Parish & Company
10260 S.W. Greenburg Rd., Suite 400
Portland, OR 97223
Tel:(503)643-6999 Fax:(503)293-3507
Email: bill@billparish.com

April 15, 2011

Mary Schapiro
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.

Sincerely,

Bill Parish

** Blog posts and related audio clips at http://billparish.wordpress.com

President Reagan was so incensed that he signed into law new legislation, the “fractions rule,” specifically designed to end this scheme.  During this period no firm was more abusive with respect to tax avoidance than General Electric. Today Reagan’s reform is being challenged in an assault on taxpayer fairness led by the private equity firm Blackstone and its CEO Steve Schwarzman (pictured below left), in conjunction with the American Bar Association (ABA).  See my August 2010 blogpost “Blackstone: Private Equity or Public Theft,” for expanded background.

Before you consider the proposition of gaining $5 of deductions with a $1 investment preposterous, listen to the brief clip below of Sanford Presant of Greenberg Traurig, one of the nation’s leading real estate attorneys.  It is actually two short clips, the first is his introduction at a major tax conference and the second an explanation of what led to the fractions rule in his own words.

Presant is a national authority in this area and has had major roles with the ABA, in addition to heading up Ernst and Young’s real estate practice. The complete audio recordings for Presant’s remarks, in addition to those of Internal Revenue Service Associate Chief Counsel Curt Wilson, can be purchased at www.dcprovidersonline.com.

Also featured in the recording is Wayne Pressgrove of King & Spaulding, who makes a case to IRS Counsel Wilson for a revenue ruling to disable the fractions rule.   It is ironic that Reagan relied on the same law firm, King & Spaulding, to craft the fractions rule in the 1980′s, and these lawyers did brilliant work.

Audio Clip 1 (0:25)
Hear Sanford Presant Introduction and Background

Audio Clip 2 (1:26)
Hear Presant Enthusiastically Explain How Investors Received $5 of Tax Deductions for Each Dollar Invested

At a 2010 ABA conference, Internal Revenue Service Associate Chief Counsel Curt Wilson volunteered to sit on a panel and explained where the IRS stands on fractions rule enforcement. Wilson is introduced by Wayne Pressgrove of King & Spaulding.

Audio Clip 3 (3:32)
Hear IRS Associate Chief Counsel Curt Wilson Discuss the Fractions Rule

Wilson notes there always seems to be “considerable angst” in the audience regarding compliance with this rule.  He added that one of the American Bar Association’s key initiatives was to amend the fractions rule. Remarkably, Wilson adds that he has seen almost no activity in this area at the IRS for years, either centrally or in the branches.  One might ask if this is just but another GE-like inspired scheme.

Earlier this year Wilson responded directly to me via email that the IRS was not planning to repeal the fractions rule.  However, the Treasury department’s February 2011 General Explanations of the Administration’s Fiscal Year 2012 Revenue Proposals were released and they include a repeal of the fractions rule (see page 90). Wilson now notes that someone else in his office is responsible for the fractions rule, yet he will not disclose who this is.

Why is this important for all investors?

This month NY Times reporter David Kocieniewski wrote a remarkable piece on General Electric, noting the company earned significant profits, yet paid no federal income tax in 2010.  The article also noted that GE maintains a “970″ employee tax department headed by John Samuels, a former United States Treasury department official.

Such situations are important for all investors to consider because long-term cash flow is a primary determinant of  investor success.  Next to labor costs, taxes are often the most significant cash outflow for most businesses.  Clearly, tax avoidance alone is not sustainable long term and such a risk should be considered.   Other firms with significant such risk include Google and Cisco Systems.  The overall point again is simply, cash flow matters.

Given the opaque nature of these tax schemes at firms such as GE and Blackstone, it is often helpful to analyze them from the bottom up.   For example, Catalent Pharma Solutions is a Blackstone-owned company that files its own 10K with the SEC.   This provides valuable information including executive non-qualified (NQ) option agreements at Catalent and footnotes explaining how entities roll up to the Blackstone parent.   Much of this information is simply not available in Blackstone’s own 10K filing with the SEC.

The following list of entities shows exactly how Catalent eventually connects to Blackstone, its parent.  The Top Level partnership, Blackstone Holdings III L.P., appears in Blackstone’s SEC filings and org chart. It is mostly owned by tax-exempt public pensions. The carried interest fees these tax-exempt pensions pay is indeed Blackstone’s primary source of income, an expense to the tax-exempt pensions and revenue to Blackstone.

If Blackstone is manufacturing non-qualified (NQ) tax deductions at the Catalent wholly-owned subsidiary level, which are actually a pass-through of the carry fees (internal carry plan) paid from tax-exempt limited partners to company executives, then this could be a significant violation of the fractions rule.  Sound bizarre?   Perhaps that is the beauty of laundering activity through so many layers of entities, combined with transfer pricing algorithms managed by leading accounting firms. Keep in mind that Blackstone has hundreds of individual companies in its various partnerships.

Please note that given the opaque nature of these issues and related complexity, my hope is that a leading journalist will confirm the facts directly with Blackstone.  This material is not copyrighted and has been provided to both Gretchen Morgenson and Floyd Norris of the NY Times for review.  It was Morgenson who reported on my findings regarding the Microsoft Corporation in 2000, similarly noting a scheme which allowed them to pay zero federal income tax.  From an investment point, again, the key observation of this analysis is that “cash flow matters.”

One could argue that the only real company in this whole structure is Catalent.  Imagine how frustrated their competitors who pay significant taxes feel.  Perhaps this is the real nexus of the national debate over taxes.  Rates should be able to come down in all categories, yet this is simply not possible until the basic tax equity issues are addressed.   What we need is enforcement of the fractions rule, specifically with respect to compensation allocations, in my opinion.

Repealing the fractions rule is now the “Holy Grail” for many private equity firms, in particular with respect to the allocation of compensation deductions.  The 2012 Treasury Department revenue proposal refers to using a less restrictive rule that does not deal with the key issue involving tax exempt entities, perhaps returning us to the days when certain insiders can invest $1 and get $5 in tax deductions.

Despite all the controversy surrounding Reagan’s Presidency, one can be certain that he would have dealt with this nonsense swiftly.  We will soon see how the current Administration does.

