The Rise of the Wall Street Tax Machine

The shelter game has been hidden and lucrative. Could it be the next big scandal?

In April, 1997, Bankers Trust, now a division of Deutsche Bank (DB ), pitched a creative new tax shelter to Enron. After the energy giant expressed interest in the scheme, BT Managing Director Thomas Finley mailed a contract on June 17 to R. Davis Maxey, head of the Structured Transactions Group in Enron Corp.'s tax unit. Buried in the fine print was an unusual provision nullifying the deal "if any law enacted after the date of this letter shall require the Transaction be registered as a 'tax shelter"' with the Internal Revenue Service.

Finley had reason to be concerned. At the time, Congress was debating the Taxpayer Relief Act of 1997, which contained a proposal requiring Wall Street's financial engineers to tell the IRS about the secret tax-avoidance schemes they were machine-vending to companies across the country. The measure would be bad news for Enron, because if the IRS found out about the dubious shelter BT had proposed, it would almost certainly challenge the transaction.

The tax bill passed in August, 1997. But Project Steele, as the Bankers Trust proposal was known, survived nonetheless. That's because Enron, which stood to save $78 million in taxes from the deal, and BT, which had $11 million in fees at stake, found a way to salvage it. Salvation came in the form of blue-chip Washington law firm Akin, Gump, Strauss, Hauer & Feld LLP. It was willing to write an "opinion letter" vouching for the legality of the transaction. For a fee of $1 million, Akin Gump delivered a 12-page opinion on Dec. 16 blessing Project Steele and saying that "the newly added provisions relating to corporate tax shelters should not be applicable" to it.

The participants all say that the deal, which allowed Enron and BT each to claim a deduction for the same pool of money-losing mortgage-backed securities owned by the investment bank, was legitimate. But now that the transaction has seen the light of day, it is being ridiculed by many tax experts. "It is like two families trying to claim the same child as a dependent," says Sheldon D. Pollack, a professor of accounting at the University of Delaware who is an expert in corporate tax shelters.

The moral of this story is that the tax-shelter business is hard to kill. But there are signs that this lucrative trade could become America's next corporate scandal. The furor that began with the revelation in February that Sprint Corp.'s two top executives attempted to avoid taxes on nearly $200 million in stock options has intensified with new disclosures about Enron's scams. One highlight: the testimony of Robert J. Hermann, head of the company's tax department, in a Mar. 5 bankruptcy court report that high-ranking officers found the shelters to be "kind of like cocaine -- they got hooked on it."

Thousands of pages of new documents released by the Enron bankruptcy examiner and the Senate, analyzed by BusinessWeek, provide the most detailed view ever of the tax-shelter trade. In particular, they shed light on how the investment bankers, lawyers, and accountants who profited from this business created and marketed their schemes. Now these professionals are in the crosshairs of plaintiffs' lawyers and regulators. Two Democratic representatives from Massachusetts, Richard E. Neal and Edward J. Markey, have asked the Securities & Exchange Commission to investigate the BT-Enron deals. While it has traditionally been hard to pin civil or criminal liability on clever shelter promoters, the Senate's bipartisan Joint Committee on Taxation is promising a regulatory crackdown. "The day of reckoning has come, I think, for shelter promoters," said Senator Charles Grassley (R-Iowa) at a Feb. 13 hearing on Enron's tax schemes. "We have to hunt them down."

The targets of Grassley's wrath are many of the brightest, most highly credentialed investment bankers, lawyers, and accountants in the country. They work in some of America's most prestigious firms, including Merrill Lynch (MER ), Bear Stearns (BSC ), J.P. Morgan Chase (JPM ), Deloitte & Touche, Ernst & Young, Shearman & Sterling, and King & Spalding. The professionals in these firms, of course, all defend what they do. They often point out that companies have a legitimate right to minimize their tax bills, that the law is unclear, and that not all shelters are illegal.

But the one thing these hotshots generally don't like to do is offer any details about the schemes they sell. These transactions are not the type of old-fashioned deals outlawed by Congress in 1986 -- simple partnerships that required a one-time investment in, say, a cattle ranch (table). Rather, they are a revolutionary leap ahead. Enron's shelters, for instance, were complex structured financings involving a wide variety of exotic financial derivatives. They required active management by in-house staff and continuing involvement by the shelter promoter. The only thing new-generation shelters have in common with their single-celled ancestors is the lack of any justification other than avoiding taxes.

