Month: July 2016

Tax Policy and Economics

Economics ,

When a politician tells you that they will bring good paying jobs back to their district you should know that they are lying.  And while it should surprise no one that politicians lie; this lie is particularly insidious because it is something that could easily be accomplished. Politicians lie about job creation because many have themselves swallowed a lie called “trickle down economics” hook, line and sinker.

The idea of paying taxes to fund government operations goes back to the early Chinese emperors. Taxes can be broad based, like the tax on tea that precipitated the American Revolution. Historically governments appreciated that if they wanted to raise a lot of money, they needed to impose taxes on the wealthier people in the system.

The US federal income tax, beginning in 1919, was always progressive. It taxed people who earned higher income at higher rates.  For most of the time between 1919 and 1970, the highest tax rate on people who earned the most was 70%.  That amount seems confiscatory and it was, but for most of that time it applied to a very small portion of the total population.

The highest period of job growth in the US was during the post-WWII era, roughly 1945-1975.  During that time, the US federal government paid for two wars, Korea and Vietnam (which was very expensive), the US interstate highway system, the cold war military buildup (intercontinental ballistic missiles, battleships and aircraft carriers) and the space program.

All of these were very expensive outlays of funds that originated with taxpayers. At the same time, virtually all of these funds were spent within the US, the great bulk of it on salaries of workers who were building the highways and the hardware that the government was purchasing.

In the mid-1970s the US economy was battered with high inflation caused in large part because oil production was taken over by a cartel (OPEC). That raised the cost of everything in the US that moved by truck which was just about everything.

The OPEC oil embargo caused shortages which resulted in people waiting in long lines to get gasoline.  It also caused home heating oil prices to soar causing difficulties and dissatisfaction during the winter months.  Those of you who remember President Gerald Ford on television with a WIN (whip inflation now) button can relate. That dissatisfaction led to the election of President Reagan in 1980.

It is actually a 1978 article that is credited with the birth of “trickle down” economics and the “Laffer curve”. The article related the events that had occurred at a dinner attended by Dick Cheney and Donald Rumsfeld, both of whom worked for Pres. Ford. At this working dinner Prof. Arthur Laffer, then at the University of Chicago, sketched a curve on a napkin as an illustration of the tradeoff between tax rates and tax revenues.

Laffer suggested that tax revenues would increase as rates decreased because the untaxed funds would be used efficiently to create businesses and jobs and hence additional revenue which could be taxed.

For his part, Laffer claims that the restaurant had cloth napkins and he would never have used one for the illustration.  He also is quick to point out that the idea that cutting tax rates increases tax revenues goes back to the 14th Century.

Economics is a science that is very much based in mathematics. At its core is the idea that people will spend money in ways that satisfy their own best interest. The primary interest is getting the same or similar goods or utility at the cheapest price, so that you can get more goods and services with the money that you have.

There are mega gigabytes of data covering income, spending, taxes and a great many formulas and equations to explain and extrapolate that data.  If you took algebra in high school you know that when you change the variables in an equation, you get different results which you can then plot on a graph.

The Laffer curve is a graph that has no equation or data supporting it.  Most economists never accepted the Laffer curve but “cutting tax rates will make the country better off, create more jobs and result in higher tax collections” is an argument that has needs little factual or statistical support. It is a bastardization of a slogan we used to have in the 1960s: “if it feels good, do it.”

The Laffer curve is the basis of the Reagan era tax cuts on the wealthiest Americans and subsequent tax cuts at the state levels that continue to this day. The sales presentation for these tax cuts was that these wealthy individuals would invest the money that they saved creating new businesses and new jobs as the money “trickled down” into the economy.

It never happened.  Several states, (Louisiana and Kansas) continue to cut state taxes and have increasing difficulty funding schools and essential services. But the slogan: “I’m going to cut your taxes so you will have more money in your pocket” wins elections.

There seems to be an abiding desire to return to the “good old days” when there were many good paying jobs in the US.  As we learned with the New Deal and in the post-war prosperity, government can create those jobs. But it also needs to pay for them.

In round numbers, if your adjusted gross income is more than $375,000 per year you are in the top 1% of US taxpayers. The average overall federal tax rate for this group is just about 25%.  This includes some business owners, some doctors, some lawyers, all NBA rookies, many entertainers and hedge fund managers. Not all create that many jobs for others.