These private equity firms failed to get the fractions rule repealed in Congress.  They then failed again in their request to obtain a revenue ruling, sponsored by the ABA, from IRS Commissioner Doug Shulman.  The ruling was designed to exempt compensation (carry fees) from fractions rule considerations. They now have remarkably gotten the United States Treasury Department itself advocating their cause per the 2012 Treasury Revenue Proposals which effectively repeal the fractions rule.

Somewhere out there is an underpaid lobbyist and about the only thing standing between their success in repealing the fractions rule is a good journalist.

The following letter was sent to Warren Buffett and his heir apparent, David Sokol, on March 24, 2011 because he like all investors will see diminished opportunities as companies are taken private by private equity firms such as Blackstone in order to implement what might be called a tax deduction pyramid scheme.

Interestingly,  Sokol resigned shortly thereafter on March 30, 2011.  By the way, does anyone really believe Warren Buffet would invest $9 billion in Lubrizol so Sokol could earn a profit of $3 million, perhaps the equivalent of a rounding error for his personal portfolio?  Similarly, does anyone really believe Sokol resigned solely based upon this investment?

In any event, here is the letter to Buffett, whom some argue is a leader in key corporate governance issues, including tax equity.

March 24, 2011

Warren Buffett

Berkshire Hathaway Inc.

3555 Farnam St.

Suite 1440

Omaha, NE 68131

cc: David Sokol

Dear Warren,

I hope you are well and enjoying things. The last correspondence we had resulted in that most memorable letter from David Sokol regarding the purchase of PacifiCcorp here in the Northwest.

The reason I am writing today is that I would like to reveal, similar to the work I did regarding Microsoft in 1999 that ultimately resulted in two reporters earning Pulitzer prizes and a veritable cottage industry of media tag alongs, a most astonishing taxation story. One that, if you do not address, will clearly hobble many of your portfolio companies.

On this issue, we should be on the same page. The challenge is that we will need to briefly visit what leading tax attorneys call the Mariana Trench of the Internal Revenue Code, that is the fractions rule, scheduled to be repealed per Obama’s 2012 revenue proposals. See link to blogpost titled “Blackstone, Private Equity or Public Theft,”at www.billparish.com

Recommendation: Have your top analyst take a look and confirm you will not only be priced out of many acquisitions but also see your portfolio companies hobbled if this is repealed. No matter how well run and efficient you are, and no matter how great the sloth at these PE firms, this will greatly impact you in my opinion.

There are many specific facets to this scheme yet they all revolve around ultimately allocating unusable tax deductions belonging to tax exempt partners to taxable partners. Most remarkable is that these are not real expenses such as depreciation but rather mostly compensation in the form of carried interest fees.

Substantive Facts:

1) Private equity funds now receive most of their funding from tax exempt sources, in particular public pensions. George Roberts and others now spend most of their time gathering such tax exempt investors.

2) The fractions rule was put in place to prevent GP’s like Blackstone and KKR from trading additional partnership benefits with tax exempts LP’s who had vast amounts of deductions that could not use, since they are tax exempt. As one leading attorney put it, investors were trading on tax benefits, at times getting 5-7 dollars of deductions for every dollar invested, and that is what brought us the fractions rule.”

3) Here is how the current scheme works and how it will cumulatively hobble you over time:

PE firms portfolio acquire companies and create vast stock option programs, what some call internal “carry plans,” and by doing so take NQ option deductions at the individual portfolio company level. In reality, this is nothing but a push down of the carry fees paid from mostly from tax exempts, which is non-deductible. These carry fees are an economic expense belonging to tax exempt, often booked as a balance sheet transfer, never hitting the P&L statement.

4) The reason this impacts Berkshire is that everything else equal, you cant compete on a long term cash flow basis with firms that pay no taxes at all In addition, as Roberts states, their strategy is to aggressively price competitors out of the various markets and then later raise prices.

While you may say, this won’t effect us Bill, do have one of your best analysts take a good took. Quite remarkable. I’ve also provided this information to the Internal Revenue Service yet they will not comment.

My basic point is that if the fractions rule is eliminated and compensation deductions, in particular carry fees, can be allocated without restriction by only needing to conform to more lenient rules, it will be one big mess. See www.billparish.com for link to blog post titled “Blackstone, Private Equity or Public Theft.”

5) IRS Perspective to Date: Curt Wilson in the office of passthroughs and special industries has noted in national ABA conferences that “although their is considerable angst regarding the fractions rule,”it has been off the IRS radar screen. He also responded to me via email earlier this year when I expressed concern over the ABA aggressively pushing for repeal, specifically lobbying him hard at national conferences, that the IRS did not support that. Remarkably, however, in February the Treasury issued guidelines for 2012 which include its repeal. When asked for additional information, Wilson replied that someone else is handling this in his office but I can’t get a response from him who this is, much less any specifics.

Please do take a look. and naturally I will make myself available if someone there would like to discuss in more detail. By the way, as you likely know, all four of the major CPA firms are making very significant revenues servicing private equity and hedge funds who aggressively use carry fees. I began my career at Arthur Anderson when it was a great firm in 1980′s. Perhaps helping prevent this repeal will also help prevent an Anderson like moment in the future for one of these firms. It is indeed possible that this is a bigger situation than LILO leasing.

Best regards.

Bill Parish

For investors, however,  “shares outstanding” do indeed matter.  Given that neither Apple nor Google have ever paid a dividend, coupled with their near tax exempt income status due to massive stock option deductions, the following analysis could be germane.

Some may argue with reason that sales and profits should be considered yet the purpose of this analysis is singular, to tune out everything except the number of mouths a company has to feed with respect to future dividends and capital appreciation.

To simply ask the following question:  How many shares would each firm have outstanding if the stock values of each were adjusted to $20 per share via a stock split. The answer for Apple is almost 16 billion, that is approx 2.3 shares for every person on the planet.

Note:  This is not a recommendation to purchase Intel nor sell the others but rather an attempt to simply state that the number of shares outstanding should indeed be incorporated into an analysis of any company.

During the last 6 months I have requested that both First Tech and Addison Avenue fulfill their responsibilites to members, specifically asking for more details regarding executive compensation, their respective investment portfolios and also allowing a 90 day period for member review rather than the planned 45 days.   To many members this merger is an “inside job” that would not be supported by members if adequate disclosures were made.  Although the CEO’s offered to meet me and discuss the issues several times, I thought it inappropriate and we have therefore only communicated via phone and email.  Adequate disclosure should speak by itself, and to all members simultaneously.

