Finance/Corporation

     The influential private equity firm, Blackstone Group, disclosed in its recent IPO prospectus that it planned to establish a charitable foundation after it goes public and would contribute up to $150m in the foundation. (See here.) This got me thinking about the combination of for-profit and not-for-profit corporations.

     Most for-profit corporations, like Blackstone, do get involved in not-for-profit activities, directly or directly. However, most of these activities are normally initiated and controlled exclusively by the management, without much input from the shareholders. Such modus operandi simply adds to the public's cynicism toward corporate America's involvement in nonprofit -- particularly because there is a different way for corporations to contribute to the nonprofit causes. Let me explain.

     The principle difference between a for-profit and not-for-profit corporation is ownership. A for-profit corporation has ownership, but a not-for-profit does not. However, what if the ownership of a for-profit corporation includes an interest in contribution by the corporation to some non-profit organizations? If that is possible, it will permit the shareholders to exercise direct control over the company's contribution to nonprofits. And I think it is possible.

     For example, Blackstone in its IPO can set up multiple classes of shares, say Classes A, B, & C. When Blackstone initially issues the shares, a portion of the purchase price will go to the company (and invested for profit), but the remaining portion will go to some nonprofit groups. (See table below.) So, if I pay $100 for one Class B share, $90 goes to Blackstone, and $10 goes to some nonprofit groups. If I later sell the share in the secondary market, however, only the for-profit portion changes hands. Different classes will have different rates of dividends and/or different voting rights as incentives to purchase Classes C or B over Class A. Additionally, more complicated plans can offer different choices and combinations of nonprofit organizations for different classes.

     Will such kind of plans work? It seems so. Will it actually happen? Maybe, although probably not any time soon!

     In recent years, a secondary market for life insurance policies has grown rapidly, accompanied by similarly exponential growth in the securitization of life insurance policies. The market is supported by a group of organizers who purchase eligible policies from the original owners, re-package them, and then sell interests in these policies to investors. (See here or NY Times 12/17/2006 article "Late in Life, Finding a Bonanza in Life Insurance" for more details.)

     Based on the numbers I was able to gather, the size of the market has grown from ~$1B in 1999 to over $10B in 2005. (See chart below.) This rapid growth was fueled mostly by institutional investors, such as hedge funds and Wall Street firms. Even Warren Buffet's Berkshire Hathaway has invested in life settlements. It has been estimated that the market can exceed $150B in terms of the face value of insurance policies involved.

     There are occasions when a senior (or a company) might want to dispose of his/her life insurance policy. For example, emergency need for cash, changed goals in health care & estate planning, overly expensive premiums, dissolution of company requiring disposal of company-owned insurances, key employee leaving company, etc. In these occasions, the policy owner can sell the insurance back to the insurance company for the cash value. Or, he/she can sell the policy in the secondary market if it offers a better deal. Such competition between the primary and secondary markets should benefit consumers as a whole.

     To continue its current pace of growth, however, the market must address several legal concerns. First, most state regulations require that the beneficiary of a life insurance police possess an "insurable interest" in the life and health of the insured. If a stranger without an "insurable interest" becomes the beneficiary of a life insurance covering the life of another person, the stranger has the monetary incentive to accelerate the death of the insured person. That is not a desirable public policy! Many states (including New York), however, have allowed a stranger to become the beneficiary if the insured person voluntarily agrees to the arrangement. Even with this exception, the risk of abuse can be real. It is important for all transactions to incorporate some safe guards. (E.g., not permitting the investors to know the identity of the insured.)

     Second, the investment interests on the re-packaged insurances sold to investors may be "securities" under the federal Securities Act of 1933 and Securities Exchange Act of 1934, and thus may be subject to the registration, disclosure, anti-fraud, and other requirements under these federal laws. In 1996, the Appeals Court of the District of Columbia held in SEC v. Life Partners that such type of investment contracts are not "securities". The Appeals Court of the 11th Circuit, however, reached the opposite conclusion in 2006 in SEC v. Mutual Benefits. In these cases, the defendants, Life Partner Inc. and Mutual Benefits Corp., were organizers in the life settlement markets. Both of them employed hundreds of agents and brokers to purchase policies from seniors and sold fractional interests on these pools of policies to investors. Because of this split between the two courts, any issuance of life settlement interests under the jurisdiction of the 11th Circuit (Alabama, Georgia, Florida) will now be subject to the federal securities laws, but not those under the jurisdiction of D.C. Such discrepancy will have to be resolved by the Supreme Court.

     Finally, as more and more organizers enter the market, competition to obtain eligible policies from seniors will increase. Potentials for fraud will rise. In fact, in October last year, the then attorney general of New York, Eliot Spitzer, brought suit against Coventry First, one of the large life settlement organizers, for allegedly rigging the bid process in buying the policies. Like many other states, New York currently does not have a law regulating the life settlement market. A model regulation, however, was released back in 2001 by the National Association of Insurance Commissioners. The model regulation was adopted by some states and contributed (at least partially) to the rapid growth of the industry. As this market grows, more and more states will eventually enact laws and regulations governing the industry. That should bring more clarity to the regulatory frameworks and sustain continued growth.

     COLI (Corporate-owned life insurance) has been around for a while. A company purchases life insurance policies (as owner and beneficiary) covering the lives of its employees for two main purposes: (1) to fund employee benefit plans; and (2) to compensate itself for the loss of covered key employees. In the former case, if the company sets up a retiree health care benefit plan for its employees, it can buy life insurances on its employees with face amounts equal to the estimated health care costs of the employees. The life insurance proceeds can subsequently be used to cover those health care costs. In the latter case, the insurance policy is called a "key-man" policy. A company buys key-man insurance policies sufficient to compensate for the losses and expenses to the company, or to buy back an employee-shareholder's shares, if a current key employee-shareholder passes away.