While the promoters of these schemes are some of the most highly paid people on Wall Street, they are not nearly as widely known as merger specialists, analysts, or fund managers. That's no accident. Well aware of the bad publicity engendered by successful tax avoidance, shelter dealers keep a low profile. The idea is simple: to prevent the IRS from finding out about the deals in the first place. On the rare occasions when the agency does discover a new scheme -- as often as not because some player has suffered a pang of conscience and anonymously tipped off enforcers by mailing a package of sales materials -- the promoters defend it to the hilt, betting they can win a soft settlement with the IRS years down the road.

Because of the culture of secrecy in the tax-shelter business, it is, by definition, impossible to estimate how big it is. But in 1999, economist Martin Sullivan made a rough estimate that corporate tax shelters cost the Treasury as much as $30 billion annually. Whether this number is accurate or not, it is clear to most experts that the industry is a big reason companies have been driving down their tax payments in recent years. "Enron is not just one bad apple," says Lee A. Sheppard, contributing editor of Tax Notes magazine.

Prior to the 1986 tax-reform act, most shelters were sold by accounting firms. But investment banks got into the business when their deal work started slowing down in the late '80s. When it came to developing tax schemes, they had two huge advantages over the accountants: the ability to sell securities and the power to raise capital. Hiring the smartest tax minds away from law firms, Wall Street started marketing sophisticated new products. "These people were geeky," says one veteran of a multinational bank's shelter division. "It was not a macho culture like M&A. They didn't hang out with CEOs. These people lived deep in the tax code."

What they lacked in style, they made up for in cash. Tax specialists charged contingency fees of up to one-third of the payments that they saved. One of the pioneers of the business was Merrill Lynch & Co. A corporate finance group led by E.S. Purandar Das, a managing director who has departed the firm, and Arshad R. Zakaria, now president of global markets and investment banking, sold tax-avoidance schemes to Allied Signal (HON ), American Home Products (now Wyeth) (WYE ), Colgate-Palmolive (CL ), and others in 1989 and 1990. The deals enabled the companies to generate huge capital losses on paper to offset big capital gains. A Merrill spokesman says: "We were not in the corporate tax-shelter business." But federal appeals courts have characterized the Allied Signal, Wyeth, and Colgate deals as shelters and rejected them. Both Zakaria and Das declined to comment.

In the early 1990s, many banks passed around nondisclosure agreements when they sold shelters. That came to a halt when Congress, in 1997, required promoters to register shelters "offered under conditions of confidentiality" with the IRS. But even if they didn't sign NDAs, corporate officers still stayed mum to avoid alerting the IRS. Investment banks, meanwhile, used secrecy as a subtle sales inducement. "We would go to a company's tax manager and say, 'This is brand new,"' says one veteran of the business. "'You are one of the first five people that we have shown this to, and we are only going to show it to five more."'

Law firms were also key players in the tax-shelter trade. From time to time, partners came up with new ideas and then marketed them with accounting firms or banks. But their primary role was writing opinion letters vouching for the legality of the deals. Under IRS rules, these legal memorandums constituted evidence of corporate good faith -- immunizing companies from penalties for disallowed tax shelters. A small club of partners, many of whom had originally been law enforcers at the IRS, dominated this business, including William S. McKee of McKee Nelson; Fred T. Goldberg and Charles Morgan at Skadden, Arps, Slate, Meagher & Flom; R.J. Ruble of Sidley Austin Brown & Wood; and Robert A. Rudnick at Shearman & Sterling. None of these lawyers agreed to speak to BusinessWeek.

But some lawyers found the whole enterprise -- and the arm-twisting applied by powerful Wall Street clients -- unappetizing. In 1999, the New York State Bar Assn.'s tax committee urged the Treasury Dept. to stop waiving fines for clients with legal opinion letters. Why? Because if the penalties increased, then attorneys would have more leverage to say no to their clients. "Every big firm felt pressure from investment-banking clients to deliver these opinions," says Dana Trier, a partner at New York's Davis, Polk & Wardwell. Treasury never acted on the suggestion.

In 1995, the tax-shelter juggernaut hit Enron -- a match made in heaven if there ever was one. Its auditor, Arthur Andersen LLP, was promoting a simple and widely marketed type of deal known as the "contingent liability" shelter. For a mere $500,000 in fees, the company saved $66 million in taxes in a deal called Tanya. The energy giant declined to discuss its tax transactions with BusinessWeek.

Enron's top management got excited. Tax chief Hermann appointed trusted subordinate Maxey to head the Structured Transactions group, which grew from one person in 1997 to 17 in 2000. Enron's low-visibility tax bureaucrats became dealmaking stars -- with ambitious revenue targets just like the company's energy traders. "Dave [Maxey] was able to build his own world and deal with the big muckety-mucks," recalls one former Enron tax-department insider. Maxey's attorney, Philip H. Hilder, said the company's deals "involve tax planning ideas fully supported by U.S. tax laws."

