TAX ME IF YOU CAN
homesheltersuncovering schemesprospects for reform

kpmg exhibits - 11
This e-mail, written by Jeff Stein, the head of KPMG's tax practice, discusses the determination by Larry DeLap, who was the partner in charge of KPMG's quality control, that KPMG should "discontinue marketing" the firm's FLIP tax shelter. Stein observes that the option used in the FLIP stock purchase deal "stood out like a sore thumb since no one in his right mind would pay such an exorbitant price for such a warrant. He also describes the investor representation letters (in which the investor would represent his economic expectations heading into the deal) on which the FLIP shelters were based as being "of dubious validity." [Note: In January 2004, KPMG announced that Jeff Stein would retire at the end of the month.]

new

From:Jeff Stein

Sent:Saturday, March 14, 1998 6:56 AM

To:Gregg W. Ritchie; Douglas J. Green; Robert

J. Wells; John T. Lanning; Larry DeLap

Subject:Simon Says

By the way - anybody who does not have a copy of the Pfaff letter, let me know and I will fax it over to you. In addition in case you want a copy of the November 6, 1997 memo detailing the proposed LLC structure written by Simon to "The Working Group" which included Ritchie, Pfaff, Larson, Bickahm and R.J. Ruble of the law firm of Brown & Wood let me know and I will fax it over to you as well. As I said below, the OPIS strategy is a stripped down version of the LLC structure.

Incidentally, I failed to mention that the research on the most troublesome issues with respect to this product was done in large measure by Simon, Harris and Margaret Luke (also IS). Those issues included:

a - Whether U.S. investor's interest in Cayman entity was disguised equity

b - The application of the at-risk rules and,

c - The basis of the shares held by the U.S. investor.

Frankly Doug - if you are the ultimate arbiter in this matter, I think you have all the facts you need at your disposal to make your decision. I will have a conversation if you and Greg feel it is necessary but that discussion would only result in a debate over the facts as presented below and Simon and Harris would need to be prresent on that call to represent what they have told me concerning their involvement in this product.

Guys - Have a terrific weekend.

exhibit 11
examine a facsimile of this document

_______________________ Forward Header __________________

Subject: Simon Says

Author: Jeff Stein at KPMG_NYO_Tax2

Date: 3/14/98 9:46 AM

Bob/John/Larry - I've copied each of you on this because of your involvement up to this point, especially with regard to the technical issues that have arisen, on managing those rare personality flare ups and in coding discussions. I feel not fear: the end is near.

After some - but not exhaustive - due diligence on my part over the last few days, here is what I was able to come up with as regard the involvement of IS in the OPIS strategy (son of FLIP). They are to be contrated with Opie and Flipper, two TV characters from the 60's. Obviously reasonable men can differ on both the facts and the conclusions but I thought I'd take a stab at laying out at least my understanding which perhaps can serve as a working document for any discussions next week. I invite any of you to please reply and let me know where I am off base on any of this. I have tried to be as honest and accurate as I can be and have toned down my normal pronation (not just a foot and running term Doug) towards exaggeration but have tried to at least add some humor.

First of all, in terms of involvement you should all have a copy of an unsolicited letter to me from Bob Pfaff extolling the virtues of Bob Simon and which indicates how integrally involved Bob has been in the development of this strategy. From my law school days, I was always told to lead with strength and if you could get a third part to say how great your client was rather than having your client say that he was great - it would better serve you. Thus, Pfaff is my first character witness who may later be called to the stand to discuss specific factual allegations in this case. I believe that letter states that "Bob (Simon) contributed significantly to making it (the basis shift strategy) a better product with less risk for all concerned." So that's Exhibit A.