     The federal tax treatments of a key-man COLI can be complicated. However, some of the main tax characteristics of a key-man COLI are:

1. The premiums of the policy are NOT tax deductible for the company;
2. The proceeds of the policy are tax free for the company;
3. The proceeds of the policy MAY be subject to estate tax for the insured employee.

     Characteristic #1 spawned various tax shelters in the 80's and 90's, which led to a series of federal COLI legislations, the most recent one being the COLI Best Practice Act incorporated in the Pension Protection Act, enacted on 8/17/2006. (See here for more details.)

     Characteristic #3, on the other hand, may pose as a problem for a company where an employee-shareholder holds a controlling interest. Internal Revenue Code §2042(2) provides that proceeds of an insurance policy owned by and benefiting entities other than the insured person will be included in the insured's estate if the insured had any "incidents of ownership" on the policy. "Incidents of ownership" includes the power to change beneficiary, to surrender or cancel policy, to obtain a loan against the policy, etc. For a controlling employee-shareholder, this means that his estate MAY have to pay tax on the proceeds of the COLI covering his life, because he does have the above powers over the company. Fortunately, subsequent IRS regulations made it clear that as long as the COLI proceeds are paid only to the company or to a third party for a valid business purpose, the controlling employee-shareholder will not be considered to have "incidents of ownership" on the COLI. (26 C.F.R. §20.2042-1(c)(6))

     Part of the reasons behind this regulation is that the company's stock price should reflect the insurance proceeds to be received by the company. That means the insured person's estate is taxed once already on the higher value of the stocks. Paying estate tax on the insurance proceeds would have been double taxation.

     To be safe, however, a company having a controlling shareholder may want to prohibit (in its shareholder agreement) the company from changing the beneficiary of the COLI to any other entity without a valid business purpose. Or, to take it one step further, to limit the power of the controlling shareholder in managing the COLI.

     A consideration in drafting a shareholder agreement or a buy-sell agreement.

-- Chinatrust's botched attempt to take over Mega Financial

     One of the biggest headlines in the financial industry this year is the surging global merger & acquisition activity. Many of these M&A deals were huge (involving billions of dollars) and likely completed with complicated financial arrangements. The inner workings of most of these financial arrangements will probably not be known to the public for a long time. In one rare instance, however, we did get the chance to peek into the intricate structure of one of such M&A deals. -- The botched attempt by Taiwan's Chinatrust Financial Holding Company (CFHC) to take over Mega Financial Holding Company (MFHC). Particularly, it's interesting to learn how CFHC incorporated derivative instruments into the intricate web of M&A gamesmanship.

     CFHC is one of the large financial holding companies in Taiwan, with ~10,000 employees. In early 2005, Taiwan government announced plans to gradually reduce the number of financial holding companies in the country by half. CFHC consequently decided to increase its stakes in another large financial holding company, MFHC (which has ~8,000 employees). According to Taiwan law, a financial holding company must obtain government approval to invest in another financial holding company. The subsidiaries of a financial holding company, however, are not subject to such a requirement, except that commercial banks are not allowed to hold more than 5% of a single company's outstanding shares.

     Thus, CFHC instructed its banking, insurance, and other subsidiaries to purchase MFHC shares in open markets. By fall of 2005, CFHC had obtained control, through its subsidiaries, of ~6.1% of MFHC shares. That was, however, not enough. CFHC further instructed the Hong Kong branch of its banking subsidiary to purchase ~$390m of structured notes issued by Barclays Bank. The structured notes were linked to MFHC stock prices, and thus would have been equivalent to ~3.9% of MFHC outstanding shares. Thus, by this time, CFHC had effectively controlled ~10% of MFHC.

     In January 2006, CFHC submitted application to the regulator for approval to acquire 5-10% of MFHC in the open market throughout the following year. The plan was announced to the public after the Chinese New Year holiday. MFHC stock surged after the announcement. CFHC then cashed in the structured notes (through a 3rd party), with sizeable profits. Then, most interestingly, the issuer of the structured notes sold the MFHC shares that it used to hedge the structured notes, allowing CFHC to pocket a majority of these shares.

     So, by June of 2006, CFHC had acquired control of ~15.6% of MFHC, and was able to gain 4 seats in MFHC's 15-seat board. If it had gone as planned, CFHC would probably have continued on to control more shares of MFHC, and eventually the board. Things turned sour, however, when regulator questioned the sale of the structured notes through a 3rd party and indicted several top CFHC executives for breach of trust and unfair enrichment. It will now be difficult, if not impossible, for CFHC to takeover MFHC.

     In this botched attempt, CFHC used the structured notes to add 3.9% of MFHC "virtual" shares to what it was able to acquire through its subsidiaries. The additional exposure allowed CFHC greater profits (rightfully or not) when MFHC shares rose after the investment plan was publicly announced. These "virtual" shares, moreover, turned into real shares when the structured notes were redeemed and the hedging stocks sold in the open markets.

     The use of derivatives is probably widespread in M&A deals, limited only by imagination. Derivative instruments, such as credit derivatives, can be rather beneficial tools for risk management or reward enhancement. However, when they are abused, it is very difficult to catch because of their private nature. Tough job for financial regulators!

HAPPY NEW YEAR 2007!!!