When Jenkens & Gilchrist, the 56-year-old national law firm based in Dallas, closed its doors for good in March of 2007, it also seemed to mark the end of one of the nation's highest profile tax scandals. Jenkens, specifically its Chicago tax practice, had been a leader in promoting and writing opinion letters for tax shelters, some of which were allegedly fraudulent. Though the firm previously had reached a civil settlement with tax shelter clients, Jenkens still was facing a federal criminal investigation. Then, finally, under an agreement reached with the government, the Department of Justice Tax Division would not criminally prosecute Jenkens for crimes related to the shelters and, in turn, the firm agreed to pay the Internal Revenue Service a $76 million penalty.1 Almost simultaneously, the firm shut down.
Despite the agreement, the tax shelter case continues to reverberate. Although the defunct Jenkens is finally off the hook, the same cannot necessarily be said for all its former partners. While the prosecutors have not said they might indict anyone connected to the case, the agreement did contain a deferred prosecution provision that does not protect Jenkens' shareholders, partners or employees — including the partner central to Jenkens' tax shelter practice: Paul Daugerdas.
Perhaps even more importantly, the DOJ's and the IRS' pursuit of Jenkens is indicative of the government's new, and potentially lethal, aggressiveness towards law firms and lawyers who provide opinion letters blessing questionable tax shelters. Attorneys have certainly been put on notice.
At the heart of the Jenkens scandal are the tax shelters it promoted, designed and implemented, allegedly impacting about 1,100 investors. The shelters featured names like SOS (Short Option Strategy), COBRA (Currency Options Bring Reward Alternatives), BLISS (Basis Leveraged Investment Swap Spreads) and BEDS (Basis Enhancing Derivatives Structure). The question is: did they have any economic substance aside from tax considerations? If not, they could be abusive and illegal. Jenkens sold opinions saying the shelters were just fine. The government did not agree.
The designs of the shelters — including the use of options, partnerships and outside financing — were exceedingly complex. But their core strategies often were relatively simple. The shelters typically shared certain “themes” of “contingent liabilities” using options. According to David Deary, of Loewinsohn Flegle Deary, LLP in Dallas, who represented several hundred investors in the class action civil settlement with Jenkens, clients in these shelters would purchase and sell digital options on a foreign currency through a limited liability company set up by the client pursuant to Jenkens & Gilchrist's instructions. These digital options then were transferred to a partnership before the digital options' expiration date.
The client's purchase cost of the options increased his basis in the partnership. But the money the client received from the digital option that he sold had no value when it came to taxes: Jenkens' opinions contended it was a “contingent liability,” which according to the firm was ignored for tax reasons under the Internal Revenue Code. Says Deary, Jenkens provided “opinion letters advising clients the digital option strategy had economic substance because the clients had a real potential of making money on the digital options. But in reality, in the opinion of the IRS, the client had no possibility of making a profit on the strategy, especially when taking into account the fees paid.”
The IRS, in an internal memo that's now public, describes the strategy used in the “Son of BOSS” shelter, promoted by Jenkens and others: The shelter “involves the contribution of a purchased option to a partnership, and the assumption by the partnership of a separate written option which the taxpayer incurred. A taxpayer claims… the basis is increased by the cost of the purchased call option but is not reduced for the assumption of obligation of a written call option. Subsequently, taxpayer claims a loss on the disposition of partnership interest even though taxpayer has incurred no corresponding economic loss.”2
How did these strategies play out in the real world? Take, for example, the situation of Dan Berce, a Dallas auto-financing executive who was facing a $3 million dollar tax hit from an $8 million sale of stock. Berce, in a petition filed in June, 2007 in Ft. Worth, Texas, by his attorney Larry Jacobs, of Houston's Boyer and Ketchand, claims his bank approached him with what it said was a way to legitimately avoid this tax liability. Berce would have to invest in a series of integrated, pre-arranged transactions involving options and using a trust. Another bank would provide the financing for these financial structures. The cost to Berce of avoiding the $3 million tax hit was $470,000, of which $350,000 would go to the law firm involved.
