Nobel Economist Scholes

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

Scholes is deep trouble.  The IRS has got him.  Very few tax shelter
schemes are concocted with any intend or expectation of profit.  The
problem is that Scholes wrote a book on business tax planning, so
ignorance is no defense.  So far its a civil case.  If he is not careful
it could cross over to criminal tax fraud.

Henry C.K. Liu


 	
Partner Testifies That Tax Shelter of Hedge Fund Was Legitimate

Bonk Johnston for The New York Times

By DAVID CAY JOHNSTON

NEW HAVEN, July 8 — A Nobel Prize-winning economist who was a partner in
Long-Term Capital Management, the hedge fund whose 1998 collapse
threatened a global financial panic, testified today in a trial that
will determine whether he and his partners must pay $56 million in taxes
and penalties.

The trial, which is in its third week and is expected to last several
weeks more, is an important test of the government's resolve in its
battle against tax shelters.

The economist, Myron S. Scholes, who developed a technique to value
stock options that is now a standard, repeatedly invoked two words —
risk and profit — in response to questions from his lawyer, David J.
Curtin of McKee Nelson in Washington. The questioning was intended to
show that the partnership, Long-Term Capital Holdings, used a legitimate
tax shelter, one that Dr. Scholes worked hard to imbue with "economic
substance," making sure everyone involved had a real risk of losses and
potential for profits.

The shelter involved acquiring stock in four major companies owned by
three people in London who participated in a separate computer-leasing
tax shelter. The stock had a value of $375 million for tax purposes but
just $4 million in the open market. The Long-Term partners used $106
million of the tax value in 1997 to wipe out an equal amount of gains
from the partnership's investments.

The I.R.S., in an audit, declared the deal an elaborate and clever sham.
The agency is seeking $40 million in taxes, plus another $16 million in
penalties, because, it says, the partners were tax sophisticates who
knew better. Dr. Scholes, for example, is the author of a book on
business tax planning.

At first, answering his lawyer's questions, Dr. Scholes gave a little
cough, his right shoulder twitched and his voice was unsure. His answers
were self-deprecating, as when he said he did not hold himself out as an
expert on taxes.

But over the next three hours his demeanor slowly transformed until he
was the confident professor, giving detailed answers in a firm voice
that demonstrated a command of intricate financial concepts and arcane
tax rules.

Regarding the shelter, Dr. Scholes testified that he knew that "we had
to have a profit, or expect to profit, from it apart from the tax
transaction" if the deal was to pass muster with the I.R.S.

Dr. Scholes said he ordered analysis, went to dinners and meetings, and
even flew to London to meet the owners of the tax-favored stock to learn
just how the shares had acquired their valuable tax attributes.

The stock had a tax value more than 90 times its market price because it
was used in computer leasing deals that were themselves tax shelters for
the Advanta Corporation, Electronic Data Systems, the Interpublic Group
of Companies, Rhône-Poulenc Rohrer and the computer leasing arm of
General Electric.

Those shelters gave tax breaks to the American companies and gave the
three London residents stock with an artificially inflated tax price, or
basis.

"To go forward, we had to have parallel tracks to understand the
underlying economics as well as the tax matters," Dr. Scholes testified.

"The only way I could see this working potentially was as an
investment," he said, adding moments later that "we were not going to
buy the tax benefits."

Dr. Scholes calculated potential profits and losses, including the price
of an option the three Londoners bought that guaranteed they could not
lose money by investing in Long-Term Capital.

He also figured out how to loan them millions of dollars, though he said
he arranged to do so at the lowest possible interest rates, rather than
the more common banking practice of charging as much as possible.

The shelter owners in London were let into the Long-Term Capital fund
even though it had been closed to other investors. They contributed
their stock with the high tax value, got back shares in the partnership
at the stock's market price and then withdrew 14 months later with what
the fund calculated was a profit of 22 percent for their brief
involvement in the long-term fund.

Dr. Scholes is expected to face cross-examination by Charles P. Hurley
of the Justice Department when the trial resumes Wednesday. His
testimony contrasted with that of an earlier witness, John M. Sykes III,
a tax partner at Shearman & Sterling in New York who wrote legal
opinions on the computer-leasing tax shelters. Under questioning by Mr.
Hurley, Mr. Sykes acknowledged that he never checked out the economic
and other assumptions of the deals he gave opinions on. Mr. Sykes said
he did not write down many significant points of his analysis, and that
even when one of the computer deals was completely reversed after it was
completed, it did not prompt him to reconsider his opinion on the
validity of the tax shelters.

Mr. Sykes's answers prompted Judge Janet Bond Arterton of the United
States District Court here to question him closely about the reasons
that Shearman & Sterling gave a weak opinion on one tax shelter, saying
it was "more likely than not" to survive an audit, and later issued a
much stronger opinion that a virtually identical deal "should" survive.
Mr. Sykes said he only signed one of the opinions.