If the tax rate for this group were raised by 5% there would be more than enough money to create 1 million good paying jobs in the US; fixing highways, highway bridges, airports, ports and other infrastructure projects that just about everyone agrees need to be fixed. Fixing the highways would also reduce commute times, gasoline consumption, air pollution and the cost of everything that moves by truck.

These workers would pay taxes on their earnings which would fund other government programs and expenditures. They would also buy homes, cars, hamburgers, movie tickets and just about everything else people buy. It is money that would truly trickle down to other businesses. These types of construction jobs usually come with medical benefits as well.

Understand that even these workers will buy products like clothing and iPhones that are manufactured overseas. Overseas workers charge substantially less per hour for their time and Apple does not repatriate the profits it earns overseas or pay US taxes on them.

That is part of the problem with the current tax system and with the current “trickle down” theory. Left to their own devices business owners will use the money that they save from tax cuts to create jobs overseas.

I appreciate that there is a certain amount of “down with the top 1%” in this but I am not advocating a mass redistribution of wealth.  If anything, it is the tax cuts in the last 30 years that have caused the current disparity between rich and poor. Swinging the pendulum back the other way for a decade or two would seem to be a good way to promote growth and overall economic stability.

 

 

 

 

 

Can Lawyers Trust Their Clients?

Issuers, Law ,

It was a simple case and a simple request. The case involved an older gentleman whose stockbroker had over concentrated his portfolio in real estate securities. When the 2008 real estate crash came the portfolio tanked. I was retained to recover his losses.

I drafted the claim and sent it to the client for his comments. I included simple instructions, “review it carefully and tell me if I have set out the facts correctly. At the hearing you will be asked to swear that this is true”.

One of the facts included in the claim was something the gentleman had told me at our first meeting; that he had never invested in real estate securities before.  This became important when the stockbroker being sued filed his answer. He said that the client had told him that he had previously invested in real estate securities and had lost money and therefore understood the transactions and the risk.

“Never happened” my client told me.

Sure enough, on cross examination, the defense attorney reminded my client that when he first became this broker’s client, years earlier, it was because the previous broker had recommended that he invest in securities that were very similar to the ones he was now complaining about.  Apparently, he had deposited a small check that he had received from a class action over a defunct real estate deal into the account early on.

The next question: “if you lost money in this type of securities before, why did you accept the broker’s recommendation to buy them again?” effectively dooming the case because the client did not have a good answer. I had not prepared him to answer the question that I never thought he would be asked.

I could attribute this to the client’s bad memory but that does not factor into every situation.

In another case, a different client revealed for the first time during cross examination that he had been accused by his wife during their divorce proceeding of molesting his own children. There was apparently enough truth to the allegation that he had been formally charged and sentenced to probation.

I always ask about past lawsuits and criminal matters at my first meeting with any client who is likely to take the witness stand. I believe that a lot of lawyers do so as well. This client did not think that it was important to tell me the truth. We did not win that case, either.

These client omissions resulted in lost cases and a fair amount of lost time.  Most lawyers do not lose too much sleep over it. There are a lot of things that can go wrong with any case. Every time two lawyers go into a courtroom, someone loses. Trial lawyers develop a thick skin.

Corporate lawyers with untrustworthy clients can get into more significant trouble. Lawyers who prepare the offering documents for the sale of securities take on a considerable amount of personal liability. Most of the big law firms that write the prospectuses for IPOs carry substantial liability insurance policies. And these firms usually do a pretty good job of getting the facts straight.

Still, if the offering is deficient and the investment fails anyone connected with the offering, including the lawyers are likely to get sued.

When I was a young lawyer learning how to prepare offering documents I attended a few seminars. One instructor offered an example of an attorney who had failed to do what he should have done and had gotten into a lot of legal difficulty.

The example went something like this:

An older gentleman who owned about $100 million worth of commercial real estate, mostly small office buildings with street level retail storefronts, wanted to retire and sell out. His son, who had no cash, wanted to continue to receive lucrative management fees and arranged a private placement to buy out his father.

Many of the tenants had been there for years and the father gave many of them long term lease extensions as he was preparing to sell. The leases were collected and reviewed by the lawyer who was preparing the private placement. These were reduced to a schedule which showed the current and projected rent roll for the buildings that was included in the private placement memorandum (PPM).