Here is a copy of the last email I received regarding this merger, one that was clearly mistakenly sent by First Tech’s law firm, Farleigh & Witt, to me.   The parties listed are the law firms managing partner, myself, First Tech’s Interim CEO and the director of regulation for credit unions in Oregon.  Putting aside the ridiculousness of copying me, what also strikes me as unusual is the ease with which the firm can communicate with the key regulator in charge of approving the merger, specifically advising the parties copied to “ignore me.”  Could one make something up as preposterous as this given the recent turbulence in the financial markets?

The recommendation to “ignore him” involved my comment that I was “stunned” to see the minimum level of disclosure regarding Collateralized Mortgage Obligations and Auction Rate Securities on First Tech’s statement.  Not to mention related disclosure issues for Addison. One need only google auction rate securities to examine the reason for the concern.   Again, this is the biggest proposed merger in credit union history and we the public confer tax exempt status on credit unions for a reason.

What the regulators should do is require both First Tech and Addision Avenue to provide a breakdown of their investment portfolios as follows:

CUSIP ID#,  Issuer,  Purchase Amount and Current Value

Other related issues include the following:

1)  Since last March I have requested that both Addison and First Tech fully disclose key executive compensation details yet they have steadfastly refused.   As a federally chartered Credit Union, Addison notes they are not required to make an IRS 990 filing, the form which fully discloses such compensation.   State Chartered credit unions like First Tech are required to make such annual filings yet in their case they filed two extension requests and make the filing only after persistent requests it be done prior to the merger.

2)  The disclosure of annual financial details for Addison Avenue are simply laughable.  Their 18 page annual report features 9 pages of photos,  various page of testimonials from members and “one simple page” of financial information.   This would be astonishing to anyone in the private sector.  If more disclosure is provided somewhere it certainly is not easy to find.

3)  Significant deferred compensation payments ballooned for the First Tech CEO during both of the two years prior to the merger.  Members should receive additional information on what clearly looks like a multi million dollar golden parachute agreement.  This should include information on which law firm drafted the plan, the terms for participation, vesting, etc.

4)  Investment Portfolios for both credit unions do not provide adequate disclosure.   Disclosures should be made as noted previously. by CUSIP ID #, purchase amount and current market value.

Many may ask, why spend the time to analyze a tax exempt credit union.  The reason is that, like public pensions, they can provide unique insight into the dynamics of the financial markets.  In addition, I have several clients who are long time members of the credit union and are frustrated by their inability to get any organized opposition to the merger.  Even the Oregonian, the State’s largest paper, has barely covered the story.

With the financial reform package now passed, all eyes are on the setting of specific rules regarding its implementation.  And while lobbyists attempt to direct the debate away from where it should be, let’s instead visit the core issue, tax rules.

This rollout of specific rules related to the Volcker Rule and related tax considerations will squarely position Paul Volcker, pictured on the lower left below and current IRS commissioner Doug Shulman, lower right, against Blackstone Group LP’s Steve Schwarzman and other leveraged buyout artists operating under the guise of “private equity.”  Why are tax rules key one might ask, especially if these rules have nothing to do with the debate over carried interest?

This is because two specific tax rules have profoundly shaped the current investment markets via a major impact on cash flow. They have also in a more basic fashion functioned as the seeds from which all the other market dysfunctions have originated. The purpose of this post is to briefly explain these two rules and then connect the dots.  Also see related March 31, 2011 post titled Blackstone Tax Engineers, Inspired by GE, attempt to repeal the fractions rule.  This post includes brief audio recordings from leading attorneys and an IRS official regarding the fractions rule.

1)  Net Operating Losses: This involves the practice of creating large pools of net operating loss tax deductions, mostly from unusable technology firms’ stock option deductions when these firms are bought by private equity funds.  These private equity firms then do leveraged buyouts of profitable companies and offset these profitable companies profits into the pool of losses to make the profitable companies tax exempt.

Back in the 1980′s this loophole was intended to be closed when Congress prohibited profitable companies from purchasing such losses and using them all immediately.  The new law required they be amortized over several years.   As former Senate Finance Chair Bob Packwood noted in an Oregonian article, the Treasury never foresaw firms escaping the loophole by using partnerships with large pools of losses to purchase profitable companies.   Essentially, the same transaction in reverse.

Who would think that a partnership whose primary asset were losses would be able to purchase profitable companies. All that was needed in the legislation to prevent this was the term “and vice versa.”  Remarkably, there has been no discussion of this amazing situation, perhaps the biggest tax story in 10 years.

2)  “The Fractions Rule” This rule was put in place at about the same time and designed to prevent tax exempt entities such as public pensions from trading tax deductions they were not entitled to use with taxable partners.  The fractions rule also was designed to discourage tax exempt entities from investing in leveraged buyouts (LBO’s) via partnerships with private equity firms and other taxable partners.   Clearly this would give such firms purchased an unfair marketplace advantage when competing with tax paying businesses.  Or put another way, who would be left to pay tax if all the tax paying firms got gobbled up by partnerships in leveraged buyouts fueled with tax exempt investor funds.

Perhaps one of the nations leading attorney regarding the Fractions Rule, Sanford Presant of GreenburgTaurig, put it best in a 2008 American Bar Association meeting when he said.  “Back then it was tough to get in to our Thursday night committee dinners, they were by invitation only.  Boy was it tough to get in to listen to some of these people and their intelligent pearls.  The real debates were… Can you get 5 to 1 write-offs.  5 to 1?  How do you get 7 to 1!  Everybody was trading on tax benefits and as part of all this backlash, we got the fractions rule.”

Presant is pictured below on the left with Wayne Pressgrove of King and Spaulding on the right.  These two brilliant lawyers represent the leading private equity and hedge funds.

In the ensuing years, once again the industry has attempted to sidestep the fractions rules intent, which applies only to “partnerships,” by using blocker “corporations” set up in the Cayman Islands and other tax havens.  As a trained CPA I find this most disappointing since the IRS rules should be based upon the “substance” of the economic activity rather than the form or structure.  In any event, there is a whole cottage industry of law firms selling advice based upon such  blocker corporation schemes.

A brilliant team of lawyers at King and Spaulding helped write the fractions rule and key to it is the expression “and vice versa.”  This is key because it would prevent the gamesmanship that has occurred with operating losses noted above. Put another way, it would limit allocating deductions from tax exempt to taxable partners in addition to allocating income from taxable partners to tax exempt partners.

