[Senate Hearing 108-473]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 108-473

   U.S. TAX SHELTER INDUSTRY: THE ROLE OF ACCOUNTANTS, LAWYERS, AND 
                        FINANCIAL PROFESSIONALS

=======================================================================

                                HEARINGS

                               before the

                PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

                                 of the

                              COMMITTEE ON
                          GOVERNMENTAL AFFAIRS
                          UNITED STATES SENATE


                      ONE HUNDRED EIGHTH CONGRESS

                             FIRST SESSION

                               __________

                        NOVEMBER 18 AND 20, 2003

                               __________

                             VOLUME 1 OF 4

                               __________

      Printed for the use of the Committee on Governmental Affairs


                    U.S. GOVERNMENT PRINTING OFFICE
91-043                      WASHINGTON : DC
____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov  Phone: toll free (866) 512-1800; (202) 512ï¿½091800  
Fax: (202) 512ï¿½092250 Mail: Stop SSOP, Washington, DC 20402ï¿½090001

                   COMMITTEE ON GOVERNMENTAL AFFAIRS

                   SUSAN M. COLLINS, Maine, Chairman
TED STEVENS, Alaska                  JOSEPH I. LIEBERMAN, Connecticut
GEORGE V. VOINOVICH, Ohio            CARL LEVIN, Michigan
NORM COLEMAN, Minnesota              DANIEL K. AKAKA, Hawaii
ARLEN SPECTER, Pennsylvania          RICHARD J. DURBIN, Illinois
ROBERT F. BENNETT, Utah              THOMAS R. CARPER, Delaware
PETER G. FITZGERALD, Illinois        MARK DAYTON, Minnesota
JOHN E. SUNUNU, New Hampshire        FRANK LAUTENBERG, New Jersey
RICHARD C. SHELBY, Alabama           MARK PRYOR, Arkansas

           Michael D. Bopp, Staff Director and Chief Counsel
      Joyce A. Rechtschaffen, Minority Staff Director and Counsel
                      Amy B. Newhouse, Chief Clerk

                                 ------                                

                PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

                   NORM COLEMAN, Minnesota, Chairman
TED STEVENS, Alaska                  CARL LEVIN, Michigan
GEORGE V. VOINOVICH, Ohio            DANIEL K. AKAKA, Hawaii
ARLEN SPECTER, Pennsylvania          RICHARD J. DURBIN, Illinois
ROBERT F. BENNETT, Utah              THOMAS R. CARPER, Delaware
PETER G. FITZGERALD, Illinois        MARK DAYTON, Minnesota
JOHN E. SUNUNU, New Hampshire        FRANK LAUTENBERG, New Jersey
RICHARD C. SHELBY, Alabama           MARK PRYOR, Arkansas

       Raymond V. Shepherd, III, Staff Director and Chief Counsel
        Elise J. Bean, Minority Staff Director and Chief Counsel
        Robert L. Roach, Minority Counsel and Chief Investigator
                     Mary D. Robertson, Chief Clerk


                            C O N T E N T S

                                 ------                                
Opening statements:
                                                                   Page
    Senator Coleman.............................................. 1, 69
    Senator Levin................................................ 4, 72
    Senator Lautenberg...........................................     9

                               WITNESSES
                       Tuesday, November 18, 2003

Debra S. Petersen, Tax Counsel IV, California Franchise Tax 
  Board, Rancho Cordova, California..............................    11
Mark T. Watson, former Partner, Washington National Tax, KPMG 
  LLP, Washington, DC............................................    13
Calvin H. Johnson, Andrews & Kurth Centennial Professor, The 
  University of Texas at Austin School of Law, Austin, Texas.....    14
Philip Wiesner, Partner in Charge, Washington National Tax, 
  Client Services, KPMG LLP, Washington, DC......................    32
Jeffrey Eischeid, Partner, Personal Financial Planning, KPMG LLP, 
  Atlanta, Georgia...............................................    32
Richard Lawrence DeLap, Retired National Partner in Charge, 
  Department of Professional Practice-Tax, KPMG LLP, Mountain 
  View, California...............................................    34
Larry Manth, former West Area Partner in Charge, Stratecon, KPMG 
  LLP, Los Angeles, California...................................    34
Richard J. Berry, Senior Tax Partner, Pricewaterhouse Coopers, 
  New York, New York.............................................    54
Mark A. Weinberger, Vice Chair, Tax Services, Ernst & Young LLP, 
  Washington, DC.................................................    55
Richard H. Smith, Jr., Vice Chair, Tax Services, KPMG LLP, New 
  York, New York.................................................    57

                      Thursday, November 20, 2003

Raymond J. Ruble, former Partner, Sidley Austin Brown and Wood, 
  LLP, New York, New York, represented by Jack Hoffinger.........    76
Thomas R. Smith, Jr., Partner, Sidley Austin Brown and Wood, New 
  York, New York.................................................    77
N. Jerold Cohen, Partner, Sutherland Asbill and Brennan, LLP, 
  Atlanta, Georgia, accompanied by J.D. Fleming..................    79
William Boyle, former Vice President, Structured Finance Group, 
  Deutsche Bank AG, New York, New York...........................    95
Domenick DeGiorgio, former Vice President, Structured Finance, 
  HVB America, Inc., New York, New York, accompanied by Brian 
  Skarlatos......................................................    97
John Larson, Managing Director, Presidio Advisory Services, San 
  Francisco, California..........................................   114
Jeffrey Greenstein, Chief Executive Officer, Quellos Group, LLC, 
  formerly known as Quadra Advisors, LLC, Seattle, Washington....   115
Mark Everson, Commissioner, Internal Revenue Service, Washington, 
  DC.............................................................   128
William J. McDonough, Chairman, Public Company Accounting 
  Oversight Board, Washington, DC................................   130
Richard Spillenkothen, Director, Division of Banking Supervision 
  and Regulation, The Federal Reserve, Washington, DC............   131

                     Alphabetical List of Witnesses

Berry, Richard J.:
    Testimony....................................................    54
    Prepared statement...........................................   303

Boyle, William:
    Testimony....................................................    95
    Prepared statement with an attachment........................   317

Cohen, N. Jerold:
    Testimony....................................................    79
    Letter dated November 18, 2003, submitted with answers to 
      questions..................................................   315

DeGiorgio, Domenick:
    Testimony....................................................    97
    Prepared statement...........................................   326

DeLap, Richard Lawrence:
    Testimony....................................................    34

Eischeid, Jeffrey:
    Testimony....................................................    32
    Prepared statement...........................................   298

Everson, Mark:
    Testimony....................................................   128
    Prepared statement with an attached chart....................   338

Greenstein, Jeffrey:
    Testimony....................................................   115
    Prepared statement...........................................   334

Johnson, Calvin H.:
    Testimony....................................................    14
    Prepared statement...........................................   286

Manth, Larry:
    Testimony....................................................    34

Larson, John:
    Testimony....................................................   114

McDonough, William J.:
    Testimony....................................................   130
    Prepared statement...........................................   349

Petersen, Debra S.:
    Testimony....................................................    11
    Prepared statement...........................................   275

Ruble, Raymond J.:
    Testimony....................................................    76

Smith, Richard H., Jr.:
    Testimony....................................................    57

Smith, Thomas R., Jr.:
    Testimony....................................................    77
    Prepared statement...........................................   312

Spillenkotchen, Richard:
    Testimony....................................................   131
    Prepared statement...........................................   361

Watson, Mark T.:
    Testimony....................................................    13
    Prepared statement...........................................   285

Weinberger, Mark A.:
    Testimony....................................................    55
    Prepared statement...........................................   309

Wiesner, Philip:
    Testimony....................................................    32

                                APPENDIX

Minority Staff Report of the Permanent Subcommittee on 
  Investigations entitled, ``U.S. Tax Shelter Industry: The Role 
  of Accountants, Lawyers, and Financial Professionals, Four KPMG 
  Case Studies: FLIP, OPIS, BLIPS, and SC2,'' released in 
  conjunction with the Permanent Subcommittee on Investigations' 
  hearings on November 18 and 20, 2003, S. Prt. 108-34...........   145

I. INTRODUCTION..................................................   145

II. FINDINGS.....................................................   147

III. EXECUTIVE SUMMARY...........................................   149

      A. Developing New Tax Products.............................   151
      B. Mass Marketing Tax Products.............................   152
      C. Implementing Tax Products...............................   153
      D. Avoiding Detection......................................   157
      E. Disregarding Professional Ethics........................   159

IV. RECOMMENDATIONS..............................................   160

V. OVERVIEW OF U.S. TAX SHELTER INDUSTRY.........................   162

      A. Summary of Current Law on Tax Shelters..................   162
      B. U.S. Tax Shelter Industry and Professional Organizations   164

VI. FOUR KPMG CASE HISTORIES.....................................   166

      A. KPMG In General.........................................   166
      B. KPMG's Tax Shelter Activities...........................   168
        (1) Developing New Tax Products..........................   172
        (2) Mass Marketing Tax Products..........................   188
        (3) Implementing Tax Products............................   206
           a. KPMG's Implementation Role.........................   206
           b. Role of Third Parties in Implementing KPMG Tax 
      Products...................................................   215
        (4) Avoiding Detection...................................   235
        (5) Disregarding Professional Ethics.....................   245

APPENDIX A
    CASE STUDY OF BOND LINKED ISSUE PREMIUM STRUCTURE (BLIPS)....   255

APPENDIX B
    CASE STUDY OF S-CORPORATION CHARITABLE CONTRIBUTION STRATEGY 
      (SC2)......................................................   266

APPENDIX C
    OTHER KPMG INVESTIGATIONS OR ENFORCEMENT ACTIONS.............   270

                              EXHIBIT LIST
                                Volume 1

   1. a. BLIPS: Bond Linked Issue Premium Structure, PowerPoint 
  presentation with eight slides prepared by the Permanent 
  Subcommittee on Investigations.................................   371

       b. SC\2\, PowerPoint presentation with five slides 
  prepared by the Permanent Subcommittee on Investigations.......   379

       c. Mass Marketing of Tax Shelters, chart prepared by the 
  Permanent Subcommittee on Investigations.......................   384

       d. Knowledge of Counter Parties, chart prepared by the 
  Permanent Subcommittee on Investigations.......................   385

  2. KPMG Memorandum, February 1998, re: Summary and 
  observations of OPIS...........................................   386

  3. KPMG Memorandum, May 1998, re: OPIS Tax Shelter 
  Registration...................................................   393
  4. Gibson, Dunn & Crutcher LLP Memorandum to KPMG, March 2000, 
  re: BLIPS Tax Opinion..........................................   400

  5. KPMG email, April 1999, re: BLIPS (``The original intent of 
  the parties was to participate in all three investment stages 
  of the Investment Program.'' It seems to me that this is a 
  critical element of the entire analysis and should not be 
  blithely assumed as a ``fact''. If it is true, I think it 
  should be one of the investor's representations. However, I 
  would caution that if there were, say, 50 separate investors 
  and all 50 bailed out of at the completion of Stage I, such a 
  representation would not seem credible.).......................   408

  6. KPMG email, February 2000, re: Product champions needed for 
  S Corp strategy (I want to personally thank everyone for their 
  effort during the approval process of this strategy. It was 
  completed very quickly and everyone demonstrated true teamwork. 
  Thank you! Now lets SELL, SELL, SELL!!)........................   412

  7. KPMG email, February 2000, re: BLIPS/OPIS (. . . the sooner 
  we get them out the door the better since the law--especially 
  the primary profit motive test--is evolving daily and not in a 
  taxpayer friendly manner. * * * As I understand the facts, all 
  66 closed out by year-end and triggered the tax loss.).........   415

  8. KPMG email, February 2001, re: SC2 Solution--New 
  Development (Quick Snapshot--We are now offering a modified SC2 
  solution. S Corp shareholders can use the structure of direct 
  significant gift to 501(c)(3) tax exempts of their choice. Net 
  tax benefit is less than original SC2 . . . shareholder ``feel 
  good'' factor is higher. We need targets and ICV's. * * * Look 
  at the last partner scorecard. Unlike golf, a low number is not 
  a good thing. . . . A lot of us need to put more revenue on the 
  board before June 30. SC2 can do it for you. Think about 
  targets in your area and call me.).............................   423

  9. KPMG email, June 2000, re: Revised SC2 Script, Rosenthal/
  Stein approval of SC2 calling script...........................   426

 10. KPMG emails, September 1998, January 1999, and October 2000 
  re: Grantor Trust Issue and KPMG Memorandum of Telephone Call, 
  May 2000, re: Grantor Trust Issue (So our best intelligence is 
  that you are increasing your odds of being audited, not 
  decreasing your odds by filing that Grantor Trust return. So we 
  have discontinued doing that.).................................   428

 11. KPMG email, March 1998, re: Simon Says (. . . and yet in 
  truth the option was 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.)..........................   439

 12. Email, May 1999, re: Who is the Borrower in the BLIPS 
  transaction (Based on your analysis below, do you conclude that 
  the tax results sought by the Investor are NOT ``more likely 
  than not'' to be realized? * * * Yes.).........................   448

 13. Email, August 1999, re: BLIPS (However, before engagement 
  letters are signed and revenue is collected, I feel it is 
  important to again note that I and several other WNT 
  [Washington National Tax] partners remain skeptical that the 
  tax results purportedly generated by a BLIPS transaction would 
  actually be sustained by a court if challenged by the IRS.)....   450

 14. KPMG email, May 1998, re: OPIS Tax Shelter Registration (If 
  for some reason the IRS decides to ``get tough'' with someone 
  vis-a-vis the old rules, I suspect it could easily pick on ANY 
  of the Big 6, or for that matter any number of law firms/
  promoters--I don't think we want to create a competitive 
  DISADVANTAGE, nor do we want to lead with our chin.)...........   451

 15. KPMG email, December 1998, re: OPIS (After December 31, 
  1998, there will be no marketing of OPIS in any circumstances.)   452

 16. KPMG email, July 1999, re: National Accounts Database 
  (VALUE PROPOSITION: . . . The all-in cost of the program, 
  assuming a complete loss of investment principal, is 7% of the 
  targeted tax loss (pre-tax). The tax benefit of the investment 
  program, which ranges from 20% to 45% of the targeted tax loss, 
  will depend on the taxpayer's effective tax rates. FEE: BLIPS 
  is priced on a fixed fee basis which should approximate 1.25% 
  of the tax loss. Note that this fee is included in the 7% 
  described above.)..............................................   453

 17. KPMG email, August 1999, re: BLIPs (Depicting the approval 
  of BLIPS and views of some at KPMG about the strategy.)........   455

 18. KPMG email, September 1999, re: BLIPS 2000 (A number of 
  people are looking at doing BLIPS transactions to generate Y2K 
  losses. We currently have bank capacity to have $1 billion of 
  loans outstanding at 12/31/99. This translates into 
  approximately $400 million of premium. This tranche will be 
  implemented on a first-come, first-served basis until we fill 
  capacity. Get your signed engagement letters in!!).............   459

 19. KPMG email, February 2000, re: Hot Tax Products (5 Month 
  Mission) (Thanks for help in this critically important matter. 
  As Jeff [Stein] said, ``We are dealing with ruthless 
  execution--hand to hand combat--blocking and tackling.'' 
  Whatever the mixed metaphor, let's just do it.)................   460

 20. KPMG email, April 2000, re: SC2 (There have been several 
  successes--the West and South Florida with many ICV's in other 
  parts of the country. We are behind. This is THE STRATEGY that 
  they expect significant value added fees by June 30. The heat 
  is on. . . .)..................................................   463

 21. KPMG Document, SC\2\--Meeting Agenda June 19th, 2000.......   464

 22. KPMG email, July 2000, re: Attaching memorandum to Tax 
  Partners and Tax Management Group. re: Selling with Confidence: 
  Skills for Successful Selling--``Positioning.''................   486

 23. KPMG email, August 2000, re: Solution Activity Reports--SC2 
  (Our team of telemarketers is particularly helpful in a number 
  of respects: --to further qualify prospects; --to set up phone 
  appointments for you and your deployment team.)................   488

 24. KPMG email, November 2000, re: SW SC2 Channel Conflict 
  (Attached is a list of SC2 targets in the Southwest that we are 
  including in an upcoming telemarketing program.)...............   490

 25. KPMG email, December 2000, re: STRATECON WEST--KICK OFF 
  PLAN FOR '01 (. . . we must aggressively pursue these high-end 
  strategies.)...................................................   492

 26. KPMG email, March 2001, re: Friday's Stratecon Call (Due to 
  the significant push for year-end revenue, all West Regional 
  Federal tax partners have been invited to join us on this call 
  and we will discuss our ``Quick Hit'' strategies and targeting 
  criteria.).....................................................   494

 27. KPMG email, April 2001, re: Friday's Stratecon Call (The 
  [tax] strategies have a quick revenue hit for us, . . .).......   495

 28. KPMG email, May 1999, re: Marketing BLIPS (One does not 
  need to understand how the program is structured to determine 
  whether someone has sufficient gain and has the tax risk 
  appetite to do an OPIS/BLIPS type strategy.)...................   496

 29. KPMG email, September 1999, re: BLIPS--managing deal flow 
  (As you know, we have until 10/15 at the latest to close loans 
  and 10/22 to activate the FX trading etc. (the 60 day 
  countdown).)...................................................   499

 30. KPMG email, October 1999, re: BLIPS (18 OPIS ``slots'' were 
  reserved for the intended BLIPS participants noted in the third 
  paragraph below.)..............................................   500

 31. KPMG email, November 1999, re: BLIPS (It occurs to me that 
  it would be useful to know something about the investment 
  performance as we call these clients to discuss their go 
  forward strategy. . . . * * * As you may be aware, the 60-day 
  anniversary of your client's participation in the Strategic 
  Investment Fund is November 22nd. As a reminder for you and 
  your client, we have summarized certain procedures that may be 
  of interest.)..................................................   503

 32. Generating Capital Losses, A Presentation for ------, KPMG 
  Peat Marwick LLP, ------, 1996.................................   505

 33. KPMG Memorandum, June 1998, re: June 11 OPIS Conference 
  Call (Use of Nondisclosure Agreements and Outside Advisors)....   517

 34. Email, July 1999, re: BLIPS--Economic Substance Issue 
  (Gentlemen, we have completed our review of the BLIPS loan 
  documents. In general, these documents indicate that the loan 
  proceeds will be invested in very safe investments (e.g., money 
  market instruments). Thus it seems very unlikely that the rate 
  of return on the investments purchased with the loan proceeds 
  will equal or exceed the interest charged on the loan and the 
  fees incurred by the borrower to secure the loan. * * * Before 
  any fees are considered, the client would have to generate a 
  240% annual rate of return on the $2.5 million foreign 
  currencies investment in order to break even. If fees are 
  considered, the necessary rate of return to break even will be 
  even greater.).................................................   521

 35. KPMG email, May 2000, re: Brown & Wood BLIPS Opinion 
  letters (As we discussed, the B&W opinion letters touch all the 
  necessary bases. The fact and representation sections are 
  almost identical to the ones in our Opinion and many analysis 
  sections are exact copies of our Opinion. Please let me know if 
  you want further details about the ``non-critical'' typos.)....   522

 36. KPMG email, July 1999, re: brown&wood (If you have a KPMG 
  opinion, you should also have a B&W opinion. We do ours and 
  they use it as a factual template for their opinion, usually 
  within 48 hours.)..............................................   524

 37. Internal Revenue Bulletin No. 2000-36, September 5, 2000, 
  Notice 2000-44, Tax avoidance using artificially high basis--
  describing a BLIPS-type transaction............................   525

 38. KPMG Document, PFP Practice Reorganization, Innovative 
  Strategies Business Plan--DRAFT (May 18, 2001).................   528

 39. KPMG email, May 1999, re: BLIPS Update (Larry [DeLap], I 
  don't like this product and would prefer not to be associated 
  with it.)......................................................   532

 40. KPMG email, December 2000, re: Weekly Tax Solutions Call 
  (Larry [DeLap]--Are you suggesting that we stop marketing the 
  solution, or that you just don't want a public discussion of 
  the solution in light of the IRS focus?).......................   533

 41. KPMG's Personal Financial Planning Presentation, BLIPS AND 
  TRACT, Carol Warley, June 1999 (BLIPS Benefit: --Avoid All Of 
  The Capital Gains And Ordinary Income Tax; --Net Benefit To 
  Client --Effective Tax Rate Less After Tax Cost of Transaction 
  of Approximately 5%)...........................................   536

 42. KPMG email, April 1999, re: BLIPS (The underlying tax 
  planning is such that the investor is likely to bail out after 
  Stage 1; i.e., after about 60 days.)...........................   543

 43. KPMG email, March 2000, re: S-corp Product (No, we don't 
  disclose all risks in all engagement letters. * * * . . . I 
  definately (sic) agree on disclosing the risks upfront and 
  would prefer to have the separate memo that states the risks 
  involved. . . . is there a way to make the risk memo be covered 
  under 7525?)...................................................   545

 44. Sutherland Asbill & Brennan LLP correspondence, July 2002, 
  re: Representations of BLIPS client............................   555

 45. KPMG correspondence to Sutherland, Asbill & Brennan LLP, 
  September 2002, re: Contract with KPMG for tax assessment for 
  BLIPS client...................................................   557

 46. KPMG email, November 2002, re: Script (Attached is a list 
  of law firms that are handling FLIP/OPIS cases. * * * Attached 
  is the script . . . waiver language and list of attorneys to 
  follow.).......................................................   560

 47. KPMG email, March 2002, re: SC2 (Given the current state of 
  affairs relative to the IRS and accounting firms, I think we 
  should not be discussing SC2 on the Monday night call at this 
  time.).........................................................   563

 48. KPMG email, August 1999, re: BLIPS Engagement Letter 
  (Attached is the engagement letter approved by Larry [DeLap].).   566

 49. KPMG email, March 2000, re: S-corp Product (1. This appears 
  to be little more than a old give stock to charity and then 
  redeem it play . . . * * * Our preference is that the client 
  donate stock to a local 401(a), . . .).........................   574

 50. KPMG email, April 2000, re: S-Corporation Charitable 
  Contribution Strategy (SC2) (This is a relatively high risk 
  strategy.).....................................................   584

 51. KPMG email, August 2001, re: New Solutions-WNT [Washington 
  National Tax] (Beginning in December . . . The shareholders 
  will most likely want access to the cash (especially if we 
  could get it to them tax-free).)...............................   585

 52. KPMG email, October 2001, re: SC2 Client (His ownership is 
  so minute, he is concerned about it being reduced any further 
  by the charitable contribution. We know that this reduction is 
  only temporary, . . .).........................................   587

 53. KPMG Document, Tax Innovation Center, Product Idea 
  Submission Form and KPMG Tax Solution Alert, April 24, 2000, S-
  Corporation Charitable Contribution Strategy...................   589

 54. KPMG document, undated, Draft PDC Talk Points 6/19, S-
  Corporation Charitable Contribution Strategy (Cold call 
  script.).......................................................   595

 55. KPMG email, March 2001, re: Florida S corporation search 
  (Request to utilize database on tax return information to 
  identify potential SC2 clients.)...............................   597