Like most shelters, Enron's were designed to maximize deductions, credits, and losses -- the currency of the tax-avoidance business. But unlike most other companies, the energy giant did not use the deals to offset current income. It did not really need to, since the company could already take advantage of immense stock-option deductions. Rather, Enron generated enormous future tax savings and then used aggressive accounting to convert those hypothetical assets into current income.

Because the deals were complex, some of them took more than a year to evaluate and set up. But they were big enough to have a major impact on the bottom line. The 12 tax-avoidance transactions the company did from 1995 to 2001 produced $2.02 billion in tax savings -- and were then turned into $2.079 billion in current income. The meticulous Maxey, meanwhile, developed a reputation for secrecy. "He was notorious for handing documents out at meetings and then collecting them back," recalls a former insider.

The first big deal that Maxey did with an investment bank was Project Steele. The key ingredient to the transaction was a pool of mortgage-backed securities owned by Bankers Trust that had lost money -- and therefore could be cashed in for tax deductions. BT transferred these securities, known as REMICs, to a new partnership known as ECT Investing Partners that it jointly owned with Enron. For its part, Enron tossed in some cash and other stray assets such as airplane leases. When these maneuvers were complete, both BT and Enron had rights to the deductions for the REMICs.

Neat trick. This would normally be illegal because the Internal Revenue Code prohibits one company (Enron, in this case) from buying another outfit (ECT) simply to acquire its deductions. To get around this rule, Enron claimed that it had a legitimate business purpose for the deal other than tax avoidance. And what was that? Believe it or not, to inflate earnings -- or, as Akin Gump put it in the firm's opinion letter, to "obtain financial income" benefits from the deal. Both Enron bankruptcy examiner Neal Batson and the Joint Committee on Taxation have criticized this legal alchemy.

In a statement, Akin Gump said that "based upon the information available to us at the time, as well as prevailing legal standards, we concluded that we could [approve] the transactions. Nevertheless, we...are reviewing our records and files to confirm the appropriateness of our advice." BT's Finley, now at Merrill Lynch, declined to speak to BusinessWeek. Deutsche Bank declined to discuss the details of BT's Enron work but said it "is confident [our actions] were lawful."

These are the types of games that lawyers and auditors are supposed to stop. But the outside professionals were making a fortune and often in cahoots on the deals. Akin Gump had helped BT develop the Project Steele shelter -- a conflict of interest that, arguably, made it impossible for the law firm to give Enron objective independent advice about the legality of the scheme. The firm says that it had "the informed consent of both BT and Enron."

Enron auditor Arthur Andersen, whose consent was necessary for Project Steele to succeed, billed a seemingly paltry $49,600 for reviewing the tax shelter in January, 1998. But it appears that in some other deals Arthur Andersen found yet another way to profit from the shelters. "Andersen's New York office also was frequently engaged by the promoter to opine on the accounting treatment for a hypothetical transaction that [Enron planned on doing], after which Andersen was engaged by Enron to approve the accounting treatment for the actual transaction," says the bankruptcy examiner's report released on Mar 5. Andersen declined to comment on the specifics of its shelter work for Enron, but a spokesman said that "investment banks and law firms were the star players" in this business and the accounting firm's "tax experts were on the sidelines."

For its part, BT collected a fee of $8.5 million on Project Steele. In January, 1998, BT invited Maxey on a jaunt in the investment bank's plane to the Boca Raton Resort & Club. A few months later, BT Chairman and CEO Frank Newman mailed a letter to Enron CEO Kenneth L. Lay celebrating the successful completion of Project Steele. The Enron chief forwarded the note to Herman and Maxey with a handwritten notation: "Good job. Thanks, Ken."

The rewards in the tax-shelter business were obviously rich. The risks, on the other hand, were minimal. Enron inundated the IRS with 2,486 tax returns in 2000. Naturally, none of these documents advertised the fact that many of Enron's deductions, and much of its income, came from tax-driven transactions. To find that out, an agency auditor would have had to request backup documentation from the company -- and then embark on a long investigation. That rarely happens. And it's rarer still for an IRS agent to uncover a sophisticated corporate tax shelter. Until the agency starts digging deeper -- or Congress helps out with new regulations -- there's little reason to believe the shelter business will disappear.

By Mike France

With Emily Thornton, Heather Timmons, and Louis Lavelle in New York

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