What surprises many non tax experts is that these special allocation partnerships can have one set of allocation rules for taxable income and deductions, and a completely different set of rules for cash flow.  The second key aspect of this situation that is creating considerable uneasiness among taxable partners in these partnerships is the rule regarding substantial economic effect, that is, you can’t be simply moving deductions and income between taxable and tax exempt investors unless the transaction has “substantial economic effect.”

This is particularly important with compensation, the numbers of which can be particularly large with private equity and hedge funds.   Large CPA firms now have entire divisions focused upon transfer pricing and expense allocations yet again one has to ask the question, if these transfers do not have underlying economic effect other than moving deductions around, why is this allowed.

It is somewhat ironic that King and Spaulding, the same firm that helped draft the fractions rule, is now leading an effort via the American Bar Association to gut the fractions rule by exempting certain key expenses and transactions.  One recent King and Spaulding partner, Dan Coates, was just elected to the US Senate and expressed interest in being on the Finance Committee, which oversees these rules via the IRS.

We’ve given up on repealing it all together, the ABA notes, and so we are now trying to be more tactical.  This has resulted in the fractions rule becoming what one leading attorney calls the “Mariana Trench” of the Internal Revenue Code.  Perhaps it is also why there has been so little enforcement to date from the IRS,  as noted by Curt Wilson, Associate Chief Counsel in the the office of Passthroughts and Special Industries, at the 2010 ABA Mid Year Tax Section meeting. Wilson noted, I find this surprising especially given the level of angst in industry over compliance with these rules.  See my letter to Wilson opposing granting this revenue ruling.

As an investment advisor I find this remarkable given the current debate over extending the Bush tax cuts.  While smaller LLC based businesses pay federal, state, property and various other forms of taxes and fees, it appears that these private equity and hedge funds are skirting the rules and paying close to nothing.  This of course introduces a significant fairness issue.

Again, the fractions rule specifically limits the trading of tax benefits from tax exempt entities to taxable partners, or vice versa.  Put another way, imagine if you were a taxable partner in a partnership and 90 percent of the other investors were tax exempt entities?  Imagine how difficult it would be to leave 90 percent of valuable tax deductions on the table as unusable?

Perhaps this is why gutting the fractions rule is one of the American Bar Association’s top priorities. (See ABA letter to IRS Commissioner later in this post.)

It could be argued that some private equity firms have become but a sophisticated shell for tax avoidance based upon a maze of interconnected companies and effectively converted to tax exempt status through the aggressive use of net operating loss tax deductions involving executive compensation and transfer pricing.  This has resulted in an unfair competitive advantage against profitable companies that pay taxes.  This has also enraged ordinary small business owners who are not using such schemes.

Investors in profitable companies that actually pay taxes get lower returns than they otherwise would have, making competing with such a scheme on a long term basis difficult.  The situation is even worse for their productive employees who suffer job losses due to takeovers inspired by this scheme, and essential government services which rely on a broad tax base.  This could be the big untold story of the current economic decline, a decline inspired and manufactured by certain private equity firms.  It also explains in large part the constant drumbeat of job outsourcing in that the first thing these private equity firms do is outsource everything off shore possible, no matter the long term consequences.

Again, Congress supposedly foresaw this potential with passage of the “fractions rule”, Internal Revenue Code 514(c)(9)(e) in the late 80′s, to prevent tax exempt entities from trading deductions they cannot use with taxable entities.  One need only examine the growth in tandem of public pensions and private equity investment to see the dimension of this issue.

In the 1980′s the big issue was depreciation on real estate being given to taxable partners by tax exempt partners in exchange for other benefits.   If this were allowed to proliferate there would be no corporate income tax as private equity partnerships manage companies from a tax exempt status and drive tax paying competitors out of the market with lower prices.

One can forget that taxes are indeed one of the most significant business expenses and eliminating this expense would provide a significant competitive advantage for these private equity firms.

Private equity funds have grown dramatically since then, most notably Blackstone, KKR and TPG.  These firms now receive most of their funding from tax exempt public pensions, foundations and endowments, at times more than 80 percent for particular partnerships.  At the same time they are aggressively investing in businesses which derive most of their revenue from government programs.  A good example is Blackstone’s recent purchase of Oregon’s largest assisted living center, Sunwest, an entity whose primary source of sales are government medicare and medicaid payments.

Somehow the public has been fooled into thinking private equity is something other than a euphemism for leveraged buyout.  And while tax exempt investors, mostly public pensions, use sophisticated LBO strategies including  these Caymen Island based “blocker corporations” to avoid paying UBIT (unrelated business taxable income), they appear to have altogether neglected the significance of the “fractions rule” and basic economic substance requirements regarding allocations of financial results.

Congress set up the UBIT rules specifically to avoid a situation in which tax exempt entities are partners in private equity partnerships and investing in leveraged buyouts, to maintain a level playing field.  The idea was to tax these tax exempt entities on profits gained from such leveraged buyouts, that is UBIT tax.

As noted, the UBIT rules regarding leveraged buyouts have  however been circumvented through the use of off shore “blocker corporations” set up as an intermediary so that the tax exempt entities are seen as investing in a corporation rather than a partnership in which activity flows directly to them as a partner, for example profits and tax deductions.

Nevertheless, the fractions rule math is pretty simple as follows: if for example 70 percent of Blackstone’s investment partners are tax exempt, then 70 percent of certain tax deductions are unusable and can not be transfer priced or allocated into a situation, whether by using equity compensation, carry fees or other expenses in which they are transferred to and used by taxable partners.

While the nation debates whether to tax private equity and hedge fund partners at ordinary or capital gains rates, more interesting is whether or not these partners like Schwarzman are in clear violation of existing IRS tax rules due to an aggressive tax strategy using stock options and carry fees, and other deductions.  Once these machinations are fully understood, the tax benefits could be disallowed if the fractions rule has been violated.

As an example, let’s briefly examine the Blackstone Group more closely, whose President Tony James visited Portland, Oregon in July 2010.  Blackstone is arguably the global leader in private equity investment.  They are also a major risk for investment advisers like myself given their ability to takeover good companies and remove them from the marketplace.  This makes my job much more difficult, not only in selecting good investments, yet also in maintaining clients who suffer an unnecessary job loss due to one of these senseless takeovers that are now proliferating.

Blackstone and other private equity firms including KKR and TPG essentially set up partnerships with tax exempt entities like Oregon PERS, LLC’s,  and often have as little as 10 percent of their own equity in the deals.  “Tax efficiency reasons” are often cited for private equity funds’ low equity participation.  The partnerships then do buyouts of both public and private companies.  The above agenda summary is from a recent presentation by Blackstone in Oregon.