 56. KPMG email, March 2001, re: South Florida SC2 Year End Push   599

 57. KPMG email, March 2001, re: SC2--Client Base Expansion.....   601

 58. KPMG email, December 2001, re: SC2 (. . . working on a 
  back-end solution to be approved by WNT [Washington National 
  Tax] that will provide S-corp shareholders additional basis in 
  their stock which will allow for the cash built-up inside of 
  the S-corporation to be distributed tax-free to the 
  shareholders.).................................................   602

 59. KPMG email, January 2002, re: SC2 (Shelly Nance is in Fort 
  Wayne, which is ``cold call central''. How can she (or he) be 
  involved in sending out messages about SC2 if it is not being 
  mass marketed.)................................................   604

 60. Permanent Subcommittee on Investigations correspondence to 
  KPMG, LLP, November 2003, re: November hearing testimony.......   609

 61. KPMG Presentation excerpts: Tax Innovation Center Solution 
  and Idea Development--Year-End Results, May 30, 2001; and Goal: 
  Deposit 150 New Ideas in Tax Service Idea Bank.................   612

 62. KPMG Presentation excerpts: Innovative Tax Solutions, July 
  19, 2001; Tax Practice Update; and Tax Practice Growth Gross 
  Revenue........................................................   614

 63. KPMG Presentation, S-Corporation Charitable Contribution 
  Strategy (SC2 Update), June 18, 2001, showing SC\2\ Revenues...   617

 64. KPMG email, May 1999, re: BLIPS--More Likely Than Not? (. . 
  . while I am comfortable that WNT [Washington National Tax] did 
  its job reviewing and analyzing the technical issues associated 
  with BLIPS, based on the BLIPS meeting I attended on April 30 
  and May 1, I am not comfortable issuing a more-likely-than-not 
  opinion letter wrt (sic) this product . . .)...................   621

 65. KPMG email, May 1999, re: BLIPS (The real ``rubber meets 
  the road'' will happen when the transaction is sold to 
  investors, what the investors' actual motive for investing the 
  transaction is and how the transaction actually unfolds. * * * 
  My own recommendation is that we should be paid a lot of money 
  here for our opinion since the transaction is clearly one that 
  the IRS would review as falling squarely within the tax shelter 
  orbit.)........................................................   623

 66. KPMG email, August 1999, re: BLIPS involvement in the NE--
  BDMs (KPMG's fee is 1.25% (125 basis points) of the gain to be 
  mitigated. This fee is included as part of the 7% investment in 
  strategy.).....................................................   628

 67. Deutsche Bank email, July 1999, re: Risk and Resources 
  Committee Paper (BLIPS Summary--The 7.7% will cover market 
  risks, transaction costs, and DBSI fees.)......................   632

 68. Email, September 1999, re: West (Larry [DeLap], just to 
  clarify, even if we have five or more investors in a single 
  BLIPS transaction, you don't think we need to register the 
  transaction as a tax shelter. Is this correct? * * * No, that 
  is not correct, Mark Ely has concluded there is a reasonable 
  basis not to register.)........................................   641

 69. Deutsche Bank/Presidio Advisors, LLC Memorandum, April 
  1999, re: BLIPS friction costs (On day 60, Investor exits 
  partnership and unwinds all trades in partnership.)............   644

 70. Deutsche Bank New Product Committee Overview Memo: BLIPS 
  Transaction (It is imperative that the transaction be wound up 
  after 45-60 days and the loan repaid due to the fact that the 
  HNW individual will not receive his/her capital loss (or tax 
  benefit) until the transaction is wound up and the loan 
  repaid.).......................................................   646

 71. First Union (Wachovia) Capital Management Group Enhanced 
  Investment Strategy Release, February 2, 1999..................   651

 72. KPMG Foreign Leveraged Investment Program, Issue and Hazard 
  Summary (Taxpayer not sufficiently ``at risk'' under section 
  465) (preliminary and final versions)..........................   652

 73. KPMG email, February 1999, re: BLIPS (. . . status of the 
  BLIPS as an OPIS replacement strategy. . . . I would think we 
  can reasonably anticipate ``approval'' in another month or so. 
  * * * Given the marketplace potential of BLIPS, I think a month 
  is far too long-- . . .).......................................   654

 74. Email, February 1999, re: BLIPS Progress Report (I don't 
  like this pressure . . .)......................................   655

 75. KPMG MEETING SUMMARY, February 1999, re: Determine if BLIPS 
  is viable......................................................   656

 76. Email, April 1999, re: BLIPS (I would not characterize my 
  assessment of the economic substances of the ``premium 
  borrowing'' in the BLIPS transaction as ``positive.'').........   660

 77. Email, April 1999, re: BLIPS Analysis......................   661

 78. Email, May 1999, re: Who is the Borrower in the BLIPS 
  transaction....................................................   662

 79. Email, August 1999, re: BLIPS Documents--Acceptance of 
  Recommended Language...........................................   663

 80. Email, May 1999, re: BLIPS (According to Presidio, the 
  probability of making a profit from this strategy is remove 
  (possible, but remote).).......................................   664

 81. KPMG email, May 1999, re: BLIPS (. . . my change in heart 
  about BLIPS was based on information Presidio disclosed to me 
  at a meeting on May 1. This information raised serious concerns 
  in my mind about the viability of the transaction, and 
  indicated that WNT [Washington National Tax] had not been given 
  complete information about how the transaction would be 
  structured . . .)..............................................   665

 82. Email, August 1999, re: BLIPS (. . . before engagement 
  letters are signed and revenue is collected, I feel it is 
  important to again note that I and several other WNT 
  [Washington National Tax] partners remain skeptical that the 
  tax results . . . would actually be sustained by a court if 
  challenged by the IRS.)........................................   666

 83. Email, January 2000, re: BLIPS 2000 (The PFP guys really 
  need your help on the BLIPS 2000 strategy. . . . so we can take 
  this to market.)...............................................   667

 84. Email, March 2000, re: Blips I, Grandfathered Blips, and 
  Blips 2000 (. . . I do not believe KPMG can reasonably issue a 
  more-likely-than-not opinion on the economic substance issues 
  for the Blips . . .)...........................................   668

 85. KPMG Memoranda, February 1999, re: BLIPS...................   669

 86. KPMG Memoranda, March 2000, re: Talking points on 
  significant tax issues for BLIPS 2000..........................   670

 87. KPMG Memoranda, S Corporation Charitable Contribution 
  Strategy, Summary of Certain Risks (The opinion also much be 
  based on all pertinent facts and the law as it relates to those 
  facts; must not be based upon inaccurate legal or factual 
  assumptions; and must not unreasonably rely upon the 
  representations, statements, findings, or agreements of the 
  taxpayer or any other person.).................................   675

 88. Email, May 1999, re: BLIPS (It was not until I heard 
  conflicting information that I questioned the original facts. 
  In the future, I will question everything Presidio and Randy 
  Bickham represent to me.]......................................   677

 89. KPMG Tax Leadership, 2003; KPMG Tax Practice Organization, 
  2002, 2001 and 2000............................................   680

 90. a. KPMG Tax Opinion Letter (Signed Final), December 1999. 
  [Redacted by the Permanent Subcommittee on Investigations].....   684

     b. Brown & Wood Tax Opinion Letter (Signed Final), December 
  1999. [Redacted by the Permanent Subcommittee on 
  Investigations]................................................   781

     c. SEALED EXHIBIT: Unredacted copies of Exhibit No. 90a. 
  and 90b (above)................................................     *

 91. KPMG Memoranda, August 1998, re: Tax Products Practice (I 
  was responsible for KPMG's position that we should not register 
  OPIS as a tax shelter and insisted that we make the business 
  case with DPP. This was of significant benefit in marketing the 
  OPIS product and will establish the direction with respect to 
  KPMG's position on future tax products.).......................   857

 92. KPMG email, September 1998, re: OPIS (These fees relate to 
  approximately $1.2 billion in notional losses for approximately 
  25 clients.)...................................................   865

 93. Email, June 1998, re: OPIS (Not only will this unduely 
  (sic) harm our ability to keep the product confidential, it 
  will DESTROY any chance the client may have to avoid the step 
  transaction doctrine.).........................................   866

                                Volume 2

 94. a.-ggg. Documents relating to FLIP/OPIS....................   869

 95. a.-BBB. Documents relating to BLIPS........................  1240

 96. a.-ll. Documents relating to SC2...........................  1692

                                Volume 3

 97. a.-pp. Documents relating to development/marketing of tax 
  products.......................................................  1951

 98. a.-ppp. Documents relating to registering, reporting and 
  filing with Internal Revenue Service...........................  2225

 99. Documents relating to investment advisory firms:

     a.-f. Quadra/Quellos........................................  2473

     g.-t. Presido...............................................  2485

100. Documents relating to law firms:

     a.-u. Sidley Austin Brown & Wood............................  2540

     v.-gg. Sutherland Asbill & Brennan..........................  2576

101. Quadra Capital Management, LP. facsimile, August 1996, 
  attaching Memorandum on UBS' involvement in U.S. Capital Loss 
  Generation Scheme (the ``CLG Scheme'') (As I mentioned, KPMG 
  approached us as to whether we could affect the security trades 
  necessary to achieve the desired tax results.).................  2607

102. Deutsche Bank Memorandum, July 1999, re: GCI Risk and 
  Resources Committee--BLIPS Transaction.........................  2612

103. Deutsche Bank email, July 1999, re: Risk & Resources 
  Committee Paper--BLIPS and Comments on Blips Collateral and 
  Credit Terms (I would have thought you could still ensure that 
  the issues are highlighted by ensuring that the papers are 
  prepared, and all discussion held, in a way which makes them 
  legally privileged.)...........................................  2615

104. Deutsche Bank email, July 1999, re: Risk & Resources 
  Committee Paper--BLIPS (Our approach is as follows: STRUCTURE: 
  . . . Priviledge (sic): This is not easy to achieve and 
  therefore a more detailed description of the tax issues is not 
  advisable. REPUTATION RISK: . . . we have been asked by the Tax 
  Department not to create an audit trail in respect of the 
  Bank's tax affaires.)..........................................  2618

105. Deutsche Bank email, February 2002, re: Updated Presidio/
  KPMG trades (I understand that we based our limitations on 
  concerns regarding reputational risk which were heightened, in 
  part, on the proportion of deals we have executed relative to 
  the other banks. * * * . . . we would like to lend an amount of 
  money to Hypovereinsbank equal to the amount of money 
  Hypovereinsbank lends to the client.)..........................  2619

106. Deutsche Bank email, April 2002, re: US GROUP 1 Pres, 
  attaching Structured Transactions Group North America 
  Presentation, November 15, 1999................................  2622

107. HVB Document, undated, re: Presidio (7% -> fee (equity) 
  paid by investor for tax sheltering)...........................  2646

108. HVB email, September 1999, re: Presidio....................  2647

109. Deutsche Bank email, April 1999, re: presidio--w. revisions 
  (. . . The holding period/life of the LLC will typically be 45 
  to 60 days. At the end of this time period, the LLC will unwind 
  all transactions, repay the loan par amount and premium amount. 
  For tax and accounting purposes, repaying the premium amount 
  will ``count'' like a loss for tax and accounting purposes.)...  2649

110. KPMG email, March 2000, re: Bank representation (The bank 
  has pushed back the loan again and said they simply will not 
  represent that the large premium loan is consistent with 
  industry standards.)...........................................  2657

111. HVB credit request for BLIPS transaction by Presidio 
  personnel, September 1999. (HVB will earn a very attractive 
  return if the deal runs to term. If, however, the advances are 
  prepaid within 60 days (and there is a reasonable prospect that 
  they will be), HVB will earn a return of 2.84% p.a. on the 
  average balance of funds advanced.)............................  2660

112. KPMG Memoranda, March 1998, re: OPIS (The attached went to 
  the entire working group. . . . I believe that the OPIS product 
  (``Son of Flip'') is a stripped down version of the LLC 
  (partnership) structure.)......................................  2678

113. Deutsche Bank email, October 1999, re: BLIPS (PKS reports 
  that a meeting with John Ross was held on August 3, 1999 in 
  order to discuss the BLIPS product. PKS represented PB 
  Management's views on reputational risk and client suitability. 
  John Ross approved the product, however insisted that any 
  customer found to be in litigation be excluded from the 
  product, the product be limited to 25 customers and that a low 
  profile be kept on these transactions.)........................  2679

114. Deutsche Bank New Product Committee Overview Memo: BLIPS 
  Transaction (11-DB will have the right to approve/disapprove 
  all trading activity in the Company. This will allow DB to 
  effectively force the closure of the company and repayment of 
  its loan to DB.) [Note: An alternative version of this document 
  was previously entered into the Permanent Subcommittee on 
  Investigations' hearing record as Exhibit No. 70.].............  2681

115. KPMG Minutes of Assurance/Tax Professional Practice 
  Meeting, September 28, 1998....................................  2686

116. Brown & Wood email, December 1997, re: joint projects (This 
  morning my managing partner, Tom Smith, approved Brown & Wood 
  LLP working with the newly conformed tax products group at KPMG 
  on a joint basis in which we would jointly develop and market 
  tax products and jointly share in the fees, as you and I have 
  discussed.)....................................................  2691

117. KPMG email, September 1997, re: Flip Tax Opinion (ALSO, OUR 
  DEAL WITH BROWN AND WOOD IS THAT IF THERE NAME IS USED IN 
  SELLING THE STRATEGY, THEY WILL GET A FEE.)....................  2692

118. KPMG Memorandum, March 1998, re: B&W Meeting (What should 
  be the profit-split between KPMG, B&W and the tax products 
  group/implementor for jointly-developed products?).............  2693

119. KPMG Memorandum, December 1997, re: Business Model--Brown & 
  Wood Strategic Alliance........................................  2696

120. Brown & Wood email, December 1997, re: Confidential Matters 
  (On another point, as I have been mentioning with you, I do 
  work for a number of people who have potentially complementary 
  tax advantaged products. Let me state up front, I am not trying 
  to push any of these on KPMG, but it might be useful if you are 
  trying to get a repitoire of products jump started to talk to 
  some or all of them. In addition, each of them has a 
  relationship with one or more financial institutions who 
  provide credit, derivatives trades, etc. necessary to execute 
  the product.)..................................................  2699

121. KPMG email, May 2000, re: BLIPS--7 percent (The breakout 
  for a typical deal is as follows: . . . Trading Loss 70 * * * 
  Attached is Kerry's breakout of the 7 percent. [Redacted] gets 
  30 bpts from the Mgt. Fee. Is this detailed enough?)...........  2701

122. KPMG email, September 1999, re: BLIPS--managing deal flow 
  (As you know, we have until 10/15 at the latest to close loans 
  and 10/22 to activate the FX trading, etc. (the 60 day 
  countdown).)...................................................  2702

123. HVB Memorandum, October 1999, re: Presidio Credit Request 
  Dated September 14, 1999 (To summarize the above, the increased 
  limits will now permit the full amount of our facility to be 
  invested in EUR deposits and do related forwards.).............  2703

124. HVB Document, Back-End Process.............................  2705

125. HVB Document, Transaction Timeline (Exchange USD Amount to 
  EUR Amount * * * USD 181,300,000)..............................  2711

126. PRESIDIO ADVISORY SERVICES, LLC Memorandum, April 2002, re: 
  Year 2000 Strategic Plan. (Over the past two years because of 
  delays in obtaining the requisite approvals to market the OPIS 
  and BLIPS products, we did not begin closing deals until 
  September of 1998 and 1999, respectively. * * * Both Deutsche 
  Bank and KPMG have requested that we replace our existing BLIPS 
  product with a new product in 2000.)...........................  2712

127. KPMG/Presidio Advisors email, October 1999, re: Couple of 
  quick questions--Liquidating distributions (Upon distribution 
  (at the end of the 60 day period), can the client designate 
  where the funds go?)...........................................  2719

128. Handwritten notes, March 1998, re: Brown & Wood (Confirm w/
  Presidio that they will register.).............................  2720

129. PRESIDIO ADVISORY SERVICES, LLC Memorandum, September 1999, 
  re: BLIPS loan test case (Four special purpose, single member 
  Delaware LLC, owned by four trusts: D. Amir Makov revocable 
  trust (1/3), JL capital trust (1/3), RP capital trust (1/6), 
  pointe du Hoc irrevocable trust (1/6)).........................  2721

130. KPMG/Presidio Advisors email, December 1998, re: BLIPS 
  meeting (Second, the tax analyses and opinion writing needs to 
  go into high gear.)............................................  2722

131. KPMG/Presidio Advisors/Brown & Wood email, December 1998, 
  re: BLIPS meeting (I spoke with R.J. this morning about a 
  ``tax-focused'' meeting next week. As a first step before 
  scheduling a meeting, we thought that we should first draft the 
  base of an opinion letter in an outline format which will be 
  circulated for comment before getting everyone together for a 
  ``all-hands'' meeting. We are currently working on the document 
  and expect to circulate it next week.).........................  2723

132. KPMG email, February 2000, re: Brown & Wood opinion 
  letter--BLIPS (Jeff Eischeid has promised the Brown & Wood 
  opinion template ready in two weeks and we need your analysis.)  2724

133. KPMG email, January 2001, re: blips (We're still working 
  with Moore & Van Allen. They've declined to write a concurring 
  opinion--their firm doesn't write such opinions as a matter of 
  policy. They are considering, this week, whether they will 
  write [redacted] a MLTN [More Likely than Not] penalty 
  opinion.)......................................................  2726

134. IRS Form 8264, Application for Registration of a Tax 
  Shelter, QA Investments, LLC registration of FLIP..............  2727

135. KPMG/Quadra Fax and Memoranda, October 1997, re: 
  Registration of FLIP...........................................  2729

136. Deutsche Bank email, July 1999, re: hi bill..presidio (i 
  informed him that you are point man on the deal and that all 
  comments should go through you)................................  2734

137. KPMG email and Memorandum, July 1997, re: Revised 
  Memorandum ((I) KPMG's Tax Advantaged Transaction Practice; 
  (II) Presidio's Relationship with KPMG; (III) Transition 
  Issues.).......................................................  2735

138. HVB Document, August 2000, Presidio--Plafond (Investors 
  have, so far, chosen to liquidate before the second (180 day) 
  phase. ie after 60 days.)......................................  2745

139. a.-t. Documents relating to Ernst & Young..................  2746

140. a.-o. Documents relating to PriceWaterhouseCoopers.........  2803

141. a.-k. Documents relating to First Union....................  2848

142. a. WNT Solutions by Primary Functional Group--FYI 2001-
  2002, November 26, 2002, reprinting first three pages of 
  document (other pages sealed, see Exhibit 139b.)...............  2871

     b. SEALED EXHIBIT: WNT Solutions by Primary Functional 
  Group--FYI 2001-2002, dated November 26, 2002..................     *

143. SEALED EXHIBIT: StrateconWest email, December 2001, re: 
  StrateconWest/FSG Solution (Please find attached the latest and 
  greatest list of strategies for StrateconWest and FSG).........     *

144. SEALED EXHIBIT: Correspondence between Brown & Wood LLP and 
  Presidio Advisors LLC, dated October 1998 and February 1999, 
  regarding billing and document preparation for tax opinion.....     *

145. Organizational Chart, KPMG Tax Practice Organization, 
  produced by KPMG LLP in response to request made by Senator 
  Levin at the November 18, 2003, hearing........................  2874

146. Statement for the Hearing Record of Reuven S. Avi-Yonah, 
  Irwin I. Cohn Professor of Law and Director of the 
  International Tax Master of Law Program at the University of 
  Michigan Law School............................................  2875

147. a.-b. Supplemental questions and answers for the record of 
  KPMG. [Note: Exhibit 147a has been redacted, full document has 
  been made a SEALED EXHIBIT.]...................................  2878

148. Supplemental questions and answers for the record of 
  Deutsche Bank..................................................  2939

149. Supplemental questions and answers for the record of HVB 
  America, Inc...................................................  2949

150. Supplemental questions and answers for the record of 
  Quellos Group, LLC.............................................  2982

151. Supplemental questions and answers for the record of 
  Sutherland Asbill & Brennan LLP [Note: Submission has been 
  redacted, full document has been made a SEALED EXHIBIT.].......  2984

152. Supplemental questions and answers for the record of Sidley 
  Austin Brown & Wood............................................  2999

153. Statement for the Record and supplemental questions and 
  answers for the record of the Los Angeles Department of Fire & 
  Police Pensions System.........................................  3016

154. Supplemental questions and answers for the record of the 
  Internal Revenue Service.......................................  3025

                                Volume 4

155. Documents relating to Footnotes found in U.S. Tax Shelter 
  Industry: The Role of Accountants, Lawyers, and Financial 
  Professionals--Four KPMG Case Studies: FLIP, OPIS, BLIPS, and 
  SC2, a Report prepared by the Minority Staff of the Permanent 
  Subcommittee on Investigations in conjunction with the 
  Subcommittee hearings held November 18 and 20, 2003: [Note: 
  Footnotes not listed are explanative, reference Subcommittee 
  interviews for which records are not available to the public, 
  or reference a widely available public document.]

