Global Policy Forum

By David Cay Johnston

Tax sheltering is one of those activities that people normally carry on behind closed doors. But in a federal courthouse in New Haven, the doors have been thrown wide open and bright lights have been trained on one room in the house of Mammon that is tax avoidance in America today.

Being revealed is a plan arranged by a great economic mind, Myron S. Scholes, winner of a Nobel in economics, while a partner in the giant hedge fund, Long-Term Capital Management. The partners hoped to recycle a tax shelter that had already enabled Rhí´ne-Poulenc Rorer, Electronic Data Systems and a half-dozen other major corporations escape taxes on a total of $375 million in earnings. Dr. Scholes sought to duplicate the maneuver for his investment group, on profits that also totaled $375 million.

Long-Term Capital, of course, would collapse in 1998 – a fall so spectacular that the Federal Reserve established a bailout to avert what it feared would become a worldwide financial panic. (The short, expensive life of Long-Term Capital and the story of its famous founders were captured in the title of a best-selling book by Roger Lowenstein, "When Genius Failed.")

For Dr. Scholes, Long-Term Capital Holdings v. United States is a test of whether his mastery of economics and tax law led him along a slippery slope toward an embarrassing and costly confrontation with the government. The trial will determine whether he and his partners must pay $40 million in taxes and $16 million in penalties and interest.

For ordinary Americans, the case may be a lesson in how the rich and well-connected can mine the tax code in ways that are unavailable to others. And for the government, the trial is a challenge with huge consequences for federal budgets: Can it encourage all taxpayers to obey the law by pursuing a few prominent cases, making examples of those it judges to be violators, mostly through civil actions like the Long-Term Capital case and a very few criminal prosecutions?

As a hedge fund, Long-Term Capital, which was officially organized in the Cayman Islands, was an unregulated investment pool that by law was open only to the very wealthy. John W. Meriwether, the Wall Street bond trader, created it in 1993 with a few of his investment friends, including Dr. Scholes and Robert C. Merton, the Harvard economist with whom Dr. Scholes shared the Nobel in 1997.

Dr. Scholes, whom colleagues have described as the consummate analyst, brought much intellectual firepower to Long-Term Capital. "This is a guy who will look at a problem and tries to devise some sort of intellectual structure that explains it," said Burton G. Malkiel, a Princeton economist who worked closely with him in the late 1980's to analyze the financial markets' crash of 1987. "If you talk to him about a problem, he immediately says, `How can we model this?' "

Dr. Scholes traces his fascination with market dynamics to his childhood in the gold-mining territory of northern Canada. What was it, he says he wondered back then, that makes prices fluctuate? "From an early age, I was very, very fascinated by uncertainty," he once said on the public television program "Nova."

The big idea that he had to offer to Long-Term Capital was to make money in the securities markets by applying a technique for valuing stock market options that he had helped invent. Known as the Black-Scholes method, it was described in a paper that he and Dr. Merton wrote in 1973 with Fischer Black of the University of Chicago. The method would become the standard for options traders; it is now widely used to value executive stock options, as well. The paper ultimately won the Nobel for Dr. Scholes and Dr. Merton.

Long-Term Capital was an instant success. With Mr. Meriwether and the two famous economists heading the investment team, it quickly raised $5 billion of equity, which they used as leverage to raise $95 billion in loans. The founding partners put in $300 million of their own money but closed the fund to outsiders, with two exceptions, both of whom are now at the core of the tax case.

Despite its name, Long-Term Capital engaged mostly in rapid-fire trading in and out of stocks, bonds and synthetic forms of ownership like futures contracts and sometimes-exotic derivatives. The firm's traders, in Greenwich, Conn., produced phenomenal returns - 28.1 percent in 1994, 58.8 percent in 1995 and 57.5 percent in 1996.

But that very success also created what Dr. Scholes saw as a problem: a huge income tax bill. Short-term trading profits were taxed at the time at 39.6 percent, the highest income tax rate. The prospect of losing such a big part of their windfall did not please Long-Term Capital investors. One day in March 1996, a possible solution came into view. From the moment that Dr. Scholes learned of it, he understood its potential to defer, even eliminate, taxes on more than one-third of a billion dollars of profits.

The tax shelter did not come to his firm by way of strangers, but from Babcock & Brown, an investment bank in San Francisco whose general counsel, Jan Blaustein, had been the girlfriend of Dr. Scholes for more than two years. They would marry in 1998. The shelter was in the form of stock, in companies like Electronic Data Systems, Rhí´ne Poulenc and Qwest, that had a combined market value of about $4 million but that also had a potential worth of more than 90 times that to Long-Term Capital's partners.

The stock had been assigned by Babcock & Brown to three London investors, who did not have to pay American taxes, through a series of multilayered leasing arrangements that gave them tax deductions worth $375 million. The Londoners could not use the deductions themselves, but they could sell the stock, and the deductions that went with them, to American investors.