The judge also pressed Mr. Sykes to explain why he never checked the
assumptions passed on to him by the three parties to the deal, all of
whom used the same investment banker, Babcock & Brown in San Francisco.

Judge Arterton asked: "How, in the business of writing opinions, can you
rely on the representations of strangers?"

"That's a good question," Mr. Sykes said.



NY Times

Partner Questioned on Tax Shelter Profits
By DAVID CAY JOHNSTON

NEW HAVEN, July 9 — The two men who faced off in federal court here this
morning seemed ill matched for a game of intellectual chess, one a
career trial lawyer for the Justice Department, the other a Nobel
laureate in economics.

They met because the Internal Revenue Service disallowed a tax shelter
that the economist, Myron S. Scholes, acquired for Long-Term Capital
Management, the hedge fund with such complex investing strategies that
its collapse five years ago required government intervention to avert a
worldwide financial panic.

The government is seeking $40 million in taxes and $16 million in
penalties and interest, in an important test of the government's resolve
in its battle against tax shelters.

Under questioning by his own lawyer on Tuesday, Dr. Scholes, a partner
in the hedge fund, coolly explained that he knew the tax shelter must
have had real economic substance to survive I.R.S. review.

Given that the shelter could provide $375 million in tax benefits but
cost the fund about $4 million, Dr. Scholes said, he worked hard to make
it viable.

Today, he appeared to wilt.

For nearly three hours, he parried questions from Charles P. Hurley, the
government lawyer, who step by step sought to show from Dr. Scholes's
own words and actions that the tax shelter could not have turned a
profit apart from the tax benefits.

Then, after he answered a question showing that the shelter could not
have turned a profit, and with no question pending, Dr. Scholes revealed
what was on his mind. "I'm being trapped here," he blurted out.

A few moments later, he stepped down for a break, and his wife, Jan, an
executive of the investment bank that brokered the shelter deal with
Long-Term Capital, stood. She had been fidgeting nervously in the fourth
row.

The couple looked at each other for a long moment at the courtroom door
and exchanged some whispered words. He then took her arm, and they
walked into an anteroom and shut the door.

The questioning that led to that moment had begun more than two hours
earlier when Mr. Hurley, a career Justice Department litigator, opened
an aggressive line of questioning aimed at impeaching Dr. Scholes's
testimony the day before, in which he minimized his expertise about taxes.

"I said I was not an expert with regard to taxes," Dr. Scholes said.

Mr. Hurley held up a copy of "Taxes and Business Strategy," a $130 text
used at Stanford's graduate school of business; the primary author is
Dr. Scholes.

Again and again Mr. Hurley went to the book, quoting from chapter
headings and plucking a detail from Page 457.

Many of Mr. Hurley's questions were framed to elicit a simple yes or no.

Often Dr. Scholes would argue with the question, then navigate a maze of
potentials, prospects, possibilities and expectations before coming to a
one-word conclusion.

Mr. Hurley: "I think the answer I wanted was in there — no."

Dr. Scholes: "Yes, and I wanted to explain why."

At another point, Dr. Scholes parsed a seemingly simple question into
three parts, two of which had two subpoints each, and turned it all into
a seamless soliloquy that lasted more than two minutes — without a
single pause or "um" — before boiling his own words down to one: yes.

Then Mr. Hurley shifted tactics. He eased up in his style and began
taking apart various dimensions of the potential profits and risks in
the tax shelter, all the while pacing back and forth at the lectern, his
suit coat buttoned, his right hand deep in his pocket.

Again and again his line of questions ended with Dr. Scholes confirming
that the tax shelter had to make a profit apart from the tax benefits.
He urged Dr. Scholes to put a figure of $900,000, maybe $1 million, on
the potential profits apart from the tax benefits.

Mr. Hurley's endgame began to emerge when he started asking about fees
for opinion letters from lawyers saying that the tax shelter should
survive an audit. The letters, by the Shearman & Sterling law firm in
New York and King & Spaulding in Washington, cost more than $900,000.

Then there was the bonus to one Long-Term executive, somewhere from
$50,000 to $100,000, Dr. Scholes confirmed.

And finally there was the big question, though it was asked so subtly
that the first time Dr. Scholes answered without much argument. Yes, he
testified, he had asked for and received a multimillion-dollar bonus
from the other partners in Long-Term Capital for finding the tax shelter
and strengthening it.

Between the opinion letter fees and the bonus for the one executive, the
tax shelter could only, barely, show a profit. Add in the millions paid
as a bonus to Dr. Scholes and the shelter could not show a profit apart
from the tax benefits.

Testimony is scheduled to resume Thursday before Judge Janet Bond
Arterton in Federal District Court.