In the spirit of the season, it’s time for shareholders of Janus Capital Group to give thanks, despite this having been a turkey of a year for their company. The cause for thanksgiving is that although Janus has had the stuffing beaten out of it for not managing some of its mutual funds properly, it’s doing a great job of managing its own money thanks, in large part, to a tax loophole.
JANUS HAS BEEN in the news almost continuously since September, when it was nailed by New York Attorney General Eliot L. Spitzer for letting well-connected investors skim profits from its mutual funds at other investors’ expense. (That’s what “market timing” mutual funds actually means.) But while Janus’s mutual funds have attracted lots of news coverage, there’s been little attention paid to a pending transaction between Janus Capital and DST Systems Inc., a big record-keeping company that counts many mutual fund families and investment advisers as customers—and even less attention paid to important corporate governance questions arising from that deal.
On the day after Thanksgiving, DST shareholders are scheduled to sign off on a complicated swap that will deliver $1 billion of tax-free cash to Janus Capital in return for most of Janus’s 34 percent stake in DST.
That cash is scheduled to arrive at Janus by year-end, and it couldn’t come at a better time.
Janus says it plans to use $600 million from the DST transaction to reduce its debt and buy back stock. The rest would be walking-around money. But those plans were made before the mutual fund scandal broke. Now, this cash influx will come in handy for paying any fines, investor reimbursements and lawsuit settlements arising from Janus’s role in the fund scandal.
Notice I haven’t said that Janus is “selling” most of its DST stake. That’s because technically, Janus isn’t selling. It’s swapping 32.3 million DST shares for the stock of a DST subsidiary that owns a smallish commercial printing and graphic design business called Output Marketing Services. In addition to its business assets, Janus put $999 million of cash into Output Marketing.
When this “cash-rich split-off” is completed, Janus will end up with the cash and the OMS business, and DST will have reduced its shares outstanding by more than a quarter.
And neither company will have paid any tax because it’s technically an exchange of stock. Had Janus sold its DST stock outright and had DST sold OMS at the value set on it by this deal, Janus and DST would have had to pay a combined total of about $500 million of income taxes.
“This is the first time this structure has been used,” says Robert Willens, a tax expert at Lehman Brothers, which isn’t involved in this deal. Willens said this transaction is using a section of the tax code designed to let partners split up a business and go their separate ways without having to pay tax. Here, though, “these guys are actually selling for cash,” Willens says.
What about the spirit of the law? “The letter of this particular law is so vast and complex,” Willens says, “that there’s no room for any spirit.”
Now, to governance questions—and to some extra tax goodies that DST hopes to get as a garnish on this tax-avoidance feast.
Governance first. Given that Janus is an interested party in this transaction, why is DST allowing Janus to vote its entire 34 percent stake in favor of the deal, which virtually assures approval?
“That’s what both parties wanted to do,” says Kenneth V. Hager, DST’s chief financial officer. Well, that’s what Janus and DST’s board and management want—we don’t know what most of DST’s shareholders want, because they haven’t been heard from. I’d vote “yes” if I owned DST stock, but I’d prefer to be asked rather than presented with a fait accompli. DST should have asked Janus to vote in proportion to other DST holders’ votes—that’s the high-class way of resolving a conflict of interest like this.
Tax techies have to relish the way DST heaps extra tax breaks onto its plate. To raise the cash going to Janus in the deal, DST sold $840 million of debt securities that can be converted into DST stock. Using a “contingent interest” provision, DST gets to deduct for tax purposes more than double the actual interest rate it’s paying on those bonds. This contingent interest is very unlikely to ever be paid, but the tax code allows it to be deducted, and it will save DST about $15 million a year in taxes.
If things go well, DST will convert the $840 million of debt into stock—”that’s our hope,” CFO Hager said. That means that DST, which is paying Janus $34.50 a share for its stock, would in effect be re-selling more than half those shares at the bond conversion price of $49.08.
But this aggregate $250 million difference between the Janus purchase price and the DST bond conversion price is nontaxable because it involves a company dealing in its own shares.
In all, this is a great pie for Janus and DST to slice up. Tax goodies all around, plus DST’s managers will get rid of a big outside shareholder that’s been looking over their shoulder; Janus also competes with many of DST’s main mutual fund customers. In short, there’s something here for everyone to be thankful for.
Except, of course, for us taxpayers.
Sloan is Newsweek’s Wall Street editor. His e-mail address is .