Just as a matter of background, in September or October of last year Bob Simon and Bob Pfaff began to have discussions on a successor to the FLIP transaction which was being marketed. These discussions took on an air of urgency when Larry Delap determined that KPMG should discontinue marketing the existing product. Simon and Pfaff met in late October and throughout November to tweak or redesign if necessary the old strategy - focusing on the Cayman partnership and adding features designed to lessen any Subpart F or other risks. They determined that whatever the new product, it needed a greater economic risk attached to it and should probably include a debt or convertible debt feature. During those 6 plus weeks, there were daily phone calls between Pfaff and Simon and numerous meetings. The involvement was significant and depended upon which IRS test we want to apply. Simon was big-time involved. Now to the heart of the discussion.

OPIS at it's core (pardon the use of core - it is not a coding term of art) is really just an updated version of the basis shift strategy developed by IS and Pfaff. It is now - and don't take this the wrong way - a watered down version (OBJECTION - OVERRULED) of what Pfaff and Simon came up with in November and which was presented to the IS leadership team by Pfaff in early December for their review and comments. It was Simon who wrote up the product for distribution to the leadership team and for circulation to Larry.

The use of a Cayman partnership instead of a Cayman corp came about through meetings Simon held with Pfaff. Although Pfaff had actually floated that idea back in July when he was still with KPMG, nobody ever pursued it. When FLIP was tabled, Simon brought it back on the table and showed Pfaff how we could achieve an even better structure with a Cayman LLC or partnership. By the way - you guy should feel free to call Pfaff to the stand and ask him to confirm or deny any of what I am saying as well as Simon's involvement.

As you may know, the Cayman entity (in both FLIP and OPIS) is nominally owned by an NRA (nonresident alien). Under the FLIP structure, there was a real question as to whether an NRA was truly an equity holder. In particular, the NRA received a preferred return, was protected from risk, and in most respects looked like a service provider or debt holder. If that were true, either of those characterizations would have lead to a tax disaster. Simon was the one who suggested buttressing the NRA's position as an equity holder and although some of Simon's suggested improvements did not make their way into the ultimate OPIS product, others did. I assume the same could be said of other team members who worked on this product. For example, I know that from discussions with Pfaff, the NRA will now have real economic risk and no longer has a preferred return. In addition, the NRA will hold both equity and debt.

In the FLIP structure, the U.S. investor bought a warrant to purchase 90% of the stock of a Cayman company for a price designed to include all the fees of the participants in the transaction. It was essential that the warrant be treated as an option to acquire stock in the Cayman company for Section 302 purposes without being treated as an actual stock. Simon was the one who pointed out the weakness in having the U.S. investor purchase a warrant for a ridiculously high amount of money - well in excess of the strike price - which in no event would have been exercised since the investor also had a cash-settled option which would enable him to gain any upside in the Cayman company without paying the strike price of exercise. It was clear, we needed the option to be treated as an option for Section 302 purpose, and yet in truth the option as really illusory and stood out more like a sore thumb since no one in his right mind would pay such an exorbitant price for such a warrant. Pfaff and Simon discussed alternatives and came up with the idea of having the U.S. investor purchase convertible debt since the investor could be expected to pay at or near the principal amount for convertible debt. Eventually this was changed to a swap (in OPIS) but the idea was the same - to get a bunch (technical term) of money into Cayman corp in a manner which would have some economic substance without itself being equity.

There have been other changes to the strategy as well based on conversations that Simon has had with Pfaff but since Simon was effectively cut out of the loop in mid-December he has not been privy to everything that has transpired.

The FLIP strategy included a loan from a foreign bank to the Cayman company. The Cayman company then turned around and purchased shares in the same bank. Later, the shares were redeemed and magically, at the same moment, the U.S. investor (related to Cayman through the warrant) would buy an option for the equivalent amount of the shares from the Bank. In kicking the tires on FLIP (perhaps too hard for the likes of certain people) Simon discovered that there was a delayed settlement of the loan which then raised the issue of whether the shares could even be deemed to be issued to the Cayman company. Naturally without the shares being issued, they could not later be redeemed. Under OPIS, the same simultaneous redemption is present, but settlement of the loan documents will occur immediately, i.e. no delayed settlement. Clearly Simon was very vocal in his concern over the delayed settlement issue and played the key role in eliminating it from the new and improved strategy.