Why should Berce think the proposed transaction was legitimate? Because according to his lawsuit, the transaction was blessed by his bank's law firm, the prestigious Jenkens & Gilchrist. Indeed, the firm would write an opinion saying the shelter was legal. (Berce has settled his claims with many of the defendants and dismissed them from the lawsuit.)3
CHICAGO TAX PRACTICE
Of course, long before getting into the tax shelter business, Jenkens and Gilchrist was well-known. The firm had been in existence for nearly 50 years. And it was fast growing. But it was not a particularly profitable firm: In 1998, average partner salaries were $380,000 while, according to American Lawyer magazine, the average profit per partner that year for the nation's top 200 was $525,000.
Paul Daugerdas joined Jenkens in 1999. He already was known in the tax shelter field, because he'd led the tax department at Chicago's Altheimer and Gray. In his first year at Jenkens, Daugerdas and his team brought in $40 million in revenues. Average salaries for all partners at the firm jumped more than $600,000 a year. During his seven years at the firm, most reports estimate, Daugerdas' personal compensation totaled $96 million.
Former Jenkens partner Harry Joe remembers: “The partners voted to acquire the Chicago tax practice. A lot of lawyers didn't understand the complexity of the shelters but relied upon others, placing a lot of faith and trust in their leaders.”
Though the shelters were superficially complex, it also may not have required too much sophistication to spot possible red flags. Recalls Richard J. Duke, of Duke Law Firm, P.C. of Birmingham, Ala., (who says he represents an alleged targeted promoter in a civil IRC Sections 6700 and 6701 tax shelter investigation unconnected to the Jenkens matter): “One of my assistants looked at those [Jenkens] shelters and said, ‘This is just assignment of income.' They may have had sophisticated footnotes — but they violated basic principles.”
The shelters certainly raised questions at the IRS, which was becoming increasingly interested in the booming shelter field. In 2002, the U.S. Senate Permanent Subcommittee on Investigations initiated an in-depth investigation into shelters and established that sale of potentially abusive and illegal shelters had become a “lucrative” business improperly depriving the U.S. Department of Treasury of “billions” in tax revenues.
Jenkens was not the government's initial target. Instead, it was the big accounting firms. For instance, in 2005, KPMG admitted to criminal wrongdoing for its tax shelter activities, entered into a deferred prosecution agreement and paid a fine of $456 million. Attorney General Albert Gonzales proudly declared that this agreement and penalty showed “corporate fraud has far-reaching consequences.”
It was during the investigation of Ernst & Young, in 2002, that Jenkens' name came up. That accounting firm began turning over information about its shelters. And clients who had entered into these shelters, which Jenkens had promoted, began to get letters from the IRS, followed by audits. Alarmed clients started to sue Jenkens. Eventually, they filed a class action lawsuit and were represented by Deary. (Other clients elected not to participate and were represented by other lawyers.) In 2005, the firm reached a settlement in the class action suit for $81.6 million.
Also in 2005, Daugerdas left Jenkens. But the settlement and his departure did not represent a fresh start for the firm; it was too late. Jenkens was still under investigation by the IRS and the Justice Department. Partners began to flee. The firm dropped from 611 partners in 2001 to 281 in 2006. Former partner Harry Joe remembers the firm's final days: “It was tragic to see this happening. It was like watching a relative die in front of you.” But Deary says, “In this case, a family member killed the relative.”
Paul Daugerdas has not been indicted for his tax shelter work, nor have any of the attorneys in his former group at Jenkens. By the end of June 2007, it seemed that most civil suits against Daugerdas have settled, although at least one was still outstanding. And despite the implied threat of the deferred prosecution agreement, there is no indication from prosecutors that Daugerdas or his team members will ever be indicted.
