Tag Archives: Financial Engineering

Are Corporations People?

Corporations are people, my friend.

Four years ago, while campaigning in Iowa for President, Mitt Romney spoke those words to protestors who were angry about low income tax rates on corporations. Romney was saying that corporations are owned by people and employ people, and that their income is ultimately returned to people. Thus, for all intents and purposes, corporations are people.

The principle was later revived when the Supreme Court of the United States outlawed most regulations and restrictions on corporate contributions to political campaigns. They reasoned that corporations (as people) possessed the right to free speech, and thus also possessed the right to speak with their money by making (largely) unregulated and unrestricted donations to candidates.

But the principle that “corporations are people” appears to have its limits. Earlier this month, for instance, Brooklyn based Etsy — the online crafts platform that claims to be building a human, authentic, and community-centric global and local marketplace — initiated a complex tax avoidance strategy. The firm’s United States unit loaned funds to its Irish unit, which then utilized the funds to buy the American unit’s intellectual assets.

Why did Etsy engineer this strategy? Well, Irish corporate income tax rates are lower than American rates. So with Etsy’s intellectual assets now housed in Ireland, any income earned from the use of those assets can be taxed at Ireland’s lower rates.

It’s a nice way to reduce one’s tax bill, isn’t it? You’re probably tempted to replicate it, if possible. Perhaps you can simply tell your employer that you’ve transferred your personal knowledge, skills, and experience to a shadow version of yourself that is based in Ireland. Then your employer can pay your salary to your shadow self, who can (in turn) pay lower income tax rates.

Is this actually possible? Regrettably not. The tax strategy is only available for corporations. Human beings are not eligible to take advantage of it.

And there’s the rub of believing in the principle that corporations are people. On the one hand, it can be utilized by corporations to enable their own tax avoidance strategies and protect their own political lobbying and contribution activities. But on the other hand, people are not permitted to take advantage of many benefits that are routinely granted to corporations.

Today, four years after Mitt Romney spoke those famous words while campaigning in Iowa, many new candidates are seeking a Presidential nomination. Should we be surprised that, unlike Mitt Romney in 2011, today’s Republican Party front-runner is gaining support by charging that corporate interests buy people, instead of claiming that corporations are people?

Global Banking: It’s The Happy Meal!

Having lurched from one scandal to another during the past year, one would think that representatives of the global banking industry would be eager to improve their public image.

Wouldn’t one?

It thus may come as a surprise that global financial specialists have chosen to publicize a recent trading innovation that has been named after a product for children.

What is the product? It’s the Happy Meal! Named after the meal with a toy at McDonald’s, an investor’s Happy Meal is a bond that is convertible to stock, packaged along with a loan of some shares of the underlying stock.

Either way, an investor in a financial Happy Meal stands to earn a profit. If the issuing corporation performs well, the bond can be converted to equity. And if it doesn’t perform well, the stock loan can be utilized to sell the corporation short.

So which investment vehicle — the convertible bond or the stock loan — is analogous to the food in a Happy Meal? And which vehicle is analogous to the toy?

Regrettably, that distinction is not altogether clear. What is indeed clear, though, is that the naming of an investment innovation after a fast food product for children is not likely to enhance the badly tarnished reputation of the world’s global banks in the eyes of the general public.

Financial Engineering: Cure For General Motors?

Three days ago, after tens of billions of American taxpayer dollars were used to bail out the auto industry under the supposition that a bankruptcy filing would lead to the catastrophic liquidations of General Motors and Chrsyler, the audit firm of Deloitte & Touche nevertheless expressed substantial doubt that GM would survive in its present form.

Deloitte & Touche, as well as other public accounting firms, call this a going concern opinion. But investors, lenders, suppliers, customers, and employees of GM might ruefully call it a kiss of death.

The primary cause of Deloitte’s pessimistic conclusion is the heart-stopping crash of automobile sales volume since the global economy collapsed in late 2008. GM has seen a 53% sales decline in the month of January 2009 alone, and an overall 40% decline since sales peaked in 2007. But what can companies like GM do to boost sales in such times of crisis?

