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It was ingenious and audacious, and officials at the Internal Revenue Service were upset. In November 2006, Fortress Investment Group filed its first documents with the Securities and Exchange Commission in advance of going public. Fortress is a fabulously profitable investment vehicle that is part hedge fund and part private equity firm, with roughly $43 billion in assets under management. Most major companies cleverly structure transactions to reduce taxes, but Fortress’ efforts — crafted by Skadden, Arps, Slate, Meagher & Flom — were Olympian. Through a dazzlingly complex structure, it managed to avoid nearly all corporate tax and steer clear of SEC scrutiny of its investments. Fortress went public in February, slipping into the market without much fanfare beyond Wall Street. The following month, its bigger, splashier rival, the Blackstone Group, also filed for an initial public offering. Blackstone’s billionaire co-founders, Stephen Schwartzman and Peter Peterson, don’t like to be eclipsed on any stage, and this offering would outdo Fortress in the daring of its legal structure. Like Fortress, Blackstone avoided most corporate tax and SEC regulation of its investments. But it went a step further, dispensing with corporate governance protections for public investors. With this trifecta of results — minimal corporate tax, little SEC regulation, and no investor protections — Blackstone achieved one of the most innovative, brash, and controversial IPOs in recent memory. Skadden had a hand in both deals: Along with representing Fortress, it was underwriters’ counsel for Blackstone’s IPO. Simpson Thacher & Bartlett, one of the premier firms for private equity clients, represented Blackstone. The IRS and the SEC had concerns about these offerings, but in the end Fortress and Blackstone got their way. Congress has cast a disapproving eye on these deals and held hearings over the summer on the taxation of these companies and their principals and on investor protection issues. To date, most of the public controversy has centered on the favorable tax break that Blackstone and Fortress principals get on the huge performance fees they earn. These fees, called “carried interest,” are taxed at a 15 percent capital gains rate, not a 35 percent income tax rate. On Nov. 9, the House passed a bill that would tax carried interest as ordinary income. The Senate is expected to take this up after Thanksgiving. Giving billionaires like Schwartzman a cushy tax break may not be fair, but there’s nothing especially clever or aggressive about the result. The law clearly allows carried interest to be taxed this way, and it has been taxed this way for ages. But other, more complicated aspects of these deals do show how Wall Street’s best corporate and tax lawyers created advantages for clients with the daring to push the edge of the law. The companies’ lawyers sound perplexed that their work has triggered any debate. “This is really mainstream Wall Street transactional planning, and for whatever reason it’s stirred up a hornet’s nest,” says Simpson Thacher tax partner John Hart, who surmises that critics may simply not like how rich Schwartzman and his partners are. In a written response to questions from The American Lawyer (an affiliate of Legal Times), Skadden corporate partner Joseph Coco stated, “We want to emphasize that, in every respect, the Fortress structure comports with the letter and spirit of the tax and securities laws.” But Victor Fleischer, an associate professor at the University of Illinois College of Law, calls this type of corporate planning “gamesmanship.” Fleischer is a former Davis Polk & Wardwell associate whose blog posts on the taxation of Fortress and Blackstone are credited with prompting Congress to examine their IPOs. (He has also written two scholarly articles on this subject, which will appear next year in the New York University Law Review and the Tax Law Review.) “As long as we have a corporate tax,” says Fleischer, “we can’t allow companies to self-help their way out of it.” NOBODY EXPECTED . . . Fortress was formed in 1998 by a group of Wall Street professionals led by Wesley Edens, a former managing partner at Lehman Brothers Holdings Inc. The firm’s five principals include a lawyer, Randal Nardone, a former partner at New York’s Thacher Proffitt & Wood. “We are an intellectual capital business,” the company states in its prospectus. Whatever that means, it makes money. From 2003 to 2005, Fortress’ net income more than doubled each year. In 2006 and early 2007, the firm’s five principals took home a collective $856 million. Wealth like this can pay for sophisticated tax planning. In its IPO documents, Fortress described how it would avoid corporate taxation by taking the form of a publicly traded partnership. Partnerships, which are usually privately held, aren’t taxed on their income. That income is taxed only when it flows to the partners. In contrast, corporations face a double layer of taxation: Income is taxed when earned by the corporation and then again when received by the shareholders as dividends.
