Corporation, Securities & Business Law Forum
December 2001 Vol. 47, No. 1
Statements or expressions of opinion or comments appearing herein are those of the editors or contributors, and not necessarily those of the association or section.
(Notice to librarians: The following issues were published in Volume 46 of this newsletter during the fiscal year ending June 30, 2001: October, No. 1; January, No. 2; April, No. 3; May, No. 4; June, No. 5.)
Contents
* Do charitable organizations have a safe haven from general real estate taxes?
* Major brokerage firms propose hollow solutions for research analyst conflict of interests
* Beware of the "bulk sales" provisions for business assets in the Illinois tax statutes
I have been both honored and privileged to have been appointed as the current chair of the section council and to have served on the section council for a number of years. I treasure the collegiality, experience and hard work of the lawyers who have served with me. I also especially wish to thank Jay Goldstein, our past chair.
Consistent with the section's mission to serve the bar and the public interest in our areas of expertise, we expect to continue to issue at least four newsletters per year and sponsor at least one continuing legal education seminar. In past surveys, our members have indicated that these are our most valued programs.
The section council also expects to redouble its efforts in support of the ISBA's goal to eliminate the unauthorized practice of law. The entire section can help by sending to me examples of harm done to the public, not to the bar, by such unauthorized practice. At the same time, the section council will be exploring ways to make the current rules against unauthorized practice more consistent with the needs of businessmen operating and expanding across state lines.
I encourage each of you to check out our ISBA Web site and use the information that is available to you as a member of the section. I also invite any comments that you might have relating to issues raised in your practices including suggestions for legislation. Over the years, those comments have been very valuable, and I anticipate that they may be even more valuable as the legal system struggles to catch up to rapid technological advances and increased concerns over security threats.
Zane M. Cohn
Zane M. Cohn & Associates, P.C.
150 N. Michigan Ave., Suite 3300
Chicago, IL 60601
O: (312) 236-4100
F: (312) 894-3210
Do charitable organizations have a safe haven from general real estate taxes?
By Brent H. Gwillim, Peoria, IL
The Illinois statute 35 ILCS 200/15-65, entitled "Charitable Purposes" provides that facilities for the aged shall be exempt from real estate taxes when the premises are actually and exclusively used for charitable or beneficial purposes, and not leased or otherwise used with a view to profit. For purposes of this article, Petitioner shall be the entity which owns the premises subject of an Application for Tax-Exempt Status, in addition to additional adjacent parcels which are tax-exempt, and Petitioner does operate a home for the aged on the property already tax-exempt and the property subject of the Application for Tax-Exempt Status. Petitioner is an Illinois not-for-profit corporation that has a section 501(c)(3) exempt status from the Internal Revenue Service. Petitioner operates facilities for the aged and said premises and facilities located on the premises are used for charitable purposes and are not used for any purpose to generate a monetary profit.
Petitioner is presently in the process of expanding its facility with the proposed construction of additional independent living units and other related facilities. The premises in question in Petitioner's application are the premises where the independent living facilities are to be located. Planning for the expansion and development and construction of the new facilities began prior to 1998. During 1999 Petitioner's facility development was no longer an intended use, but by 1999 the subject premises were in actual process of development and adaptation for exempt use.
In 1999 Petitioner (a) owned fee simple title to the premises; (b) had given notice to the tenant farmer to terminate the tenant farmer's tenancy effective January 1, 1999 (notice dated March 11, 1998); (c) had commenced preparation of the master site plan and schematic drawings which were all preliminary architectural work, and in addition had hired and prepared a market feasibility study; (d) had the second phase of the zoning proceedings approved; and (e) an engineer was hired in the spring of 1999, and a subcontractor was contracted to commence and complete all soil testing work, in addition to the placing of stakes for commencing construction.
In 1999 Petitioner expended approximately $700,000 in development and adaptation costs. These costs were itemized on the financial information that was made available to the administrative law judge in the proceedings.
Petitioner's case is very similar to the facts set forth in Weslin Properties, Inc. v. The Department of Revenue 157 Ill. App. 3d 580 (1987). In this case the appellate court specifically stated that "exemptions have been allowed where property is in the actual process of development and adaptation for exempt use." As the evidence indicates as presented to this court, Petitioner expended large sums in its development and adaptation costs for the proposed project. As stated previously, in addition to a feasibility study and design development Petitioner actually had work performed on the premises in the form of soil testing and the setting of stakes for the commencement of construction.
