Comcast. So why do these two completely independent firms get to “game the system” with respect to the allocation of net operating losses belonging to GE via a special allocation partnership, subsequent to a sale of the business? One might ask, is this a fraud upon taxpayers, investors, both or simply much ado about nothing? When I make such an observation to a leading journalist, they need to be able to see a footnote that confirms or refutes my claim. This is as basic as corroborating total revenues per the income statement.
It is understandable that many journalists have expressed no interest in covering the proposed repeal of the “fractions rule,”simply because they don’t understand it. The reason of course is that these public partnership firms are not providing adequate disclosure to the SEC. In addition, something appears very amiss at the Treasury department. Who is behind this repeal, really? If you do a search of Blackstone’s 10K you will find no references to the fractions rule, nor related financial adjustments made to confirm to it. Similarly, no one at the Internal Revenue Service is willing to discuss this. (See attached letter to Curt Wilson, Associate General Counsel Passthroughs at the IRS).
At http://billparish.wordpress.com you can also see a blogpost that features a brief audio, taken from an American Bar Association Conference in which one of the nations leading attorneys, Sanford Presant, explains how investors received $7 in tax deductions for each $1 invested prior to the fractions rule. Also included is a brief audio clip from a top IRS official, Curt Wilson, who volunteered to sit on a panel, noting he sees no enforcement issues with the “fractions rule.”
“How can we transfer our angst over the fractions rule to you,”a King and Spaulding attorney asked the IRS’s Wilson? Wilson later told me that the fractions rule was not being considered for repeal yet it is now in the 2012 Revenue Guidelines for repeal. Wilson will not confirm who is involved in the repeal nor its specifics. Again, in my mind this will be the genesis of a crisis if not prevented, similar to the repeal of Glass-Steagall or the rules regarding derivatives trading.
Per my analysis, firms with inadequate cash flow disclosure to the commission with respect to NOL and fractions rule related considerations include, but are not limited to Bank of America, Goldman Sachs, JP Morgan Chase, Morgan Stanley, Citigroup, General Electric, Comcast, Blackstone, KKR, TPG (via acquisitions including J Crew since TPG is not publicly traded), Apollo and Fortress.
For example, if Blackstone is going to purchase a publicly traded company and thereby assumes significant accumulated NOLs, those valuable NOLs must be disclosed fully to existing shareholders prior to a sale. In addition, the same partnership must disclose the impact of the fractions rule, specifically, how much of the deductions cannot be taken due to having tax exempt investors in the purchasing partnership. Such investors often represent more than 80 percent of all funds in major private equity partnerships.
Also relevant are the limitations on the deductibility of purchased NOLs, and whether they are being fully deducted using a reverse scheme, in which an entity with significant NOLs purchases a firm paying significant taxes, thereby escaping the required amortization reform put forth by Reagen. My original research identified this scheme in 2001 subsequent to the takeover of Time Warner by AOL.
It is not enough to say, we need not disclose such information since it is an item on our tax return. Full disclosure and materiality mandate such disclosure of material tax driven cash flow items directly on the cash flow statement or in the footnotes.
In another example, if TPG purchases J Crew and by doing so receives $1 billion in net operating losses, a large part of which are tax deductions created from stock options, how are these valuable net operating losses treated. These expenses never resulted in a cash outlay, and if the partnership at TPG buying J Crew has 80 percent tax exempt investors, are these NOLs being stripped away in violation of the fractions rule prior to being put in the partnership? And, if so, is this not a violation of the fractions rule resulting in a LILO like leasing doubling up of tax deductions for taxable general partners, etc?
One could argue such non-disclosure to the SEC is manufacturing a tax deduction pyramid or flipping scheme in which private equity firms take companies private, public, private again and then public. Each time creating staggering NOLs in the form of stock option or carried interest deductions, not resulting from an outlay of cash for equipment or wages, but rather a paper tax deduction pyramid scheme.
Regarding Blackstone, another potential issue includes the valuation of partnership interests that create valuable tax deductions? Are these straight up or are they the equivalent of a stock option back dating scheme being used that is aimed to increase tax deductions by awarding such units at artificially low strike prices, achieving the same impact as backdating? Of course tax exempt partners may not care, yet what of the future cash flow impact for public unit holders? In reviewing the history and Blackstone’s limited public disclosure, something just does not look right, in my opinion.
Furthermore, if Blackstone executives exchange unvested NQ options with Blackstone partnership units based upon carried interest, the strike price value difference between each should be fully disclosed to shareholders, not simply in aggregate.
In my original research on stock options back in 1999 I often noted this backdating impact and was simply amazed that at the time there was no concern. It was sad to see how this developed into a legal feed bucket for law firms that never acknowledged the most damaging part of the scheme, that being the creation of a tax deduction pyramid scheme.
In 2000, I arranged a related story on this for Gretchen Morgenson of the NY Times involving two employees at Microsoft who expressed an interest in becoming clients. I tentatively agreed to accept them as clients only if they were willing to discuss their situation with Morgenson given the important tax governance related involving their situation. Similarly, Morgenson agreed that, if she did the story, she would mention my simple idea regarding a pivotal tax reform.
The couple had exercised options but failed to sell shares to pay the tax until they filed their return several months later. The subsequent drop in Microsoft’s stock price left them with a large tax bill and insufficient assets to pay the tax. I had expected that the story, which appeared on the front page, would include my comment that the IRS provide a one-time adjustment in such situations, provided the total options were less than x in value. Unfortunately the comment did not appear yet it was however recognized as a key story with Morgenson being awarded the Pulitzer Prize.
My guess is that the Times advertisers, including Microsoft and Cisco Systems, did not want the story done because if employees were allowed to “look back” on a one time basis, this would clearly eliminate the tax deduction the companies were taking. More centrally, it would challenge the stability of this innovative tax deduction pyramid scheme that began with NQ options and has now morphed into carried interest.
Of course this is particularly germane if a CEO orchestrates the sale of a public company and stays on with the private equity firm as a shareholder. Perhaps Tony James, Blackstone’s president, put it best by saying,“Now we can just exchange the unvested portion of an executive’s NQ options with our partnerships units and not expend valuable cash in order to bring them on board and get the deal done.” You can see this summarized at http://billparish.wordpress.com in two blog posts. One is dated August 2010 and the second March 31, 2011. Both provide important background for this letter.
I spoke with Mark Zehner in your office about this issue last fall, specific to the fractions rule, and frankly must reflect significant disappointment at the lack of follow up, especially given the stellar work he did in the municipal finance area. This is not a UBTI driven issue unique to tax exempt investors in public partnerships but rather an assault on the basic integrity of“the key financial statement” used by advisors like myself to analyze the merits of a particular investment opportunity, the cash flow statement.
We all want the economy to turn around, yet in my opinion, that will only happen when integrity and confidence are restored to the cash flow statement. Doing so will allow numerous peripheral areas to self correct ranging from capital flows to overall tax equity.
Thank you for considering these thoughts and of course I will make myself available for follow up commentary. The opportunity to develop some level of dialogue with the commission would be much appreciated. This could include someone at the commission suggesting I be invited to speak at a major conference, etc.
** Blog posts and related audio clips at http://billparish.wordpress.com