Blocker corporation: A corporation created as a subsidiary to a publicly traded partnership that takes nonqualifying fee income and turns it into qualifying dividend income. The corporation blocks the “bad” fee income from reaching the partnership. Carried interest: The share of profits taken by managers of private equity funds and hedge funds. Typically, they get 20 percent of profits generated by their funds. For decades, the Internal Revenue Service has taxed carried interest as capital gains at a rate of 15 percent. In contrast, income from other fees and services is taxed at ordinary income rates, which run as high as 35 percent. Corporate taxation: The two-layered system of taxation on income earned by corporations. The income is taxed first at the 35 percent corporate rate. Dividends are taxed a second time when received by the shareholders. Investment Company Act of 1940: A law enacted after a series of scandals in which investment managers paid themselves excessive fees and harmed small investors. The law, which typically applies to mutual funds and similar investment vehicles, aims to safeguard investors by requiring significant disclosures from investment companies and by limiting activities and fees that could lead to self-dealing by managers. Partnership taxation: The single-layered system of taxation on income earned by partnerships. The partnership itself does not pay tax on its income. Instead, the income flows through to the partners and is taxed at that level. Publicly traded partnership rules: A test set out in Section 7704(b) of the Internal Revenue Code for a publicly traded entity seeking to be taxed as a partnership and not as a corporation. Under the test, the partnership must receive at least 90 percent of its revenue from interest, dividends, royalties, and other passive-type income. Qualifying income: The type of income that meets the 90 percent test for publicly traded partnerships. Regulated investment company: A company that is regulated under the Investment Company Act of 1940. Regulated investment companies cannot qualify for partnership taxation.

Twenty years ago, Congress cracked down on publicly traded partnerships when companies of all sorts — from amusement parks to the Boston Celtics — were going public this way. Concerned about the erosion of the corporate tax base, Congress passed a law aimed at eliminating most such partnerships, except for some in the oil, gas, and other natural resources industries. To get tax treatment as a partnership, a publicly traded entity is now required to receive at least 90 percent of its income from natural resources activities or from interest, dividends, rent, and other “passive-type income.” When Congress made this change, the government didn’t anticipate that companies like Fortress and Blackstone might someday claim this special treatment, says Linda Carlisle, who was then a Treasury Department lawyer. “In 1987, we thought that if you were a Blackstone-type company, you would be regulated as an investment company.” Regulated investment companies cannot qualify for partnership tax treatment. “I’m not saying anything bad about Fortress or Blackstone,” adds Carlisle, now a partner at White & Case, “but this was a new type of business that was not envisioned.” Professor Fleischer notes that when The Goldman Sachs Group, which was a partnership, went public in 1999, it didn’t try to avoid corporate taxation. “Now this new generation of firms has decided to structure themselves so they’re not paying corporation-level tax,” he says. AN AGGRESSIVE MOVE Fortress had to do some wriggling to fit into this publicly traded partnership niche. The shoehorn was held by a team of Skadden lawyers led by corporate partner Coco and tax partners Charles Morgan and John Rayis. Fortress’ general counsel, Alan Chesick, is a former Skadden associate. Like most private equity and hedge funds, Fortress earns enormous management fees, calculated at 2 percent of the assets it manages. For the first six months of 2007, Fortress’ management fees were $215 million. These fees do not qualify as “passive-type income,” which created a big problem: With one third of its revenue derived from these fees, Fortress wouldn’t come close to the 90 percent qualifying income test. So Skadden pulled another page from the oil and gas playbook. It created a “blocker” subsidiary to change the nature of this management fee income. The blocker receives the “bad” fee income and pays it out to the parent company as “good” dividend income. Wiping the fee income clean in this way allows the publicly traded parent company to meet the 90 percent test. The downside to using a blocker is that it’s a corporation and therefore has to pay corporate taxes. But Skadden had a solution. The blocker would borrow a large amount of money from another Fortress subsidiary, according to two people familiar with the deal. The blocker’s interest payments on this debt, which are deductible, would wipe out much of its taxable income. Fortress’ prospectus shows the outlines of how this was done. Fortress transferred $433 million to a subsidiary called FIG Asset Co. FIG Asset loaned a “portion” of this amount to the blocker, which is called FIG Corp. (The document doesn’t reveal exactly how much was