As John Corzine faces the music on Capitol Hill, the pressing question is “where is the money?”  That is, how can hundreds of millions of dollars of clients’ funds not be easily located? This occurred because the clients of MF Global signed the account agreement which allows their assets to be held in street name.  So, how does holding assets in street name matter?  It matters because the assets are no longer the property of the clients, but of the brokerage house, and are subject to the firm’s creditors on bankruptcy.

To understand this you need to know that, over years, more and more investors have been holding assets in street name.  In essence, the client’s assets are “dematerialized” existing only on the electronic books of the issuer and an electronic depository house known as DTCC.

Holding assets in street name is good for investors for a variety of reasons. It makes buying and selling much easier for you, collecting interest payments more timely and simple, and even protects you against the loss or theft of physical stock or bond certificates, while reducing the costs associated with transfers and deposits. However, when your securities are held in the name of your brokerage or bank, they, not you, have most the rights of ownership. The issuer corresponds only with broker, and sends the broker interest and dividend payments, and sends the broker the forms to vote on corporate issues (those envelopes you tend to toss in the trash).

The result is that, when securities in your account are held in street name, says Eric Brunstad, Visiting Lecturer in Bankruptcy Law at Yale Law School, it’s really not your property. It’s like depositing money in a bank account. Your cash isn’t sitting in the vault in a box with your name on it. You are simply a creditor of the bank. Maybe you should have read the fine print, after all.

THE FINE PRINT

Often clients do not read the extremely small print on their account agreements.  That fine print of an account agreement generally includes one clause that reads something like this:

All securities, commodities and other property held, carried or maintained by you in your possession in any of my accounts may be pledged and repledged by you from time to time, without notice to me, either separately or in common with other such securities, commodities and other property for any amount due in my accounts or for any greater amount, and you may do so without retaining in your possession or control for delivery a like amount of similar securities, commodities and/or other property.

This means your broker, subject to SEC rules, can lend your stock to short sellers, hedge funds, corporate raiders and buyout funds and possibly even give those investors voting rights and control for key periods, and not have offsetting collateral in house. Your brokerage firm generally keeps all this money. As the Bear Stearns Clearing agreement puts it, “As a result of such activities…the Clearing Agent Group may receive and retain certain benefits to which you will not be entitled.”

So, what happens when a Brokerage Fails? 

If a brokerage were to be taken over by the Securities Investor Protection Corp (SIPC – the governing authority) for insolvency, says Brunstad, first, customer name securities are distributed back to their owners. Securities held in street name, (the vast majority) however, would likely be included in the pot of customer property, which is later distributed ratably to customers. This could make it difficult for you to recover all of your securities, in some instances possibly tying them up for several years, according to the U.S. General Accounting Office (GAO-03-811 , Report to Congress: (Securities Investor Protection, July 2003, pp. 23.)

In the past, the payouts from SIPC have been prompt (no longer than a week) and have covered all of the assets of their clients.  However, if further pressure arises from the financial crisis and a truly major brokerage house fails (rather than being taken over as Bear Stearns was) we may see another financial crisis, with the government not having the resources for another TARP rescue.

In sum, just because something is a common practice doesn’t mean it’s a good idea.

There are some simple things you can do about this.

1.      Only maintain a Margin Account if you absolutely must borrow money against your securities.

2.      Ask to open a Cash Account, and read the Agreement, being sure that you do not authorize your broker to use your holdings for any purposes you don’t like or don’t get paid for.

3.      Instruct your broker in writing to register your securities in your name whenever possible — and get an explanation of any issues or fees this might raise.

4.      The safest bet is to set up a custodial account at a Trust Company or a Bank with Trust powers, and have your securities delivered and/or registered there. Securities held by trust Companies or banks for their customers are registered in the name of a separate nominee than the bank’s proprietary property at DTCC, and barring fraud or misappropriation, will not get caught up in a bank’s insolvency. The bank will manage the paperwork and charge a negotiable custodial fee. Some will do it for free provided you agree to do your securities business through them.

You cannot register the vast majority of securities in your own name. You must use a nominee registered at DTCC. The difference between a brokerage’s account nominee and a bank custody-or trust-type account nominee is that the nominee (the bank or trust company) in the latter is only used for client’s property, and the institution is bound by law and contract not to use the securities so registered for any purpose.