      Footnote No. 1, SEALED EXHIBIT.............................     *

      Footnote No. 3, See Hearing Exhibit No. 38 (above).........   528

      Footnote No. 4, See Hearing Exhibit No. 16 (above).........   453

      Footnote No. 10, See Attachments (2)...................3027, 3036

      Footnote No. 11, See Attachment............................  3045

      Footnote Nos. 15-16, See Hearing Exhibit No. 106 (above)...  2622

      Footnote No. 47, See Hearing Exhibit No. 62 (above)........   614

      Footnote No. 48, See Attachment............................  3047

      Footnote No. 49, See Hearing Exhibit No. 38 (above)........   528

      Footnote No. 50, See Attachment............................  3053

      Footnote No. 52, See Attachment............................  3054

      Footnote No. 55, See Footnote No. 52 (above)...............   587

      Footnote No. 56, SEALED EXHIBIT............................     *

      Footnote No. 57, See Attachment............................  3244

      Footnote Nos. 58-59, See Footnote No. 57 (above)...........   601

      Footnote No. 65, See Attachment............................  3245

      Footnote No. 66, See Hearing Exhibit No. 14 (above)........   451

      Footnote No. 68, See Attachment............................  3248

      Footnote No. 69, See Attachment............................  3351

      Footnote No. 70, See Footnote 69 (above)...................   644

      Footnote No. 71, See Hearing Exhibit No. 61 (above)........   612

      Footnote No. 72, See Footnote No. 52 (above)...............   587

      Footnote Nos. 73-74, See Footnote No. 69 (above)...........   644

      Footnote Nos. 76-77, 79-81, See Footnote No. 52 (above)....   587

      Footnote No. 82, See Footnote No. 69 (above)...............   644

      Footnote No. 83, See Footnote No. 52 (above)...............   587

      Footnote No. 84, See Attachment, Footnote No. 52 and 
        Hearing Exhibit Nos. 96ff, 96hh, and 96kk (above3375, 587, 1692

      Footnote No. 87, See Hearing Exhibit No. 73 (above)........   654

      Footnote No. 88, See Hearing Exhibit Nos. 73 and 85 (abov654, 669

      Footnote No. 89, See Hearing Exhibit No. 74 (above)........   655

      Footnote No. 90, See Hearing Exhibit No. 75 (above)........   656

      Footnote Nos. 92-93, See Hearing Exhibit No. 64 (above)....   621

      Footnote No. 94, See Hearing Exhibit Nos. 64, and 76-79 
        (above)............................................621, 660-663

      Footnote Nos. 95-96, See Hearing Exhibit No. 65 (above)....   623

      Footnote No. 97, See Hearing Exhibit No. 12 (above)........   448

      Footnote No. 98, See Attachment............................  3468

      Footnote No. 99, See Attachment and Hearing Exhibit No. 65 
        (above)...............................................3469, 623

      Footnote No. 100, See Hearing Exhibit No. 65 (above).......   623

      Footnote No. 101, See Hearing Exhibit No. 81 (above).......   665

      Footnote No. 102, See Hearing Exhibit No. 39 (above).......   532

      Footnote No. 103, See Attachment...........................  3472

      Footnote No. 107, See Attachment...........................  3474

      Footnote Nos. 108-109, See Hearing Exhibit No. 13 (above)..   450

      Footnote No. 110, See Hearing Exhibit No. 83 (above).......   667

      Footnote No. 111, See Hearing Exhibit Nos. 84 and 86 
        (above)................................................668, 670

      Footnote No. 113, See Hearing Exhibit No. 41 (above).......   538

      Footnote No. 115, See Hearing Exhibit No. 38 (above).......   528

      Footnote No. 116, See Hearing Exhibit No. 2 (above)........   386

      Footnote No. 117, See Attachment...........................  3475

      Footnote No. 121, See Attachment...........................  3482

      Footnote No. 122, See Attachment...........................  3492

      Footnote No. 123, See Hearing Exhibit No. 87 (above).......   675

      Footnote No. 124, See Hearing Exhibit No. 49 (above).......   574

      Footnote No. 125, See Attachments (2) and Hearing Exhibit 
        No. 49 (above)........................................3495, 574

      Footnote No. 126, See Attachments (3) and Hearing Exhibit 
        No. 49 (above)........................................3506, 574

      Footnote No. 127, See Hearing Exhibit No. 59 (above).......   604

      Footnote Nos. 128-129, See Footnote No. 52 (above).........   587

      Footnote No. 130, See Attachment and Hearing Exhibit No. 54 
        (above)...............................................3517, 595

      Footnote No. 131, See Hearing Exhibit No. 23 (above).......   488

      Footnote No. 132, See Attachment...........................  3519

      Footnote No. 133, See Hearing Exhibit No. 6 (above)........   412

      Footnote No. 134, See Hearing Exhibit No. 20 (above).......   463

      Footnote No. 135, See Attachment...........................  3520

      Footnote No. 136, See Hearing Exhibit No. 25 (above).......   492

      Footnote No. 137, See Hearing Exhibit No. 8 (above)........   423

      Footnote No. 138, See Attachment...........................  3522

      Footnote No. 139, See Hearing Exhibit No. 27 (above).......   495

      Footnote No. 140, See Hearing Exhibit No. 19 (above).......   460

      Footnote No. 141, See Attachment...........................  3523

      Footnote Nos. 142-143, See Hearing Exhibit No. 55 (above)..   597

      Footnote No. 144, See Attachment...........................  3530

      Footnote Nos. 145-148, See Footnote No. 144 (above)........  3530

      Footnote No. 149, See Attachment (Partial document 
        reprinted, full document SEALED EXHIBIT).................  3557

      Footnote No. 150, See Attachment (Partial document 
        reprinted, full document SEALED EXHIBIT).................  3568

      Footnote No. 151, See Attachment...........................  3572

      Footnote No. 152, See Attachment...........................  3573

      Footnote No. 154, See Attachments (2)......................  3575

      Footnote No. 155, See Footnote No. 135 (above).............  2729

      Footnote No. 156, See Attachment...........................  3579

      Footnote No. 157, See Attachments (3), Footnote No. 156 and 
        Hearing Exhibit No. 56 (above)..................3581, 3579, 599

      Footnote No. 158, See Hearing Exhibit No. 55 (above).......   597

      Footnote No. 159, See Hearing Exhibit No. 24 (above).......   490

      Footnote No. 160, See Attachments (2)......................  3591

      Footnote Nos. 161-162, See Footnote No. 157 (above)........  3581

      Footnote No. 163, See Attachment...........................  3596

      Footnote Nos. 166-167, See Hearing Exhibit No. 21 (above)..   464

      Footnote No. 168, See Attachment, Footnote No. 156 and 
        Hearing Exhibit Nos. 21 and 139m (above)..3606, 3579, 464, 2746

      Footnote Nos. 169 and 171, See Hearing Exhibit No. 21 
        (above)..................................................   464

      Footnote No. 174, See Footnote No. 152 (above).............  3573

      Footnote No. 176, See Hearing Exhibit No. 63 (above).......   617

      Footnote No. 177, See Hearing Exhibit No. 62 (above).......   614

      Footnote No. 178, See Hearing Exhibit No. 23 (above).......   488

      Footnote No. 179, See Attachment...........................  3607

      Footnote No. 180, See Footnote No. 57 (above)..............  3244

      Footnote No. 181, See Footnote No. 151 (above).............  3572

      Footnote No. 183, See Attachment...........................  3620

      Footnote Nos. 184-185, See Footnote No. 57 (above).........  3244

      Footnote No. 186, See Attachment (Partial document 
        reprinted, full document SEALED EXHIBIT).................  3621

      Footnote Nos. 187-188, See Footnote 186 (above)............  3621

      Footnote No. 189, See Footnote No. 56 (above) SEALED 
        EXHIBIT..................................................     *

      Footnote Nos. 190-191, See Hearing Exhibit No. 38 (above)..   528

      Footnote No. 192, See Attachment and Hearing Exhibit No. 38 
        (above)...............................................3623, 528

      Footnote Nos. 193-194, See Hearing Exhibit No. 38 (above)..   528

      Footnote No. 200, See Hearing Exhibit No. 137 (above)......  2735

      Footnote No. 201, See Attachment (Partial document 
        reprinted, full document SEALED EXHIBIT).................  3929

      Footnote No. 203, See Attachment and Hearing Exhibit No.3632, 623

      Footnote No. 204, See Hearing Exhibit No. 21 (above).......   464

      Footnote No. 205, See Hearing Exhibit No. 8 (above)........   423

      Footnote No. 208, See Hearing Exhibit No. 21 (above).......   464

      Footnote No. 211, See Hearing Exhibit Nos. 51 and 58 
        (above)................................................585, 602

      Footnote No. 213, See Footnote No. 84 (above)..............  3375

      Footnote No. 214, See Hearing Exhibit No. 110 (above)......  2657

      Footnote No. 217, See Footnote No. 84 (above)..............  3375

      Footnote No. 218, See Hearing Exhibit No. 64 (above).......   621

      Footnote No. 220, See Hearing Exhibit No. 5 (above)........   408

      Footnote No. 221, See Hearing Exhibit No. 7 (above)........   415

      Footnote No. 222, See Hearing Exhibit Nos. 38 and 64 
        (above)................................................528, 621

      Footnote No. 223, See Attachments (2) and Hearing Exhibit 
        No. 15 (above)........................................3635, 452

      Footnote No. 227, See Attachment...........................  3641

      Footnote No. 228, See Footnote No. 223.....................  3635

      Footnote No. 230, See Hearing Exhibit No. 105 (above)......  2619

      Footnote No. 231, See Footnote Nos. 157 and 163 (above)3581, 3596

      Footnote No. 232, See Attachment...........................  3643

      Footnote No. 234, See Hearing Exhibit No. 105 (above)......  2619

      Footnote No. 235, See Attachments (4)......................  3644

      Footnote No. 236, See Hearing Exhibit No. 105 (above)......  2619

      Footnote No. 238, See Footnote No. 117.....................  3475

      Footnote No. 239, See Attachments (2) and Hearing Exhibit 
        Nos. 111 and 129 (above); two addition items for this 
        footnote are SEALED EXHIBITS...................3660, 2660, 2721

      Footnote No. 240, See Attachment and Hearing Exhibit No. 70 
        (above)...............................................3665, 646

      Footnote No. 241, See Footnote No. 235 and Hearing Exhibit 
        No. 138 (above)......................................3644, 2745

      Footnote No. 242, See Hearing Exhibit Nos. 103 and 104 
        (above)..............................................2615, 2618

      Footnote No. 243, See Hearing Exhibit No. 70 (above).......   646

      Footnote No. 244, See Attachment...........................  3668

      Footnote Nos. 245-246, See Hearing Exhibit No. 113 (above).  2679

      Footnote Nos. 248-250, See Hearing Exhibit No. 110 (above).  2657

      Footnote No. 251, See Footnote No. 84......................  3375

      Footnote No. 252, See Hearing Exhibit No. 105 (above)......  2619

      Footnote Nos. 253-255, See Hearing Exhibit No. 106 (above).  2622

      Footnote No. 256, See Attachment...........................  3670

      Footnote No. 257, See Attachment and Hearing Exhibit No. 
        106 (above)..........................................3671, 2622

      Footnote No. 258, See Hearing Exhibit No. 106 (above)......  2622

      Footnote No. 261, See Footnote No. 201 (above).............  3929

      Footnote No. 262, See Attachment...........................  3672

      Footnote No. 263, See Attachment...........................  3678

      Footnote No. 265, See Attachment, Footnote No. 244 and 
        Hearing Exhibit Nos. 70 and 108 (above)...3679, 3668, 646, 2647

      Footnote No. 266, See Attachments (2) (One document 
        partially reprinted, full document is (SEALED EXHIBIT)...  3681

      Footnote No. 267, See Footnote No. 266 (above).............  3681

      Footnote No. 268, See Attachment...........................  3687

      Footnote No. 270, See Footnote No. 154 (above).............  3575

      Footnote No. 271, See Footnote No. 237 (above) (Found in 
        the files of the Subcommittee)...........................     *

      Footnote No. 272, See Attachment...........................  3690

      Footnote No. 273, See Footnote No. 272 (above).............  3690

      Footnote No. 274, See Attachment...........................  3697

      Footnote No. 275, See Attachments (5)......................  3703

      Footnote No. 276, See Footnote No. 275 (above).............  3703

      Footnote No. 278, See Hearing Exhibit No. 101 (above)......  2607

      Footnote No. 279, See Attachment...........................  3711

      Footnote No. 280, See Attachment...........................  3712

      Footnote No. 281, See Footnote No. 117 and Hearing Exhibit 
        No. 112 (above)......................................3475, 2678

      Footnote No. 282, See Hearing Exhibit Nos. 64, 69 and 81 
        (above)...........................................621, 644, 665

      Footnote No. 283, See Hearing Exhibit No. 81 (above).......   665

      Footnote No. 284. See Attachment...........................  3714

      Footnote No. 285, See Attachment...........................  3717

      Footnote No. 286, See Attachment (Four additional items for 
        this footnote are SEALED EXHIBITS).......................  3718

      Footnote No. 293, See Hearing Exhibit No. 120 (above)......  2699

      Footnote No. 294, See Hearing Exhibit No. 119 (above)......  2696

      Footnote No. 295, See Attachment...........................  3719

      Footnote No. 296, See Footnote No. 117 and Hearing Exhibit 
        Nos. 42 and 112 (above).........................3475, 543, 2678

      Footnote No. 299, See Footnote No. 156 (above).............  3579

      Footnote No. 301, See Attachment...........................  3722

      Footnote No. 302, See Attachment...........................  3754

      Footnote No. 303, See Hearing Exhibit No. 21 (above).......   464

      Footnote No. 306, See Attachment...........................  3756

      Footnote No. 307, See Attachment...........................  3757

      Footnote No. 308, See Footnote No. 307 (above).............  3757

      Footnote No. 310, See Hearing Exhibit No. 128 (above)......  2720

      Footnote No. 312, See Footnote No. 52 (above)..............  3054

      Footnote No. 313, See Attachments (3)......................  3767

      Footnote No. 314, See Hearing Exhibit No. 38 (above).......   528

      Footnote No. 319, See Attachments (2)......................  3775

      Footnote No. 320, See Attachment...........................  3779

      Footnote No. 321, See Attachments (2)......................  3795

      Footnote Nos. 322-323, See Footnote No. 320 (above)........  3779

      Footnote No. 324, See Attachment and Footnote No. 320..3801, 3779

      Footnote No. 327, See Attachment...........................  3812

       Footnote No. 328, See Attachment..........................  3813

       Footnote No. 329, See Attachments (2).....................  3814

       Footnote No. 330, See Footnote No. 329 (above)............  3814

       Footnote No. 331, See Attachments (3).....................  3816

       Footnote No. 332, See Attachments (3).....................  3822

       Footnote No. 333, See Hearing Exhibit No. 21 (above)......   464

       Footnote Nos. 335-336, See Hearing Exhibit No. 43 (above).   545

       Footnote No. 337, See Hearing Exhibit No. 128 (above).....  2720

       Footnote No. 338, See Hearing Exhibit No. 103 (above).....  2615

       Footnote No. 339, See Hearing Exhibit No. 104 (above).....  2618

       Footnote No. 340, See Footnote No. 154 (above)............  3575

       Footnote No. 341, See Attachment..........................  3830

       Footnote No. 342, See Attachments (2).....................  3831

       Footnote No. 343, See Footnote No. 203 (above)............  3632

       Footnote Nos. 344 and 346, See Hearing Exhibit No. 28 
        (above)..................................................   496

       Footnote No. 347, See Footnote No. 122 (above)............  3492

       Footnote No. 348, See Hearing Exhibit No. 28 (above)......   496

       Footnote Nos. 349-350, See Footnote No. 163 (above).......  3596

       Footnote No. 351, See Footnote No. 117 (above)............  3475

       Footnote No. 352, See Footnote No. 52 (above).............  3054

       Footnote No. 355, See Attachment..........................  3835

       Footnote No. 356, See Footnote No. 355 (above)............  3835

       Footnote No. 359, See Attachment and Footnote No. 203 
        (above)..................................................  3840

       Footnote No. 360, See Hearing Exhibit No. 121 (above).....  3482

       Footnote No. 361, See Attachment and Hearing Exhibit No. 
        58 (above)............................................3842, 602

       Footnote No. 362, See Footnote No. 361 (above)............  3842

       Footnote No. 363, See Attachment..........................  3847

       Footnote No. 364, See Attachment..........................  3848

       Footnote No. 367, See Footnote No. 154 (above)............  3575

       Footnote Nos. 368-369, See Footnote No. 52 (above)........  3054

       Footnote No. 370, See Hearing Exhibit No. 115 (above).....  2686

       Footnote No. 371, See Footnote No. 52 (above).............  3054

       Footnote No. 372, See Hearing Exhibit No. 114 (above).....  2681

       Footnote No. 373, See Attachments (2) and Footnote Nos. 
        154 and 203 (above)............................3850, 3575, 3632

       Footnote No. 374, See Footnote No. 373 (above)............  3850

       Footnote No. 375, See Footnote No. 144 (above)............  3530

       Footnote No. 376, See Footnote No. 150 (above)............  3568

       Footnote No. 377, See Footnote No. 151 (above)............  3572

       Footnote No. 378, See Footnote No. 355 (above)............  3835

       Footnote Nos. 379-382, See Hearing Exhibit No. 115 (above)  2686

       Footnote No. 383, See Attachment and Hearing Exhibit No. 
        46 (above)............................................3853, 560

       Footnote No. 384, See Hearing Exhibit No. 44 (above)......   555

       Footnote No. 385, See Attachment..........................  3854

       Footnote No. 386, See Hearing Exhibit No. 38 (above)......   528

 
   U.S. TAX SHELTER INDUSTRY: THE ROLE OF ACCOUNTANTS, LAWYERS, AND 
                        FINANCIAL PROFESSIONALS

                              ----------                              


                       TUESDAY, NOVEMBER 18, 2003

                                       U.S. Senate,
                Permanent Subcommittee on Investigations,  
                  of the Committee on Governmental Affairs,
                                                    Washington, DC.
    The Subcommittee met, pursuant to notice, at 9:02 a.m., in 
room SH-216, Hart Senate Office Building, Hon. Norm Coleman, 
Chairman of the Subcommittee, presiding.
    Present: Senators Coleman, Levin, and Lautenberg.
    Staff Present: Raymond V. Shepherd, III, Staff Director and 
Chief Counsel; Joseph V. Kennedy, General Counsel; Mary D. 
Robertson, Chief Clerk; Leland Erickson, Counsel; Mark 
Greenblatt, Counsel; Steven Groves, Counsel; Frank J. Minore, 
Detailee, GAO; Kristin Meyer, Staff Assistant; Steve D'Ettorre, 
Staff Assistant; Bryan Nelson, Intern; Elise J. Bean, Staff 
Director/Chief Counsel to the Minority; Bob Roach, Counsel and 
Chief Investigator to the Minority; Laura Stuber, Counsel to 
the Minority; Brian Plesser, Counsel to the Minority; Julie 
Davis, Professional Staff Member; Christopher Kramer, 
Professional Staff Member to the Minority; Beth Merillat-
Bianchi, Detailee, IRS; Jim Pittrizzi, Detailee, GAO; Rebecca 
Dirks, Intern; Ken Seifert, Intern; Jessilyn Cameron, Brookings 
Fellow; Grant Bosser (Senator Sununu); Nate Graham (Senator 
Bennett); Kevin Carpenter (Senator Specter); Mimi Braniff 
(Senator Stevens); David Berrick (Senator Lieberman); Gita 
Uppal (Senator Pryor); Rudy Broiche (Senator Lautenberg); and 
Mandana Parsazad (Senator Dayton).

              OPENING STATEMENT OF SENATOR COLEMAN

    Senator Coleman. This hearing of the Permanent Subcommittee 
on Investigations is called to order.
    I want to thank you for attending today's hearing. Today 
and Thursday we will focus on a set of issues developed by this 
Subcommittee's Ranking Member, Senator Levin. And, Senator 
Levin, I would like to commend you for your tireless efforts to 
prevent the abuse of our tax code by those willing to exploit 
loopholes and avoid paying legitimate taxes. You have done 
tremendous work in this area, and it is a pleasure for me to 
work with you.
    In a bipartisan fashion, PSI has developed a deeper 
understanding of the history of individual tax shelters. PSI 
has uncovered how those shelters work, how they were marketed 
to potential investors, and how they were structured in order 
to avoid scrutiny by the Internal Revenue Service. Due to the 
complexity of these schemes, our hearings will focus only on a 
few of the shelters, but there are many others like them.
    There is an old English proverb that says, ``A clean glove 
often hides a dirty hand.'' Today we will hear firsthand how 
the ethical standards of the legal and accounting profession 
have been pushed, prodded, bent, and in some cases broken for 
enormous monetary gain. The fact is abusive and potentially 
illegal tax shelters sold to corporations and wealthy 
individuals rob the U.S. Treasury of billions of dollars in 
lost tax revenues annually.
    Let me be clear: While some of the products we discuss 
today are not technically illegal, they are most certainly 
ethically questionable and demonstrate a deliberate effort on 
the part of the participants to fly underneath the regulatory 
radar of the IRS. This is not a victimless crime. It is not the 
government that loses money. It is the people of America, 
average working families who will bear the brunt of lost 
revenues so that a handful of rich lawyers, accountants, and 
their clients can manipulate legitimate business practices to 
make a profit.
    According to the GAO, a recent IRS consultant estimated 
that for the 6-year period 1993 to 1999, the IRS lost an 
average of between $11 and $15 billion each year from abuse of 
tax shelters. The GAO reports that an IRS database tracking 
unresolved abusive tax shelter cases over a number of years 
estimates potential tax losses of about $33 billion from listed 
transactions and another $52 billion from unlisted abusive 
transactions, for a total of $85 billion.
    As I said, this is not a victimless crime. To put this in 
context, if the IRS proactively shut down these abusive tax 
shelters and collected the diverted revenue, it would have 
helped to finance a substantial portion of our efforts in Iraq. 
Abusive tax shelters are fashioned in the likeness of 
legitimate transactions as permitted under the IRS Code. The 
transactions themselves are highly complex, involving 
accounting firms, major financial institutions, investment 
firms, and prestigious law firms. Not only are these 
participants necessary for the transaction, they provide the 
added benefit of making detection by the IRS difficult. 
Moreover, these entities provide a veneer of legitimacy, for 
abusive tax shelters are, in fact, illusory and sham 
transactions with little or no economic substance, driven 
primarily for favorable tax consequences.
    There are three ovearching issues that these hearings will 
address. The first is the Internal Revenue Service's ability to 
enforce the Nation's tax laws. There is no doubt that our tax 
laws are very complex and give rise to different 
interpretations. The Service's interpretation is not legally 
controlling, and taxpayers have the right to ignore it if they 
think a court will uphold their reading of the statutes and 
regulations. But the IRS does have a right to challenge tax 
strategies it thinks are invalid. In order for the Service to 
challenge strategies and for the courts to rule, they must be 
aware of how taxpayers are applying the law.
    The Subcommittee's investigation has uncovered evidence 
that the transactions studied here were deliberately designed 
to avoid detection by the IRS. Even an illegal strategy works 
if the government never finds out about it. Even more 
disturbing, the IRS has specific rules that require the 
promoters of certain tax products to notify the IRS whenever a 
taxpayer uses one of them. This gives the IRS the opportunity 
to review how the taxpayer has applied law to his or her 
specific situation.
    Evidence suggests that the accounting firms knowingly 
evaded this requirement and that the IRS has not been as 
forceful in its administration of this registration requirement 
as it could be.
    When transactions are hidden from the government, it loses 
its ability to enforce the law. The perception can quickly 
arise that fair application of revenue statutes is a sucker's 
game, that those who are rich and powerful ignore it or 
interpret it to their own benefit, and that only the average 
guy gets stuck with his full share. The system that relies 
primarily on voluntary compliance cannot afford to allow this 
perception to seem real.
    Second, for a long time both the accounting and legal 
industries have been justifiably proud of their professions. 
Both have held themselves up to the public as practicing a high 
standard of professional ethics and giving the public honest 
access to a complex body of doctrine. Given the complexity of 
tax and accounting law, Americans with any wealth are 
increasingly dependent on professional advice in order to 
reconcile their personal interests with legal requirements. If 
clients cannot have absolute confidence in the accuracy of the 
advice they get, these professions no longer will merit the 
high standard we have previously given them.
    This leads naturally to the third major theme of these 
hearings. We all know that an institution, especially one as 
large as the accounting firms appearing here today, cannot be 
held strictly responsible for every action of all their 
employees. Individual workers often have motives and take 
actions that are directly contrary to the intentions of a 
company's leaders. But because we foresee these conflicts, the 
existence of strong internal controls has become a key 
component of modern management practices. These controls are 
meant to ensure that no single employee or group of employees 
is allowed to subject the firm to a large amount of risk 
without the leadership's approval.
    We will hear evidence that the internal controls that the 
accounting and law firms seem to have had in place did not 
work. The people responsible for ensuring firm quality often 
raise serious questions about the transactions we will discuss 
today. Yet it appears that their advice and recommendations 
were often disregarded in the effort to boost revenue.
    These three issues--the ability of the IRS to learn of 
aggressive tax strategies, the possibility of misleading advice 
to taxpayers, and the breakdown of internal controls--all raise 
serious issues about future policy toward the tax industry. I 
am hopeful that the information Senator Levin has helped us 
uncover will lead to positive reforms.
    I look forward to hearing from our panelists this morning, 
and I especially look forward to Senator Levin's questioning of 
the panelists. I know we will all learn a great deal today.
    With that, I will turn it over to the distinguished Ranking 
Member, Senator Levin.

