Could a Rainmaker Destroy Your Firm?
Scott Langlinais | December 15, 2021
The following is a case study I'll present to attendees of our Strengthen Your Control Environment seminar. The discussion that follows takes the attendees' minds away from the idea of controls as perfunctory items on a checklist and shifts them toward the mindset of discipline as a function of organizational culture. This case illustrates how effectively a top-line focus cannot only undermine an entire control system but also eradicate the organization and destroy livelihoods.
The euphoric episode is protected and sustained by the will of those who are involved, in order to justify the circumstances that are making them rich. And it is equally protected by the will to ignore, exorcise, or condemn those who express doubts.
— J. K. Galbraith, A Short History of Financial Euphoria, New York, New York: Penguin Books, 1993.
Do you think: That could never happen here? Maybe not. Though it never hurts to think about such problems every once in a while and consider whether we're getting a little loose in our oversight of certain areas.
Take a read and answer the questions that follow.
Paul Daugerdas, a lawyer and certified public accountant, was a long-time accounting partner at Arthur Andersen. In 1999, he became the managing shareholder of the newly formed Chicago office of Jenkens & Gilchrist, PC (J&G), a national law firm headquartered in Dallas, Texas. He brought the firm an innovative and highly profitable strategy to create tax shelters for clients.
For over 10 years, individuals at J&G, BDO Seidman, and two national banks marketed, implemented, and defended shelters known as Short Sale, Short Option Strategy, Swaps, and Hedge Option Monetization of Economic Remainder (HOMER). The shelters allowed clients to select their amount of tax loss (i.e., their own benefit in avoiding taxes), and the client would pay a fee of 5–10 percent of the desired tax loss.
Ultimately, seven people from the four firms were named in a criminal indictment for generating $7 billion in fraudulent tax deductions. In the indictment, all of the tax shelters are explained in detail. The Short Sale shelter seems to have been the least complicated.
The Short Sale shelter was implemented through three entities set up by J&G: a single-member LLC, a partnership, and an S Corporation. Through the LLC, client funds were used to borrow U.S. Treasuries from Bank A, which were short-sold, generating cash proceeds which were transferred to the partnership. Although the cash was treated as a partnership asset (increasing the client's tax basis in the partnership), J&G took the position that the obligation to cover the short sale was not a liability for tax purposes; notwithstanding the obligation to replace the Treasuries, the precise amount to do so was not yet fixed or determined. The short sale would ultimately be closed before year end, the partnership would be liquidated typically through transfer of partnership assets to the S Corporation, and the client's stepped up basis in the partnership would carry over to the partnership assets. Subsequent sale of those assets produced a reportable tax loss for the client.
Every shelter's transactions were convoluted and lacking in economic substance, but in every case, the tax losses greatly exceeded any actual economic loss suffered by the client. The firms generated nearly $400 million in fees/premiums from the shelters: J&G ($230 million), BDO Seidman ($44 million), "Bank A" ($99 million), and "Bank B" ($5 million). Mr. Daugerdas personally received more than $95 million in compensation for the shelters. 1
In 2007, J&G shut its doors, ending the existence of a prestigious nationwide law firm. In 2014, Mr. Daugerdas was sentenced to 15 years in prison for orchestrating the scheme. 2
Questions To Consider with Your Team
- Without looking back, could you explain the structure of the Short Sale shelter? Can you take a stab at describing what Hedge Option Monetization of Economic Remainder might mean?
- Many believe complexity equals sophistication, which then justifies a larger fee for the product or service. What are the implications for your control environment if someone is unable to elegantly and clearly explain the what-when-where-why-how of your offering?
- Many organizations reward individuals for achieving short-term goals (e.g., sales quotas or quarterly revenues), whereas others reward employees based on long-term success (e.g., profit shares or vesting stock grants). And not all rewards are monetary—recognition, genuine appreciation, and a stable environment can be very rewarding.
- How is performance rewarded in your organization, if at all? Is performance measured based on individual success or organizational success? Has anyone considered the unintended consequences of your incentive-based rewards? What are some ways people could game the system?
- How is top performance handled in your organization? Are top performers untouchable?
- Do you think any set of internal controls could've stopped the partner from selling these tax shelters? Why or why not?
Conclusion
The point of the exercise isn't to get anyone into the habit of mistrusting employees or making it seem like J&G missed a problem so obvious that anyone in their right mind could've avoided the disaster. This was a successful firm for many years, loaded with top talent.
The most highly educated, "successful" businesspeople can remain willfully blind to hazards. Sometimes, it's because of a simple belief—we're too focused on the money we're making to worry about what we might lose later on. We all know pitfalls seem more obvious in retrospect.
In any case, we also know it is extremely difficult to challenge authorities who bring in cartloads of cash. This is why it's critical for organizational leaders to be the ones to initiate such conversations, to take a hard look at cases such as these ahead of time, challenge assumptions, and consider whether they might be allowing—intentionally or not—problems to fester.
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