The evidence presented at the hearing established the policies in force at Petitioner's entity and further established that Petitioner is a charitable institution using the premises exclusively for charitable purposes. This is the issue raised by the Department of Revenue, in that the Department has taken the position that the premises to be used for independent living facilities which are part of Petitioner's overall campus, are not utilized for charitable purposes and therefore are not subject to tax-exempt status. The evidence presented to the Administrative Law Judge established that Petitioner uses a Use Agreement with the independent living residents which does provide of payments to Petitioner, with refunds to be made to the residents at such time as the residents vacate the independent living facility. The evidence also established that Petitioner uses funds paid by residents for furthering its charitable purposes and that it makes no profit and that all funds are used to further the organization's charitable goals. The case of Resurrection Lutheran v. Department of Revenue 212 Ill. App. 3d 964 at page 971, states "A charitable institution does not lose its tax-exempt status merely because the persons who are unable to pay for its services are required to do so, so long as the institution makes no profit and all funds are used to further the organization's charitable goals." The fees paid by the residents are used for construction of facilities and Petitioner's regular operating expenses. The Petitioner realizes no profit from any funds paid by the residents.
The evidence as presented in the administrative hearing proceedings by Petitioner supported and confirmed the guidelines set forth in Methodist Old Peoples Home v. Korzen 39 Ill. 2d 149 (1968), which guidelines are as follows: (1) The organization has no capital, capital stock or shareholders; (2) earns no profits or dividends; (3) derives its funds mainly from public and private charity and holds them in trust for the objects and purposes expressed in its charter; (4) dispenses charity to all who need and apply for it; (5) does not provide gain or profit in a private sense to any person connected with it; and (6) does not appear to place obstacles of any character in the way of those who need and would avail themselves of the charitable benefits it dispenses.
The evidence has shown that (1) Petitioner is an Illinois not-for-profit corporation with a 501(c)(3) tax-exempt designation from the Internal Revenue Service and has no capital, capital stock or shareholders. (2) Petitioner earns no profits or dividends. All funds generated through payments by residents or funds received by donation from public and private organizations are used to further Petitioner's charitable purposes in developing its facilities and programs. (3) Petitioner derives its funds mainly from public and private charity and holds them in trust for the objects and purposes expressed in its charter and policies. (4) Petitioner dispenses charity to all who need and apply for it, as evidenced by the financial commitment and policy of the Petitioner where no individual has ever been denied access to its facility based upon financial need or asked to vacate the facility based on financial need. Each year the evidence has established that Petitioner has, through a subsidiary, distributed large sums each year to individuals who have financial needs. (5) Petitioner does not provide gain or profit in a private sense to any person connected with the organization. All funds expended are for operating services . (6) Petitioner does not place any obstacles of any character in the way of those who need or would avail themselves of the charitable benefits it dispenses. Petitioner is a full service home for the aged that provides independent living facilities, intermediate living facilities and skilled care facilities, the latter of which are licensed by the State of Illinois. The evidence has also shown that Petitioner maintains Medicare and Medicaid residents, in addition to meeting financial needs of residents. In addition, Petitioner admits individuals to its facilities without regard to race, creed, religious affiliations, sex or ability to pay.
In addition to the cases cited herein, Petitioner cites two additional cases that support the Application for Tax-Exempt Status of the subject premises. These cases are Decatur Sports Foundation v. Department of Revenue 177 Ill. App. 3d 696 (1988) and Illinois Institute of Technology v. Cal Skinner, Jr., County Treasurer 49 Ill. 2d 59 (1971).
The issue that needs to be addressed is the question of charitable use of premises used by charitable organizations for a purpose which the Department of Revenue may claim is not a charitable purpose. Are premises used for independent living facilities being used for charitable purposes? In planning or structuring a charitable organization which provides various benefits to its clients or residents one must keep in mind the charitable use of property if the entity wishes to obtain tax-exempt status for the premises.