               OPENING STATEMENT OF SENATOR LEVIN

    Senator Levin. Thank you, Mr. Chairman, for your comments 
and for your support of this investigation that began a year 
ago when I was Chairman here, but has continued with the 
support of Senator Coleman. We are grateful for that and for 
what this is going to lead to, hopefully, as he points out. 
What we must point toward are a series of significant reforms 
if we are going to change the practices which we are going to 
hear described this morning.
    My statement is something of a long statement because I do 
want to set forth what these shelters are in detail so that we 
can understand them. I know I have the understanding of our 
Chairman in proceeding this way. Normally I would try to limit 
an opening statement to 10 minutes, but this one could go 15 
minutes or so, and I thank the Chairman for his understanding 
of that, even though we have a very difficult time schedule 
this morning.
    Unlike legitimate tax shelters, abusive tax shelters have 
no real economic substance. They are designed to provide tax 
benefits not intended by the tax code and are almost always 
convoluted and complex. Crimes like terrorism or murder or 
fraud or embezzlement produce instant recognition of the 
immorality involved. But abusive tax shelters are MEGOs--that 
means ``my eyes glaze over.'' Those who cook up these 
concoctions count on their complexity to escape scrutiny and 
public ire.
    The tax shelter industry is also fundamentally different 
than it was a few years ago. Instead of individuals and 
corporations going to their accountant or law firm and asking 
for tax planning advice, the engine driving the industry is now 
a horde of tax advisers cooking up one complex scheme after 
another, so-called tax products, generally unsolicited by 
clients, and then using elaborate marketing schemes to peddle 
these products across the country.
    In order to gain a deeper understanding of the issues 
involved in the marketing of these products, the Subcommittee 
conducted an in-depth case study examining four tax products 
designed, marketed, and sold by a leading accounting firm, 
KPMG, to individuals or corporations to help them reduce or 
eliminate their U.S. taxes. These four products are known to 
KPMG and its clients as BLIPS, FLIPS, OPIS, and SC2.
    We are releasing a 125-page Minority Staff Report today 
detailing what we found in these four case histories.\1\
---------------------------------------------------------------------------
    \1\ The Minority Staff Report appears in the Appendix on page 145.
---------------------------------------------------------------------------
    The testimony today will disclose a tawdry tale: A highly 
compromised internal review and approval process at KPMG; 
highly aggressive marketing efforts to sell tax schemes aimed 
at producing paper tax losses; and schemes which attempt to 
disguise tax reduction scams as business activity, in the case 
of BLIPS, or a charitable donation, in the case of SC2.
    An excerpt from a long e-mail by a top KPMG tax 
professional on whether KPMG should approve BLIPS for sale to 
clients illustrates the skewed priorities. He said that the 
decision on BLIPS came down to this: ``My own recommendation is 
that we should be paid a lot of money here for our opinion 
since the transaction is clearly one that the IRS would view as 
falling squarely within the tax shelter orbit.''
    Being paid a lot of money for a dubious tax scheme--that is 
what it all comes down to.
    The testimony today will pull back the curtain on the 
pressure-cooker environment within KPMG to mass market its tax 
products to multiple clients. Again, one detail illustrates the 
extent of the problem: The full-fledged telemarketing center 
that KPMG maintained in Fort Wayne, Indiana, and staffed with 
people trained to make cold calls to find buyers for specific 
tax products. The telemarketing scripts, the thousands of cold 
calls made to sell the tax product known as SC2, the revisits 
to potential buyers who said no the first time, all show KPMG 
pushing its so-called tax products.
    The testimony today will also show the lengths to which 
KPMG went to hide its tax products and its sales efforts from 
the IRS. Despite its 2003 inventory of 500 active tax products, 
KPMG has never registered and thereby disclosed to the IRS the 
existence of a single one of its tax products. It has claimed 
in court and to the Subcommittee staff that it is not a tax 
shelter promoter.
    Today's testimony will disclose, however, that some tax 
professionals within the firm advised the firm, to no avail, to 
register some of its products as tax shelters.
    You will also hear about improper tax return reporting by 
KPMG, file clean-ups, and other efforts to hide their 
activities from the IRS and public scrutiny.
    Finally, you will hear today and in the hearing on Thursday 
that in ventures as large and profitable as the marketing of 
these tax shelters, there were many professionals ready to join 
forces with KPMG to carry out the complex financial structures 
required to camouflage the tax schemes behind a facade of 
economic substance. These professionals included banks, which 
financed the loans for sham transactions designed to create a 
veneer of economic substance; investment advisory firms, which 
cooked up phony financial transactions to create the appearance 
of a business purpose; and law firms, which wrote boilerplate 
legal opinions to justify dubious tax schemes and to shield 
taxpayers from penalties.
    With such a formidable array of talent and expertise, 
potential clients were persuaded to buy and use the deceptive 
shelters KPMG was peddling, and the U.S. Treasury was 
effectively defrauded of taxes owed as a result.
    We are going to focus on two shelters, BLIPS and SC2. Let's 
first look at BLIPS. We have some charts here on the screens, 
and some of you have, hopefully, charts in front of you.\1\
---------------------------------------------------------------------------
    \1\ See Exhibit No. 1a. which appears in the Appendix on page 371.
---------------------------------------------------------------------------
    BLIPS stands for Bond-Linked Issue Premium Structure. 
Inside KPMG, BLIPS was called a ``loss generator'' because the 
intent of the tax product was to generate a paper loss that the 
buyer could then use to offset other income and to shelter that 
other income from taxation.
    For this example, we will suppose the BLIPS buyer--let's 
call him the taxpayer--has a taxable gain or taxable income of 
$20 million that the BLIPS transaction is intended to shelter 
by creating a $20 million paper loss.
    On the first slide, we will see the first step is the BLIPS 
taxpayer setting up a shell corporation called a limited 
liability company, or LLC. The taxpayer gives this shell 
company out-of-pocket cash equal to 7 percent of the $20 
million paper loss that he wants to create. In this case, that 
means the taxpayer provides $1.4 million. This money will be 
used for fees for the firms that are part of this scheme and 
for an investment program set up as the fig leaf of economic 
substance to hide what is really a tax scam.
    On the next slide, we will see what happens next, which is 
a bank makes a so-called 7-year loan of $50 million to the 
shell company, LLC. The BLIPS taxpayer agrees to pay an above-
market interest rate on the loan, say 16 percent interest. 
Because he is willing to pay such a high interest rate, the 
bank also credits him with a so-called $20 million loan premium 
that is, not coincidentally, equal to the tax loss that the 
taxpayer is buying from KPMG. If the taxpayer later pays off 
the loan early, as planned, the bank will charge a prepayment 
penalty that, not coincidentally, will approximate the loan 
premium and make sure that it is repaid. The bank credits the 
taxpayer's account, which stays at the bank, with the $50 
million so-called loan and the $20 million premium, for a total 
of $70 million.
    There are more wrinkles. For instance, in order to get the 
$70 million, the taxpayer and the shell company have to agree 
to severe restrictions on how the loan proceeds can be used. 
And they must maintain collateral in cash or liquid securities 
in an account at the same bank equal to at least 101 percent of 
the loan and premium amount, meaning about $70.8 million.
    Now, think about that for a moment, because this collateral 
requirement is one key to understanding why this loan is a 
sham. A cash collateral requirement of 101 percent means that 
none of the loan proceeds can really be put at risk. That 
money, more than the amount of the loan itself, has to be kept 
safe in an account at the bank which, on paper, loaned it.
    The next slide: Enter Presidio. They are the investment 
advisory firm that works hand in glove with KPMG and handles a 
lot of the legwork of the transaction. Presidio directs two 
companies it controls--Presidio Growth and Presidio Resources--
to participate in the transaction.
    Next, Presidio and the taxpayer's shell company form a 
partnership called a strategic investment fund or SIF. The 
taxpayer's shell company, that LLC, contributes all of its 
assets to the partnership: The $1.4 million in cash from the 
taxpayer and the $70 million credit from the so-called loan and 
loan premium. The Presidio companies contribute about $140,000. 
Based on these contributions, the taxpayer has a 90-percent 
interest and Presidio collectively has a 10-percent interest in 
the strategic investment fund.
    The next slide: Here is the switcheroo. The shell company 
decides with the consent of the bank to assign or transfer the 
so-called bank loan to the fund.
    Next slide: Here comes the fig leaf. The fund takes the 
money it has and supposedly engages in foreign currency 
transactions. The fund takes the so-called loan proceeds, the 
$70 million, and simply converts them into euros and puts the 
euros in what one bank calls a synthetic dollar account. The 
fund also signs a contract to guarantee that it can convert the 
euros back to the same number of dollars at no risk in 30 or 60 
days. The fund also puts at risk a very small amount of money, 
never more than what the taxpayer has contributed, by shorting 
foreign currencies pegged to the U.S. dollar. Not much of an 
investment program.
    While the BLIPS loan is supposed to last 7 years, every 
taxpayer that bought it, 186 out of 186, pulled out early, as 
planned. They quit. They pulled out because the point of BLIPS 
is not to invest money but to generate a paper loss for tax 
purposes before the end of the tax year.
    The last slide on BLIPS: Now we are at the unwind. At day 
60, the taxpayer pulls out of the partnership. The partnership, 
the fund, repays the so-called loan to the bank, plus a 
prepayment penalty to cover the premium so that the whole $70 
million is returned to the bank. The fund then distributes any 
remaining assets to its partners, which usually is little or 
nothing. The taxpayer's $1.4 million is usually gone, mostly in 
fees, but that is a price that he is more than willing to pay 
for the $20 million tax loss.
    Because of the way the loan was structured, KPMG told the 
taxpayer he can claim that his cost basis to participate in the 
partnership is equal to the $20 million loan premium and the 
$1.4 million in cash that he contributed to the partnership. 
That means he supposedly can claim a $21.4 million loss on his 
tax return.
    Now, if this does not make much sense to you, it is because 
the whole transaction is an elaborate concoction to create the 
impression of economic substance. The taxpayer did not use the 
$70 million loan proceeds at all due to the collateral 
requirement. He parked that $70 million in a synthetic dollar 
account at the bank and used his own money to make a few safe 
currency transactions. He could have made those without any 
loan at all. The point of the loan was simply to generate a tax 
loss to shelter the taxpayer's other income.
    KPMG approved BLIPS for sale in October 1999 and sold it to 
186 people until, in September 2000, the IRS listed it as a 
potentially abusive tax shelter. In 1 year, KPMG obtained at 
least $53 million in fees, making BLIPS one of KPMG's top 
revenue-producing tax products.
    Now let's look at the second shelter, SC2, which stands for 
S Corporation Charitable Contribution Strategy.\1\
---------------------------------------------------------------------------
    \1\ See Exhibit No. 1b. which appears in the Appendix on page 379.
---------------------------------------------------------------------------
    An S corporation is organized under Subchapter S of the tax 
code, and its income is attributed to its shareholders and 
taxed as ordinary individual income instead of corporate 
income. Instead of generating a phony paper loss, this tax 
product generated a phony charitable donation.
    The first step is that KPMG approaches an existing S 
corporation, usually owned by one person, with a purported 
charitable donation strategy. The corporation takes several 
steps to prepare for the SC2 transaction. First, assuming that 
the S corporation had, let's say, 100 shares of common stock, 
on KPMG's advice, the S corporation issues and distributes to 
its sole shareholder an additional 900 non-voting shares plus 
7,000 warrants to buy 7,000 more shares of the company stock in 
the future. The corporation also issues a non-distribution 
resolution stating that the company will not distribute any of 
its income to its shareholders for a specified period of time, 
usually 2 or 3 years.
    Next, KPMG introduces the individual shareholder to a 
qualified tax-exempt charity, which KPMG has made a major 
effort to identify, and the individual donates the 900 non-
voting shares to this charity. The charity signs a redemption 
agreement with the corporation, which allows the charity to 
require the corporation to buy back the donated stock after a 
specified period of time, usually the same amount of time 
specified in the corporation's non-distribution resolution.
    The redemption agreement and non-distribution resolution 
are the keys to understanding why SC2 is a sham. Everyone 
participating in this situation knows from the outset that the 
stock donation is not intended to be permanent. It is intended 
to be temporary. The clear understanding of all the parties is 
that the charity will be selling the donated stock back to the 
donor in a few years.
    But the appearance for the moment is that the S corporation 
now has two shareholders: The charity owns 900 non-voting 
shares, and the individual owns 100 voting shares and 7,000 
warrants.
    On the next slide, we will see that for the next 2 or 3 
years, while the charity is a shareholder in the S corporation, 
due to the non-distribution resolution the corporation 
allocates but does not actually distribute 90 percent of its 
net income to the charity and 10 percent to the individual 
shareholder.
    The difference between ``allocation'' and ``distribution'' 
is critical. Under Federal tax law, an S corporation 
shareholder, unless tax-exempt, pays income tax on the net 
income ``allocated'' to it on the company books, not on the 
cash actually ``distributed.'' According to KPMG, that means 
that the 90 percent of company income allocated to the charity 
is tax-exempt, while the individual has to pay taxes on only 
the 10 percent allocated to him. That is true even though the 
charity often never sees a nickel of the money supposedly 
allocated to it and agrees, indeed, to forego that income.
    On the third slide, we will see the following: We are 2 or 
3 years down the road after significant net income has been 
accumulating inside the company, when the charity's redemption 
rights kick in. The charity sells back the 900 non-voting 
shares to the S corporation for cash. While this cash payment 
pales in comparison to the amount of sheltered corporate 
income, because of the way the shares are valued, it is, 
nonetheless, a significant amount for the charity.
    Now the payout, the fourth slide. This is where the 
individual shareholder makes out.
    The charity has sold back its shares and is no longer a 
shareholder in the S corporation. All of the income that has 
been built up in the corporation for the last 2 or 3 years is 
distributed to the individual shareholder. KPMG advises him 
that on the 90 percent of the income allocated to the charity 
previously, which is now his, he can claim the income is 
capital gains, taxable at the lower capital gains rate, rather 
than the higher ordinary income rate.
    KPMG approved SC2 for sale in March 2000, and over the next 
2 years sold it to about 58 corporations. This tax product 
became one of KPMG's top tax products in the years 2000 and 
2001, generating more than $28 million in fees for the firm. 
KPMG discontinued the sales in late 2001. In early 2002, the 
IRS asked KPMG to produce documents related to SC2 and is now 
reviewing the product.
    We may hear this morning that KPMG has seen the light, and 
that it and the other large accounting firms no longer develop 
and sell these types of aggressive shelters. Let's hope that is 
the case. However, the report that we are releasing today 
depicts a powerful engine going at full speed, developing and 
selling 500 active tax products at KPMG as of February 2003. 
That was the response date for the subpoena of this 
Subcommittee.
    Having claimed all during this year to my staff that these 
tax products are legitimate, KPMG's prepared testimony today is 
that the firm not only has turned off, but dismantled, that 
500-cylinder engine.
    List me as skeptical. I am simply afraid we cannot trust 
the industry to police itself.
    We need to take strong and forceful action to stop the 
pilfering of our treasury and the damage to the credibility of 
our tax system. We need stronger penalties on tax shelter 
promoters, an end to auditor conflicts of interest, a better 
economic substance test, and more enforcement dollars for the 
IRS to go after tax shelter promoters and their abusive 
schemes. These and other actions are outlined in the report 
that my staff has released today.
    These reforms are, of course, only part of the answer. The 
firms involved in designing, hawking, and implementing these 
dubious tax products need to restore professional pride. KPMG 
now says it has stopped selling aggressive tax products. 
Pricewaterhouse Coopers has withdrawn from a number of 
transactions and refunded some client fees. Ernst & Young says 
it will no longer market certain transactions to its public 
company audit clients and will require those clients to obtain 
audit committee approval before Ernst & Young will sell tax 
shelter services to their executives. That is a start.
    The engine of deception and greed needs to be turned off, 
dismantled, and consigned to the junkyard where it belongs. 
That is what happened after the Enron collapse. Exposure helped 
put an end to some deceptive financial scams. If that is the 
result of this investigation, it will move the production and 
promotion of abusive tax shelters out of big business, although 
it may well be picked up by fly-by-night hucksters from whom 
such behavior is less surprising.
    Again, my thanks to you, Mr. Chairman, for your great 
support of this effort.
    Senator Coleman. Thank you, Senator Levin. Senator 
Lautenberg, would you like to make an opening statement.

            OPENING STATEMENT OF SENATOR LAUTENBERG

    Senator Lautenberg. Yes, thanks very much, Mr. Chairman, 
and I commend you for holding this hearing today and Thursday 
regarding the tax shelter industry. These are particularly 
timely subjects to review, and if Senator Levin had not so 
artfully described the way you do it--and maybe sent some 
people out of the room looking for a way to fulfill the pattern 
that you have described--I learned something this morning, and 
it is a very tough situation that we find ourselves in.
    Over the past few years, our economy has been racked by 
corporate and accounting scandals so big and previously 
unimaginable, and I come out of the corporate world and 
remember expressions like the Big Eight, diminished to 
certainly lesser status and prestige and respect that these 
large firms had. But in many cases, they turned out to be 
conspirators with companies like Enron that have gone belly up. 
People lost their jobs, their life savings, their retirement 
savings, and their faith in the fundamental fairness of our 
stock market.
    The situation worsens as we look at other organizations 
getting into places like the mutual fund industry, the New York 
Stock Exchange itself, all talking about concealing the truth 
from the public, hiding things. And that is where we are when 
we look at what has happened here with tax sheltering.
    The marketing, the use of questionable, even abusive tax 
shelters for individuals with very high incomes evolved, and 
many of the questionable tax shelters at issue today were 
created during the biggest, longest economic expansion in our 
Nation's history. I will assume that the witnesses will confirm 
that the economic good times during the mid and late 1990's 
created such wealth that there was enormous pressure to find 
new ways to shelter that wealth. So a veritable army of the 
best and the brightest accountants, lawyers, and investment 
bankers went to work on behalf of their high net worth clients.
    I was a corporate Chief Executive Officer for many years, 
and my company, ADP, did very well, but I am a bit old-
fashioned because I believe that the better you do, the more 
taxes you should pay, not less. So much for progressivity.
    How much money are we talking about? According to the 
General Accounting Office and the Internal Revenue Service 
database, tracking unresolved abusive tax shelter cases over a 
number of years, estimates potential tax losses at about $33 
billion from listed transactions, and another $52 billion from 
non-listed but questionable transactions. That is $85 billion. 
I want to put it in perspective. We just borrowed $87 billion 
from future generations to pay for the ongoing war and 
reconstruction in Iraq. It may be said that these tax shelters 
complied with tax laws and IRS regulations, but I think there 
is something inappropriate, to say the least, about how much 
time, energy and expertise is helping to save some of our very 
richest to hide more of their multimillion dollar income from 
taxation when we are notably short of funds to meet our 
national obligations, especially with young men and women in 
harm's way who do what they do regardless of some of the 
economic loss that they experience as a result of being away 
from their jobs, away from their community, and away from their 
families.
    A few weeks ago I participated in a panel discussion in New 
York City hosted by Atlantic Monthly Magazine on the future of 
corporate America. There were two current CEOs also on the 
panel, and they complained about the burdens imposed upon them 
by the Sarbanes-Oxley Corporate Accountability Bill that 
Congress passed last year. My response was simply: If you tell 
the truth, then it would not have been necessary to develop the 
strict regime that says everybody has to report along the way 
about what the results were. The fact of the matter is that if 
industry and the professionals associated with it outside of 
the companies, outside of the firms that are creating and 
marketing these tax shelters, if they will not police 
themselves, then the Congress is going to do it for them. They 
will not sit by while greed-fueled corporate malfeasance wipes 
out jobs, savings, and lives.
    Today's hearing raises questions about the accounting 
industry's role in devising and peddling tax shelters, and I 
hope that it is going to shed some light on the useful things 
that Congress might do with regard to definitions, disclosure 
requirements and increased penalties. Clearly though, the 
primary responsibility for cracking down on abusive tax 
shelters rests with the accounting profession itself, and I am 
heartened by the response of some firms, particularly Ernst & 
Young, to this scandal. But we have a long way to go to fix 
this mess.
    I thank you, Mr. Chairman, for holding the hearing.
    Senator Coleman. Thank you, Senator Lautenberg.
    I would now like to welcome our first panel to today's 
important hearing. Debra Petersen, tax counsel with the 
California Franchise Tax Board; Mark Watson, a former partner 
with KPMG's Washington National Tax Practice; and finally 
Calvin Johnson of the University of Texas at Austin's School of 
Law. For the record, let me mention that Mr. Watson is 
appearing before the Subcommittee this morning under 
Subcommittee subpoena.
    I thank each of you for your attendance at today's hearing 
and look forward to hearing your testimony.
    Before we begin, pursuant to Rule 6, all witnesses who 
testify before this Subcommittee are required to be sworn. At 
this time I would ask you to please stand and raise your right 
hand.
    Do you swear that the testimony you are about to give 
before the Subcommittee will be the truth, the whole truth, and 
nothing but the truth, so help you, God?
    Ms. Petersen. I do.
    Mr. Watson. I do.
    Mr. Johnson. I do.
    Senator Coleman. I would note that we are using a timing 
system today. When you see the lights go from green to yellow, 
yellow means getting close to quitting and red means that it is 
time to quit. I would like to limit the testimony to 5 minutes, 
but your entire prepared testimony will become part of the 
official record.
    So with that, Ms. Petersen, we will have you go first this 
morning, followed by Mr. Watson, and finish up with Mr. 
Johnson. After we have heard all the testimony, we will turn to 
questions.
    Ms. Petersen, you may proceed.

