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Let's make the discussion of corporate charter freedom more concrete by looking at KKR's publicly traded "common units." We have already encountered KKR in the MetLife v RJR case, doing what it usually does: LBOs (and subsequent resale). KKR is a private equity firm that is in the business of buying entire companies, managing them for a couple of years, and then reselling them, hopefully at a higher price. To leverage their returns, KKR and other private equity firms tend to finance the acquisitions with a lot of debt, as KKR did in its purchase of RJR Nabisco. Beyond financial engineering and tax savings (because debt is tax-advantaged), private equity firms promise to generate returns through superior management.
It's a bit too simplistic to say that KKR or other private equity firms buy companies (from here on, I will just talk about KKR). In truth, KKR raises and manages funds that buy the companies. The investors in these funds tend to be large institutional investors, above all pension funds. In return for its services, KKR charges the funds an annual management fee (generally around 2% of the money invested), a performance fee (a/k/a carried interest, roughly 20% of profits generated), and various service fees.
The funds tend to be organized as Limited Partnerships, or L.P.s. A limited partnership is a statutory creation that is treated as a partnership for tax purposes and yet offers limited liability to the so-called limited partners. Partnerships do not pay corporate income tax. Instead, any partnership income is treated as income of the partners. In addition to its limited partners, an L.P. must have at least one so-called general partner. Like a partner in a traditional partnership, the general partner has management authority (the limited partners have none) and unlimited liability for the L.P.'s debts. In practice, and in KKR, the general partner of the fund is another limited liability vehicle, be it a corporation, a limited liability company (L.L.C.), or another L.P. (whose general partner will be another limited liability vehicle).
KKR has three layers of limited partnerships: the funds, their general partners (who are L.P.s themselves), and the general partners' general partner, KKR & Co. L.P. Public investors own "common units" a/k/a limited partnership interests in KKR & Co. L.P. KKR's founders maintain control of KKR & Co. L.P. through full ownership of its "Managing Partner," i.e., general partner, KKR Management LLC. The founders and KKR's senior managers also maintain 70% of the economic equity as limited partners of the funds' general partners. In sum, common unitholders own 30% of KKR's equity and no control. (The actual structure of KKR is even more complicated, but the preceding sketch suffices for present purposes.)
The reasons to structure the publicly traded vehicle as a limited partnership reside mostly in tax law. KKR & Co. L.P.'s prospectus describes its tax treatment as follows:
… an entity that is treated as a partnership for U.S. federal income tax purposes is not a taxable entity for U.S. federal income tax purposes and incurs no U.S. federal income tax liabilities. Each partner of a partnership is required to take into account its allocable share of items of income, gain, loss and deduction of the partnership in computing its U.S. federal income tax liability, regardless of the extent to which, or whether, it receives cash distributions from the partnership, …
An entity that would otherwise be classified as a partnership for U.S. federal income tax purposes may nonetheless be taxable as a corporation if it is a "publicly traded partnership," unless an exception applies. …. We are a publicly traded partnership.
However, an exception to taxation as a corporation, referred to as the "Qualifying Income Exception," exists if at least 90% of the partnership's gross income for every taxable year consists of "qualifying income" and the partnership is not required to register under the Investment Company Act. Qualifying income includes certain interest income, dividends, real property rents, gains from the sale or other disposition of real property, and any gain from the sale or disposition of a capital asset or other property held for the production of income that otherwise constitutes qualifying income. [NB: These types of income also tend to be taxed at a lower rate than ordinary income, making it especially valuable not to subject them to corporate income tax.]
Our Managing Partner has adopted a set of investment policies and procedures that will govern the types of investments we can make (and income we can earn), including structuring certain investments through entities, such as our intermediate holding company, classified as corporations for U.S. federal income tax purposes (as discussed further below), to ensure that we will meet the Qualifying Income Exception in each taxable year. …
In addition, the limited partnership offers governance flexibility. Among other things, section 17-1101 of the Delaware Limited Partnership Act provides
(c) It is the policy of this chapter to give maximum effect to the principle of freedom of contract and to the enforceability of partnership agreements.
