Outside The Box

E.F. Hutton Listens

           I was introduced to E.F. Hutton’s Corporate Finance Department in 1976. E.F. Hutton was big in tax shelters, accounting for an estimated 60% of all limited partnerships sold. Kutak Rock did an estimated 80% of E.F. Hutton’s tax shelter work. At one point, fourteen of our securities lawyers in the Omaha office were working full time on E.F. Hutton matters. One of the partners actually quit his job and became Vice President and Head of Tax Shelter Origination at E.F. Hutton.

           Needless to say, we spent considerable time in New York and on the road. Kutak Rock even opened a New York office. Our first assignment for E.F. Hutton Corporate Finance was a coalmine syndication at Grand Junction, Colorado. In the process, I became close friends with Paul Bagley. Paul was Vice President and Manager of Corporate Finance. He later became Executive Vice President, Managing Director and Head of Corporate Finance.

           One day I got a call from Paul telling me to read an article in Forbes. He told me I was to be on the next plane to New York. The magazine had an article  suggesting that an E.F. Hutton offering was fraudulent. It featured a picture of a person in a Robin Hood hat, with the caption “Among his merry band of robbers was E.F. Hutton & Company, Inc.”

           We discovered that the Forbes article was largely exaggerated. But we did discover a crack in the system. All of the major underwriters, including not only E.F. Hutton, but also firms like Merrill Lynch, Prudential Bache and Shearson Lehman, were relying on “canned” due diligence packages graciously provided by the selling syndicators. The major firms were selling these securities. That wasn’t good enough. In order to comply with Rule 10b-5, an underwriter had to conduct its own investigation. It has a duty to protect the customer. In the words of Yogi Berra, it was déjà vu all over again because no one believed rule 10b-5 would apply, but it did.

           Identifying this need gave us lots of credibility, and performing the due diligence investigations gave us lots of work. E.F. Hutton’s tax shelter sales, which had been in a separate department, were made a part of Corporate Finance reporting to Paul. I didn’t do much due diligence. That was left to others. I was too busy doing Paul’s creative and innovative work.

           Bill Nicoletti, an investment banker who worked for Paul, told me that Apache Petroleum Company was looking for a way to list its partnership interests on the New York Stock Exchange. He said that if I could find a way, he would take the client away from its existing underwriters and we would be counsel.

           The problem with listing limited partnerships on the New York Stock Exchange was that under the law in effect at that time, a limited partner had general partners’ liability between the time he was admitted to the partnership and the time his name was recorded with the Secretary of State. The Stock Exchange would not tolerate even a millisecond of general liability. The other exchanges and the over-the-counter market were of the same view. You could have public partnerships, but you could not give the interests liquidity because they couldn’t trade in any organized market.

           After several months of wrestling with this problem, I was leafing idly through the CCH Securities Law Reporter while talking on the telephone, when I  came across a Form C-5. I thought, “What the hell is a Form C-5?” It turned out to be the form for registering American Depository Receipts (ADRs) with the SEC. ADRs are used in connection with foreign securities. You can’t issue shares of stock in a Japanese company to Americans, because the shares are written in Japanese and are denominated in Yen. What happens in practice is that thousands of Japanese shares are put into a depository, and fractional interests in the shares are issued in English and denominated in dollars.

           It was déjà vu all over again (again), because that is what we did in the case of First Municipal Leasing Corp. I proposed that we have a single limited partner, which was a fiduciary. The limited partner would issue Beneficial Assignment Certificates (fractional interests) against the limited partnership interest that it held. The investors would never become limited partners per se, but they would be entitled to all the rights, privileges and economic benefits accorded to limited partners.

           This structure not only worked, it caught fire. Hundreds of copy-cat offerings ensued. Limited partnerships had true liquidity for the first time.

           I consider this the most significant accomplishment of my legal career because of the volume of public partnerships which followed. Unfortunately, the program was too good for investors, and too bad for the U.S. Treasury. This was because of the tax benefits accorded to limited partnerships. Congress eventually ended the proliferation of public limited partnerships by taxing them in the same way that corporations are taxed.

           I represented E.F. Hutton and also Silver Screen Partners in connection with Silver Screen’s organization and first public offering. I had represented Paul Bagley in putting together International Film Investors, L.P. a few years earlier. The investors did not do well, even though International Film produced the blockbusters Gandhi and The Killing Fields. Paul was determined that if E.F. Hutton ever did another film financing, the investors would at least get their money back.

           The first Silver Screen offering was done for HBO, which wanted to produce its own films. HBO was obligated to pay the investors money back after five years if they did not earn it back out of the films. It was like a 5-year interest free loan to HBO, with strict guidelines on the use of proceeds.

           Silver Screen Partners II, III and IV were done for the Walt Disney Company (which includes Touchstone Pictures.) Nearly a billion dollars was raised for Disney to make 46 films.

           Several executives at Disney claimed credit for doing the Silver Screen deal. But the deal was just a mark-up of the first Silver Screen, done with HBO. The Disney executives and their lawyers didn’t really have their heads into the documentation. They missed a very important point: the owner of the films was the Silver Screen Partnerships. This was required in order for the investors to claim the tax benefits. When Disney discovered that it didn't own films like Pretty Woman, Good Morning Vietnam, Three Men and a Baby, and Who Framed Roger Rabbit it was unhappy to say the least.

           Disney had the right to acquire the films at fair market value, which it elected to do. Fair market value was determined to be approximately $1 billion, which was paid to the Silver Screen Partnerships. Success has many fathers, but failure is an orphan. It is said that everyone at Disney disclaimed responsibility for Silver Screen and this billion dollar oversight.

           A person who wanted to do a partnership to finance Mr. Donut stores approached Paul. He considered Mr. Donut too weak to support an offering, but decided to use the opportunity as a platform to test another idea he had — an insured lease financing.

           We approached Hardee’s and they agreed to work with us. We found a small insurance company with $10 million in capital. The fact that the insurance company was small was not an impediment. The risk would be diversified over a large number of restaurant properties owned by different people. They were not likely to all fail at once. We actually didn't expect any failures at all. But the presence of the insurance company in the transaction gave the investors protection and confidence in the offering.

           The key to the financing was a heavily negotiated and technically difficult Franchise Support Agreement to be entered into by Hardee’s. It was difficult because it had to be strong enough to give the insurance company comfort that Hardee’s would take over any failed franchises and run them, and at the same time had to be weak enough so that the accountants would not treat the agreement as a liability.

           The first offering sold $18,000,000 and subsequent offerings were more and more successful until nearly $1 billion had been raised. Franchise Finance Corporation of America eventually became a part of GE Capital.