As Tony James noted in his presentation which led to a $200 million investment in a Blackstone partnership, they can now use Blackstone stock as currency to attract top executives by swapping out their unvested stock options for Blackstone options.

That may be convenient yet IRS rules are very clear in prohibiting the trading of valuable tax deductions between taxable entities and tax exempt entities such as public pensions due to abuses in the 1980′s.

Specifically, the “fractions rule”., IRC, 514(c)(9)(E)  was adopted and it only allows the taxable entities to take their share of economic interest in the partnerships.  For example, the taxable partners could only take 100 percent of the equity compensation tax deductions when there are no tax exempt partners.

What it also does not allow is an aggressive strategy using transfer pricing and allocations to circumvent the rule.  Such strategies may reduce tax exempt entities exposure to UBIT yet the fractions rule must still be met.

What the IRS clearly did not want was tax exempt entities like CalPERS and Oregon PERS taking a greater share in profits in lieu of trading unusable tax deductions, deductions they were not entitled to  as a tax exempt entity.  A related specific purpose of the rule was to provide a disincentive to do leveraged buyouts, thereby capturing large interest expense deductions and allowing taxable partners to avoid all tax on their profits.   And while Congress debates whether or not to levy ordinary income or capital gain tax rates on private equity managers, it is conceivable that a tax rate of 75 percent could still result in no tax being paid by general taxable partners such as Blackstone’s Schwarzman.

Many creative and aggressive tax strategies have been adopted by large law and accounting firms to try to get around this fractions rule.   These firms, once referred to as the Big 8, yet now the “Final 4,” all have large divisions focused on hedge funds, private equity and transfer pricing related strategies, to minimize taxation.  In addition to being Blackstone’s auditor, Deloitte is also the auditor of record for Oregon’s private equity portfolio.

The question becomes, are the taxable partners at Blackstone using capitalized carry fees and aggressive transfer pricing rules to avoid all taxation?  My practice includes roughly 20 PERS participants here in Oregon and I made a public records request for Blackstone, KKR and TPG’s K-1 partnership filings, yet was told that Oregon does not receive them for most partnerships and for those it does, maintains no file of them.

Remarkably, the Oregon Attorney General’s office adopted the philosphy that since Oregon PERS is tax exempt they need not ask for nor review this critical document reported to the IRS, but rather rely exclusively on documents prepared by Blackstone, KKR and TPG for information.  For this reason the OIC does not even maintain files for K-1′s in general.  This is somewhat ironic since the current Chair of the Council is Harry Demorest, former managing partner of Arthur Andersen’s Portland Office.  Demorest  managed the tax practice at Arthur Andersen before assuming control over the entire office and clearly if anyone should understand the importance of receiving a K-1, it is Demorest.  Another council member, Richard Solomon, is also a practicing CPA.

The following are samples of the few K-1′s they maintain at Oregon PERS.  They are for KKR and TPG  and were obtained via public information request.  When asked for a simple description regarding the accounting treatment for carry fees, which do not appear directly on these K-1′s as capital transfers,  the Treasurer’s office refused to provide this information.

One obvious question is why the K-1 capital accounts are so low in relation to the publicly available investment summary by partnership.  Many things could explain this yet where is the basic transparency.  And why won’t the Oregon Investment Council even disclose the accounting treatment they are using for the significant carry fees being paid to general partners?  Also of interest is perhaps that KKR’s K-1 is done on a “tax books” basis while TPG uses GAAP accounting.

One could argue that tax exempt investors have nothing to gain from receiving a K-1, yet that is simply ridiculous.  The K-1 is a key document that includes information regarding values, distributions, etc.  My guess is that this is prevalent among public pensions and would it not be interesting to compare the K-1′s provided to taxable partners to those provided to tax exempt partners?

These private equity firms are famous for providing a wide range of “figures” on key reports and related valuations.   The Financial Times, (see summary visual) has reported that Blackstone valued one  investment at 125 percent higher than TPG when even though this investment is in the latter company for an equal amount.   These valuations are critical because they drive transfer pricing, related deductions and allocations, etc.

Goldman Sachs even has its own internal specialized exchange which values private equity interests and is where many such private equity interests are bought and sold.  It is called the GSTrUE system and is only accessible on approved Bloomberg terminals.  Remarkably, not even the Institutional Trading areas at TD Ameritrade or Charles Schwab have access.  Perhaps this “dark exchange” needs a little daylight cast, especially since the biggest investors in such partnerships are taxpayers via the various public pension systems.

Let’s face it, taxes can be boring yet this discussion is important to all investors given that the current level of “buyouts” is removing many quality investments from the market that are later loaded up with debt so that the private equity firms can more quickly earn their “carry fees,” which are generally 20 percent of all profits after returning the original investment to partners.   What also results is a job destruction machine that undermines the economy and stability of the financial markets, not to mention the tax base.  Most importantly, this undermines investor confidence with the perception that investing has become an insiders’ game of manipulation.

Here is a summary of a few potential “discussion issues” to consider affecting just one private equity firm, Blackstone.

1)  The CEO of Blackstone Tony James noted in a public meeting in Oregon that Blackstone options are being used in exchange for unvested options for various purposes, including attracting key management talent.   He also noted that Blackstone uses numerous internal “non-profit” cost centers to serve its various portfolio companies in the subsidiary partnerships, many of which have tax exempt investors.   The question becomes how this impacts transfer pricing and the allocation of valuable tax deductions.

One related question is the following: by manipulating the cost of products and services provided to portfolio companies, are they essentially creating compensation related carry/stock option tax deductions at the Blackstone level to be allocated to taxable partners, when they belong to tax exempt investors and should be unusable?

2)  Blackstone’s 10K for the period ending 12/31/2009 does not disclose what would be material adjustments for disallowed equity compensation deductions belonging to tax exempt investors.  These pertain to equity compensation in which the executives provide services to portfolio companies.  At the July 2010 Oregon PERS  public meeting, James used the example of hiring Gerry Murphy of Kingfisher, one of the UK’s largest firms, by swapping his unvested options for Blackstone options.  James also highlighted the service Murphy provides to specific portfolio companies in the partnerships.

If Blackstone is creatively allocating expenses to its various partnerships, why hasn’t it disclosed the portion of this equity compensation and other related deductions which should be disallowed because they belong to tax exempt partners via an allocation of related expense.