Simon was also the one who suggested and prepared investor's representation letters which dealt primarily with the investor's economic expectations heading into the deal. Prior to that we had some 20 or so representations buried in a 50 page opinion. Because the investor himself was not making the representations, they were of dubious validity. Representation letters will now be issued on all OPIS deals and wherever possible in the old FLIP deals.

Additionally, all the time spent by John Harris on this project (and it is considerable) has been run through international services contracts. A very significant issue in OPIS is whether the partnership anti-abuse regulations apply. John is the author of that entire section, which was used word for word in the OPIS draft. Incidentally, although admittedly not entirely relevant is the praise that WNT had for that particular section. Indeed, the OPIS draft that Randy Bickham circulated was primarily taken from an earlier draft of a partnership structure that John Harris had worked on with Bob Pfaff before Bob left the Firm.

finally, and although this may be considered by Greg as an admission against interest, it was Greg who stated in writing to I believe Bob Simon that the "the OPIS product was developed in response to your and OPP tax's concerns over the FLIP strategy. We listened to your input regarding technical concerns with respect to the FLIP product and attempted to work solutions into the new product". I assume Greg does not mean that he worked those technical solutions into the product himself or with just Mr. Bickham. I will leave the discussion on Mr. Bickham and the evaluation of his international technical skills made independently by two senior IS partners to another discussion.

In conclusion - The development of the OPIS strategy was a team effort with the primary technical thrust for the improved product coming from IS. Given the similarity of this product to FLIp and the extensive involvement of Simon and Harris working alongside Pfaff, I do not believe there is any credible claim that PFP invented a new strategy or product called OPIS and it would take an absolute disregard of the facts to reach such a conclusion. As I said above, FLIP is a watered down version of what Simon and Pfaff presented to the IS leadership team in December. I believe that all that has been accomplished over the past two months since Simon has been cut out is that as many of the expensive modifications that could be taken out of OPIS have been and one change has been made, that being the swap rather than the debt instrument (which adds nothing of substance). I also believe that some of the features that gave this product more economic substance have also been eliminated but I will obviously defer to Larry who is the one who should opine on the relevant technical impact of the modifications and eliminations to the product.

What I thought we were trying to achieve here was bringing the best minds we had in this Firm together in order to design the best product to go to market with. That we did and for five or so months that Simon and Harris have been involved working with Pfaff, not once did anyone ask, including Sandy Smith who is ultimately responsbile for the financial results in that geopgraphy, who is going to pay IS for the time and effort being spent by the IS group in Denver. That was the same path we went down when Pfaff and Larson worked on the original FLIP strategy. To now say that the hundreds of hours that IS spent in designing this strategy was either nominal or does not rise to the level of substantial is not only offensive but I can guarantee you will not result in a greater sense of teamwork going forward as we attempt to better leverage ourselves with the FCS group.

What I thought we were trying to accomplish in creating that group was not having independent pockets of professionals spending time developing independent strategies that were not nearly as powerful as what we could accomplish working together as a team. That should be what we're trying to accomplish rather than this "mine is bigger than yours" thing we seem to be experimenting with. Somebody tell me what we're doing here by suggesting a reward system that is based on anything but team. Truth be told on this one, IS has probably been responsible for 90% of the OPIS idea when you examine the final product and compare it to FLIP, along with what led to OPIS, who suggested the key modifications to the FLIP strategy, and the key product characteristics of OPIS. Let's just stay with our 50 50 deal and forget about the Ides of March.

previousnext

 

home + introduction + gimme shelter + uncovering schemes + prospects for reform
interviews + links & readings + tapes & transcripts
press reaction + producer's chat + credits + privacy policy
FRONTLINE + wgbh + pbsi

posted february 19, 2004

FRONTLINE is a registered trademark of wgbh educational foundation.
web site copyright 1995-2014 WGBH educational foundation

 

SUPPORT PROVIDED BY

RECENT STORIES

FRONTLINE on

ShopPBS