By keeping the customer property totally separate from bank property, it will not get caught up in any bank failure. Brokerages do not do this. If you have more money, you can negotiate your own deal (we have)… but anyone with a few bucks can open an account at a bank, trust company  or similar organization and ask that your securities be held in a customer-only nominee name. Most will do it.

Many paintings in museums are never exhibited, loaned or de-accessioned, illustrating the complex relationship between art and money.  

Logic says that it is better to sell art rather than store it, especially where the work is of lesser quality by the same artists as exhibited by the museum, since the freed up funds could be used to restore other art in the collection, or acquire new art needed to enhance the collection on exhibit.  This is not a trivial question, since there is estimated to be 900,000 paintings in public collections in the US today, with 720,000 not on display alone.

One argument has been that the art in storage is "low value" (that is less good than the work on display) but this begs the question why the museum or collector is taking up scarce and badly needed storage space for such poor quality works?  Worthy paintings could be sold to other museums or collectors with lesser quality collections, without taking them any more out of view than they would be in the permanent storage of the museum.  

The real problem is the imbalance between the value perception of art and the value perception of money.  A mediocre work being sold is seen as a loss by members of the press and public (for a museum) and to the collector and their friends while the corresponding financial amount added to the museum’s endowment or collector’s resources is not seen as a gain.  For museums, this is even extended to the use of moneys from sale of art.  The Art Museum Director's Code rule that moneys from the sale of art can only be used to buy more art, as well as the implicit corollary to the rule that the art should be of the same period as the sold art, may make sense form the point of view of avoiding fights over who gets to use the funds, but it makes no sense if the art is preserved while the museum collapses - the Barnes collection being a case in point.  

Alternatively, if not sold, then why not leased?  Some do for some high prestige items like the Tutankhamen exhibits, but very few do.  Even at a below market lease fee for commercial art of 5%, the leased art could add a healthy dose of income to the museums.  Museums are not required to account for the fair market value of their art in storage, or show it on their balance sheet, presumably because if the donors ever knew how much capital the museum was leaving fallow, they would be less likely to make donations.  Collectors do not think about making their collection “work” by leasing art or through associated sales like catalogs or websites.

Money controls what is displayed, in part, by museums since curators will always display a work that they had to pay money for, while neglecting that artwork that they accrue by gift or are long standing items in the collection.  It makes some sense to market a $35 million recently acquired Giacometti to the public than an unvalued donated collection of sculpture.  Curators and collectors may say it is not about the money, but is.

Estate plans are all about strategy, but when the estate plan involves a family business, the estate planner needs to look beyond the tax issues and into how the estate plan will help the client’s business strategy.  Testing how well the plan works with the business plan requires some very different tests:

Test 1: Will your strategy help your client beat the market?

Test 2: Does your strategy tap a true source of advantage for the client?

Test 3: Is your strategy granular about where it effects how your client competes?

Test 4: Does your strategy put your client ahead of trends?

Test 5: Does your strategy rest on privileged insights?

Test 6: Does your strategy embrace uncertainty?

Test 7: Does your strategy balance commitment and flexibility?

Test 8: Is your strategy contaminated by bias?

Test 9: Is there client conviction to act on your strategy?

Test 10: Have you translated your strategy into an action plan for your client?

Source: Ten timeless tests can help you kick the tires on your strategy, and kick up the level of strategic dialogue throughout your company. McKinsey Quarterly, Jan. 2011, Chris Bradley, Martin Hirt, and Sven Smit.  http://www.mckinseyquarterly.com/Have_you_tested_your_strategy_lately_2711

Registration at mckinseyquarterly.com  is required to read the full article.  

Erskine Summary:

SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 275 Release No. IA-3222; File No. S7-37-10 RIN 3235-AK81 

See http://www.sec.gov/spotlight/dodd-frank.shtml

The Securities and Exchange Commission is adopting rules to implement new exemptions from the registration requirements of the Investment Advisers Act of 1940 for advisers to certain privately offered investment funds; these exemptions were enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

As required by Title IV of the Dodd-Frank Act – the Private Fund Investment Advisers Registration Act of 2010 – the new rules define “venture capital fund” and provide an exemption from registration for advisers with less than $150 million in private fund assets under management in the United States.