Blocker corporations may solve their UBIT tax issues, yet the fractions rule must also be independently satisfied.

Many other related questions arise when exchanging options for firms acquired.  These deductions need to stay at the acquired firms, yet their value would have been created by the transfer of the Blackstone options, even if the Blackstone Group LP company is not taking a deduction.

Where is the disclosure in Blackstone’s 10K regarding the disallowed carry executive compensation expense?  The firm recognized almost $24 billion of such carry related compensation expense reducing its income by more than $3 billion in 2009.

3)  The Blackstone 12/31/2009 10K displays the line item stating “non-cash equity compensation” of $3 billion.  This resulted in a net loss as shown of approximately $2.4 billion in 2009.

If this entire amount of equity based compensation listed above pertains to a tax deduction, as it usually does with respect to such a line item on a “cash flow statement,” this would imply that Blackstone pays no federal income tax for activity in 2009.

Granted they may indeed pay tax related to other areas, for example, property tax, timing differences from prior year.  The key question becomes, how much of this equity compensation amount pertains to services provided to portfolio companies and what part should be disallowed given that the portfolio company is now partly owned by a tax exempt entity?   Also, is this a material omission by Blackstone’s auditor, Deloitte?

4)  The Chair of the Section on Taxation for the American Bar Association wrote the following letter directly to the IRS commissioner Doug Shulman on January 19, 2010 concerning partnership allocations permitted under section 514(c)(9)(E).    What he is specifically asking for is a revenue ruling to permit more aggressive strategies with respect to the allocation rules regarding partnerships with tax exempt entities, i.e, violating the spirit of the fractions rule.  The entire letter with extensive comments can be accessed on-line with a Google search.

Following the letter in this blog post is a list of clients for the lawyer whose firm King &  Spalding was a key contributor in authoring the letter.

The key attorneys noted as contacts involved with drafting this letter to IRS Commissioner Doug Shulman on behalf of the American Bar Association are the following.

In a testament to their legal prowess, the first attorney noted works for King & Spalding, a firm that lists three of the four largest CPA firms, Price Waterhouse Coopers, Ernst & Young and KPMG as  clients, along with Goldman Sachs, Citigroup, Bank of America and Wells Fargo.

At the same time the ABA is seeking a revenue ruling waiver from the IRS, the private equity and hedge fund industries are pursuing a simultaneous track in Congress.  This was introduced in the 110th Congress and reintroduced as H.R.3497 in the 111th Congress.  Both bills are sponsored by Sanford Levin of Michigan (not to be confused with younger brother Carl Levin in the U.S. Senate).   H.R. 3497 has only three co-sponsors and has been referred to the appropriations committee where Sanford Levin is chairman.

Perhaps most interesting is that at the same time U.S. Representative Sanford Levin is introducing a bill that could dilute the fractions rule, he is also introducing another bill, H.R. 1935, to tax private equity partners at ordinary income rates.  The irony is that his one bill, H.R. 3497, could indeed result in no tax, regardless of the rate.

Meanwhile his younger brother Carl Levin is co-sponsoring a bill with Jeff Merkley of Oregon designed to help states avoid teacher layoffs.  Carl Levin has also been a leader in the effort to reform stock option accounting.  It is unfortunate that a key driver in the funding gap in state governments is increased Public Employee Retirement System contributions due to significant investment losses and concern over the lack of liquidity with respect to their private equity portfolios.

I have some simple advice for the current administration.  Aggressively enforce the fractions rule and prohibit tax exempt organizations from using blocker corporations or any other vehicle that ultimately results in a leveraged buyout within three years of a firms’ acquisition by a partnership in which they participate.  If we simply eliminate the fuel for these senseless takeovers, that is tax exempt pension and endowment money, we’ll go a long way toward protecting good companies along with their employees and current investors.

For those of you wanting to enjoy a little Sunshine and rub shoulders with Wayne Pressgrove and other key voices from the American Bar Association in this debate, including leaders at the Internal Revenue Service, consider attending the upcoming conference in January at the Boca Raton resort.  Details are provided below.  Perhaps it is somewhat ironic that indeed the Blackstone Group now owns the Boca Raton resort via one of its real estate partnerships.

Perhaps also ironic is that Blackstone’s novel approach of issuing a publicly traded security on the New York Stock Exchange, one that is not a stock but rather a partnership allowing tax benefits to flow directly to general partners, may afterall allow many of those same benefits, if indeed such deductions lack economic substance, to flow right back to the Treasury.   For taxpayers, both individuals looking at higher rates and corporate alike, including the likes of Warren Buffett who has roundly criticizes this structure,  this could amount to “sweet justice.”

Perhaps my alma matter, the University of Oregon, may indeed set a good precedent by defeating the Auburn Tigers, Pressgrove’s alma matter, the week prior in the BCS championship series.  Spending several hours putting this post together should allow me at least a little comic relief

What results are significant losses to both long term investors and the economy in terms of unnecessary unemployment resulting from senseless consolidation.   Let’s hope Congress finally requires these private equity firms to register with the SEC and disclose basic fundamentals, including where they are based and how they value their portfolio companies.  Doing so will not only preserve millions of valuable jobs yet also help investors realize long term gains and companies reduce their reliance on excessive leverage.

Private Equity firms’ impact on employment assessed

Tom Abate, Chronicle Staff Writer

Friday, May 14, 2010

The 1,205 California companies backed by private equity firms employ an estimated 1.2 million Californians, according to a report from a trade group representing the largest of these buyout entities.

The Private Equity Council also estimates that 10.9 million Americans work for 9,473 companies run by the more than 1,500 such investment firms nationwide.

Private equity firms combine capital from general partners with investments from limited partners, such as pension funds, and use this capital to buy, reorganize and resell companies. Seagate Technology, the disk drive manufacturer with operations in Scotts Valley, is a local example of a company that went through a period of private equity control and re-emerged a publicly traded concern.

The council, whose dozen members include the Bay Area’s Hellman & Friedman and Silver Lake, based its findings on the activities of the broader private equity investment establishments of which its members are among the largest entities.

The council report comes at a time when critics, including AFL-CIO President Richard Trumka, have asked Congress to rein in the activities of private equity investors.

“They are unregulated and shrouded in secrecy, and they extract big profits, while the companies, their employees and many of their investors lose,” Trumka wrote in a recent opinion piece.

Oregon-based investment adviser Bill Parish, a critic of private equity firms, likened their investment style to the leveraged buyouts of the 1980s.