 TESTIMONY OF DEBRA S. PETERSEN,\1\ TAX COUNSEL IV, CALIFORNIA 
        FRANCHISE TAX BOARD, RANCHO CORDOVA, CALIFORNIA

    Ms. Petersen. Thank you, Mr. Chairman. I am testifying 
today on behalf of Controller Steve Westly and the California 
Franchise Tax Board. On their behalf, I would like to thank you 
for this opportunity to give testimony on some of the most 
egregious tax scams that we have ever seen.
---------------------------------------------------------------------------
    \1\ The prepared statement of Ms. Petersen appears in the Appendix 
on page 275.
---------------------------------------------------------------------------
    In recent years the Franchise Tax Board has seen a gross 
proliferation of abusive tax schemes and tax shelters that have 
been aggressively marketed to taxpayers. We have been appalled 
at the positions taken to justify these transactions and 
schemes. These are designed and sold as tax-saving strategies 
and are veiled with a limited technical reading of the tax law 
and a flimsy excuse for a valid business purpose. The 
transactions are designed to create artificial losses and to 
make use of losses and deductions a second time.
    Based on the GAO's report that you have mentioned, the $85 
billion report, we estimate that California's share of that $85 
billion is $3.5 billion. So California is very concerned about 
abusive tax shelters, and we are dedicated to cracking down on 
tax sheets and abusive tax shelters.
    In the words of Controller Steve Westly, ``California loses 
hundreds of millions of State tax dollars each year as a result 
of these sophisticated tax schemes. This is legitimate tax 
money owed to the State of California that funds our schools, 
helps our elderly, and fuels our emergency and transportation 
services. With a record deficit currently plaguing our State, 
we are very motivated to pursue these cases.''
    We have already taken a number of steps to curb the 
promotion and use of these tax avoidance schemes. First of all, 
in 1998 we rolled out a computer program system that would help 
us to trace the flow-through of pass-through entity income to 
the ultimate person that should be reporting that income.
    Then on September 13, 2003, the State of California, along 
with 33 other States, signed a memorandum of understanding with 
the Small Business Self-Employed Operating Division of the 
Internal Revenue Service. We have been, and will continue to 
cooperate with the Internal Revenue Service in the 
identification and audit of tax shelters.
    In October 2003, the Governor of California signed into 
legislation a bill that provides for reporting requirements, 
increases existing penalties, and imposes new penalties for tax 
shelters. Our new law provides for a voluntary compliance 
initiative, wherein taxpayers who voluntarily file amended 
returns and pay the full amount of the tax and interest related 
to tax shelter benefits claimed on their return can avoid the 
new and increased penalties. We are hoping that many taxpayers 
will be wise and take advantage of the voluntary compliance 
initiative, especially since we plan not to settle tax shelter 
issues. Our bill was modeled after the Tax Shelter Transparency 
Act, and we hope that Congress will pass this legislation at 
the Federal level in the near future.
    We also passed legislation that would shut down one of the 
most egregious tax avoidance scams that we have ever seen. We 
saw banks form solely-owned registered investment companies for 
the purpose of paying no State income tax on their earnings on 
their loan portfolios. Contrary to the spirit and the intent in 
the Investment Act of 1940, they have registered these 
companies solely to avoid State income tax. We worked in 
cooperation with the Securities and Exchange Commission on that 
issue.
    Our Executive Director, Gerald Goldberg, chairs the 
Corporate Income Tax Shelter Working Group of the Multistate 
Tax Commission. Some of the goals of the working group is to 
share information among the States regarding tax shelters and 
abusive tax transactions, and to develop anti-abuse legislative 
tools. Apart from the MTC, the State of California has been 
working directly with several States to coordinate information 
about State level tax shelters that we have encountered.
    While we are pleased with the progress that we have made to 
identify and close down tax shelters, we think that more needs 
to be done in order to prevent creative minds from formulating 
new shelters and schemes that circumvent tax laws. We need to 
focus more on promoters and tax return preparers who sign tax 
returns without proper disclosure, and in some cases attempt to 
bury transactions on tax returns. Imposing penalties, however 
stiff, is not good enough. The preparers count on the audit 
lottery. Even disgorgement of the profit made on the 
transaction is not enough to discourage these practices. If the 
preparer is caught 1 in 10 times, then 9 out of 10 times they 
win. So even if they have to pay back $1 million out of $10 
million that they earned on the promotion of a shelter, they 
still come out $9 million ahead. In addition, the firms very 
often have insurance to cover themselves on these transactions.
    Second, we would like to see the registration exemptions be 
examined to see whether they should be removed for these types 
of transactions. Requiring registration of the 1933 Act and 
other acts will provide disclosure of more information about 
the transactions and will cost the promoter more. The fact that 
the tax laws required registration under the Investment Act of 
1940 in order to conduct the scam that they were trying to do 
with their loan portfolios enabled us to see that transaction 
at an early stage, and were able to shut it down.
    Senator Coleman. Ms. Petersen, I ask if you could summarize 
here.
    Ms. Petersen. Sure. We would also like to see some 
whistleblower statutes to encourage good and honest people to 
come forward with information that would help us to find these 
shelters.
    Finally, we need to beef up the enforcement agencies. We 
had one prominent California tax litigator note that the reason 
that we were seeing so many shelters is that ``the enforcer had 
backed off.'' Clearly we need to have enforcement activity in 
order to encourage self-compliance.
    Senator Coleman. Thank you, Ms. Petersen. Mr. Watson.

  TESTIMONY OF MARK T. WATSON,\1\ FORMER PARTNER, WASHINGTON 
        NATIONAL TAX PRACTICE, KPMG, LLP, WASHINGTON, DC

    Mr. Watson. Chairman Coleman, Senator Levin, and Members of 
the Subcommittee, good morning.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Watson appears in the Appendix on 
page 285.
---------------------------------------------------------------------------
    My name is Mark Watson. I am here today to provide 
information to the Subcommittee regarding my experience working 
at KPMG. In particular, I understand that the Subcommittee 
wants me to address certain tax strategies that were approved 
and implemented during my tenure at KPMG.
    Before answering the Subcommittee's questions, please let 
me give a brief description of my background and my role at 
KPMG. I am a graduate of Texas A&M University, where I received 
a bachelor's degree in finance and a master's degree in tax.
    In 1992, I joined KPMG as a staff accountant in their 
personal financial planning practice, and I was located in the 
Houston, Texas office. In 1994, I came to Washington on a 2-
year rotation in KPMG's Washington National Tax Practice, which 
was the group responsible for providing technical tax support 
to KPMG's field offices. In 1996, I moved to KPMG's Dallas 
Field Office, where I continued to work in the personal 
financial planning practice. KPMG promoted me to partner in 
1997.
    I returned to Washington in 1998 as the partner in charge 
of the Personal Financial Planning Group within the Washington 
National Tax Practice. I developed significant experience in 
the areas of individual income tax, fiduciary income tax, and 
estate and gift taxes, as these were the areas of focus for the 
Personal Financial Planning Group at that time, and that group 
provided technical tax support to KPMG's field offices 
regarding those matters.
    Also at around this time, KPMG's Washington National Tax 
Practice assumed the additional role of participating in the 
review and analysis of potential tax strategies that were to be 
sold and marketed to KPMG clients and others.
    When I was in the Washington National Tax Practice I 
reported to Phil Wiesner, who was the partner in charge of that 
practice at that time. I also reported to Doug Ammerman, who 
was the partner in charge of KPMG's Personal Financial Planning 
Practice. During this time the Personal Financial Planning 
Group of the Washington National Tax Practice was comprised of 
approximately eight individuals, and I was responsible for 
supervising those individuals.
    In the summer of 2000, KPMG transferred me out of the 
Washington National Tax Practice on a 2-year overseas 
assignment. After I completed that overseas assignment, rather 
than return to a position in the Personal Financial Planning 
Practice, I decided to leave KPMG. Today, I continue to work in 
the tax area, focusing on estate planning.
    I would now be happy to address any questions that the 
Subcommittee may have.
    Senator Coleman. Thank you. Mr. Johnson.

 TESTIMONY OF CALVIN H. JOHNSON,\1\ ANDREWS & KURTH CENTENNIAL 
  PROFESSOR, THE UNIVERSITY OF TEXAS AT AUSTIN SCHOOL OF LAW, 
                         AUSTIN, TEXAS