Major brokerage firms propose hollow solutions for research analyst conflict of interests
By Andrew J. Stoltmann and Thomas A. Hargett, Maddox Koeller Hargett & Caruso, Chicago,
I. Introduction
In the last three months, brokerage firm research departments have come under intense scrutiny for alleged undisclosed conflict of interests. On July 1, 2001, the NASD proposed tougher disclosure rules for analysts. The SEC recently warned investors to treat analysts' advice with a great deal of caution. The New York Attorney General's Office launched an inquiry into whether analysts are providing unbiased stock recommendations. The U.S. House of Representatives Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises held hearings in June of 2001 examining the quality of analysts' research. Only days before the Congressional hearings Merrill Lynch settled a high profile arbitration action for $400,000 against Henry Blodget, their star Internet research analyst. As a result of some of these actions, the Securities Industry Association recently released "best practice" guidelines in an attempt to ensure research analysts are working in the best interests of investors rather than for the firms' investment banking divisions.
II. The perceived problem
Many individual investors relied upon the research provided by analysts at major brokerage firms believing it to be unbiased and credible. However, the same securities firms whose analysts purport to give investors' unbiased stock advice also employ investment bankers who profit significantly from investment banking relationships with the same companies followed by the research department. Some argue this has made research analysts at brokerage firms salesmen rather than unbiased evaluators of the merits of a company as an investment. As the argument goes, this results in analysts publishing unrealistic and overly optimistic projections of a company's future stock price.1
Most institutional investors understand the conflict of interests present in the research departments of most major brokerage firms. Scott Black, President of Delphi Management, stated in the February 12, 2001 edition of American Prospect "[M]ost analysts are simply putting out promotional literature. They're there to sell stocks and drum up other business."2 Tweedy, Browne Company, in their May of 2001 letter to shareholders, stated "If you pardon our cynicism, many of these analysts also work for investment banking houses that are collecting generous fees for bringing Internet and Internet related companies public. In a more rational world, this would be called a conflict of interest."3 Byron Wein, stock market strategist for Morgan Stanley, in Time Magazine on April 2, 2001, stated "It is clear that the profession has some serious work to do to rebuild confidence" as he urged analysts to be "intellectually honest and independent." Unfortunately, many individual investors were not aware of the conflicts of interest present in brokerage firm research departments.
There are four factors that commonly compromise the objectivity of analysts. First, there are the investment banking relationships between the brokerage firms and the companies they follow. The investment banking business is an extremely lucrative business for brokerage firms. Jay Ritter, economist at the University of Florida, estimates the underwriting revenues for Wall Street from 1999-2000 were $7.3 billion. Underwriting a company's securities offerings and providing other investment banking services can bring in more revenues for firms than brokerage firm operations. As a result, some believe analysts are prohibited from providing any negative information about companies who employ the firm's investment banking services.
When hiring a securities firm for investment banking business, many companies assume the firms' research analysts will provide glowing reports regardless of the actual merits of the company. An unfavorable analyst report may harm the firm's efforts to cultivate investment banking relationships that most brokerage firms deeply covet. A negative research report is many times enough for that company to take their future investment banking business elsewhere.
Recent academic studies and surveys indicate this problem is widespread. A survey of analysts and companies by Tempest Consultants found that 88 percent of brokerage analysts polled said the companies they cover would retaliate against a 'sell' recommendation by replacing their firms with competitors for future investment banking business. Fifty-four percent of analysts surveyed said they believe companies would temporarily exclude them from company briefings while 25 percent of companies surveyed admitted they would cut off access if an analyst issued a sell rating on their company.4
Maureen McNichols, a professor of Public and Private Management at Stanford University, published a study that concluded that analysts "bow to pressure from investment bankers or clients and issue more favorable reports than warranted." Her study concluded that analysts for underwriting firms had more favorable recommendations and long-term growth forecasts than analysts that were unaffiliated with an underwriting deal.
A study entitled "Analyst Credibility: The Investor's Prospective" published in the Journal of Managerial Issues by Jane Cote, Associate Professor of Accounting at Washington State University found that analysts are frequently pressured to offer favorable recommendations or at least temper negative opinions. No fewer than 61 percent of analysts responding to a survey reported personal experience with management threatening reduced future access to the company, severing business ties to the investment firm, lawsuits and even having the analyst terminated."5
The second factor that compromises analysts' objectivity is the compensation structure for research analysts. An analyst's pay and job security is often directly linked to the number of investment banking deals the analyst lands or to the profitability of the firm's investment banking division. The analyst therefore has an incentive to help ensure that the brokerage firm continues its investment banking relationship with the brokerage firm by providing positive research on the company.