“Private equity is a euphemism for leveraged buyout,” he said.

The council report cited numerous studies that rebut critics and bolster its contention that private equity investors improve the companies they acquire and resell. These include:

– A 2008 study of 5,000 transactions over 25 years commissioned by the World Economic Forum and led by Harvard Business School Professor Josh Lerner that said private equity investment over time often slows or halts existing job losses and can drive job growth in new facilities.

– Two separate World Economic Forum reports in 2009 that said private-equity owned companies are better managed and reward employees for improved performance with higher wages, benefits and job security.

“Private equity investment over time strengthens companies, makes them more competitive and drives benefits to workers and investors,” council spokesman Robert Stewart said in a statement.

The purpose of this comment is to use the proposed merger between First Technology Credit Union, based in Portland. Oregon, and Addison Avenue Credit Union, based in Palo Alto, California, to highlight that while banks are taking a beating over executive compensation, almost no attention has been given to credit unions.  Doing so reveals a full spectrum of situations, some needing additional disclosure.  Also included are simple reform proposals.  Also see updated blog post on October 20, 2010 following approval by Oregon State regulators.

After discussing proposed reforms, this analysis will raise questions regarding the First Technology merger and offer a simple strategy regarding how to evaluate your credit union:

Proposed Reforms:

1)  Make all compensation to credit union executives in excess of $500,000, indexed to inflation going forward, taxable to the credit unions at ordinary income rates and all compensation and benefits in excess of $1 million to bank executives non-deductible for tax purposes. This will provide a strong incentive for both credit unions and banks to self regulate a fix on excessive compensation.

2)  Require both federally and state chartered credit unions to include complete disclosure of executive compensation on quarterly call reports.  Currently, only State Chartered credit unions are required to disclose this information via annual 990 filings with the IRS. This is especially important in mergers such as that proposed by First Technology since their merger partner is Federally chartered.

3)  Limit credit union board member terms to a total of 8 years, after which they would be unable to participate as board members for 4 years.  In First Technology case some board members have served more than 15 years.

First Technology and Addison Credit Union Merger Analysis:

This is a merger that makes no sense and will result in meaningless job loss, regardless of what is publicly stated.  Also not disclosed are the specific financial terms offered to executives, i.e. is Sargent getting a payout for the merger, etc?   While this may make sense in private industry, it makes no sense for tax exempt organizations like credit unions.

First Technology CEO Sargent, who is attempting to orchestrate this merger, earned $820,000 in reportable compensation in 2008, per IRS filing 990, in addition to $1,532, 000 in other compensation from related entities for a total of $2,352,000.  No where is this total compensation package of $2.3 million are the specifics or total amount directly disclosed to members.   The second highest overall compensation if roughly $400,000.   In addition, it has not been disclosed exactly what the terms of “other related compensation from related entities” includes, primarily deferred comp.  See summary from page 8 or 2008 IRS 990 filing below.

The CEO of Addison Avenue, Benson Porter, was previously Chief Administrative Officer for Washington Mutual Bank for 11 years thru February 2007.  The bank later collapsed in September 2008.  There are no public disclosures regarding his compensation agreement nor whether he or Sargent get a merger bonus or other related financial benefit.

First Technology has roughly 400 employees and rather than merging its board should focus on finding a new CEO, especially given the large number of qualified candidates available.  A secondary benefit would be to preserve a good number of quality jobs that would be needlessly lost to consolidation.

Compensation Summaries are listed for 3 of Oregon’s  largest credit unions, after which is a summary of how to evaluate your credit union.  Overall, Advantis has a balanced reasonable structure while Onpoint and First Technology raise obvious questions.

First Technology Credit Union: 2008 Summary of Compensation

Advantis Credit Union:  2008 Executive Compensation

Onpoint (Portland Teachers): 2008 Executive Compensation

How to Evaluate Your Credit Union:

1) Determine if state or federally chartered.  If state chartered simple go to the following website and print off the annual form 990 filed with the IRS:  www.foundationcenter.org   Once there, highlight the “find funders” tab and select “990 finder.” Input the name of your credit union and then print off the report, roughly 20-30 pages.

2) Evaluate the executive pay structure as an initial test in that excessive compensation is an early warning sign.  Look for “other compensation” and if excessive write a letter to the Supervisory (Audit) Committee and copy the Chairman of the Board to determined its nature.  This letter should not go directly to management.  In First Technologies case other compensation in 2008 is mostly deferred comp, which was listed as zero in the 2007 filing.

3)  For federally chartered credit unions visit www.cuna.org   This is the Credit Union National Association responsible for regulating federally chartered credit unions.

4)  Review the allowance for loan losses and divide this total into total loans outstanding.  This provides a good view of how well the credit union is preparing for future loan losses.  In First Tech’s case, this allowance is $11M on a portfolio of $1.2 billion, or approximately .9 percent.   To me this seems especially low, meaning net income and related capital ratios are likely overstated.  A more normal ratio, especially given the current environment, would be 1.5 percent.  The reason this is important is that it shows how well the credit union is prepared, with reserves, for future loan losses.

Furthur Comments on First Technology Merger: As an Independent SEC Registered Investment Advisor, my purpose for this analysis is to support various clients, who are members of First Technology, and oppose this merger.

If you have further thoughts or observations the best person to contact is Jeff Manning of the Oregonian, who has already been briefed on this blog post.  Manning is a superb reporter who specializes in financial institutions.  His email is  jmanning@news.oregonian.com  Telephone:  503-294-7606   The truth is that good journalists love getting feedback and so don’t hesitate to contact him.

Turning around the banking industry is imperative to restarting the economy and initiating the next business cycle.  For this reason my research has focused heavily on this proposed investment. Pictured above, center, giving his presentation to the Oregon Investment Council is former JP Morgan CEO William Harrision. While Sickinger’s article highlighted Harrision’s role,  the Bloomberg “exclusive” made no mention.

In preparation for this meeting, I provided the same information to the Oregonian and Bloomberg reporters, although in Bloomberg’s case it was provided to the local Oregon based Bloomberg reporter Anthony Effinger.   Also provided to Effinger prior to this “Bloomberg Exclusive” article containing major inaccuracies was a letter to State Attorney General John Kroger (letter included at end of post) noting that the partnership’s structure was not legal given that it was done on “tax efficiency” grounds.   Simply put, this would be like me being in a partnership with the City of Portland and trading the City’s depreciation deductions on City Hall for a slightly higher equity position.  Although creative,  this is not legal since the City, even though a partner, is tax exempt and has no depreciation deductions.