What was not disclosed was the fact that the father had also provided side letters to many of the tenants who he considered to be his friends allowing them to terminate their leases on short notice if market conditions deteriorated, which of course they did a few years later. Several tenants vacated and several more asked for rent reductions threatening to vacate based upon the side letters that had never been disclosed.

The investors sued and won. The state securities commissioner alleged fraud and the attorney was lucky to settle the case and retain his license to practice.

Attorneys who participate in the issuance of securities are obligated to conduct a reasonable investigation of the facts to make certain that what they disclose is accurate and complete.  This lawyer just accepted what his client told him at face value and suffered the consequences. That was the lesson that was being taught. Lawyers cannot trust their clients.

A few months ago I was approached by a small company that needed a private placement memorandum in order to crowdfund about $600,000. The company had already spent about $250,000 developing its product and was now getting ready to buy inventory and kick–off the business.

They did not want me to write the document. They had prepared it themselves using a software package that asked a lot of questions and spit out a private placement memo. All they wanted from me was to review the document and to “bless it”.  They had budgeted $1500 a legal review because they reasoned it could not take an attorney that long to read the document.

They told me that the software package was recommended as the best by several prominent bloggers and websites.  The software package was popular so they were confident that the resulting document would be fine.

Software templates for private placement memos have been around for a long time. There are dozens available today. For an attorney working without a secretary or paralegal, they certainly might have some utility.

Allowing a company to use a software template to write its own PPM without an attorney is like handing a child a loaded gun. Someone is going to get hurt. In most cases, it is probably going to be the investors.

I told the company what I would charge to review the document, make changes as needed and conduct a reasonable investigation to make certain that the facts were properly disclosed. It was more than $1500. They chose to find what they wanted elsewhere.

Several weeks later I came across the offering on one of the less expensive crowdfunding platforms.  I accessed the documents and saw that the PPM was mediocre at best. It just did not read very well.

They had removed some of the standard risk factors that I would have included for any startup. The prior work histories of the key executives were uneven. Some went back 10 years; others 5 years. There apparently was no marketing study and no discussion of the competition.  The PPM stressed how successful the company was going to be without a realistic discussion of what might go wrong.

The sales and profit projections were questionable.  They were projecting explosive growth in short order even though the company had not yet made its first sale. The company had nothing to support that projection except its own hopes and dreams.

I assume that some lawyer took their $1500 and signed off on the PPM as they presented it.  Some of the crowdfunding platforms require an attorney to review the PPM; some do not.

Most of the lawyers that I have met or corresponded with in the crowdfunding arena and the mainstream financial markets would insist on a reasonable investigation of the facts in any offering that they prepared. In most cases, you cannot do an investigation for a startup correctly for $1500.

I think it fair to question why the founders of a startup who are planning to get rich cannot budget more for a competent attorney than they do for pizza. I appreciate that lawyers have a bad reputation, but at the very least there should be some agreement that we are a necessary evil if the company is going to seek funding from investors.

The investigation is done partially to protect the lawyers from their own clients. It may not be what the entrepreneurs want to hear, but lawyers are not expected to trust their clients and the markets are safer and more efficient for it.

 

Feminism in Finance

Capital Markets, Investors, Issuers ,

This article is a response to a discussion on Founders Dating.  A female entrepreneur who was seeking funding for her business had discovered that she was pregnant. She wanted to know if the Founders Dating community thought that it was necessary for her to disclose that fact to prospective investors.

Almost universally, the men who responded thought that she must. They would not trust her, they said, if she had asked them to invest in her company without disclosing the pregnancy to them up front. I thought this response bordered on absurdity and I said so.

If the female entrepreneur had asked my advice, I might have asked if she thought the pregnancy or childbirth would materially impact the business. If she said no, I would have advised her not to disclose it. That is what I posted and virtually all the men and a few of the women took the contrary view.

If I was preparing the prospectus for an IPO of the same company, I would be obligated to do some due diligence about each of the key executives in the company to make certain that their disclosures were accurate. I would never think to ask anyone if they or their spouse was expecting a child. It is not an event that would normally be disclosed. The SEC would certainly not punish anyone for failing to disclose it.