Jaded business professionals might retort, with a bit of sarcasm in their voices, “How about selling better quality automobiles for more affordable prices?” Yes, that is always a good idea …

… but many companies, including GM, have often resorted to financial engineering strategies as well.

Gary Winnick: The King Of Financial Engineering

Shortly after the technology bubble of the late 1990s burst, for instance, the telecommunications firms Global Crossing and Qwest Communications engaged in a series of swap transactions that were designed to boost declining sales numbers. Though the transactions were not designed to significantly increase net earnings, they were required to maintain revenue levels and thus persuade investors that the firms had bright futures as high growth businesses.

Such high growth businesses, of course, usually trade at high price/earnings multiples; thus, these swap transactions helped senior executives maintain personal levels of compensation that were determined by their firms’ stock market valuations. Global Crossing and Qwest were publicly excoriated by a committee of United States Congressmen, who accused them of conjuring up “sham transactions” for the private benefit of their senior executives.

But Gary Winnick, the head of Global Crossing at the time, protested that these transactions were perfectly legal acts of financial engineering; he said that they were developed and booked in order to keep his firm competitive in the financial markets. Although he was raked over the coals during Congressional public hearings, he never spent a single day in jail.

Other Tales of Financial Engineering

Similar types of swap transactions have been developed and implemented throughout recent American corporate history. Many firms engage in sales and leaseback transactions, for instance, that appear to have no valid business purpose other than the financial engineering of balance sheet and income statement items. By the time that the original owner of an asset leases it back from its purchaser in such a transaction, there is usually no discernable impact whatsoever on the business operations or overall cash flows of either firm.

And Enron, for instance, used internal transfer prices between its own divisions to establish extremely high market rates for a series of commodity transactions that were traded on its own system; they then used these data points as benchmarks for revenue transactions with third parties. The revenue rate setting process itself was considered perfectly legitimate (and even quite clever) at the time; Enron quite possibly would have escaped any criticism about these practices if not for the collapse of the firm for other reasons.

And what of GM and its fellow automobile manufacturers? Well, the automobile industry has actually engaged in internal transactions of questionable economic value for decades. In 1996, for instance, the Ford Taurus only managed to hold onto its “Best Selling American Automobile” title because more than half of all its sales that year were made to rental car companies. Ford, not coincidentally, had been a partial owner of Hertz and Budget for many years, while GM was a partial owner of Avis and National for many years as well. In other words, the automobile rental agencies that purchased Ford and GM automobiles were often partially owned by the manufacturers themselves.

What’s An Auditor To Do?

So what is an auditor to do when confronted with an income statement of an organization that claims to produce the best selling automobile in the nation, but that sells 51% of its output to special entities? Or an energy company that marks-to-market its asset values on the basis of transactions that are placed on a private system that it directly owns and, in fact, thoroughly dominates? Or a firm that has removed significant amounts of debt from its books with a series of sales-and-leaseback transactions that have no underlying economic value whatsoever? What, exactly, is an auditor to do?

Unfortunately, even government regulators are not opposed to the use of financial engineering transactions that serve no discernable underlying business purpose. For instance, many regulators are still espousing the development of a gigantic government-owned “bad bank” to purchase problem assets from our wobbly private financial institutions, an idea that Paul Krugman derides as “the belief that fancy financial engineering can create value out of nothing.” And, in a sense, each tax incentive that has ever been passed by a governmental entity is designed to encourage businesses and individuals to engage in transactions that they would not have otherwise considered if not for the incentives themselves.

So what’s an auditor to do? Sadly, the conventional wisdom appears to encourage them to sign off on the financial engineering activities of their client organizations. And what is GM to do? If it continues following the same conventional wisdom, it may continue engaging in these very activities as well.

Unless, of course, our society finally realizes that the individuals and firms who followed the conventional wisdom are the ones who are responsible for creating our present economic crisis to begin with …

… and with that realization, in the blink of an eye, we might finally start down the path to a sustainable recovery.