Additional Bloomberg errors include its claim that the firm will earn management fees along with a percentage of the profits and that the presentation was made by Sageview.  The truth is that Sageview is proposing taking 25 percent of the ultimate holding companies value in “stock options,”  not profits.  This represents a dramatic increase in overall fees when compared to the standard “carry fee.”

In addition, the presentation was made by former JP Morgan CEO William Harrison (see photo from meeting).  Harrison is a controversial figure,  as is his fellow partner, the former CEO of Waccovia, since it was under Harrison’s watch at JP Morgan that the explosion in toxic derivatives occurred that ultimately took down the banking industry.  Harrison and his Community Bancorp partnership were presented by Sageview as being independent of Sageview, yet they are not.

This proposed investment is a significant event for the banking industry in that Oregon PERS is ligitimizing funding a partnership created by two of the current debacles key architects.  This makes no sense when Oregon PERS could go out and find much better partners with better terms. Especially given that the proposed structure provided a triple public subsidy in the form of 90 percent FDIC backing on the loans, 90 percent funding from public pensions and ultimately large stock option gains they will be able to take a full deduction on, even though only a small portion will be recognized as an expense given the expense is calculated on the date of grant while the deduction is based upon the date of exercise.  Excessive stock options are indeed the most abused executive perk and should be closely monitored by all investors in that in this case they are a license to fleece other investors, in this case Oregon PERS.

Link to Ted Sickinger Well Reported Story:

Letter to Oregon Attorney General John Kroger

To:        John Kroger, Oregon Attorney General

From:  Bill Parish, Parish & Company
10260 SW Greenburg Rd., Suite 400
Portland, Oregon  97223
Tel: 503-643-6999
Email:  bill@billparish.com

cc::      Mary Shapiro, SEC Chairman
Sheila Bair, FDIC Chariaman
Ron Wyden, US Senator, Financial Services Committee
Paul Krugman, NY Times
Ted Sickinger, Oregonian
Nigel Jaquiss, Willamette Week
Glenn Simpson, Wall Street Journal
Gretchen Morgenson, NY Times
Matt Krantz, USA Today
Anthony Effinger, Bloomberg

February 26, 2010

Dear John.

On Wednesday the Oregon Investment Council voted, subject to final
approval of terms, to invest $100 million in a partnership, Sageview,
designed to purchase failed banks.  Clearly, this will be a profitable
investment yet I would appreciate your opinion regarding whether this
is legal on two specific grounds.

In his proposal former JP Morgan CEO William Harrison noted that the
OIC would, at a minimum, make twice its investment given that the FDIC
has offered to back 90 percent of the loans in the failed banks
acquired.   Harrison also noted that most of the funds they accumulate
for these buyouts will be obtained from public pensions and their key
focus will be to takeover community banks, not large banks.

Rather than earn the typical private equity fund “carry fee”  of 20
percent they would instead take stock options equivalent to roughly 25
percent of the holding company they eventually plan to take public.
“Tax efficiency” reasons were cited by firms principals for this
structure.  One might also note that this represents a dramatic
increase over the carry fee since it is on the entire value of the
entity.

While some may be incensed that a key architect of this current
debacle, former JP Morgan CEO Harrison,  would return and lead a
partnership in this area to prey on smaller banks given the literal
creation of toxic derivatives at JP Morgan under his watch,  I would
simply like your opinion regarding whether or not this is legal in two
areas.

1)  Structure:  Harrison’s buyout holding company, CBC, is being
organized by the private equity firm Sageview Capital.  Sageview notes
that Sheila Blair of the FDIC “loves this structure “since public
pensions can be passively involved and private equity firms can put
forth the perception they are not controlling the entity since a
holding company is being used.  When asked about the reality that
Sageview, a private equity firm,  is really controlling the holding
company entity, they replied  “it’s not like these people we have put
on the board are my brother in law.”   Harrison also noted he would
include Mark Shapiro and various others he has collaborated with in the past.

My basic point is that it seems that the OIC is neglecting basic
corporate governance fundamentals here.  Whether they agree with Paul
Volcker, former Fed Chairman, and former SEC Chairman Bill Donaldson
that banks should not be invested in private equity and hedge funds is
perhaps not relevant.  What is relevant is the mockery they are making
of effective corporate governance and its potential to discredit an
important institution before the taxpayers, PERS.

2)  Tax Efficiency:  As a public non-taxed entity it is my
understanding that it is patently illegal to trade tax benefits in
terms of organizational structure.  If all of Sageview’s partners were
non-public entities, this would be irrelevant yet how can a public
entity openly engage in “tax efficiency’ strategies with a private
partnership.  Sageview has twice noted that their rationale for only
investing 10 percent as a general partner and instead taking 25
percent of the holding company in stock options is for “tax
efficiency” purposes related to the partnership structure.

Due to other tax related debacles in Oregon, including the spiraling
cost of energy credits that will indeed cost more than 10 times what
the legislature budgeted,  my hope is that you will work with the OIC
to generate better terms rather than allow PERS participants to be
fleeced with such an options package for Harrison and other
principals.

You do have legal counsel at these meetings that has simply not
recognized the importance of corporate governance including but not
limited to his allowing incomplete minutes to be published with
respect to the nature of public comments provided   An example might
be  John Doe made a comment before the counsel without noting the
subject of the comment.  This is simply ridiculous.

As an SEC registered investment advisor I would also like to invest my
clients funds in struggling quality community banks yet am concerned
that not even the best run bank could defend itself against the triple
public subsidy structure Sageview is advocating.  Extracting subsidies
from the IRS, FDIC and public pensions at once might be called a
triple play in baseball terms yet if you believe in corporate
governance and something that remotely represents a level playing
field, perhaps your office should take a look.   Thank you for
considering these observations.

All the best,

Bill Parish

Geitner actually proposed that these unregulated hedge and private equity funds could be a key part of the solution to the current financial mess, a mess they created.   While Volcker is calling for immediate registration of hedge and private equity funds with the SEC, Geitner and Summers, both of whom have strong ties to these funds, are silent on the issue.

One has to ask how long the markets, in particular the equity markets, will wait for transparency and integrity to be restored before sending a strong message to President Obama.  Below is an excerpt from a Bloomberg article summarizing Volcker’s concerns with respect to Summers and Geitner’s inaction.