    Mr. Johnson. My name is Calvin Johnson, and I teach tax and 
accounting at the University of Texas in Austin.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Johnson appears in the Appendix 
on page 286.
---------------------------------------------------------------------------
    My general conclusion is that tax shelters have done real 
damage to the national tax system. Former IRS Commissioner 
Charles Rossotti, said that the IRS is losing the war on tax 
compliance. Some 80 percent of the most sophisticated taxpayers 
are avoiding their share of tax, he said. And I think that the 
figures support that assessment. Real or effective tax rates 
are running at a maximum of 10 percent for corporations and 
investors, and these are the people that Congress wants to and 
needs to tax at 35 percent. The tax system is not in healthy 
shape.
    Every day a cadre of well-trained, well-paid, highly-
motivated tax professionals have been launching vicious attacks 
on the tax base, and they have done considerable damage. KPMG 
charged over $80 million for its BLIPS and SC2 shelters. We can 
be confident that they destroyed many times that in terms of 
tax. Uncle Sam seems to be losing the war against tax shelters.
    I have two short comments on remedies. The first one is on 
retroactivity. KPMG sold a shelter called BLIP or Son of Boss, 
which depended upon the creation of artificial accounting 
losses by having real liabilities, real economic liabilities 
assumed, be ignored for tax purposes. The tax law was said to 
be blind to the assumption. Congress fixed the problem by 
retroactive amendment of the Internal Revenue Code, and then 
Treasury fixed the specific problems of BLIPS with a 
retroactive amendment to the regulations going back for 4 
years.
    I applaud the retroactive cure. The statute that BLIPS 
attacked was drafted by the best minds in the country right 
before the Internal Revenue Code of 1954, spending a lot of 
time and deliberation on this system. Sometimes a vicious 
attack like BLIPS opens up a hacker's windows in the best-
designed system in the world. Sometimes it does not, but the 
litigation is required and the long war of litigation prevents 
full enforcement of the law. Congress has to react by fixing 
the hole retroactively.
    I hope that the Treasury and the Congress will also fix the 
so-called SC2 shelter retroactively to deny all of KPMG's 
customers any tax benefits. SC2 creates a second class of stock 
which sub-S corporations are prohibited to have because it 
tries to separate the tax on the income from the ownership of 
the underlying capital. SC2 also separates the tax from the 
real economic ownership of the income.
    Going beyond the specific shelters, I would hope that the 
IRS and Congress would set up a joint institution to conduct 
legislative audits. The office would have the duty of fixing 
the tax law when the shelters have ripped it open. Litigation 
is a long and ugly process. Far better to cure the rips the 
shelters have caused by retroactive fixes.
    My second comment is on auditor independence. An auditor, a 
CPA, has to have an attitude of extraordinary skepticism, even 
hostility, to the firm that it is auditing. Nothing else will 
satisfy the zealous loyalty to investors and to the capital 
markets that CPAs must have. In this post-Enron world, CPAs 
cannot be offering tax shelters or business advice. The CPAs 
are trying to be both the cop, the FBI Task Force, and also the 
consigliore to the very same don, to the very family at the 
very same time, and it does not work. They are not helping the 
public investors in the capital market.
    The remedy is simple. Firms auditing SEC statements need to 
separate their auditing and advising functions into two 
unrelated companies by spinoff or sale. In fact, I believe that 
under current law, the Sarbanes-Oxley Act, accounting 
committees may not approve for the sale, the purchase of a tax 
shelter from their auditing CPA. It is a violation of their 
duty to ensure independence and none of them should ever be 
approved. I think the auditing committees are going to face 
personal liability every time they say yes to these under any 
circumstances.
    Thank you very much.
    Senator Coleman. Thank you very much, Professor Johnson.
    Professor Johnson, my first question will be to you. How 
would you grade Senator Levin's description of BLIPS? 
[Laughter.]
    Mr. Johnson. I thought it was superb. This man can come 
down and teach my class, and bump me for a while.
    Senator Coleman. Thank you.
    Senator Levin. I was going to say thanks for asking, but I 
was not sure what the answer was.
    Mr. Johnson. I'm on your side.
    Senator Coleman. Ms. Petersen, in your prepared testimony 
you talked about BLIPS transactions lacking economic substance. 
Can you further explain that? What does it mean to lack 
economic substance?
    Ms. Petersen. Economic substance has a number of tests that 
you look at. One is that there are no economic advantages other 
than the tax savings. The tax benefits outweigh the economic 
risks and the potential profit, and third, that there's no 
business purpose separate from the tax consequences. So usually 
there's just no justifiable business purpose for the 
transaction other than to reduce taxes, and the transaction 
usually lacks the potential to generate a profit.
    Senator Coleman. We focused today on BLIPS and SC2. Clearly 
though there are a range of these schemes that are out there: 
COBRA, which was marketed by Ernst & Young; Son of Boss, which 
was marketed by Pricewaterhouse Coopers. Do they all bear the 
general characteristics that you testified to today?
    Ms. Petersen. Yes. In each of those cases you can see where 
they're trying to create an artificial or non-economic loss, 
and very often they will use different mechanisms to be able to 
inflate, in those situations, the basis of a pass-through 
entity, so that the owner gets a higher basis than they should 
normally be entitled to without any risks, and then they go and 
claim that as a loss when they dispose of the----
    Senator Coleman. So you have it within the industry--first, 
let us back it up. People made a lot of money in the 1990's.
    Ms. Petersen. Yes.
    Senator Coleman. There is a lot of cash out there. And you 
have within the industry, either a loophole in the law or 
blinders on the law enforcers. A whole industry is saying, we 
can come up with ways in which there is very little risk, but 
an opportunity to write off massive loss. Would that be an 
accurate assessment?
    Ms. Petersen. That is correct.
    Senator Coleman. Aside from holding the tax preparers 
accountable, how do we prevent this? Many of these firms have 
come and said, we do not do this any more, they have 
acknowledged this as headed down the wrong path--but how do we 
stop this tomorrow? What is it that we need? You talked about a 
Taxpayer Transparency Act. Would it be your testimony that a 
Taxpayer Transparency Act are things that we can do to prevent 
this in the future?
    Ms. Petersen. Yes, very definitely that would help, but we 
would also like to see--I think Mr. Johnson may have touched 
upon this--Sarbanes-Oxley Act, that same concept, extended to 
tax return preparers, to say, if you're going to sell and 
market these shelters, then you cannot sign the tax return for 
the taxpayer investor that's claiming those. You need to send 
them to another firm. Let another firm take an independent look 
at the transactions and make the adequate disclosures on there.
    We would like to see some sort of a licensing or 
registration of tax return preparers, because until you are 
able to take away their ability to do their profession, if 
you're only looking at penalties, they're going to continue to 
do what they do as long as economically it makes sense to do 
that.
    And we would like to see the ethical standards raised for 
tax preparers. Right now they have this idea that as long as 
it's not illegal or there's nothing that blatantly tells them 
you cannot do this particular thing, they're going to go ahead 
and try and take those positions, and so we really need to have 
them come up on their standards and try to support the whole 
spirit and the purpose of the laws.
    Then we'd like to see publication of a list of opinion 
providers, whose opinions are really inadequate. Sometimes 
these opinions mislead the person that they're giving the 
opinion to, to think that they're going to be able to avoid 
penalties, when the reality, they're kind of circular. They 
rely strictly on the taxpayer making representations. And 
that's how the opinion is given. So we would like to see, as we 
find these firms that give faulty opinions, to publish that, 
let the public be put on alert that they can't rely on those 
opinions issued by those firms.
    We also see great abuse with the fee structure. Some of the 
firms use contingency fees, meaning up front they'll go in and 
sell the work that they're going to do and say, we'll take a 
percentage of the benefits that you get derived from that----
    Senator Coleman. You have any problem with firms marketing 
SC2? I mean my sense is that with SC2 in particular, they are 
doing cold calling out there to Subchapter S corporations. You 
have a concern with that?
    Ms. Petersen. Yes. You're talking about companies that 
probably wouldn't otherwise be looking to get in these types of 
investments, now feeling the pressure that everybody's doing 
this, that they ought to take advantage of this, and they might 
not have otherwise thought of this.
    Senator Coleman. Let me ask you one other question. What is 
the culpability to the taxpayer in these schemes?
    Ms. Petersen. Well, the taxpayer is going to have to pay 
back the amount of tax that they sheltered, that was 
incorrectly sheltered, and then they're going to also be 
subject to potential penalties. Right now California probably 
has stiffer penalties than the Feds do because we enacted our 
legislation and you haven't enacted that yet.
    Senator Coleman. But do you absolve them of culpability if 
they have an opinion from their accounting firm, they have a 
legal opinion, typically from a law firm in these cases--and we 
are going to examine that more on Thursday--in spite of that, 
do they still have culpability?
    Ms. Petersen. They may, because even though they might try 
to rely on the opinions, if the opinion is faulty or if it is 
issued by someone that has promoted that particular shelter, 
we're going to look at it and say that your reliance is invalid 
and that you can't do that.
    Senator Coleman. Mr. Watson, I want to focus a little bit 
on your knowledge of and involvement in dealing with BLIPS in 
particular. Did you have a chance to review the BLIPS 
transactions when this concept was being developed?
    Mr. Watson. Yes, I did.
    Senator Coleman. Who was responsible? I presume there had 
to be some discussion, when you were establishing something 
like BLIPS, somebody had to be saying, well, is it legal? Is it 
not legal? Can you talk to me how that worked within the firm?
    Mr. Watson. Sure. Perhaps I should just overview the 
process that we went through to review and approve BLIPS. BLIPS 
was one of the first tax strategies that was put through KPMG's 
newly-structured review process, and that new review process 
was implemented probably in the fall of 1998. The review 
process involved KPMG's Washington National Tax Office, the Tax 
Innovation Center, which was recently created, and KPMG's 
Department of Professional Practice.
    The Washington National Tax Office's role was to review, 
and if possible, approve a tax strategy based on the applicable 
tax law. So that's where the legal analysis was made.
    The Tax Innovation Center was there to really facilitate 
the review process in the sense of making sure that adequate 
resources were available and then participating or helping with 
the development of marketing materials and the deployment of 
approved strategies.
    And finally, the Department of Professional Practice's role 
was to determine that, if a tax strategy was approved by the 
Washington National Tax Office, whether the business risks 
associated with that strategy were appropriate for KPMG to be 
involved with, and they also made sure that the auditor 
independence rules were sufficiently addressed.
    So that's how we went through the review process. We really 
had three different groups looking at the various issues, both 
from a tax standpoint and from a business risk standpoint. And 
to answer your question, yes, these issues were debated, they 
were examined at some length. And in fact, the review process 
with BLIPS officially started on February 11, and after 
numerous meetings, numerous e-mail messages and hundreds of 
hours of tax research, it was finally approved around May 10, 
1999.
    Senator Coleman. According to judicial precedent, there 
must be reasonable opportunity to earn pre-tax profit. Do you 
believe that the BLIPS transaction allowed for this, and if 
not, why not?
    Mr. Watson. That was my primary concern with the BLIPS 
transaction. I was never comfortable that BLIPS provided a 
reasonable opportunity to make a reasonable pre-tax profit, and 
I didn't believe that it could make a reasonable pre-tax profit 
primarily because of what Senator Levin disclosed in his 
opening statement, that very little of the proceeds were going 
to be invested in a manner that could generate a sufficient 
rate of return.
    Senator Coleman. And you in fact sent out an e-mail raising 
this issue; is that correct?
    Mr. Watson. Yes, sir, that's correct.
    Senator Coleman. I have a copy of it. It is Exhibit 80,\1\ 
and if staff could give Mr. Watson a copy. It is an e-mail 
dated Wednesday, May 5, 1999, 9:21 a.m. In that you say, 
``According to Presidio, the probability of making a profit 
from this strategy is remote, possible but remote. Thus, I 
don't think a client's representation that they thought there 
was a reasonable opportunity to make a profit is a reasonable 
representation. If it isn't a reasonable representation, our 
opinion is worthless.''
---------------------------------------------------------------------------
    \1\ See Exhibit No. 80 which appears in the Appendix on page 664.
---------------------------------------------------------------------------
    Can you talk to me about Presidio's role? Did you have an 
opinion from Presidio as to what they thought of this 
transaction?
    Mr. Watson. Yes. This e-mail message was the result of a 
meeting that I attended on April 30 and May 1, 1999, where 
Presidio, members of Presidio, were present to explain the 
investment strategy, in essence, to the partners who were going 
to be selling this transaction.
    Senator Coleman. Can you explain again Presidio's 
involvement in the transaction?
    Mr. Watson. Presidio was the investment adviser. They 
arranged for the investment side of this transaction to take 
place.
    Senator Coleman. In the KPMG tax opinion that I have had a 
chance to review, Presidio represents there is a reasonable 
opportunity for pre-tax profit. My question is, does this 
representation seem credible based on the May 5 e-mail?
    Mr. Watson. It did not seem credible to me, no.
    Senator Coleman. Can you explain how they got there?
    Mr. Watson. Senator, I don't know how they go there on this 
issue. This was my primary concern and the reason I continually 
raised the issue with Mr. Wiesner and Mr. Smith, but they 
decided that this was a reasonable representation and that the 
opinion letter could be issued.
    Senator Coleman. I also understand that you were concerned 
about who was the borrower in the BLIPS transaction and the 
fact that the bank required the loan to be paid in 60 days. Can 
you explain the significance of these issues and why you feel 
they negatively impacted KPMG's ability to issue an opinion to 
its clients?
    Mr. Watson. Well, the who's the borrower issue really 
related to whether you could get the basis with respect to the 
premium, in other words, the $20 million loss that Senator 
Levin described. We were concerned that the individual taxpayer 
would not be treated as the true borrower, but rather the 
investment fund itself would be treated as the true borrower, 
because the bank really had significant restrictions on the use 
of the money. It was just really transferred from one account 
at the bank to another account at the bank in a very short 
period of time. So we feared that an easy attack on this 
transaction was for the IRS to just argue that the taxpayer 
never really borrowed the money, and therefore there is no 
basis for which to claim a loss.
    Senator Coleman. Were these concerns ever resolved to your 
satisfaction?
    Mr. Watson. Not to my satisfaction, no, and nor to Mr. 
Rosenthal's satisfaction, who expressed some significant 
concerns specifically on who's the borrower issue.
    Senator Coleman. Two other questions, three questions. Who 
is Larry DeLap?
    Mr. Watson. Mr. DeLap was the partner in charge of KPMG's 
Department of Professional Practice for the tax practice at 
that point in time.
    Senator Coleman. Do you recall a telephone conversation 
with Larry DeLap, during which you indicated to him that all of 
your concerns were resolved regarding the BLIPS transactions?
    Mr. Watson. I don't recall that conversation, Senator. It 
may very well have taken place, and in fact, I will assume that 
it took place, but I'm quite certain that I did not tell Mr. 
DeLap that I was comfortable with the BLIPS transactions or 
that all my concerns had been resolved, and in fact that's 
completely inconsistent with the e-mail messages that I wrote 
both before and after the date of this purported conversation.
    Senator Coleman. The last question, and we will do another 
round. Do you consider it unusual for KPMG to go forward with 
the strategy despite the fact that several technical partners, 
yourself, apparently Mr. Rosenthal, had significant problems 
with it, and if so, why do you believe they went forward with 
it anyway?
    Mr. Watson. Well, I was disappointed with the decision, but 
again, a lot of people were involved in this review process, a 
lot of smart partners with significant experience, including 
Mr. Wiesner, Mr. Smith, Mr. DeLap, and Mr. Eischeid. And so, 
when they decided that, despite our reservations, despite our 
concerns, to move forward, there was really nothing left for me 
to say.
    Senator Coleman. Senator Levin.
    Senator Levin. Let me go through some of those e-mails with 
you. On May 7 and May 10, you and Mr. Rosenthal, that is Steve 
Rosenthal, met with Mr. Wiesner and Mr. Smith to discuss your 
concerns. Mr. Wiesner announced apparently at that point that 
the decision was made to move forward with BLIPS. What took 
place at those meetings? Did you express your problems with 
this BLIPS deal?
    Mr. Watson. I recall that we met to discuss my concerns and 
Mr. Rosenthal's concerns regarding economic substance and who 
was the borrower. I wouldn't describe the meeting as a 
substantive conversation, but we did lay out our concerns, and 
Mr. Smith and Mr. Wiesner did respond with why they thought it 
was not a problem, cited some cases, which Mr. Rosenthal later 
researched and replied that he was still not comfortable with 
the who's the borrower issue.
    Senator Levin. There are two distinct problems that you 
had, is that correct? One was who was the borrower.
    Mr. Watson. Correct.
    Senator Levin. It was your conclusion that there were grave 
doubts that the borrower here was the taxpayer; is that 
correct?
    Mr. Watson. I was concerned about that, yes.
    Senator Levin. When you say you were concerned, you 
indicated in your e-mails and otherwise, as I understand it, 
that the borrower here was really effectively the partnership 
if there was any loan at all. Is that correct?
    Mr. Watson. That's what I was afraid of, yes, that the 
conclusion would be that the partnership borrowed the money and 
not the individual taxpayer.
    Senator Levin. That would be because?
    Mr. Watson. That would be because the bank controlled the 
funds and the taxpayer actually never received the funds.
    Senator Levin. There was, in addition to that question--
assuming there was a loan, who was the borrower--there was the 
underlying question of whether or not there was a loan at all. 
Is that correct?
    Mr. Watson. Yes. That was a concern as well, whether this 
was truly a bona fide loan.
    Senator Levin. The reason that you had doubts about that 
was because?
    Mr. Watson. Again, because of the significant restrictions 
placed on the loan proceeds.
    Senator Levin. Would you list those restrictions?
    Mr. Watson. I think you adequately listed it. It was the 
collateral requirement that was contained in the loan documents 
that in essence prohibited those loan proceeds from being 
invested in any manner other than money market type 
instruments.
    Senator Levin. The collateral requirement was for how much?
    Mr. Watson. At least 101 percent, if I recall correctly.
    Senator Levin. Ms. Petersen, let me ask you about both 
BLIPS and SC2. Before I do that, let me just go back.
    Is it fair to say, Mr. Watson, without going through all of 
the e-mails, that you expressed your problems with BLIPS on a 
number of occasions in a number of ways to Mr. Wiesner, Mr. 
Eischeid, and Mr. DeLap?
    Mr. Watson. Yes, sir, it is, numerous times.
    Senator Levin. Now let me go to Ms. Petersen.
    I want to get yours and the other witness's quick 
assessments of the two tax products that we are focusing on 
here today, BLIPS and SC2. In your opinion, do these two tax 
products comply with Federal tax law?
    Ms. Petersen. No.
    Senator Levin. Mr. Watson.
    Mr. Watson. I think they comply with a technical reading of 
Federal tax law, yes. I did not think these were fraudulent 
transactions. But as to BLIPS I did not believe that it met the 
standard of more likely than not primarily because of the 
economic substance issue.
    Senator Levin. And more likely than not would mean that you 
did not believe it was more likely than not that they would be 
sustained in a court?
    Mr. Watson. Correct, that they would be--that the tax 
results would be sustained by a court of law if challenged by 
the Internal Revenue Service.
    Senator Levin. Mr. Johnson, in your judgment were these two 
tax products in compliance with Federal law?
    Mr. Johnson. I think the IRS can beat them.
    Senator Levin. Should they beat them?
    Mr. Johnson. Oh, absolutely.
    Senator Levin. If we look at the chart with the three mass 
marketing quotes on them, I think this is Chart 3. I am sorry, 
it is Chart 1c.\1\ I gave the wrong number.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 1c. which appears in the Appendix on page 384.
---------------------------------------------------------------------------
    The first line is from a KPMG e-mail: ``Look at the last 
partner's scorecard. Unlike golf, a low number is not a good 
thing. A lot of us need to put more revenue on the board.'' 
This is talking about tax shelter sales.
    Another internal KPMG e-mail: ``Sell, sell, sell.''
    A third KPMG e-mail: ``We are dealing with ruthless 
execution, hand-to-hand combat, blocking and tackling. Whatever 
the mixed metaphor, let's just do it.''
    Professor Johnson, what is your reaction to that kind of 
culture?
    Mr. Johnson. Certainly not surprise. KPMG's assessment is 
they're making a lot of fees and that the penalties that will 
be incurred on them are not high enough going to stop them. 
Oliver Wendell Holmes said that it's a case of holding in the 
bad man. You simply can't rely on an ethical role. The 
penalties of money or maybe a little bit of jail time are the 
only thing that are going to do it.
    Senator Levin. Ms. Petersen, what is your reaction to those 
kind of comments?
    Ms. Petersen. I think it is just reflective of the greed of 
the firms, the desire to make as much money at any cost that 
they possibly can.
    Senator Levin. I want to get a little more detail from you, 
Ms. Petersen, about the BLIPS shelter. You testify about it in 
your written testimony, but you did not get into it in any 
detail. You did in response to the Chairman's question a bit, 
and I want to press you a little more on that. In your review 
of BLIPS, would you go into the question of whether or not 
there was economic substance in a little more detail than you 
did to the Chairman's question?
    Ms. Petersen. I think you described in great detail of how 
the transaction is put together.
    Senator Levin. Would you describe it in your words though, 
whether or not you believe there was economic substance?
    Ms. Petersen. I don't think there is economic substance to 
that transaction. Again, the only way that they are creating 
that loss is not because the investor or the taxpayer was out 
$20 million, because they borrowed everything. They only got 
there as a phony paper loss. So they inflated the basis of the 
partnership or pass-through entity's based and then took that 
as a loss. It had nothing to do with the amount of money that 
was invested by the taxpayer.
    Senator Levin. You have done some examinations, I believe, 
of the BLIPS transactions; is that correct?
    Ms. Petersen. I've looked at the BLIPS transaction, yes.
    Senator Levin. Have you seen any taxpayers who made a 
profit as an investment? In other words, putting aside the tax 
benefit here, the tax loss, which was created by this shelter, 
did you see any taxpayers who made a profit on that small 
investment portion that they put in?
    Ms. Petersen. I don't recall. I can tell you that these 
things were very short-lived and came and went over maybe a 60-
day period of time.
    Senator Levin. Was the loan ever at risk here, the so-
called loan ever at risk?
    Ms. Petersen. Looking at the terms of the loan and the 
restrictions on that loan, no, I don't think so.
    Senator Levin. Also looking at the collateral requirement?
    Ms. Petersen. The collateral requirement, that's right.
    Senator Levin. Where was that loan? Was that not retained 
in the bank?
    Ms. Petersen. I don't know.
    Senator Levin. Was the loan needed for that small 
investment that was there? I know it was needed obviously to 
create the tax loss, but in terms of the small investment 
portion of this deal?
    Ms. Petersen. No. It was only there just to create the 
loss.
    Senator Levin. It was what?
    Ms. Petersen. Only there just to create the loss.
    Senator Levin. Did you have a chance to review the opinions 
that were issued by KPMG relative to this shelter?
    Ms. Petersen. Yes, I did.
    Senator Levin. Based on that review, do you think that the 
KPMG BLIPS opinion letter was one that a client could gain some 
assurance from?
    Ms. Petersen. The difficulty I found with that opinion 
letter is that it relied very heavily on representations, and 
in particular on a representation made by the taxpayer, that 
they had reviewed the economics of the transaction, and they 
made a statement that they were going to be able to make a 
profit. But you have to question whether the taxpayers 
themselves really understood the complexities of these 
transactions to be able to make that determination. In that 
opinion, there's about 16 pages discussing economic substance, 
and the conclusion of it is strictly based on the 
representation that was made by the taxpayer.
    Senator Levin. On the SC2, you mentioned in your written 
testimony that the SC2 opinion letters that you reviewed were 
``grossly deficient.''
    Ms. Petersen. Yes.
    Senator Levin. Can you elaborate on that point, to be my 
final question for this round?
    Ms. Petersen. Well, the opinion letters that I saw dealt 
with some of the code sections, but failed to really address 
any of the tax doctrines that we look at in these cases. So 
they didn't talk about step transaction. They didn't talk about 
assignment of income. They didn't talk about those doctrines 
which is what you have to look at to say, does this thing hang 
together or not? They didn't address economic substance. They 
didn't address any of those types of things, just went down 
through a series of code sections. Well, we can do this here. 
Here's a case that we think we don't meet the facts of those 
cases, and we think we're clean on this transaction.
    Senator Levin. In your judgment were they grossly 
deficient?
    Ms. Petersen. Yes.
    Senator Levin. Thank you. My time is up.
    Senator Coleman. Thank you, Senator Levin. Senator 
Lautenberg.
    Senator Lautenberg. Thanks, Mr. Chairman.
    I am a little bit more interested in how we got to where we 
are because of the criticism I hear from my former colleagues 
in the corporate world, that the government is complicating 
life so much and interfering in many ways with their ability to 
make forecasts, etc., all of which I consider as part of an 
incredible conspiracy to deceive the public and the government.
    I am kind of curious about how were colleagues of yours in 
the accounting world seduced into cooperating with these 
deceptions we saw out there? What kind of devices were 
traditionally used to say, to exchange it for simply a pat on 
the back as it used to be for a good job? How much of this was 
affected as a result of the division of the firm into 
essentially two principal parts, one the auditing side and the 
other the consulting side?
    Mr. Watson. First, with respect to your question about the 
auditing and consulting side, I had no involvement with the 
audit practice so I can't answer what kind of activity was 
taking place in the audit practice. My experience was solely 
limited to the tax practice.
    With respect to your question about how professionals were 
seduced, I don't know that professional were seduced, per se. 
There certainly was a tremendous amount of pressure being 
applied from the leadership at KPMG to review, and if possible, 
approve these transactions, because they had tremendous 
marketplace potential to generate revenue for KPMG. 
Nonetheless, I feel, at least based on my experience, that, 
with the exception of economic substance in the case of BLIPS, 
a thorough review was applied and the professionals did act in 
a professional manner to reach their conclusion.
    Senator Lautenberg. Mr. Johnson, do you have any knowledge 
or observation about what it is, what happened when the 
accounting firms split their business? Was that then a lead in 
to sharing the profits more directly, as opposed to simply the 
audit function which made sure the books were presented 
honestly? We saw a huge change in character during this period 
of time, and I am wondering where it went wrong. I did a lot of 
work for the accounting firms in my former corporate life.
    Mr. Johnson. I think the bottom is obviously money. There 
is an awful lot of money to be made by beating the IRS, and the 
IRS is perceived increasingly as being a paper tiger that 
doesn't have enough smarts, doesn't have enough ability to stop 
anything. If the IRS is going to leave millions of dollars 
hanging around on the table, then I think their perception is 
all they're doing is going in and picking it up.
    There is no question that the accounting firms are now 
considerably compromised in their independence. They're 
supposed to be very skeptical about the firms that they're 
auditing. They are serving the investing public to ensure fair 
disclosure. I think the country was utterly shocked by Arthur 
Andersen, the one that had the best reputation of all, to find 
out that firm was teaching Enron how to make their financial 
statements absolutely meaningless by guiding them through the 
elaborate mine field set up by accounting standards to protect 
investors.
    I don't think the accountants understand the degree of 
righteous anger that investors have against firms like Arthur 
Andersen. Enron went from the 7th largest company in the 
country to overnight being absolutely worthless, and all who 
touched Enron lost their nest eggs, lost their life savings. 
And Arthur Andersen helped them do it. They were supposed to be 
the cops. They were supposed to be somebody that you could 
depend on. They were supposed to be the sign of absolutely 
moral rectitude, and it turns out that they were co-
conspirators. They had been co-opted and captured in full. 
There is no question that this making a lot of money, giving 
advice, selling sleazy tax shelters to the client is utterly 
inconsistent with their cop role, and I think the cop role has 
been utterly compromised. I think that accountants simply have 
no business having that business advisory function and the cop 
function within the same firm. They've got to split up, they've 
got to spin off or sell. We depend on the accountants' credibly 
to ensure that we're getting good financial statements, and 
those people are turning out to eat too many donuts. The cops 
are eating too many donuts.
    Senator Lautenberg. There is a lot of slippage here, and it 
is discouraging and demoralizing for the public. What do they 
do? They see their pension fund evaporating in front of their 
eyes, and much of that is caused by this incredible greed 
culture which has developed in the country, where a CEO comes 
in and signs a 5-year contract, and is forced emotionally and 
financially to say, if you do not join in you are kind of maybe 
stupid. Join in. Get your stock price up. Forget about what the 
company is going to look like 5 years, 10 years from now, what 
you turn over to a successor when that happens, because 
inevitably it does, and the bonuses are in the so many millions 
that it is hard to conceive that that could be created without 
permanently damaging the companies, and it has in many 
instance.
    There was a comment made about board members. I predict 
that one day you will see a class of professional that works 
exclusively boards, because otherwise you cannot get someone to 
leave their regular business responsibilities, come over, join 
in, take a hit if one occurs by permitting something to sneak 
through, and I think that that cozy cooperation between a board 
and the CEO or the chairman or whomever makes these 
recommendations for board memberships is going to find that 
there are not people around who they can be so proud of to come 
along and join their boards unless the protections are so high 
that it alters the thinking function of the board member.
    What do we think about expanding, as Ms. Petersen said, the 
Sarbanes-Oxley Act requirements to the accounting function? Is 
it a good idea for government to get more involved at this 
juncture. How do we cure the problem that we have? This is not 
simply the tax shelters, and that is what I said initially, and 
that is to make sure that the public is getting a fair shake on 
the information on the data they receive.
    Mr. Johnson. I think separating the auditing function and 
business advising functions is a first step, an absolutely 
mandated first step, that you can't be simultaneously trying to 
help and trying to be a cop against an audited firm.
    Senator Lautenberg. Ms. Petersen, do you have a view?
    Ms. Petersen. I think I gave my comments, but I think you 
need to remember that the firms have a tax preparer side, so 
there's the tax side, there's the auditing side. They may have 
business consulting. And what we're missing is looking at the 
tax return preparers, and that's the concern we have, is what 
are those preparers doing? What are their duties? What are the 
requirements on them?
    Senator Lautenberg. What are their opportunities? That is 
the question, you see.
    Ms. Petersen. Their opportunities are great.
    Senator Lautenberg. Yes. The opportunities for deception, 
there is almost a demand out there to see how clever you can be 
and avoid paying tax, and I find it irritating. Again, having 
spent 30 years of my life in the corporate world gives me a 
little bit different insight, and I believe that if you make 
it, you pay, and that is the way it ought to be, fairly 
straightforward. I see the Center for Budget Policy Priorities, 
a research group, said preliminary tax for this year indicate 
corporate taxes account for just 7.4 percent of total tax 
receipts, down from in the 1960's when it was 21 percent of 
total receipt. I do not say that 21 percent should be the mark 
we are trying to toe, but there has been far less required of 
wealth taxpayers now than there perhaps has ever been. It is 
not fair and deprives us of revenue opportunities.
    The fact is that my time has expired. [Laughter.]
    Thank you very much.
    Senator Coleman. Thank you, Senator Lautenberg.
    Mr. Watson, I think you indicated in response to Senator 
Levin's question that you thought the BLIPS was thoroughly 
reviewed?
    Mr. Watson. With the exception of the economic substance 
issue, yes.
    Senator Coleman. I am trying to understand how we get from 
a thorough review of very bright professionals, where there 
clearly--I am not an accountant. I did not do too well in 
math--and as I look at this, I ask where is the substance? 
Where is the risk? I am trying to understand how we got there. 
In fact, let me direct this question to Mr. Johnson. I will 
come back to you, Mr. Watson.
    Professor Johnson, is it your sense, Professor, that what 
you have here is kind of a risk versus benefit kind of 
analysis. The risk is a buck, the benefit, whether caught or 
not caught is 10 bucks. So why not do it? Is that your sense?
    Mr. Johnson. Absolutely. Phil Wiesner is not a rogue 
elephant. He's not an unusual member of this community. He is 
core to management. This is a KPMG official decision by the 
core of management, and it's really unfair to consider this to 
be an aberration. It's not an aberration. It is a system, 
people reacting to the system in places in which the penalties 
are very low, trivial, nonexistent, and the rewards of not 
paying tax are very high. I'm not sure we should get 
moralistic. It's just a matter of creating the right system 
incentives and throwing some people in jail.
    Senator Coleman. But is this because the law allows it? I 
mean, again, this is not just KPMG, it is all the firms. Ms. 
Petersen talked about a variation of these, opportunities for 
folks to wipe their loss off the books and avoid paying taxes. 
Is it because the law allows it or because the IRS does not 
catch it?
    Mr. Johnson. Well, it's a combination of both. They're 
finding--they're creating hacker's windows. The tax law looked 
like it was beautiful and a good safety net, and worked and 
fully described, and then--these are very highly motivated, 
very well trained, very well paid professionals who are sitting 
there in a skunk works full time. The best minds of our 
generation are now spent in skunk works tax shelters. Sometimes 
they work, or at least they appear to work.
    Senator Coleman. What is a skunk works? I am sorry, I 
missed that.
    Mr. Johnson. A skunk works is----
    Senator Coleman. We do not have those where I grew up in 
Brooklyn.
    Mr. Johnson. A skunk works is a factory that creates dirty 
tricks in the middle of war. It's the creative people who 
figure out how to do nasty things to the Nazis or Commies or 
the IRS, one or the other its kind of the same view. They are 
the high-tech people that are going to do a whole bunch of 
dirty tricks. Sometimes those people win, even against a well-
designed tax system.
    Sometimes we have to have extensive litigation to fix 
these. The only justification for litigation is that it's a 
little bit better than the trial by combat that it replaced. 
After 10 years of litigation, sometimes the IRS wins. So a lot 
of it is that they're very creative destroyers, and they 
succeed in destroying stuff. Then sometimes it's just that the 
IRS doesn't have as much talent, doesn't have as many 
resources. Everybody kind of hates the IRS, so they sit there 
being held back, and they don't compete as well. They don't 
wake up in the morning with that same sense of viciousness that 
the skunk works people do. You've got to give the skunk works 
credit. There are times in which in this war over money the 
most talented lawyers win it. Is it compliance or is it 
illegal? The answer is, well, sometimes their schemes are so 
brilliant they in fact--work. They created a loophole. They 
really did create it. They won. And you can take it all the way 
to the Supreme Court and they've still created the loophole.
    Senator Coleman. One last question. One of your 
recommendations of action for the Federal Government, allow the 
government to turn over the suit for damages to aggressive 
plaintiff lawyers for a reasonable fraction of the return. Can 
you discuss that?
    Mr. Johnson. Yes. In fact, the plaintiffs' lawyers are 
starting to get active in this stuff. They think that there is 
a breach of contract action. You know, you promised to save me 
$10 million worth of tax and the IRS caught me, and I want my 
$10 million from you. And that is kind of a regular contract.
    I will say if there is anybody who is as talented, vicious, 
hard-driving, and smart as the skunk works tax shelter people 
are, it is the plaintiffs' bar. The plaintiffs' bar are very 
talented people, and in some sense, if we want our tax 
enforced, maybe we ought to put talent against talent.
    There is a lot of damage that has been done, just pure 
uncompensated damages to Uncle Sam, to our country, and it 
seems to me quite ordinary law to say if you have done damage, 
then you ought to be obligated in a civil court of law to make 
amends, pay compensation for the damage that you have done. The 
system works in other areas. I think it might work here.
    Senator Coleman. Thank you, Professor. Senator Levin.
    Senator Levin. Thank you. Sometimes these very creative 
schemes that the skunk works produce are found to be legal. Is 
that correct? They have created a loophole, as you put it.
    Mr. Johnson. Yes.
    Senator Levin. Is it also true that sometimes they are 
found to be illegal?
    Mr. Johnson. Yes.
    Senator Levin. So when you say it is a combination of both, 
there are some that turn out that will be found not to be 
illegal, and there are some that will be found to be illegal. 
Is that accurate?
    Mr. Johnson. Yes. Jerome Kurtz, who was Commissioner of 
Internal Revenue Service some years ago, had to define a tax 
shelter as those that did not comply with the law because the 
IRS function is to force compliance with the law. But a tax 
shelter goes way beyond that.
    There are a lot of cases in which you rip the fabric apart 
of a perfectly good system and make it into jelly, make it into 
Alzheimer's networks or something completely dumb, completely 
paralyzed, completely open and unable to collect tax. That is 
why I think you need a legislative audit, a combination of 
Congress and IRS who can go back and say, no, maybe that was 
the interpretation, but it is a bad interpretation, that is not 
what we intended to do. We intended to write a beautiful tax 
system that worked. The Supreme Court often says the taxpayers 
should win on an interpretation that is outrageous, and those 
things need to be fixed retroactively very fast. You need to 
repair your tax base.
    The tax base is sacred. Countries decline and disappear 
when their taxpayers get in bad shape, and ours is in awful 
shape and it needs to be defended against this crap.
    Senator Levin. I could not agree with you more, but also, I 
think part of that is that some of the tax shelters which have 
been created are ``abusive but found to be illegal.'' Is that 
correct?
    Mr. Johnson. Absolutely. I hope all these get found to be, 
but, it is----
    Senator Levin. Found to be illegal?
    Mr. Johnson. Yes, found to be illegal. But it is still----
    Senator Levin. All right. Let me now go----
    Mr. Johnson. It is still up in the air. You know, on some 
of these you have not decided.
    Senator Levin. I think they were, and I hope they are found 
to be.
    Now let me go back to Mr. Watson. If you would, would you 
turn to Exhibit 88? \1\ I want to go through this with you.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 88 which appears in the Appendix on page 677.
---------------------------------------------------------------------------
    These are a series of e-mails, and if you look at the one 
from you to a bunch of folks, Eischeid, Ammerman, relative to 
BLIPS on May 5, and these two dots--do you see those two dots 
there? OK. Now, I want to read these to you because it seems to 
me these are very significant and come to the heart of the 
matter as to what your reaction was to BLIPS.
    ``According to Presidio, the probability of making a profit 
from this strategy is remote, possible but remote. Thus, I 
don't think a client's representation that they thought there 
was a reasonable opportunity to make a profit is a reasonable 
representation. If it isn't a reasonable representation, our 
opinion letter is worthless.''
    Now, when you said that, ``according to Presidio,'' that is 
what Presidio told you at a meeting, which is where you got 
started really worrying about this BLIPS thing. Is that 
correct?
    Mr. Watson. Yes, Senator, that's correct.
    Senator Levin. Because what they told you at that meeting 
was different than what you had previously understood. Is that 
correct?
    Mr. Watson. That's correct.
    Senator Levin. All right. Now, the next dot: ``The bank 
will control via a veto power over Presidio how the `loan' 
proceeds are invested. Also, it appears that the bank will 
require this `loan' to be repaid in a relatively short period 
of time, e.g., 60 days, even though it is structured as a 7-
year loan. These factors make it difficult for me to conclude 
that a bona fide loan was ever made. If a bona fide loan was 
not made, the whole transaction falls apart.''
    Now, those were your words, right?
    Mr. Watson. Yes, sir.
    Senator Levin. And in your judgment--you have given us your 
judgment already here this morning--you had doubts that a bona 
fide loan was made.
    Mr. Watson. Yes.
    Senator Levin. And if it was not, this whole transaction, 
in your words, falls apart. Correct?
    Mr. Watson. It would not produce the tax results desired.
    Senator Levin. All right. Now, if you were told by--it 
would not produce it.
    Mr. Watson. It would not produce the desired tax results.
    Senator Levin. In other words, the IRS would not allow it 
because it was not consistent with the tax code. Is that 
another way to say that?
    Mr. Watson. Well, if there was no bona fide loan, then 
there was never any basis to claim a loss for.
    Senator Levin. And, therefore, they could not properly 
claim the deduction.
    Mr. Watson. That's correct.
    Senator Levin. All right. Now, Presidio told you, as I 
understand your e-mail, that the probability of making a profit 
from this strategy is remote, possible but remote. Is that 
correct?
    Mr. Watson. That's correct.
    Senator Levin. And then when you stated your concerns to 
the folks that you talked to, they said we are going to get 
some additional representations from Presidio. Is that correct?
    Mr. Watson. That's correct. This problem was cured through 
representations.
    Senator Levin. Just representations, which they obtained 
from Presidio. Correct?
    Mr. Watson. Correct.
    Senator Levin. And here is one of the representations that 
was made to ``cure the problem.'' Presidio has represented to 
KPMG the following--this is dated December 31, 1999. It is not 
in the exhibits. ``Presidio believed there was a reasonable 
opportunity for an investor to earn a reasonable pre-tax 
profit, in excess of all associated fees and costs, and without 
regard to any tax benefits that may occur.'' That was exactly 
the opposite of what Presidio acknowledged to you, wasn't it?
    Mr. Watson. It was, yes.
    Senator Levin. And yet after you told the folks at KPMG 
that Presidio told you that, in fact, there was little 
probability of making a profit, or to put it differently, it 
was remote, they made a representation that Presidio said the 
opposite, and this came after you told them what Presidio had 
told you. Is that correct?
    Mr. Watson. That is correct, yes.
    Senator Levin. All right. My time is up. I had one more 
subject.
    Senator Coleman. Senator Levin, do you want to pursue one 
more subject?
    Senator Levin. Just one more quick subject, if I can, and 
that has to do with the issue of grantor trusts, and this is 
something of a separate issue.
    The Subcommittee has come across some material suggesting 
that with respect to OPIS and BLIPS, grantor trusts were used 
to net out gains and losses and to obscure reporting at the 
individual taxpayer level. Can you explain--well, let's go to 
Exhibit 10 \1\ because I think time-wise we are going to have 
to cut through a little quicker.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 10 which appears in the Appendix on page 428.
---------------------------------------------------------------------------
    In Exhibit 10, you appear to be expressing your views that, 
with regard to your own analysis of the use of grantor trusts 
relative to the OPIS transaction, that those grantor trusts, in 
your words, ``Notwithstanding the conclusion reached in the 
`grantor trust memo,' I don't think netting at the grantor 
trust level is a proper reporting position. Further, we have 
never prepared grantor trust returns in this manner. What will 
our explanation be when the Service and/or courts ask why we 
suddenly changed the way we prepared grantor trust return/
statements only for certain clients? When you put the OPIS 
transaction together with this `stealth' reporting approach, 
the whole thing stinks.''
    That is in Exhibit 10. Those are your words?
    Mr. Watson. Yes, sir.
    Senator Levin. And is that what the firm was doing?
    Mr. Watson. That was my understanding, yes, that the 
grantor trusts were being used to disguise the OPIS and perhaps 
the BLIPS transactions.
    Senator Levin. And then you also wrote in January 1999 a 
memo in which you said the following: ``You should all know 
that I do not agree with the conclusion reached in the attached 
memo that the capital gains can be netted at the trust level. I 
believe we are filing misleading, and perhaps false, returns by 
taking this reporting position.''
    Was that your position then?
    Mr. Watson. Yes, it was.
    Senator Levin. Is it your position now?
    Mr. Watson. Yes, it is.
    Senator Levin. All right. And then, finally, in Mr. 
Eischeid's memo, which appears at the top of the page, he 
writes, relative to a conference call, ``We concluded that each 
partner must review the WNT memo''--and WNT stands for 
Washington----
    Mr. Watson. Washington National Tax.
    Senator Levin. National Tax, which is part of KPMG, right?
    Mr. Watson. Correct.
    Senator Levin. ``. . . memo and decide for themselves what 
position to take on their returns--after discussing the various 
pros and cons with their clients.''
    Therefore, your conclusion was essentially ignored. Is that 
correct? It was left up to each of the partners?
    Mr. Watson. Yes, Senator, it was.
    Senator Levin. Thank you.
    Senator Coleman. Senator Levin, I am going to follow up 
with one question just based on that last line of questioning 
that you had, the issue of grantor trusts here. IRS Notice 
2000-44, according to that notice, using a grantor trust is 
criminal activity?
    Mr. Watson. They threatened criminal penalties in that 
notice, yes, sir.
    Senator Coleman. Can you give me a sense of the time 
sequence of that memo versus your communications here? Did the 
memo come out before or after?
    Mr. Watson. The notice came out in, I believe, August 2000. 
These e-mail messages were taking place in January 1999. So 
this actually related to the OPIS transaction, but the desire 
was to use that same reporting position with respect to the 
BLIPS transaction.
    Senator Coleman. Thank you, Mr. Watson.
    This panel is excused. We thank you very much.
    I would now like to welcome our second panel to today's 
hearing: Philip Wiesner, Partner in Charge of KPMG's Washington 
National Tax Client Services, Washington, DC; Jeffrey Eischeid, 
a partner in KPMG's Personal Financial Planning Office, 
Atlanta, Georgia; Richard Lawrence DeLap, a retired National 
Partner in Charge of KPMG's Department of Professional 
Practice-Tax, Mountain View, California; and, finally, Larry 
Manth, the former West Area Partner in Charge for KPMG's 
Stratecon, Los Angeles, California.
    I want to thank you all for your attendance at today's 
hearing, and I look forward to your testimony. Before we begin, 
pursuant to Rule VI, all witnesses who testify before the 
Subcommittee are required to be sworn. At this time, I would 
ask you to please stand and raise your right hand. Do you swear 
that the testimony you are about to give before the 
Subcommittee will be the truth, the whole truth, and nothing 
but the truth, so help you, God?
    Mr. Wiesner. I do.
    Mr. Eischeid. I do.
    Mr. DeLap. I do.
    Mr. Manth. I do.
    Senator Coleman. Again, as I noted with the other panel, we 
will be using a timing system. I would like you, if you are 
going to make prepared statements, to limit them to 5 minutes. 
We will enter your entire written testimony into the record.
    Again, I am going to give an opportunity for opening 
statements, starting with Mr. Wiesner, Mr. Eischeid, Mr. DeLap, 
and Mr. Manth.