While the Senate voted to exempt private equity fund advisers in addition to venture capital fund advisers from the requirement to register under the Advisers Act, the Dodd-Frank Act exempts only venture capital fund advisers. The rule defines a venture capital fund as a private fund that: (i) holds no more than 20 percent of the fund‘s capital commitments in non-qualifying investments (other than short-term holdings) (“qualifying investments”). For example, one commenter suggested that the definition of venture capital fund include a fund that incurs leverage of up to 20% of fund capital commitments without limit on duration and invests up to 20% of fund capital commitments in publicly traded securities and an additional 20% of fund capital commitments in non-conforming investments.

Section 403 of the Dodd-Frank Act amended section 203(b)(3) of the Advisers Act by repealing the prior private adviser exemption and inserting a “foreign private adviser exemption” defined in new section 202(a)(30) of the Advisers Act as an investment adviser that has no place of business in the United States, has fewer than 15 clients in the United States and investors in the United States in private funds advised by the adviser, and less than $25 million in aggregate assets under management from such clients and investors.

Erskine Summary:

Source: SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 275 [Release No. IA-3220; File No. S7-25-10] RIN 3235-AK66 Family Offices AGENCY: ACTION: Securities and Exchange Commission.

See http://www.sec.gov/spotlight/dodd-frank.shtml

SUMMARY: The definition of family office provided in the rule is designed to limit the exclusion from Advisers Act regulation solely to those private advisory offices that the SEC believes the Advisers Act was not designed to regulate and to prevent circumvention of the Adviser Act’s protections by firms that are operating as commercial investment advisory firms.

The Securities and Exchange Commission (the “Commission”) is adopting a rule to define “family offices” that will be excluded from the definition of an investment adviser under the Investment Advisers Act of 1940 (“Advisers Act”) and thus will not be subject to regulation under the Advisers Act. Recognizing this past practice, section 409 of the Dodd-Frank Act instructs that any family office definition the Commission adopts should be “consistent with the previous exemptive policy” of the Commission and recognize “the range of organizational, management, and employment structures and arrangements employed by family offices.”  Section 409 also includes a “grandfathering clause” that precludes the SEC from excluding certain family offices from the definition solely because they provide investment advice to certain clients and had provided investment advice to those clients before January 1, 2010.

First, the exclusion is limited to family offices that provide advice about securities only to certain “family clients.” Second, it requires that family clients wholly own the family office and family members and/or family entities control the family office.

A family office excluded from the Act is limited to an office that advises only “family clients.” Family clients include current and former family members, certain employees of the family office (and, under certain circumstances, former employees), charities funded exclusively by family clients, estates of current and former family members or key employees, trusts existing for the sole current benefit of family clients or, if both family clients and charitable and non-profit organizations are the sole current beneficiaries, trusts funded solely by family clients, revocable trusts funded solely by family clients, certain key employee trusts, and companies wholly owned exclusively by, and operated for the sole benefit of, family clients (with certain exceptions).

Under the rule, a “family member” includes all lineal descendants of a common ancestor (who may be living or deceased) as well as current and former spouses or spousal equivalents of those descendants, provided that the common ancestor is no more than 10 generations removed from the youngest generation of family members. The rule also treats as a family client any irrevocable trust in which one or more family clients are the only current beneficiaries.

by John Richards of Brigham Young University, 6/30/2011

Source: http://vcexperts.com/vce/news/buzz/archive_view.asp?id=1073&referrer=buzz&mail_id=buzz1271

Erskine Summary:

It is common for entrepreneurs to offer to their investors preferred stock in their new ventures to raise capital, and Blue-blooded venture investors like to do preferred stock arrangements because they get more ownership of the company.

Venture debt is another means of financing new ventures, however. For example, UTFC Financing Solutions LLC, a Utah firm specializing in venture debt, funds entrepreneurs by extending loans with attached warrants. Usually, the loan must be paid back with terms of 14 percent interest over five years or so, plus UTFC receives the right to purchase a small percentage of the company.

