By Richard Stoyeck
What happens when a world renowned accounting firm decides to market tax shelters to its elite clientele? The first thing that happens is that the client buys them because of the source. In this case the source is utterly reliable; KPMG is one of the oldest and biggest Public Accounting firms in the world. They number among their clients over 100 of the Fortune 500 companies. This includes General Electric with a $100 million per year in fees. Internationally, KPMG is just as big and powerful, with over 1600 partners. When the firm sneezes, the industry notices.
Somebody else was noticing too
They came to the conclusion that they could make a fortune by selling tax shelters to their client listing, and they were right. Clients leaped at the opportunity to take 3 to 1 and better write-offs from the schemes that KPMG came up with. The fees generated were mind-boggling, far more profitable than any other aspect to the accounting business. After all, once you put a tax deal together, your costs were fixed. If you could amortize the cost of a deal over more clients, there was that much more to be made for the firm.
The clients naturally assumed the deals were good because the KPMG name stood behind the deal. The problem was the "at-risk" provision of the Internal Revenue Code. Unless the client is at risk to be called on additional money by the terms of the deal, than the deal is deemed to be bogus by the IRS. The IRS was taking note of what KPMG was doing, and went after the firm, and this means the clients too.
KPMG got greedy. They weren't happy just marketing to their wonderful client list. Upon realizing the gold mine they had, they decided to market it to EVERYONE. A United States Senate committee reported that KPMG was marketing the shelters through a cold-calling operation run out of Fort Wayne, Indiana. Calling day and night, and using the Illustrious KPMG name, it was dialing for dollars.
Just about every millionaire in the country would take KPMG's call, and many followed through and became clients. Other large public accounting firms took note of the action, and began their own forays into tax shelter marketing. The IRS once again took note, and developed an internal committee to deal with the excesses. When the IRS realized that the clients in these deals were not at risk, the accounting firms got called on the carpet for their actions.
The smart firms settled with the IRS, and turned over their client lists of who participated in these deals, and the clients wound up settling too. The clients not only settled, but they paid interest and penalties as well. KPMG's Chairman, Eugene O'Kelly on the other hand decided that they were going to take on the government, and NOT settle. This was a bold move (bold means stupid) for a bold firm to make. O'Kelly had a brain tumor and dropped out of the picture as they say, and left the problem in the lap of Timothy Flynn, the new Chairman.
Flynn's Dilemma
Here's the problem. The government was in the process of making a decision to GO CRIMINAL on KPMG. The law specifies that if the accounting firm responsible for the tax shelter has totally abused the process, than criminal actions may proceed. If you remember it was only a few short years ago that Arthur Andersen, at the time a celebrated Public Accounting firm, was criminally indicted because of their actions involving the Enron audit.
The verdict went to a jury in that case, and the jury decided on behalf of the government. Once the verdict went against Arthur Andersen, by law they were no longer allowed to sign off on audits of publicly traded companies reporting to the SEC. This meant Andersen could no longer service publicly traded companies. They immediately went out of business. At a later time, the verdict was overruled on appeal, but it was too late. The company had already gone out of business.
KPMG was not facing an Arthur Andersen type indictment for marketing bogus tax shelters. The clients who bought them were facing their own troubles. Assessment letters went out nullifying the shelters, taxes were recomputed for the years involved, and interest and penalties were added. This is truly one of the worse pieces of mail you will ever receive from you postman. You had to make sure you had an empty stomach when you read it.
KPMG – Do you bite the bullet or take the shot?
The new Chairman Flynn was between a rock and hard place. He knew criminal charges would probably wipe out the firm. Clients would scatter to the winds, and be picked up by the competition, just waiting for it to happen. The government also was in a tough corner. Remember they had already SHUT DOWN Arthur Andersen. There were only four major firms left. Do you take down another one, leaving three?
Flynn decided to make the gamble. He met with Federal prosecutors and throws himself at their mercy. He announces that the firm had been wrong in what it did. The government made no promises, but the admission gave the government room to maneuver. Keep in mind that this case had been going on for several years. During that period, the prosecutors played musical chairs, as they are constantly leaving the government to go into more lucrative private practice.
Government cuts a deal
The government decided for the moment it was not in the people's interest to put KPMG out of business. They deferred prosecution of KPMG for the moment, but the firm had to pay a $456 million penalty to the government. That's right, it approached a half a billion dollars. In January, a federal judge was satisfied that KPMG had put in place sufficient internal controls to prevent a recurrence of this type of behavior. The judge killed the deferment, and the firm will not be criminally prosecuted.
The firm's senior management committee has denied having any knowledge of these tax shelters, to which we say SURE. This is the most profitable part of the firm amounting to hundreds of millions of dollars, and the guys in charge are nowhere to be found. Once again, let's be clear about this – SURE.
By the way, so far KPMG has reached a $154 million settlement with the clients who purchased the shelters. Scores of clients chose not to participate, and are independently suing KPMG. There will be hundreds of millions of additional settlement to be share among the 1600 KPMG partners who are already griping that the tax division should be taking the hit alone for the settlements. The question we ask - is this any way to run an accounting firm?
Goodbye and Good Luck
Richard Stoyeck
About the Author: Richard Stoyeck's background includes being a limited partner at Bear Stearns, Senior VP at Lehman Brothers, Kuhn Loeb, Arthur Andersen, and KPMG. Educated at Pace University, NYU, and Harvard University, today he runs Rockefeller Capital Partners and StocksAtBottom.com
Value Investing at StocksAtBottom.com/ez.html
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