Daugerdas has retained a publicist, Carolyn Grisko, a heavyweight in Chicago, where she was former campaign manager for Mayor Richard M. Daley. Grisko chose not to be interviewed for this article. She said only that Daugerdas is currently consulting and provided this standard quote: “Paul Daugerdas believed all of the strategies were perfectly legal at the time and proper.”
Other people close to Jenkens lack this sangfroid. Indeed, they become quite emotional when talking about Daugerdas and his Chicago tax practice colleagues: “It would be a real injustice if they don't get indicted. They dreamed this up. Daugerdas was at the center of it. And now the firm is no more.”
Attorneys close to the case note that an indictment still might come and offer two theories as to why it hasn't yet.
One theory is that the government is waiting to include him in a big haul. Generally, tax shelters involve webs of players from different institutions. A typical shelter could involve an accounting firm or bank selling the shelter, a law firm writing an opinion letter about its legitimacy, and a major national or even international bank providing financing for the options used. Daugerdas and his firm was merely one member of this problem-solving team. In previous tax shelter cases, in addition to settling with the accounting firms, prosecutors also have settled with the banks involved. For instance, in the KPMG shelter case, the German bank Bayerische Hypo-und Vereinsbank AG (HVB)4 entered a deferred prosecution agreement with the government, admitting to illegal participation in several tax shelters, paying a $29 million fine. An HVB official, Dominick DiGeorgio, also pleaded guilty, admitting his role in spearheading the shelters. Because the investigation in the Jenkens case has so far been much narrower in scope, focused only the activities of the firm itself and not the banks or the individual players, attorneys close to the case speculate that the government could be “waiting until the time is right, to bring everyone in at one time.”
Another theory is that prosecutors are holding their cards close to their vests while they appeal the failed case against Jeffrey Stein.5 The government case against Stein, former deputy head of KPMG and a tax partner there, seemed like a sure thing when KPMG formally settled in January 2007. But the government's case got into trouble over whether prosecutors had improperly pressured KPMG not to pay for its employees defense. In July 2007, a federal judge dismissed the case against Stein and 12 other former KPMG employees, finding that prosecutors had so overstepped and, as a result, had deprived some defendants of their counsel of choice. “This is intolerable in a society that holds itself out to the world as a paragon of justice,“ said Judge Lewis A. Kaplan of the U.S. District Court for the Southern District of New York. Prosecutors appealed immediately.
Lawyers in the shelter world speculate that the government will want to proceed with the case against Stein before trying to take on Daugerdas, because doing otherwise could prematurely reveal its strategy in the Stein case.
Of course, it could simply be that the government has no case against Daugerdas or his former Chicago tax practice colleagues.
Meanwhile, others connected to the tax shelter business are certainly feeling the long arm of the law. There is now almost a daily drumbeat of new tax shelter indictments, deferred prosecution agreements or guilty pleas. The May 2007 indictment of four Ernst & Young (current or former) tax partners for their shelter work is the most recent example.
And all these cases point to larger issues in the government's tax prosecution policy.
The IRS has taken a hard line with accounting firms since late 1999, intensifying its efforts in the last few years. The most obvious example is the federal prosecution of the now-defunct Arthur Andersen.6
What is newer is the pursuit of law firms. Viva Hammer, who was with the office of Tax Policy in the U.S. Department of Treasury from 2000 to 2006 (and is now a partner at Crowell & Moring in New York), remembers her time in the government: “All the opinion letters came from law firms. But the law firms weren't targeted heavily. I'm surprised it took them [prosecutors] so long to do this.”
Hammer notes that tax is a culture, that tax law is composed of words, not math, and that the words are imprecise. She notes that there's a new attitude toward opinion letters as a result, in part, of a change in the culture within the government and courts. “Lost amidst the noise and hand wringing is that tax is in some ways like the fashion industry. What is considered good and heinous can change with the winds, like fashion.” Tax prosecution is following new trends, in ways not always predictable. Still, Hammer is quick to point out that by any standard, many of the recently scrutinized tax shelters were poorly structured and “silly.”