A side-by-side comparison of three rounds in a standard investment scenario shows that the use of venture debt over equity reduces by 10 percent the amount of the company the entrepreneur has to give to investors.  The venture debt investor gets one important thing: reduced risk, expressed mostly through a secured credit position and priority over equity investors.

International practitioners discussed tax strategies through the use of "blockers" at a recent meeting of the International Tax Institute in New York.

Source:  International Tax Updates on Checkpoint Newsstand Tab 6/16/2011

The Erskine Company Summary:

Blockers are entities placed in a structure that change the character of the underlying income or assets to obtain tax results that may be otherwise unavailable. For example, many hedge funds use foreign corporations as blockers for their investors to invest in the fund or so that the fund may invest in portfolio companies. Willard B. Taylor of Sullivan Cromwell LLP, considered the use of a U.S. partnership to elect into the Controlled Foreign Corporation (CFC) foreign tax credit rules or out of the Passive Foreign Investment Company (PFIC) rules.

As an example, he considered the acquisition of a foreign corporation that would be a PFIC by U.S. investors (mostly with less than 10 percent interests). Generally, to qualify as a regulated investment company (RIC), at least 90 percent of a fund's annual gross income must consist of the items specified in Code Sec. 851(b)(2) ("qualifying income") in addition to satisfying an asset test.  Income (including dividend and subpart F) from the RIC's investment in the foreign corporation complies with the requirements of Code Sec. 851(b)(2). In effect, the underlying commodity assets have been converted to RIC qualifying income.

Publicly-traded partnerships that are required to meet the gross income exception of Code Sec. 7704(c) (e.g. 90 percent or more of partnership's gross income must consists of dividends, interest, natural resources, real estate and other passive income). In the hands of the partnership, the income may take the form of dividends, gain on sale of subsidiary's stock, subpart F income (if foreign sub) or PFIC inclusion, etc. Hart said that some taxpayers had taken the strategy one step further and placed debt in the subsidiary corporation.

Hart also outlined a strategy for tax-exempt investors seeking to invest in a U.S. partnership that either makes leveraged investments or investments that generate income not excluded from unrelated business taxable income (UBTI). To get around this limitation, an S-corporation can form a partnership where it and the Non-Resident Aliens (NRA(s)) are partners resulting in substantively the same economic and legal rights as though the NRA(s) were direct shareholders in the S-corporation.  Taylor described a structure whereby a foreign corporation with investments in U.S. real estate could effectively elect out of FIRPTA.

The foreign corporation would technically owe less than 50 percent of the value of each REIT; the balance could be owned by a U.S. subsidiary of the foreign corporation or by a U.S. investor that agrees to hold its investment in the REIT for at least five years.

Defined Value Formula Clause Set Values for S-corp Stock Donated to Charities. Hendrix, TC Memo 2011-133.

Erskine Comment: The use of charitable deductions through donations of closely held family business stock is possible, and often desirable, where there is a keen desire to preserve family or local ownership of a company as well as a desire to have capital in the family business that might otherwise have been paid out in taxes to remain in the community.  Care needs to be taken in making such gifts, however, since the IRS will try to challenge the gift on any grounds, even the catch all “against public policy” grounds.

Erskine Summary:

The Tax Court has held that defined value formula clauses properly set the fair market value of S corporation stock transferred by married donors to various family trusts and a charitable foundation. By rejecting IRS's arguments, the court found that the formula clauses were reached at arm's length and were not void as contrary to public policy.

The dispute involved gifts of stock in the John H. Hendrix Corp. (JHHC) by John H. Hendrix and his wife, Karolyn M. Hendrix (Donors). In 1999, Donors sought estate planning advice from an attorney because they wanted to give some of their JHHC stock to their three adult daughters and to a charitable entity. Because the stock was hard to value, the attorney suggested that Donors use a formula clause to define the stock transfer at the time of the gift in terms of dollars rather than in percentages, while fixing for federal gift tax purposes the value of the transfer of the stock. He also advised them to establish a donor-advised fund at a nonprofit community organization. They followed this advice and chose the Greater Houston Community Foundation (Foundation) to administer their contemplated donor-advised fund. The attorney advised Foundation that Donors wanted to contribute (1) $20,000 to establish a donor-advised fund, and (2) JHHC nonvoting stock.