If the issue is that the pregnancy might take this executive away from the business for a period of time, distract her or impede her ability to do her job then I would be obligated to ask every key executive at the company: Do you have a special needs child or elderly parents?  Are you healthy? How often do you drink alcohol? Do you have a prescription for oxycodone?

You can see where this goes. Any of these would potentially have a greater impact on the executive’s time and performance than an average pregnancy and birth.

No one would suggest that a male executive disclose his wife’s pregnancy even if the company had a policy that would give him extended parental leave after the birth. That is the salient point. This is a prejudice against women. It really has nothing to do with a clear business decision.

If anything, it is easier to plan for the “disruption” that a birth might have with the timeline the company is forecasting. Every schedule needs some slack. Once a pregnancy is known, the business can plan for it.

Much of the discussion seemed focused on the fact that the investors, mostly angels rather than professional VC’s, were concerned that the entrepreneur had divided her attention away from the business. They were concerned that she would not be giving 100% of her attention to the business that they were funding.

This kind of thinking is archaic, inappropriate and demonstrates how poorly these angel investors approach the task of evaluating a business that they are considering funding. To me they were signaling their own ineptitude and a foolish approach to investing their own money.

What these angel investors are saying is that they are not confident the business has a team in place sufficient to deal with the absence of a key player. That might be true if this were a concert tour and the primary artist became pregnant. For almost every other business it should never be an issue. With a CEO or senior executive, if childbirth truly impacts their productivity then that loss in productivity can be picked up by another member of the executive team.

Underlying the desire of these angel investors to have disclosure of this pregnancy was a knee-jerk opinion that women do not make good judgments. Underlying was the attitude: why did she get pregnant when she was trying to start a business? Respectfully, it is none of your business, even if it is your money.

Whether you attend business school at Harvard or at a state university, students are generally taught that the CEO and management team should have 3 types of vision; 1) vision on the product (costs and quality); 2) vision on the market (customers and competition) and 3) vision on the bottom line (overhead and cash flow).  It is a good, simple approach that investors can evaluate. It is a standard that does not care if the entrepreneur is male or female.

The implication is that a woman could not have this requisite vision if she also had vision on her infant. That makes no sense. I could not find a reputable study that supported this, nor would I expect to find one. A lot of women have children and return to work.

I graduated for an all male college in 1971. When I started law school that fall, my law school class of 120 students included exactly 12 women, because there was a 10% quota for women.  When I started working on Wall Street after graduation women were mostly secretaries. A handful of women were in middle management, but none were in upper management. The firm had a few thousand stockbrokers; probably less than 20 were women because people did not think women knew a lot about investments and managing money. Throughout the business world the glass ceiling was very real.

It was not unusual to hear what would now be considered inappropriate remarks about women at any time. It was not inappropriate to ask a woman to bring you a cup of coffee, no matter what her job title or expect her to straighten up the conference room after a meeting. A lot of people, including a lot of women, thought that women joined the workforce to find husbands.

Women were treated as second class citizens in the business world. In many respects they still are.  The Founders Dating discussion highlighted how this problem still exists.

Today approximately one-half of college graduates are women and it seems reasonable that one-half of the venture capital would be directed to companies that women own or control. But that is not the case. It is not going to happen unless and until these archaic attitudes about women’s ability and judgment are dispelled.

The problem needs to be approached from both directions.

Angel investors need to get a little perspective. Investors in large companies do not ask about the executives’ personal lives when they make an investment. A small company is no different.  If you cannot evaluate a business as a business and insist upon knowing the details of the managements’ personal lives, I suggest that you keep your money in your pocket.

Steve Jobs had returned from a commune shortly before he started Apple. Should his personal life have been considered by investors or just his product? And to be sure, Jobs is not an anomaly. Back in the 1970’s men could not get jobs, let alone funding, if their hair was over their collars.

As importantly, women need to call out this foolishness whenever it occurs. At least one woman in the Founders Dating discussion supported the idea that a pregnancy should be disclosed. I would have expected many women to tell the men to get real. Few did.

There are more and more successful women stepping up and providing capital to businesses being started by other women. That is laudable but does not touch on the problem.

I found the fact that not a single woman on Founders Dating raised significant objections to the entire discussion to be an indication of why this type of prejudice continues. Ignoring this problem will not make it go away.