  TESTIMONY OF PHILIP WIESNER, PARTNER IN CHARGE, WASHINGTON 
    NATIONAL TAX, CLIENT SERVICES, KPMG, LLP, WASHINGTON, DC

    Senator Coleman. I understand, Mr. Wiesner, that you will 
not be making an opening statement?
    Mr. Wiesner. That is correct, Senator.
    Senator Coleman. Mr. Eischeid.

 TESTIMONY OF JEFFREY EISCHEID,\1\ PARTNER, PERSONAL FINANCIAL 
              PLANNING, KPMG LLP, ATLANTA, GEORGIA

    Mr. Eischeid. Mr. Chairman and Members of the Subcommittee, 
on behalf of KPMG there are four main points that I would like 
to call to your attention:
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Eischeid appears in the Appendix 
on page 298.
---------------------------------------------------------------------------
    One, the tax strategies being discussed today represent an 
earlier time at KPMG and a far different regulatory and 
marketplace environment. None of the strategies--nor anything 
like these tax strategies--is currently being presented to 
clients by KPMG.
    Today, KPMG advises our clients on the enormous range of 
potential outcomes under the tax laws and how to achieve the 
best outcomes in their individual cases. We have provided the 
Subcommittee with materials that describe hundreds of these 
approaches. None of these are aggressive tax strategies like 
FLIP, OPIS, BLIPS, and SC2.
    Two, the strategies presented to our clients in the past 
were complex and technical, but were also consistent with the 
laws in place at the time, which were also extremely 
complicated.
    Three, the strategies did undergo an intensive and thorough 
review, a process that resulted in vigorous, sometimes even 
heated, debate.
    Four, KPMG understands that the regulatory environment and 
marketplace conditions have changed. This has led to 
significant changes within KPMG over the past 3 years.
    We would like to elaborate on each of these points.
    First, the tax strategies under review were all presented 
under regulatory and marketplace conditions that do not now 
exist. Today, KPMG does not present any aggressive tax 
strategies specifically designed to be sold to multiple 
clients, like FLIP, OPIS, BLIPS, and SC2.
    These strategies were presented at a time when the U.S. 
economic boom was creating unprecedented individual wealth and 
a demand for tax advice aimed at achieving tax savings. All 
major accounting firms, including KPMG, as well as prominent 
law firms, investment advisers, and financial institutions gave 
tax advice, including presenting these types of tax strategies 
to clients.
    In KPMG's case, other firms often provided investment 
advisory and other non-tax services in connection with these 
transactions. All of these relationships were consistent with 
KPMG's legal and professional requirements.
    Second, it is true that these strategies were complicated 
and that the tax consequences turned on careful and detailed 
analyses of highly technical tax laws, regulations, rulings, 
and court opinions. But all of these tax strategies were 
consistent with the laws in place at the time.
    It is important to note that no court has found them to be 
inconsistent with the tax laws. In some cases, the IRS has 
agreed that taxpayers should be allowed to retain a portion of 
the tax benefits they claimed as a result of implementing a 
strategy.
    For all of the strategies being reviewed by the 
Subcommittee, KPMG provided our clients with a ``more likely 
than not'' opinion as to their tax consequences. In other 
words, we informed our clients that, based on the facts and 
actions they took, they would have a ``more likely than not''--
or a greater than 50 percent--chance of prevailing if the IRS 
challenged the transaction.
    The tax laws are complicated and often ambiguous and 
unsettled. As a result, KPMG's opinions regarding these tax 
strategies were long, detailed, and technical. Our clients were 
told that, in addition to a possible tax benefit, the law 
required a transaction to have a business purpose, profit, 
charitable, or other non-tax motive. They were required to 
provide us with representations to that effect. Our clients 
were sophisticated and typically had their own attorneys, 
accountants, and investment advisers. Throughout the process, 
KPMG made it very clear to clients that they were undertaking 
complex transactions on which the law was ambiguous and often 
had not been clarified by either the IRS or the courts.
    Our third point is that because we understood that these 
tax strategies might be subject to an IRS challenge, KPMG put 
them through a rigorous review process before they were 
approved for presentation to multiple clients. The tax 
strategies also underwent very careful analysis of the IRS 
requirement for registering tax shelters in effect at the time.
    Many tax partners with different areas of expertise 
participated in the review process. That, combined with the 
fact that we were dealing with a ``more likely than not'' 
opinion, is the reason there was a lively and often lengthy 
debate among partners over the interpretation and application 
of tax laws, regulations, rulings, and opinions. Many of the 
materials provided to the Subcommittee document this internal 
debate.
    Finally, KPMG has changed. We learned a number of important 
lessons from our previous tax policies and practices. As a 
result, KPMG has made substantial improvements and changes in 
our practices, policies, and procedures over the past several 
years. My colleague, Richard Smith, will describe these in 
greater detail.
    In the practice I head, Personal Financial Planning, we 
have shifted our approach from one focused on taking solutions 
to clients to one that works with clients to address their 
individual situations. This is consistent with KPMG's current 
leadership philosophy and more conservative approach to the tax 
service practice.
    We understand that simply being technically correct is not 
enough. We know we need to respond better to the continuing 
changes in the tax laws and regulations and the needs of our 
clients. We also need to ensure that no action taken will call 
into question the integrity, reliability, and credibility of 
KPMG.
    Thank you.
    Senator Coleman. Thank you, Mr. Eischeid.

 TESTIMONY OF RICHARD LAWRENCE DELAP, RETIRED NATIONAL PARTNER 
 IN CHARGE, DEPARTMENT OF PROFESSIONAL PRACTICE-TAX, KPMG LLP, 
                   MOUNTAIN VIEW, CALIFORNIA

    Senator Coleman. Mr. DeLap, I understand that you will not 
be making a prepared statement.
    Mr. DeLap. That is correct.
    Senator Coleman. Thank you. Mr. Manth.