On December 31, 1999, each Donor, the trustees, and Foundation executed an agreement that includes a defined value formula clause that set the value of the irrevocably assigned 287,620 shares of the Donors' JHHC nonvoting stock to a GST trust and to the Foundation.

The IRS arguments contesting the valuation of this taxable gift were that 1) the formula clauses were invalid because they were not reached at arm's length, and 2) that they were void as contrary to public policy. On both arguments, the Tax Court disagreed.

First, the Tax Court said that the mere facts that Donors and their daughters were “close” and that Donors' estate plan was beneficial to the daughters did not necessarily mean that the formula clauses failed to be reached at arm's length. The court also noted that economic and business risks assumed by the daughters' trusts as buyers of the stock (i.e., the daughters' trusts could receive less stock for their payment if the JHHC stock was overvalued) placed them at odds with Donors and the Foundation. In addition, for a variety of reasons, the court found no collusion between Donors and Foundation. Second, while the court observed that it can disallow a deduction on public policy grounds if allowing such a deduction would severely and immediately frustrate sharply defined national or state policies proscribing certain conduct, the formula clauses at issue did not immediately and severely frustrate any national or state policy. To the contrary, they supported a fundamental public policy of encouraging gifts to charity.

Erskine Summary: With the seeming full return of the public M&A market, David Fox and Daniel E. Wolf, both partners at Kirkland & Ellis, have briefly commented on a number of recent trends in public Mergers & Acquisitions deal terms.  Here are some of the highlights from their commentary:

Deal Certainty — As we argued 18 months ago, the unexpected developments in deal certainty provisions for strategic and financial buyers in the immediate aftermath of the credit crisis did not represent a new "market" or "deal paradigm" but rather reflected a more thoughtful and nuanced approach to issues of certainty of closing in light of market conditions.

Hybrid Go-Shop — The hybrid go-shop, where no-shop prohibitions on post-announcement active solicitation of competing offers apply but the bifurcated termination fee structure feature of the go-shop is used, with a lower break-up fee applying in the event the unsolicited topping bid surfaces during a defined initial period after the deal signing, has continued to make slow inroads in the strategic market since we last addressed this issue six months ago.

Fiduciary Change of Recommendations — While it has long been accepted that target boards must contractually maintain the right to change their recommendations of, and, in many agreements, terminate, the initial deal in favor of a "superior proposal", lawyers have long debated whether seller boards should or must maintain the right to change their recommendation in favor of the initial deal even absent a superior proposal.

Fees/Expense Reimbursements on "Naked No Votes" — While most merger agreements provide for a break-up fee (usually between 2% and 4% of deal value) upon a rejection of an initial deal by the target shareholders while a competing bid is on the table (in many cases payable if and when the an alternative deal is completed during a "tail" period following the rejection and termination of the first deal), historically the remedies in favor of a buyer in the case of a so-called "naked no-vote" (i.e., a rejection by target shareholders absent a competing bid) have been very limited.

Defining "Willful Breach" — Most merger agreements provide that, other than any applicable break-up fee obligations, the parties have no further liabilities to each other following a termination with the exception of claims for "intentional" or "willful" breaches.

Some practitioners were surprised by the Delaware Chancery court decision in the Hexion litigation that held that in order for a breach to be "knowing and intentional", and therefore engender post-termination damages claims, the relevant act merely had to be conscious (i.e., not accidental) and not with knowledge or intent to breach the merger agreement. Some have sought to "reverse" the Hexion outcome by defining "willful breach" as an "act...with the actual knowledge” however, in a number of recent takeover deals such as Bucyrus/Caterpillar, ABB/Baldor, and Exxon/XTO, the parties have included social covenants in the merger agreement itself.

In light of recent Delaware decisions such as Lyondell, Dollar Thrifty and Atheros confirming that target boards have wide latitude in running a sale process and agreeing to deal protections, especially when selling to strategic buyers, we expect that the slow creep of deal protections in favor of buyers may continue unless and until checked by judicial review.

Here is the full article: http://vcexperts.com/vce/news/buzz/archive_view.asp?id=1059&referrer=buzz&mail_id=buzz1258