loaned.) FIG Asset would not have to pay corporate tax on the interest that it received in return because it is taxed as a partnership. This was an aggressive move. “Everybody understood you could put a little bit of debt in [a blocker], but they had this huge loan in there,” says one lawyer familiar with the deal. “People at the IRS were hopping mad when they saw [the loan]. The impression at the IRS was that Fortress had got too greedy.” An IRS spokesperson said the agency could not comment about individual taxpayers. The Skadden tax lawyers knew this structure could be controversial, according to one person who worked on the deal. “The Skadden folks were very, very worried,” he says. The IRS might deny the interest deduction on the grounds that the blocker’s debt was purely a tax avoidance device. Skadden partner Fred Goldberg Jr., a former IRS commissioner, met with Treasury officials. The corporate tax fraternity is a small, collegial world, and it’s not uncommon for lawyers in the private sector to discuss tax issues with Treasury officials. One lawyer familiar with the deal says Skadden wanted to alert Treasury to this issue so that the department would not be “caught flat-footed.” Treasury spokesperson Andrew DeSouza said the department does not comment on the occurrence or substance of private meetings. In his written response, Skadden’s Coco said the firm did not request and did not get any assurance from Treasury on tax matters. He also maintained that the blocker does not have an unusually high amount of debt. When asked if IRS officials were upset with that amount of debt, Coco wrote, “The amount of debt was not disclosed in the Fortress offering documents and calls into question the accuracy of any such statement.” Coco stressed that the blocker is a “fully taxable U.S. corporation.” Being taxable and actually paying taxes, however, are two different things. Coco declined to say how much corporate tax Fortress has paid or accrued this year. Coco wrote, “Virtually all corporations in America and worldwide are capitalized in part with debt, the interest on which is deductible for tax purposes.” He added that Congress sanctioned the use of publicly traded partnerships for activities that have historically been conducted in partnership form, and, therefore, private equity funds should qualify. SILENCE FROM THE SEC Across town, another group of Washington, D.C., officials were studying Fortress’ IPO documents. One of the thorniest issues in these complex filings was whether Fortress should be regulated by the SEC as an investment company under the Investment Company Act. Fortress desperately wanted to avoid this classification. It would force the secretive firm to disclose specific information about its investments, ban lucrative incentive fees, and prevent highly leveraged investments. Fortress had previously escaped investment company status because its investors were limited to high net worth individuals. Now that it was going public, it needed to find another way to steer clear of the law. Skadden got assistance in this arcane area from Sidley Austin, the underwriters’ counsel. Sidley may seem a surprising choice for such a landmark securities offering, but the firm has a strong Investment Company Act group, then led by Thomas Smith Jr. The Sidley team was headed by partners J. Gerard Cummins and Edward Petrosky Jr. Fortunately for Fortress, its lawyers knew the SEC official in charge of investment companies, Andrew Donohue. They had worked with Donohue when he was global general counsel of Merrill Lynch Investment Managers, which he left in May 2006. Merrill was also an underwriter for both the Fortress and Blackstone offerings. (Five months after Fortress went public, Sidley’s Smith joined Donohue at the SEC, taking a job as his senior adviser.) The �40 Act is complicated, but essentially looks at the nature of a company’s assets to determine if it should be regulated. Companies, such as mutual funds, that primarily hold investment securities are investment companies. Companies that primarily make products are not. Fortress is a holding company that describes itself as an “alternative asset manager.” It reveals little about these assets in its SEC filings. Before Fortress went public, the SEC asked the company’s lawyers why it shouldn’t be considered an investment company. Basically they said that Fortress is in the investment management business, not the investment securities business. The SEC didn’t appear to be convinced at first. It asked for “a more thorough analysis” of why the investments in Fortress’ funds are not investment securities. In a deft feat of abstract reasoning, Fortress answered that its primary assets are management contracts with its underlying funds, and these contracts are not securities. In the end, the SEC dropped the issue. Fortress went public on Feb. 9 without having to register as an investment company. It raised $634 million by selling 38 percent of its stock. Investors snapped up shares: On the first day of trading, the price nearly doubled, jumping from $18.50 to $35 a share. One lawyer who closely followed the offering says the SEC decided in the end to take a hands-off approach: “The SEC thought this was a gray area. . . . [It thought] if Congress doesn’t like