Unfortunately, brokerage firm analysts typically know that a negative research report means no future investment banking business and can sometimes even cause an analyst to lose his or her job. Mitch Zacks of Zacks Investment Research stated in 2001 that the "way an analyst can get fired is to damage an existing investment banking relationship with a company or sour a future investment banking relationship."6 In 1994, Bell South refused to rehire then Salomon Bros. as a lead underwriter for a large bond issue after a Salomon analyst described the company as one of the worst run of the seven Baby Bells.7 Marvin Roffman, an analyst of Janney Montgomery Scott, a well-known regional brokerage firm, was fired by the firm after he issued a report concluding that Donald Trump's Taj Mahal was too risky of an investment.8 Richard Lilly, an analyst for JW Charles Securities, was fired by the firm after he unearthed fraud by the management of a company he was following. Lilly's employer refused to let him file a scathing research report against the company.9
The third factor that compromises analysts' objectivity is personal ownership in the shares of the company the analyst follows. Some brokerage firms engage in "venture investing" where firms and analysts acquire a stake in a start-up by acquiring discounted, pre-IPO shares. Analysts therefore profit from owning the securities they follow and they have an incentive to provide glowing recommendations, regardless of the merits of the company. An analyst who owns the security he follows clearly has a conflict of interest opening up the potential to be less than honest in an assessment of the merits of the company.
The final factor that tarnishes analyst's objectivity is the extra commissions brokerage firms typically receive for a positive research report. A "buy" or "strong buy" recommendation by a brokerage firms research department helps the firm generate more purchases of securities which leads to additional commissions for the brokerage firm. Stockbrokers often use glowing research reports as a sales tool when soliciting the purchase of a stock from their clients or prospective clients. It is easier to convince a client to purchase a security when the firm's research department has a "strong buy" or "buy" recommendation on a stock.
Academic research indicates the above noted conflicts are more than just theoretical problems. Kent L. Womack, a finance professor at Dartmouth's Amos Tuck School of Business, and Roni Michaely, a Cornell University finance professor, found that the stock recommendations of brokerage firms without investment banking ties tend to be more accurate. Their stocks rose an average of 3.5 percent within a year, versus a decline of 11.6 percent over the same period in stocks recommended by brokerage firms involved in investment banking with the companies they cover.10
A study from the Harvard and Wharton Business Schools entitled "The Relationship Between Analysts' Forecasts of Long-Term Earnings Growth and Stock Price Performance Following Equity Offerings" concluded:
Our evidence suggests that the coexistence of brokerage services and underwriting services in the same institution leads sell-side analysts to compromise their responsibility to brokerage clients in order to attract underwriting business. Investment banks claim to have "Chinese Walls" to prevent such conflicts of interest. Our evidence raises questions about the reliability of the "Chinese Walls." We document that analysts affiliated with the lead underwriter of an offering tend to issue more overly optimistic growth forecasts than unaffiliated analysts. Furthermore, the magnitude of the affiliated analysts' growth forecast is positively related to the fee basis paid to the lead underwriter. Finally, equity offerings covered only by affiliated analysts experience the greatest post-offering underperformance, suggesting that these offerings are the most overpriced.
David Dreman, a well-known Wall Street contrarian and financial columnist, and Michael Berry, a professor of business at James Madison University, published a study in The Financial Analysts Journal in 1996 that reviewed 94,251 analyst forecasts between 1971 and 1996. The conclusion of their study was that the typical analyst forecast missed the target (that is, varied from the actual result) by 42 percent. While the average error over the 25-year period was 42 percent, in the last eight years they examined (1989 through 1996), analyst forecasts missed the target by an average of 50 percent.11
III. The proposed solution by the Securities Industry Association
In June of 2001, the Securities Industry Association ("SIA"), backed by the 14 largest underwriting firms in the securities industry, released "best practice" suggestions on how to ensure analysts work in the best interest of investors and not their investment banking clients. In releasing the guidelines, SIA President Marc Lackritz stated "Analysts play a very important role by providing thoughtful and independent analysis for investors. These 'best practices' are part of many efforts to ensure that our industry abides by the highest professional standards."12
The primary suggestions released by the SIA involve the following:
* Don't link analysts' pay "directly" to investment-banking deals;