What is clear is that the trend now is to go after shelter promoters and all of those involved with them. The May indictment of the four current or former Ernst & Young partners speaks to this trend. But even here there is nuance and policy complications, if not contradictions. The firm itself was not charged. Why?
A May opinion in the Stein case discussed what's known as the “Thompson memorandum,”7 written on Jan. 20, 2003, by Deputy Attorney General Larry D. Thompson and articulating for U.S. attorneys the guidelines for determining whether to bring criminal prosecutions against firms and their agents. Though the memo doesn't go into great detail about collateral damages, these and similar guidelines typically mention some concern about damages to non-culpable employees. In the view of Gary Mauney of Lewis & Roberts PLLC in Charlotte, N.C., who represented investors who opted out of the Jenkens class action civil settlement, “this administration's apparent tack is not to indict a firm or entity unless there's an ultra-compelling reason to do so as opposed to indicting individuals.” Perhaps it varies on a case-by-case basis. Jenkens, of course, was never indicted but merely subject to a penalty. Yet there was obvious collateral damage to the firm's other employees.
Today, according to Viva Hammer, “the (income) tax world is… very, very conservative. People are afraid to enter into plain vanilla transactions,” which she views as an absurd and an extreme result of the recent shelter cases. Despite the fallout from Jenkens and other cases, people still have a right to think about saving on taxes, she notes. But, Hammer does suggest: “If you are going to structure your transactions, do it carefully and thoughtfully. And do it intelligently.”
- U.S. Department of Justice, United States Attorney Southern District of New York, March 26, 2007.
- Department of the Treasury, Internal Revenue Service, Office of Chief Counsel, CC 2003-020, Notice 2000-44 (June 25, 2003). IRS definitions and thinking about contingent liabilities and abusive transactions involving basis shifting is available on the IRS' Freedom of Information Act (FOIA) website at www.irs.gov/foia/index.html. See Part IV - Items of Interest, Settlement Initiative for Section 302/318 Basis-Shifting Transactions, Announcement 2002-97, at www.irs.gov/pub/irs-utl/ann_2002-97_basis_shift_-_10-04-02.pdf.
- Berce v. Banc One Investment Advisors Corp., No. 067-209444-05 (Tex. Dist. Ct. 2007). According to Dan Berce's attorney, Larry Jacobs: “Jenkens, Daugerdas, (a domestic) bank (all entities) and Vicky Little, who worked for one of the bank's defendants, have settled with Berce and have been dismissed from the case. The New York-based law firm that Berce alleges participated in the fraud on Berce, represented the international bank entities in the deal, and after the dismissal remained the only defendant. Pursuant to an order granting the law firm's motion to compel arbitration, Berce moved to join the firm in Berce's related NASD arbitration against the international bank. Just recently, the panel in the NASD arbitration dismissed the arbitration against the international bank without prejudice and referred all parties to their judicial remedies. So, the firm is back in state district court in Ft. Worth. Berce has amended his lawsuit in Ft. Worth and named the international bank as additional defendants.”
- Neal M. Douglas et. al. v. United States, Case 5:03-cv-04518-jw (N.D. Cal., filed April 24, 2006). See pages 3, 4 and Exhibit C.
- Jeffrey Stein et al. v. KPMG, LLP, No 06-4358-CV (2d Cir. May 23, 2007). See http://online.wsj.com/public/resources/documents/wsj_lb-stein.pdf.
- Arthur Andersen, LLP, one of the “big five” accounting firms, effectively collapsed in 2002 over its role as the auditor of Enron. The DOJ prosecuted Andersen, which voluntarily agreed to surrender its license to practice as CPAs in the United States. Though the firm was convicted of obstruction of justice for its Enron-related work, this conviction was overturned by the U.S. Supreme Court in 2005. Even so, Andersen, at least as a major auditing firm, is no more.
- Thompson memorandum, at www.usdoj.gov/dag/cftf/business_organizations.pdf.