The Londoners would make money on the transaction, the American investors would eliminate their tax liability on up to $371 million in stock-trading profit. And Babcock & Brown and its network of lawyers, banks and other associates would earn big fees. Everybody would be happy - everybody, that is, except the federal government. And so it was that in auditing Long-Term Capital's tax returns, the Internal Revenue Service disallowed the use of $106 million of deductions to reduce the taxes owed by partners of the firm. Long-Term Capital then paid part of the $40 million in taxes that it owed, but sued for a refund in Federal District Court in New Haven, where the trial has been under way for three weeks and appears to be about half way over.

Both sides knew that the outcome would depend on whether Long-Term Capital could convince Judge Janet Bond Arterton that it had not simply bought the shares in question for use as a tax dodge, but had done so for a legitimate economic purpose. Under a doctrine known as economic substance, courts have long held that if a business transaction has no value except to create tax losses, then it can be disallowed by the I.R.S. Otherwise, tax lawyers could just move symbols around on pieces of paper, and their clients would never pay taxes.

In testimony last week, Dr. Scholes tried to show that the acquisition had an economic rationale beyond just acquiring tax losses. He viewed the transaction, he said, as a way to establish and a strong business relationship with Babcock & Brown. It was a relationship that he hoped to develop, he said, though he acknowledged that his partners did not share his passion. Indeed, once the tax shelter deal was finished, so was Long-Term Capital's relationship with Babcock & Brown.

On cross-examination by the government, Dr. Scholes, who was the principal author of a $130 textbook, "Taxes and Business Strategy," that he used to teach graduate business students at Stanford, tried to minimize his knowledge of taxes. He conceded, however, that he knew that basic tax rules required wringing a profit from a tax shelter without regard to its tax benefits if the shelter was to stand. His testimony also showed that he worked hard to imbue the tax-favored stock with value, ordering analyses, soliciting legal opinions and even flying to London to meet with one of the three owners to make sure, he said, that they were not people who would bring disrepute on Long-Term Capital.

His way to show a profit from the tax shelter was to make both the three Londoners and Babcock & Brown investors in Long-Term Capital, even though the firm, in theory, had been closed to outside investors. That presented another problem. Neither the Londoners nor Babcock & Brown wanted to put up any money, and neither was willing to assume any risk of losing money should the fund go broke, as it would do in 1998.

So Dr. Scholes arranged to lend them millions of dollars at an interest rate of 7 percent, which, contrary to usual banking practice, was lower that the rate he could have gotten from most clients. Then he used his expertise as one of the creators of the Black-Scholes method to write several options guaranteeing that the investors could not lose money, he told Charles P. Hurley, the lead Justice Department lawyer in the case.

In one of the deals, the three Londoners put tax-favored stock with a market value of $2.5 million into Long-Term Capital and, at the low interest rates, borrowed $5 million, more than half of which went to pay off an existing loan they had on their stock. To make sure that they could not lose the value of their stock or the amount they borrowed, they paid $61,000 for a put option designed and priced by Dr. Scholes.

After 14 months, the Londoners cashed out and walked away with a 22 percent profit, by Dr. Scholes's calculations. They also paid the partnership fees of about $900,000, he estimated in testimony. Those fees, plus the value of the new relationship with Babcock & Brown, were the profits that Dr. Scholes said made the tax shelter valuable in its own right.

Against that, Long-Term Capital paid more than $500,000 to the Shearman & Sterling law firm in New York for an opinion letter. The letter said that one part of the tax shelter deal should survive an I.R.S. audit. Long-Term Capital paid $400,000 to King & Spalding in Washington for a similar opinion letter on another part of the deal.

Larry Noe, the tax director of Long-Term Capital, received a bonus of between $50,000 and $100,000 for his work in bringing in the tax shelter, though Dr. Scholes made it clear that the firm had resisted paying anything extra to Mr. Noe for his successful efforts on the partnership's behalf.

Taken together, those costs equaled or exceeded the $900,000 in fees that Dr. Scholes was able to wring from the tax shelter apart from the tax benefits. In other words, unless the $900,000 was all profit, the shelter could not make a profit apart from the tax savings.

Then came the coup de grí¢ce. Mr. Hurley slipped in a question about whether Dr. Scholes had sought, and received, a bonus for himself of several million dollars for his role in strengthening the tax shelter. Dr. Scholes confirmed that he had, but that it had been paid in extra partnership shares, not cash.

Counting his bonus, the tax shelter cost far more than its economic value of $900,000 in fees, making it hard to prove it met the economic-substance requirement. On the witness stand, Dr. Scholes appeared to realize how Mr. Hurley's questioning had shown that apart from the tax benefits, the deal could not have come to close to turning a profit, in large part because he took that bonus. "I'm being trapped here," he blurted out.

Dr. Scholes has told friends that most of his wealth has been wiped out in the collapse of Long-Term Capital. If the court rules in the government's favor, he stands to owe millions of dollars to the I.R.S.

For the brilliant boy who grew up in hard-scrabble gold-mining country and went on to win the world's greatest intellectual honor, the dissection of his work by a government lawyer seemed to come as a shock. When he stepped down, he walked over to his wife, Jan, who had begun to fidget in her seat as Mr. Hurley's carefully planned cross examination set the snare that the great economist stepped into. Dr. Scholes was visibly shaken, his head cast down so that no one could see directly into his eyes as he and his wife slipped into an anteroom and shut the door.

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