it, it can pass a law.” Duke University law professor James Cox, who has written treatises on securities regulation, says he believes that an overwhelmed SEC punted: “At the end of the day, [the SEC] faced a hugely complex issue under fairly tight time demands.” The SEC declined to comment. BLACKSTONE GOES FURTHER Despite its groundbreaking structure, Fortress’ public offering didn’t attract much criticism. That changed when Blackstone proposed to go public. Blackstone has $80 billion in assets under management, twice that of Fortress. Companies owned by Blackstone through subsidiaries include Equity Office Properties Trust, Freescale Semiconductor Inc., and Houghton Mifflin Co. In contrast to Fortress’ lower-profile principals, Blackstone’s Schwartzman flaunts his wealth, estimated by Forbes at $3.5 billion. In February he threw a lavish 60th birthday bash for himself at the New York Armory, with Donald Trump and Barbara Walters attending and Rod Stewart performing. The New York Times marveled over the event, calling it “a coronation of sorts” for Schwartzman. The next month, Blackstone filed documents with the SEC to go public. Blackstone’s legal team was led by chief legal officer Robert Friedman (a former Simpson Thacher partner) and Simpson tax partner Hart and corporate partner Joshua Bonnie. Like Fortress, Blackstone would take the form of a publicly traded partnership to avoid corporate tax. Also like Fortress, Blackstone used blocker subsidiaries to turn fee income into dividend income to qualify for this tax treatment. (It’s not clear if Blackstone’s blockers are heavily debt-laden to wipe out taxable income.) Blackstone also maintained that it need not be regulated as an investment company under the �40 Act. The Simpson lawyers added a cherry to this parfait of corporate benefits. They set up Blackstone as a limited partnership. Partnerships are exempt from rules that give shareholders rights and protections mandated by the New York Stock Exchange and, arguably, Delaware law. Blackstone’s shareholders have no voting rights, its board isn’t independent, and the company says it has no fiduciary duties to its shareholders. (Fortress, on the other hand, is a limited liability corporation and has more investor protections. It is still, however, taxed as a partnership.) After Blackstone filed with the SEC, a reporter from The Wall Street Journal called the AFL-CIO, which has a department that monitors corporate law developments. Heather Slavkin, the group’s senior legal and policy adviser, was asked to look at the documents. She recalls her reaction: “About two hours into this, I ran down and said, �I think this is an investment company.’ This was a big concern.” If Blackstone were an investment company, the law would force it to offer better investor protections. �A BIG CONCERN’ The AFL-CIO embarked on a campaign against Blackstone’s IPO, writing letters to Congress and the SEC and enlisting experts in the �40 Act. One lawyer in the deal suggests that the AFL-CIO took aim at Blackstone because unions feel threatened by private equity firms, which often buy distressed companies and lay off workers. Slavkin says that’s not so, noting that the union supported Cerebus Capital Management’s purchase of the Chrysler Group. “We don’t have a problem with private equity in general,” Slavkin says. “We think it’s a valuable way to diversify funds. But we think there needs to be more transparency and accountability.” The AFL-CIO lined up a knowledgeable ally in Mercer Bullard, a professor at the University of Mississippi School of Law. Bullard had worked as an assistant chief counsel in the SEC’s Investment Management Division. Since leaving the SEC in 2000, he has been a persistent champion for mutual fund investors through his advocacy group, Fund Democracy. “I was stunned the SEC was letting Blackstone go forward,” says Bullard, who testified before Congress on Blackstone’s offering. “Blackstone falls squarely within the definition of an investment company.” Duke’s Cox agrees: “This was a clear violation of the Investment Company Act. . . . [The SEC] appeared to be rolling over and turning a blind eye to this.” Bullard adds that investment company status wouldn’t have to be fatal to Blackstone’s IPO. The SEC could have granted the company exemptions, such as allowing incentive fees. Bullard admits he didn’t catch this investment company issue when Fortress went public: “Everybody missed the boat on Fortress, including me.” Corporate law expert John Coffee of Columbia Law School isn’t as adamant that Blackstone should be regulated: “On pure formalism, I think it is an investment company. [But ] I think the SEC could have gone either way.” Coffee has a much bigger problem with Blackstone’s corporate governance, which he calls “pathological.” In congressional testimony in July, he complained that the company’s shareholders are “voiceless, voteless, and stripped of legal remedies.” Coffee adds in an interview, “There’s no reason that the decision to use an LP rather than an LLC should make all the corporate governance rules irrelevant.” Bullard is similarly offended by the lack of shareholder protections: “Their governance goes back to the Stone Age. It’s outrageous that the New York Stock Exchange and the SEC sat by.” He does, however, give Blackstone credit for not hiding its bad governance. “The disclosure [in the SEC filings] is really good,” he states. “They say, �We can self-deal right and left.’ ” A spokesman for the NYSE says that Blackstone is following all the rules that apply to partnerships. Simpson’s Bonnie asserts that Blackstone believes its management structure, in which a small circle of managers controls decisions, has been a key reason for its success. QUESTIONS FROM THE HILL By the summer, lawmakers in Congress were raising questions. In June, Sens. Max Baucus (D-Mont.), chairman of the Senate Finance Committee, and Chuck Grassley (R-Iowa), the committee’s ranking member, introduced a bill that would tax publicly traded private equity firms as corporations. Rep. Henry Waxman (D-Calif.), chairman of the House Oversight and Government Reform Committee, asked the SEC to delay Blackstone’s offering, citing risks to individual investors. The SEC resisted any delay, and Blackstone went public as scheduled on June 21, raising $4.13 billion by selling 12 percent of its stock. Still, Congress wanted some answers. During a June 26 hearing before the House Financial Services Committee, Rep. Paul Hodes (D-N.H.) complained to SEC Chairman Christopher Cox, “The structure of Blackstone looks like an investment company whose disclosures are incomprehensible. The message to investors is, as long as you create a complex enough corporate structure, you can evade [the Investment Company Act].” Cox, a Latham & Watkins partner before he was elected to the House from California, responded with a lawyerly explanation that appeared to favor form over function. “The funds that Blackstone manages are indeed investment companies, but the fund manager is not, under the law,” he said. “For the life of me,” exclaimed Hodes, “I cannot see who is protecting investors in the Blackstone IPO.” Two weeks later, at a July 11 hearing, Senate Finance Committee members asked Donohue, the director of the SEC’s Investment Management Division, why the agency did not treat Blackstone and Fortress as regulated investment companies. Donohue repeated the reasoning used by Fortress in its correspondence with the SEC: These companies are in the investment management business, not the investment securities business. Fleischer, the University of Illinois law professor, claims Fortress and Blackstone are trying to have it both ways: They want the benefit of partnership taxation while avoiding the headache of being a regulated investment company. To achieve this, the companies take inconsistent positions, arguing that their income is mostly passive for tax purposes and active for Investment Company Act purposes. “It’s arbitrage between two different regulatory schemes,” Fleischer says. In a Jan. 18 letter to the SEC, Fortress maintained that it is not an investment company because 75 percent of its recent income came from management fees and other services. But in its IPO prospectus, it states that it should be taxed as a partnership because its income will primarily consist of interest, dividends, and other types of qualifying income. “I think Blackstone and Fortress are active companies,” Fleischer says. “They’re anything but passive.” Both Skadden and Simpson call this analysis too simplistic. In his written response, Skadden’s Coco emphasized that these are different tests with different rules. “There is no question that a very active company can satisfy the qualifying income tax test,” he wrote. Simpson’s Bonnie agrees, noting, “Candidly, I have always found this criticism to be quite a canard.” REAL FALLOUT? It’s not clear whether, after the initial surge of outrage, a statutory fix will make it out of the Senate. Duke professor Cox notes the substantial political influence of billionaire hedge fund and equity fund managers and the financial services industry. Blackstone in particular has opened its wallet in Washington. It spent $3.74 million on lobbying in the first six months of 2007, with most of that going to Ogilvy Government Relations. Blackstone also helped form a lobbying group called the Private Equity Council, which has spent $1.02 million to hire Akin Gump Strauss Hauer & Feld and others. Fortress has kept a lower profile, spending $100,000 on lobbying, though in August it hired Skadden to lobby on its behalf. Investors may not care about details like investment company regulation or corporate governance protections when their stock is rising. But at press time Blackstone had been trading below its IPO price for all but a few days. Fortress was doing better, although at press time it too was trading below its offering price. Blackstone and Fortress may be the first in a wave of similar offerings by private equity firms, hedge funds, and anyone else who can squeeze into this structure. Och-Ziff Capital Management Group, a $30 billion hedge fund, went public on Nov. 14 using similar techniques. KKR & Co. has likewise filed papers with the SEC to go public. Both companies have experienced legal teams behind them: Skadden is representing Och-Ziff, and Simpson has KKR.

Susan Beck is a senior writer at The American Lawyer , an ALM publication, where this article originally ran.

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