(d) To the extent that, at law or in equity, a partner or other person has duties (including fiduciary duties) to a limited partnership or to another partner or to another person that is a party to or is otherwise bound by a partnership agreement, the partner's or other person's duties may be expanded or restricted or eliminated by provisions in the partnership agreement; provided that the partnership agreement may not eliminate the implied contractual covenant of good faith and fair dealing.
Utilizing this flexibility, section 7.9 of KKR & Co. L.P.'s limited partnership agreement provides:
(a) Unless otherwise expressly provided in this Agreement, whenever a potential conflict of interest exists or arises between the Managing Partner … and the Partnership … or any Partner …, any resolution or course of action by the Managing Partner … in respect of such conflict of interest shall be permitted and deemed approved by all Partners, and shall not constitute a breach of this Agreement … or of any duty hereunder or existing at law, in equity or otherwise, if the resolution or course of action in respect of such conflict of interest is (i) approved by Special Approval*, (ii) on terms which are, in the aggregate, no less favorable to the Partnership than those generally being provided to or available from unrelated third parties or (iii) fair and reasonable to the Partnership, taking into account the totality of the relationships between the parties involved (including other transactions that may be or have been particularly favorable or advantageous to the Partnership). The Managing Partner and the Conflicts Committee* (in connection with any Special Approval by the Conflicts Committee) each shall be authorized in connection with its resolution of any conflict of interest to consider such factors as it determines in its sole discretion to be relevant, reasonable or appropriate under the circumstances. The Managing Partner shall be authorized but not required in connection with its resolution of any conflict of interest to seek Special Approval of such resolution, and the Managing Partner may also adopt a resolution or course of action that has not received Special Approval. Failure to seek Special Approval shall not be deemed to indicate that a conflict of interest exists or that Special Approval could not have been obtained. If Special Approval is not sought and the Managing Partner determines that the resolution or course of action taken with respect to a conflict of interest satisfies either of the standards set forth in clauses (ii) or (iii) above, then it shall be presumed that, in making its determination, the Managing Partner acted in good faith and in any proceeding brought by or on behalf of any Limited Partner, the Partnership or any other Person bound by this Agreement challenging such determination, the Person bringing or prosecuting such proceeding shall have the burden of overcoming such presumption. Notwithstanding anything to the contrary in this Agreement or any duty otherwise existing at law or equity, and ... to the fullest extent permitted by the Delaware Limited Partnership Act, the existence of the conflicts of interest described in or contemplated by the Registration Statement [i.e., the prospectus] are hereby approved, and all such conflicts of interest are waived, by all Partners and shall not constitute a breach of this Agreement or any duty existing at Law or otherwise.
(e) Except as expressly set forth in this Agreement, to the fullest extent permitted by law, … the Managing Partner … shall [not] have any duties or liabilities, including fiduciary duties, to the Partnership, any Limited Partner or any other Person bound by this Agreement, and the provisions of this Agreement, to the extent that they restrict or otherwise modify or eliminate the duties and liabilities, including fiduciary duties, of the Managing … otherwise existing at law or in equity, are agreed by the Partners to replace such other duties and liabilities of the Managing Partner ….
[* Section 1.1 defines, inter alia,
"'Conflicts Committee' means a committee of the Board of Directors of the Managing Partner composed entirely of one or more directors or managers who meet the independence standards (but not, for the avoidance of doubt, the financial literacy or financial expert qualifications) required to serve on an audit committee of a board of directors established by the Securities Exchange Act and the rules and regulations of the Commission thereunder and by the National Securities Exchange on which the Common Units are listed for trading."
"'Special Approval' means either (a) approval by a majority of the members of the Conflicts Committee or, if there is only one member of the Conflicts Committee, approval by the sole member of the Conflicts Committee, or (b) approval by the vote of the Record Holders representing a majority of the voting power of the Voting Units (excluding Voting Units owned by the Managing Partner and its Affiliates)."]
Are you troubled by KKR's contracting out of (1) the corporate income tax and/or (2) corporate fiduciary duties?
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