How Hedge Funds Ride Herd in America

Let me try to connect some dots. I think this adds up to an interesting comment on how things get done in the good old USA. This example does not pass my “smell test”.

Start with something called a “Safe Harbor”. This is a legal designation that is established by the IRS. The activities of entities inside the Safe Harbor are free from taxation. The critical variable in determining whether Safe Harbor status is granted is if the activities of those seeking tax-free status are conducting trade or business in the USA.

I will go you two extreme examples. Toyota, a foreign corporation, has plants and retail outlets in the USA. They are clearly conducting trade or business here. No Safe Harbor status for Toyota. On the other extreme consider an individual in Europe who owns some US Treasury securities as a passive investment. They are not conducting trade or business, so the interest income is tax-free.

These two examples are pretty clear-cut. The problem is that everything in the middle of these two extremes is not so clear. Those who want the benefits of tax-free status, but have a question mark as to whether they in fact deserve the favored treatment, have to petition the US IRS and get a letter ruling to clarify their status. If they get a favorable ruling, they are off to the (tax-free) races.

Next consider this article (Link) from the NY Times June 8th. This article discusses a new phenomenon in US finance. Hedge Funds are becoming lenders. They are acting as banks. They have customers, they loan money to them. This is becoming a big deal. From the article:

Hedge fund managers have been called plenty of names. Now, they can add another: local banker.

Middle-market companies, which generate $6 trillion in revenue a year and employ 32 million people in the United States, are borrowing billions of dollars from the hedge funds for product development, strategic acquisitions and even day-to-day operations like payroll and utilities.

Okay, we have two distinct issues. Safe Harbor status and hedge funds who are actually bankers. Now the dots that connect these two.

Consider the role of Managed Fund Association (“MFA”). MFA is the D.C. lobbying arm of the hedge funds. They make that pretty clear in their web site:

MFA is the voice of the global alternative investment community. Our members are professionals in hedge funds.

So what is MFA doing to promote business and make money for the hedge funds? They are doing everything possible to get Safe Harbor status for inward lending to the hedge funds for offshore money.

Hedge funds want to make loans to US companies; they will finance this activity with untaxed money from abroad. Consider this letter (link) sent to Treasury (the IRS) by MFA on 6/1/11.

From the letter:

For the reasons discussed below, we respectfully request that guidance under section 864(b) of the Internal Revenue Code be included in the forthcoming 2011-12 Guidance Priority List.

MFA continues to be concerned that the absence administrative guidance under section 864(b) of the Code concerning whether certain activities by otherwise passive non-U.S. investors, including (but not limited to) activities involving the acquisition of loans and other debt securities as well as the receipt of certain types of fees, will be treated as falling outside the safe harbors.

The guidance can be issued in the form of clear safe harbors and there is no doubt that guidance of the type requested will reduce the potential for burdens on, and controversy between, the IRS and taxpayers.

What’s this about? Hedge funds who make loans need financing for the loans. They have no deposit base, so where will they get the money to make the loans? The answer is: From offshore. The process of raising money is made much easier and cheaper if there is a private letter from the IRS that insures that the activity of offshore lenders is deemed tax free in the USA. That’s why the big push from those nice folks at the MFA.

Here’s the rub however. Community banks in the US pay income tax on their lending to US customers, and so do US investors in bank loan mutual funds, partnerships, etc. So the proposal by the hedge funds (MFA) would give them a leg up against traditional lenders. They would get a tax break on their activity, while everyone else would suffer.

What’s the downside to giving tax breaks to hedge funds? From the NYT article:

These lenders typically charge interest rates that are several percentage points higher than banks.

The lending force also poses a significant risk to the companies and the broader economy, given the unregulated nature of this shadow banking system.

Another worry is that funds will trade on nonpublic information they receive as lenders. A March study in The Journal of Financial Economics found a spike in investors betting against the shares of companies that took hedge fund loans.

My bet is that the hedge funds and the MFA will get their way. Another big tax break will be created that benefits few and costs everyone else a bundle. How could that possibly happen? Easy. The hedge funds have clout, and they are using it:

MFA members include the vast majority of the largest hedge fund groups in the world who manage a substantial portion of the approximately $1.9 trillion invested in absolute return strategies.

If you want a good example as to why the recently passed FINRA legislation is just a joke, this is the perfect example. If you have money and power in this country you can do damn near anything you please, and you can also do it without paying any taxes.

Notes:
-Lending activity within our boarders has always been deemed as conducting trade or business. So this carve-out for hedge funds constitutes a significant change in policy.

-The powerful NY Bar Association has weighed in on this issue and fully supports the position of the MFA. Why? Because the NY lawyers would make a bundle promoting and setting up the safe harbor activity. Can you say “enlightened self interest”? The NY Bar on this topic (link).

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