 TESTIMONY OF LARRY MANTH, FORMER WEST AREA PARTNER IN CHARGE, 
          STRATECON, KPMG LLP, LOS ANGELES, CALIFORNIA

    Mr. Manth. Mr. Chairman and Members of the Subcommittee, I 
had not planned to make a statement at today's hearing, but 
simply to appear here to answer the Subcommittee's questions 
regarding a tax strategy known as SC2, a tax strategy for which 
I was primarily responsible during a portion of my time as a 
partner there. But I have seen some press articles on today's 
hearing, and I note that they contain some misstatements about 
SC2. I wanted to take this opportunity to set the record 
straight, and I appreciate the Subcommittee allowing me to do 
so.
    First and foremost, there is no question that there was a 
real donation of S corporation stock to a tax-exempt 
organization. The tax-exempt organizations involved received 
real and quantifiable benefits from these donations. Tax-
exempts that redeemed their S corporation stock have received 
literally millions of dollars in cash which have directly 
benefited thousands of police and fire fighters. Almost all the 
press reports state that under SC2, the charity sells back its 
shares to the S corporation for fair market value. This is 
true. But it doesn't tell the whole story.
    One key element of SC2 is that the charity does not, in 
fact, have any obligation to sell the shares back to the S 
corporation. A number of tax-exempt organizations have not 
redeemed their shares after 2 years. Some are actually seeking 
a better valuation or waiting for a greater return from their 
stock at some future point. Basically, the charity controls the 
stock and does not have to sell it back to the S corporation.
    I have also read descriptions that say that should the 
charity decide not to sell its stock, other S corporation 
shareholders can exercise warrants for additional shares of 
stock, thereby making the charity's shares much less valuable. 
Actually, just the opposite would happen. An S corporation 
shareholder who wanted to exercise the warrants would have to 
come up with a substantial amount of money to pay for the new 
stock. That money would be paid into the S corporation and 
raise its market value. This would reduce the charity's 
percentage ownership share, but the charity would end up owning 
a smaller percentage of a much more valuable company. In other 
words, owning 10 percent of $1 million is a lot better than 
owning 90 percent of $100,000.
    Some articles reported that S corporations that implemented 
SC2 passed resolutions to limit or suspend dividends or other 
distributions to shareholders, basically to keep the charity 
from getting any share of earnings. So far as I know, a 
resolution limiting or suspending distributions was not an 
element of SC2. In fact, KPMG recommended that S corporations 
make distributions during the period tax-exempts held their 
stock. Such payments made the S corporation stock even more 
attractive to the charity, while still allowing substantially 
more income to be reinvested in the S corporation than before 
the stock was donated to the charity. There are tax-exempt 
organizations that have received hundreds of thousands of 
dollars in distribution income while they were holding S 
corporation stock.
    Finally, some articles referred to pledges that individual 
S corporations made to guarantee that charities would receive 
at least the original value of their stock at the time it was 
redeemed. It was my experience that some SC2 transactions 
involved such a pledge, but that in most transactions, no 
pledge was offered or even requested.
    Essentially, SC2 was a strategy that involved a gift to a 
charity, a tax-free build-up of income, and a deferral of 
income so that it could be subject to capital gains tax in the 
future. This is virtually identical to another tax strategy 
that is still widely available to taxpayers. It is called the 
charitable remainder trust, and Congress wrote it into the tax 
laws many years ago so that it is not only legal but encouraged 
by law.
    I note this because, along with all the factors I have 
described, it further supports KPMG's position that SC2 was 
consistent with the law and regulations governing charitable 
giving and S corporations. Thank you.
    Senator Coleman. Thank you, Mr. Manth.
    Mr. Manth, let me just follow up as I recall listening to 
Senator Levin's testimony and talking about distribution of 
income. I believe his testimony was that there was not 
distribution of income. This was one of the concerns. And your 
testimony is to the contrary.
    Do you know--and I do not have the information in front of 
me. Is there a percentage of the times in which there was 
distribution versus non-distribution?
    Mr. Manth. I don't know. We recommended that the S 
corporations make dividend distributions.
    Senator Coleman. Do you have any information as to whether, 
in fact, that was practiced?
    Mr. Manth. I know it was done, but I don't have that in 
front of me.
    Senator Coleman. OK. Can I ask you about registration of 
this product with the IRS as a tax shelter? Do you know whether 
it was registered?
    Mr. Manth. I do not believe it was registered.
    Senator Coleman. Can you help me understand that? I think 
that is one of the concerns here about not registering. It 
would appear to me obviously if you register something and the 
IRS knows it is there, they have got a better shot at taking a 
look. Here it is not registered. Can you talk to me, tell me 
the reason for that?
    Mr. Manth. Well, I have been out of the business for a 
while, and my recollection in the registration there are two 
types of registrations. There was what we referred to as the 
old 6111(c) registration, which was really if there were 
significant deductions created in excess of an investment, then 
you would have to register. And then there were the new 
regulations that came out on registration, and I believe that a 
thorough review of registering SC2 was done on both. And it was 
concluded that it was not a registerable transaction.
    Senator Coleman. And I would ask any of the individuals 
from KPMG about BLIPS. Was that registered?
    Mr. Eischeid. No, sir, it was not.
    Senator Coleman. And as a result of not registering, I 
would take it, then, the IRS would not know if an individual 
taxpayer had gotten a certain amount of gain, if they had made 
a lot of money on some business transactions.
    My sense with BLIPS is that, in fact, by setting BLIPS up, 
the IRS would not know that information.
    Mr. Eischeid. Senator, that is not my impression or 
understanding; that, in general, and specifically with respect 
to BLIPS, the taxpayers would report on their income tax 
returns their taxable income, including the income from sales 
of stock or the businesses that they owned as well as the tax 
effects of the BLIPS investment transaction that they entered 
into.
    Senator Coleman. Mr. Wiesner, were you in charge of 
resolving the issues associated with economic substance?
    Mr. Wiesner. Yes, Senator, I was.
    Senator Coleman. And then did you ultimately approve the 
BLIPS transaction despite the concerns raised by Mr. Watson and 
perhaps others?
    Mr. Wiesner. Yes, Senator, I did. It was after about a 5-
month review process in which we very intensively reviewed 
every issue that our whole team of professionals would raise 
with respect to the transaction.
    Senator Coleman. One of the things, though, that concerns 
me here regards the exchanges between Watson and Presidio and 
then the ultimate opinion by Presidio, which seems to 
contradict an earlier representation.
    Did Mr. Watson ever inform you that he had met with 
Presidio and that they had indicated to him the chance of 
making a profit from a BLIPS transaction was--I think his words 
were ``possible but remote''?
    Mr. Wiesner. Yes, Senator, I believe--I don't know if he 
sent me the e-mail or just informed me about it. But when he 
did, we would have looked further into the issue and examined 
it in greater detail in order to make ourselves comfortable 
that, in fact, there was an economic profit potential in the 
transaction.
    Senator Coleman. And then Presidio comes back--and Senator 
Levin went into this in a little more detail--with a 
representation saying that there was a reasonable opportunity 
to earn a pre-tax profit. Is that correct?
    Mr. Wiesner. Yes, sir, that's correct. When they came--
after we had met with Presidio and gotten comfortable with 
additional information that we could then rely upon their 
representation.
    Senator Coleman. What kind of additional information did 
they give you to reverse their sense about the possibility of 
pre-tax profit?
    Mr. Wiesner. Senator, at this point I do not have a 
specific recollection of it. I don't know if Mr. Eischeid has a 
more specific recollection.
    Mr. Eischeid. Senator, actually, in terms of the referenced 
meeting, I believe Mr. Watson spoke to April 30 and perhaps May 
1, I was physically present at that meeting, and I came away 
with a distinctly different impression with respect to the 
investment program outlined by the Presidio investment advisory 
firm. And it was not that the possibility of obtaining a profit 
from entering into those transactions was remote.
    Senator Coleman. BLIPS was at least represented as a 7-year 
investment strategy, marketed as such. I understand that all 66 
deals in 1999 closed after the first phase of 60 days, and few 
of the other remaining deals actually transitioned to stage 
two. Can you help me understand how you market something as a 
7-year strategy and yet all the transactions close out in the 
60 days?
    Mr. Eischeid. I think, Senator, as Presidio articulated the 
investment program, it was a multi-stage investment that took 
on varying degrees of risk as the strategy matured and 
progressed. And at any point in time, the investors had a 
choice as whether to contribute additional equity to the 
investment program and to continue their investments in these 
foreign currencies and the like. And certainly one of the 
considerations that those investors undertook was what was 
going to be the income tax consequences of their adoption of 
this investment strategy, and, importantly, as was discussed 
earlier, what would be the consequences that were anticipated 
when they terminated their investment in this strategic 
investment fund.
    Senator Coleman. We had a 15-minute vote posted. What I am 
going to do, Senator Levin, is I am going to finish my 
questioning in just a couple of minutes, and then we will 
adjourn the hearing and come back after the vote. The other 
possibility is I could finish my questioning quickly, go vote, 
you continue, and I will come back. Do you want to keep it 
going?
    Senator Levin. Are there two votes or one, do we know?
    Senator Coleman. Could we check to see whether there are 
two votes or one?
    We touched upon, Mr. Eischeid, the concept of netting at 
the grantor trust level, and it was just touched upon by Mr. 
Watson at the end. Has KPMG engaged in transactions with 
clients or provided the clients with the option of netting?
    Mr. Eischeid. The netting issue was, I think, discussed at 
some length within KPMG, and there was, as you can tell from 
some of the documentation, a rigorous debate and disparate 
views expressed. And from that documentation, you can see that 
my primary objective was to make sure that our professionals 
were not doing something that I would term wrong, that proper 
reporting was occurring.
    When it comes to that type of tax return preparation issue, 
historically our firm has approached that with respect to 
relying on our partners, the individual tax return preparers, 
to analyze the law and to make the proper determination with 
respect to the returns that they are preparing to ensure that 
they are complete and accurate.
    Senator Coleman. Exhibit 38,\1\ Are you the author of a 
memo labeled ``PFP Practice Reorganization, Innovative 
Strategies Business Plan''? Can we show the witness a copy of 
the memos? I just want to know if you are the author. The piece 
that I have, it talks about history, and in the last paragraph, 
the fiscal 2001 IS revenue goal was $38 million, the practice 
is to have $16 million through period ten, the shortfall from 
plan is primarily attributed to the August 2000 issuance of 
Notice 2000-44. This notice specifically described both the 
retired BLIPS strategy and the current SOS strategy. 
Accordingly, we made the business decision to stop 
implementation of SOS transactions and stay out of the loss 
generator business for an appropriate period of time. In 
addition, there is no word that the softening in the overall 
economy, e.g., the decline in new IPOs, the devaluation of 
technology stock valuations, adversely affected our ability to 
broadly sell our modernization tax advisory services suite of 
solutions.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 38 which appears in the Appendix on page 528.
---------------------------------------------------------------------------
    Do you recall whether you--is that your memo?
    Mr. Eischeid. I believe that it was, Senator. It was a 
draft that I put together as I was contemplating what business 
plan that I would put forth for the innovative solutions 
practice.
    Senator Coleman. Let me see if I can kind of sum up the 
environment, because you talk about that in your statement. 
There was a lot of cash being generated and a lot of profit in 
the 1990's, and I take it that you are out there, and Ernst & 
Young and Pricewaterhouse, and everybody is out there and 
coming up with, ``creative solutions in which folks who are 
generating profits, it would mean they pay taxes on that, can 
minimize their tax liability.'' A fair statement?
    Mr. Eischeid. Yes, Senator, I think that our profession was 
actively engaged in reviewing and evaluating and creating what 
we termed solutions or strategies to help our clients minimize 
their tax liability.
    Senator Coleman. And there is nothing illegal about helping 
folks minimize their tax liability.
    Mr. Eischeid. Correct.
    Senator Coleman. But help me understand. As I listened to 
Senator Levin's description of BLIPS and listened to the 
witnesses, it does not seem to be economic substance in there. 
There does not seem to be much at risk. And so help me 
understand how, with all this rigorous review, you in effect 
have these transactions in which there is no real risk, there 
is very limited potential to make real profit, and folks have 
the capacity to write off $20 million, $30 million, or $40 
million. Help me understand how it got to that place and why 
folks think it is OK or thought it was OK.
    Mr. Eischeid. Well, Senator, I think that, first of all, we 
are talking about a period that was several years ago, and we 
are talking about transactions that are admittedly, quite 
aggressive in terms of the application of the tax laws. I think 
that our firm, myself included, believed that those 
transactions were legal and that they met the literal 
requirement of the Internal Revenue Code and the regulations 
and so forth.
    I will tell you here today that our firm would not approve 
that type of transaction to be introduced to our clients, that 
we have made the determination that it is too close to the 
line, so to speak, as to what is more likely than not 
ultimately going to prevail once it is judicially determined.
    Senator Coleman. Thank you.
    We have a vote. What I am going to do is I am going to 
adjourn the hearing for approximately 10 minutes until the 
return of Senator Levin. He will then continue his questioning. 
There are two stacked votes. I will not be back for that since 
I will do the second vote, too, but then I will come back.
    The hearing then will stand adjourned for approximately 10 
minutes until the return of Senator Levin.
    [Recess.]
    Senator Levin [presiding]. We are going to proceed now, and 
Senator Coleman will be back a little later. There is a second 
vote going on, and he is going to wait there for the second 
vote to begin.
    Let me start with you, Mr. Eischeid. Three of the four 
products that we are looking at--FLIP, OPIS, and BLIPS--operate 
in a similar way, and my question to you is this: Isn't it the 
case that all of these are primarily tax-reduction strategies 
that have financial transactions tied to them to give them a 
colorable business purpose?
    Mr. Eischeid. Senator, I am not sure that that would be how 
I would characterize those transactions. I certainly viewed 
them as investment strategies that certainly had a significant 
income tax component to them.
    Senator Levin. My question to you, though, is: Are these 
not primarily tax-reduction strategies?
    Mr. Eischeid. I think you would have to speak to each 
individual taxpayer to ascertain their primary purpose for 
entering into the transaction, and I think you would get 
different answers, depending on which taxpayer that you spoke 
to. I suppose I would also just simply point out that, not to 
get overly technical, but primarily it tends to be a term of 
art in sort of the tax professional world that is very 
difficult, frankly, to pin down.
    Senator Levin. Is it not the case that these were designed 
and marketed primarily as tax-reduction strategies?
    Mr. Eischeid. Senator, I would not agree with that 
characterization.
    Senator Levin. All right. Now, let's look at what other 
parties involved in transactions said about that issue. If you 
look at Exhibit 1d.,\1\ this is a compendium of how other 
parties involved in these shelters characterized them, and it 
is pretty clear what the consensus is here.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 1d. which appears in the Appendix on page 385.
---------------------------------------------------------------------------
    First is a UBS Bank memo regarding FLIP. ``The principal 
design of this scheme is to generate significant capital losses 
for U.S. taxpayers which can then be used to offset capital 
gains which would otherwise be subject to tax.''
    Then there is the memo of one of the investment advisory 
firms involved in FLIP, which was Quadra: ``KPMG approached us 
as to whether we could effect the security trades necessary to 
achieve the desired tax results. The tax opportunity created is 
extremely complex.''
    Then at First Union, now Wachovia, regarding FLIP: ``Target 
customers. Who are the target customers? Capital gain of $20 
million or more. Potential benefits: Individual capital gain 
elimination.'' You do not see anything in there about 
investment, do you?
    And then you have got an HVB employee--HVB is a German 
bank--regarding BLIPS: ``Seven percent is the fee equity paid 
by investors for tax sheltering.'' That is the way that 
particular bank employee looked at it.
    And then you look at a Deutsche Bank internal memo: ``It is 
imperative that the transaction be wound up due to the fact 
that the high-net-worth individual will not receive his or her 
capital loss or tax benefit until the transaction is wound 
up.''
    Now, do you still claim that these tax strategies were 
primarily investment strategies and not tax-reduction 
strategies? Is that your testimony under oath here that they 
were not designed primarily as tax-reduction strategies?
    Mr. Eischeid. Senator, my testimony is that these were 
investment strategies that were presented to individual 
taxpayers that had tax attributes that those investors found 
attractive.
    Senator Levin. Well, let me ask my question again, then. Is 
it your testimony that these were not designed and marketed 
primarily as tax-reduction strategies?
    Mr. Eischeid. Senator----
    Senator Levin. I am talking now about designing and 
marketing. Were these designed and marketed primarily as tax-
reduction strategies?
    Mr. Eischeid. Senator, I can't speak to any and all of the 
marketing activities. You know, for example, you read----
    Senator Levin. Well, just speak to what you know.
    Mr. Eischeid. Thank you----
    Senator Levin. From what you know, were these designed and 
marketed primarily as tax-reduction strategies?
    Mr. Eischeid. And what I know is that they were not, that I 
personally had a number of conversations with clients and 
prospective clients, and they were always characterized as 
investment transactions with a significant pre-tax economic 
purpose that was embedded in the overall transaction.
    Senator Levin. All right. Now, look at what the 
professionals at KPMG said about the purpose of the 
transactions. Take a look at Exhibit 32.\1\
---------------------------------------------------------------------------
    \1\ See Exhibit No. 32 which appears in the Appendix on page 505.
---------------------------------------------------------------------------
    When KPMG and the financial advisory firm Quadra pitched 
FLIP to that UBS Bank, this is how the product was presented. 
Here is the title: ``Generating Capital Losses.'' That is the 
title of the presentation.
    If this is an investment strategy, why does KPMG describe 
it and pitch it to potential partners as a product designed to 
generate capital losses?
    Mr. Eischeid. Senator, I don't believe I've ever seen this 
document before.
    Senator Levin. Well, now that you look at it, can you give 
me an explanation?
    Mr. Eischeid. I don't know what purpose this document might 
have been used for.
    Senator Levin. This was the pitch of FLIP to a potential 
partner bank, UBS.
    Mr. Eischeid. OK.
    Senator Levin. That is the purpose.
    Mr. Eischeid. I'll accept your statement, sir. I have no--
--
    Senator Levin. Now that you know, can you explain why it is 
characterized the way it is?
    Mr. Eischeid. No, sir, I cannot explain why someone used 
that phrase, sir.
    Senator Levin. All right. Now let's look at the strategy 
that you were involved with, Exhibit 41.\1\ This is the 
presentation of BLIPS prepared by Carol Warley. Do you know who 
she is?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 41 which appears in the Appendix on page 536.
---------------------------------------------------------------------------
    Mr. Eischeid. Yes, Senator.
    Senator Levin. All right. She is the BLIPS regional 
deployment champion, is she not? Or was she not?
    Mr. Eischeid. I don't remember her being the regional 
deployment champion, but she may have been, yes.
    Senator Levin. She was intimately involved with BLIPS?
    Mr. Eischeid. Yes, Senator.
    Senator Levin. Now, look at the chart on page 4 of that 
exhibit, if you would.
    ``BLIPS Benefit: Avoid all of the capital gains and 
ordinary income tax. Net benefit to client--effective tax rate 
less after tax cost of transaction of approximately 5 
percent.''
    Are you familiar with that?
    Mr. Eischeid. No, Senator, I'm not.
    Senator Levin. Well, this is BLIPS. You were intimately 
involved with BLIPS, weren't you?
    Mr. Eischeid. Yes.
    Senator Levin. Well, this is your document, isn't it? This 
is a KPMG document.
    Mr. Eischeid. It appears to be a document prepared by Carol 
Warley, yes, sir.
    Senator Levin. She works for KPMG?
    Mr. Eischeid. Yes, she does.
    Senator Levin. Was she wrong? Was she wrong that was the 
purpose of BLIPS? That is the only purpose stated: Avoid all of 
the capital gains and ordinary income tax. Do you see anything 
there about this investment you made reference to?
    Mr. Eischeid. Senator, I have no knowledge of what Carol 
Warley was trying to communicate----
    Senator Levin. Have you ever seen that document before?
    Mr. Eischeid. No, I have not.
    Senator Levin. Is this a KPMG document? Do you know that 
much?
    Mr. Eischeid. It appears to be, yes, Senator.
    Senator Levin. All right. But you don't--you think that is 
inaccurate, that statement?
    Mr. Eischeid. If the statement is that that is the sole 
benefit of BLIPS, then, yes, Senator, I would say that is 
inaccurate.
    Senator Levin. Does BLIPS avoid all of the capital gains 
and ordinary income tax? Is that a benefit of BLIPS?
    Mr. Eischeid. A potential benefit of BLIPS, sir, would be 
the reduction of one's income tax liabilities, yes, Senator.
    Senator Levin. Well, is this accurately stated that a BLIPS 
benefit is to avoid all of the capital gains and ordinary 
income tax? Is that accurate or not? It is a KPMG document. Is 
it an accurate statement or not?
    Mr. Eischeid. When you say a KPMG document, it certainly 
appears to be--to have been prepared by a KPMG professional----
    Senator Levin. It says here KPMG 0049642, proprietary 
material, confidentiality requested. Are you denying this is a 
KPMG document?
    Mr. Eischeid. Senator, at least in terms of your reference, 
I think that's an indication that it is a document that KPMG 
produced, and as you indicated, the cover seems to indicate 
that it was prepared by Carol Warley. I have no indication as 
to what purpose she might have intended to use this document 
for. It does not appear to me, at least on cursory review, that 
it would have been prepared for use in a discussion with a 
client of KPMG.
    Senator Levin. Take a look at Exhibit 18.\1\
---------------------------------------------------------------------------
    \1\ See Exhibit No. 18 which appears in the Appendix on page 459.
---------------------------------------------------------------------------
    Now, this is a document that you signed, and this says, ``A 
number of people are looking at doing BLIPS transactions to 
generate Y2K losses.'' That refers to year 2000 losses. Are you 
familiar with that document?
    Mr. Eischeid. Yes, Senator.
    Senator Levin. Is that accurate?
    Mr. Eischeid. I believe it was.
    Senator Levin. ``We currently have bank capacity to have $1 
billion of loans outstanding at 12/31/99. This translates into 
approximately $400 million of premium. This tranche will be 
implemented on a first-come, first-served basis until we fill 
capacity. Get your signed engagement letters in!! ''
    Are those your words?
    Mr. Eischeid. I believe they were, yes, sir.
    Senator Levin. And then take a look at Exhibit 16.\2\ This 
is from you to Michael Comer. It says here at the top, look at 
the last line in that first paragraph, ``Innovative Strategies 
is a portfolio of value-added products that are designed to 
mitigate an individual's income tax as well as estate and gift 
tax burdens. BLIPS is just one of the products in the 
innovative Strategies portfolio.''
---------------------------------------------------------------------------
    \2\ See Exhibit No. 16 which appears in the Appendix on page 453.
---------------------------------------------------------------------------
    So BLIPS, according to your memo, was ``designed to 
mitigate an individual's income tax as well as estate and gift 
tax burdens.'' Is that true? Was that true when you wrote it?
    Mr. Eischeid. Yes, sir, I believe that one of the 
attributes of the BLIPS strategy was the income tax mitigation.
    Senator Levin. Well, I know you are trying to make it one 
of the attributes, but in your words, it was that this was a 
product ``designed to mitigate.'' Was BLIPS designed to 
mitigate an individual's income tax and estate and gift tax 
burdens? Yes or no.
    Mr. Eischeid. Senator, as I previously testified, I think 
that is one of the attributes that was designed into the 
strategy, both the income tax consequences as well as, as we've 
heard previous testimony on, the economic investment attribute.
    Senator Levin. Do you see anything about investment 
attributes in your memo here as to what it was designed to do? 
Now, you can't blame this on Carol Warley. She wrote the other 
thing. You said, well, you are not familiar with that KPMG 
document, but this one you are familiar with. And here you are 
saying it was ``designed to mitigate.'' My question is: Do you 
see any reference here to investment strategy on that memo of 
yours?
    Mr. Eischeid. No, Senator, I don't. I think that you are 
somewhat reading ``designed'' out of context.
    Senator Levin. Give me the whole context.
    Mr. Eischeid. Well, I think my intention here was to 
reference the innovative strategies in general as a portfolio 
of value-added products----
    Senator Levin. Which are? Keep finishing the sentence.
    Mr. Eischeid. In the aggregate, in general, are designed to 
help mitigate an individual's income as well as estate and gift 
tax burdens. So that the----
    Senator Levin. That is the purpose----
    Mr. Eischeid [continuing]. Entire portfolio and the purpose 
of that portfolio was to aggregate in a sense in a place a 
number of different strategies that taxpayers might be 
interested in discussing that have some significant income tax 
consequence associated with them.
    Senator Levin. When it says BLIPS is one of the products in 
that portfolio, now look at the context. Is there any doubt in 
your mind that it is, according to that previous sentence, 
therefore, a value-added product designed to mitigate an 
individual's income tax as well as estate and gift tax burden?
    Mr. Eischeid. Senator, I don't know how to change my answer 
to----
    Senator Levin. Well, try an honest answer. Just give me a 
direct answer to this. You are making a reference here to a 
portfolio whose purpose is to mitigate on individual's taxes. 
That is what your own memo says--the other ones you said you 
weren't familiar with. They were all KPMG stuff, but you are 
not familiar with that. Now it is yours. You are Jeff. Now, how 
do you avoid looking that straight on and saying, I did say 
that, BLIPS is a product designed to mitigate an individual's 
income tax because it is part of Innovative Strategies 
portfolio?'' Why not just give us a straightforward answer?
    Mr. Eischeid. I'm trying my best, sir.
    Senator Levin. Why isn't that the straightforward answer?
    Mr. Eischeid. I think the straightforward answer is that 
that was one of the attributes of the BLIPS products----
    Senator Levin. One of the attributes.
    Mr. Eischeid [continuing]. And that we certainly recognized 
that and that was one of the factors that our clients were 
quite interested in.
    Senator Levin. Take a look at Exhibit 16--well, let me just 
ask you about the fees. How were the fees priced for BLIPS? 
What fee did you charge your customers?
    Mr. Eischeid. Our fees would vary depending on the 
circumstances. We would negotiate a fee with our clients, 
determine an amount, and put that in----
    Senator Levin. Wasn't it based on the tax loss?
    Mr. Eischeid. I don't believe that we looked at our fee in 
that way, no, Senator.
    Senator Levin. Take a look at Exhibit 16,\1\ near the 
bottom. BLIPS contact, you are the contact here, too. Here is 
the fee. ``BLIPS is priced on a fixed-fee basis which should 
approximate 1.25 percent of the tax loss.'' Are those your 
words?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 16 which appears in the Appendix on page 453.
---------------------------------------------------------------------------
    Mr. Eischeid. Well, my only hesitation is really to try and 
refresh my recollection with respect to this e-mail. It very 
well may have been my words. I don't recall writing that.
    Senator Levin. Is it true?
    Mr. Eischeid. That would not be my view or my testimony, 
sir.
    Senator Levin. It is not your testimony. That is the whole 
point. Was it true or not? Was BLIPS priced on a fixed-fee 
basis approximating 1.25 percent of the net tax loss?
    Mr. Eischeid. In a very indirect way, yes, sir. The fee 
that we would typically use as the starting point of our 
negotiation we developed a shorthand around, which we used as 
1.25 percent of what we referred to as the loan premium amount. 
And as you indicated earlier, that loan premium amount 
translated into tax basis for the investor.
    Senator Levin. And that was the intent, was it not, of that 
premium?
    Mr. Eischeid. I'm sorry. I don't understand the question, 
sir.
    Senator Levin. Was that the intent of the premium, to be 
approximately the net tax loss that the investor would gain 
from this whole transaction?
    Mr. Eischeid. We believed that that was the appropriate tax 
treatment of that loan premium, yes, sir.
    Senator Levin. Was that the tax loss which you told 
taxpayers that they could expect, approximately, from this 
transaction?
    Mr. Eischeid. We generally told taxpayers, I believe, that 
the tax treatment of that loan premium, whatever that amount 
would be, should translate into tax basis for them, yes, sir.
    Senator Levin. Tax basis which would be then deducted from 
any capital gain or income that they had?
    Mr. Eischeid. Depending on what ultimately happened with 
that tax basis, yes.
    Senator Levin. Was it the intent to be something which 
would be a deduction from their income?
    Mr. Eischeid. I think the answer would generally be yes, 
that the taxpayers would anticipate using that tax basis at 
some point in time and reflecting that on their income tax.
    Senator Levin. They were so informed of that, were they 
not?
    Mr. Eischeid. Yes, sir. I mean I believe they were informed 
as to the tax consequences of their participation in the BLIPS 
investment program.
    Senator Levin. My time is up. Thank you.
    Senator Coleman. Mr. DeLap, because you did not give an 
opening statement, I just want to do a little background here. 
Can you tell us what position you held at KPMG during the 
period that FLIPS, BLIPS, OPIS and SC2 strategies were being 
developed and marketed?
    Mr. DeLap. In February 1997, I became a partner in charge 
of a newly-created Department of Professional Practice Tax, and 
I held that position until June 30, 2002, at which time I 
turned it over to my successor, and then I retired from the 
firm on September 15, 2002.
    Senator Coleman. Could you tell us what your 
responsibilities entailed?
    Mr. DeLap. The responsibilities generally related to seeing 
that firm personnel complied with various regulatory rules, 
Internal Revenue Service, SEC, AICPA, and State accountancy 
boards. It entailed helping set policy, recommending policy 
changes to leadership, involved making revisions as necessary 
to the firm's tax services manual, involved an annual quality 
performance review of the tax personnel in the various 
operating offices relative to compliance with firm policies and 
procedures. It included review of all contingent fee engagement 
letters to determine whether they complied with rules of the 
SEC, AICPA, and State boards accountancy.
    Senator Coleman. Did you have any role in the approval of 
the aforementioned strategies, the FLIPS, the OPIS, or the 
BLIPS?
    Mr. DeLap. With respect to tax strategies intended to be 
discussed with multiple clients, the rule was to review those 
strategies from a policy standpoint, to determine that the 
manner in which they were taken to clients, complied with the 
various regulatory rules and firm policy.
    Senator Coleman. So you were involved then in the process, 
had a chance to raise concerns prior to approval?
    Mr. DeLap. That is correct.
    Senator Coleman. In regard to BLIPS strategy, during your 
review is it correct that you raised over 20 points that needed 
to be resolved prior to your approval?
    Mr. DeLap. As I recall, I received a proposed pro forma--
proposed model tax opinion regarding BLIPS that set forth the 
facts, discussion and technical analysis, I think, sometime in 
April 1999. I read that proposed opinion, and as I recall I had 
a list of 29 concerns that I sent back to Washington National 
Tax for further development.
    Senator Coleman. Did you also share the concern about the 
couple mentioned before, the client ability to make a profit, 
and also I think the question of who is the borrower? Did you 
have concerns about those issues?
    Mr. DeLap. Yes.
    Senator Coleman. Do you recall whether those concerns were 
ever satisfied, were ever resolved to your satisfaction?
    Mr. DeLap. Ultimately I determined that the analysis 
prepared by Washington National Tax, the final analysis, I 
thought addressed those concerns.
    Senator Coleman. Help me understand, how do you get an 
opinion issued, a more likely than not opinion issued when--and 
it is easy in hindsight, we are looking back at this now, and I 
presume it is tough sitting down there, but we are looking back 
at this and we are seeing stuff that did seem to be substance, 
did not seem to be risk, did not seem to be profit, seemed to 
be transactions that you can lay out on a chart, but nothing 
you can put your hands around. How do you get to a more likely 
than not analysis based on that? I learned in law school not to 
ask more than one question, but I am asking more than one 
question. See if you can pull them together. Did you get to 
that more likely than not because folks simply thought the IRS 
would not know or did not have the resources or would not 
pursue it, or was there a valid intellectual basis for that 
more likely than not opinion?
    Mr. DeLap. I believe, Senator, that it was based on a 
rigorous analysis of the technical rules. The analysis and the 
conclusion, from a technical standpoint was reached by 
Washington National Tax, so I might need to deflect that 
particular question to Mr. Wiesner.
    Senator Coleman. Mr. Wiesner.
    Mr. Wiesner. If I can supplement Mr. DeLap's answer. We 
came to the conclusion--we started in February 1999, and had 
intensive meetings with the Presidio people and their economic 
people. They laid out the transaction for us. At the end of the 
first meeting we had everybody around a table. We had the 
Presidio people leave, and put on a white board all the issues 
that we saw that were raised in the discussion, assigned those 
issues out to an appropriate technical resource within 
Washington National Tax, and then over a series of the next 2 
months, 3 months, tried as best we could to resolve the issues 
that had been raised. And it was only after spending probably 
about 1,000 hours of time that we were able to arrive at our 
more likely than not conclusion.
    Senator Coleman. From a lay person sitting here, the sense 
is that there is a lot of money to be made here, and revenues 
are driving outcome. How much of a factor did revenues play in 
these decisions?
    Mr. Wiesner. Senator, from my point of view, money was not 
a consideration. We certainly were aware at Washington National 
Tax that this was an item of priority for the PFP practice, but 
the practice that we keep the resources assigned to the project 
and deal with the issues, and tell us sooner rather than later 
whether you can or cannot get to the more likely than not level 
of comfort.
    Senator Coleman. You did on BLIPS though, $53.2 million in 
fees?
    Mr. Wiesner. Being in Washington National Tax, which we are 
not in the operating office, I'm not familiar with the exact 
amount of fees, Senator.
    Senator Coleman. I will go back to Mr. DeLap. This issue of 
registration, I need to understand that. We initially 
understand that you took the position that the BLIPS products 
should be registered as a tax shelter with the IRS, and I heard 
today and understand that BLIPS was never registered. Did you 
agree with the decision not to register?
    Mr. DeLap. The registration statute left the implementation 
interpretation of the statutory words to regulations which were 
originally prepared in the 1980's in response to the syndicated 
tax shelters marketed generally by investment banks back in the 
early 1980's, and it was difficult to--or close to impossible 
in some cases to interpret those regulations as they might 
apply to the type of strategy like BLIPS. My view at the time 
was that it would have been--it would be preferable for 
Presidio to register the strategy, as I viewed Presidio as the 
organizer. I was told that Presidio declined to register. The 
Vice Chairman of Tax discussed the registration issue with the 
partner in charge of the Practice and Procedures Group in 
Washington National Tax, who is the firm's expert on procedural 
matters including registration. His conclusion was, at that 
time, that there was a reasonable basis not to register.
    Based on that technical conclusion by the partner in the 
Practice and Procedures Group, I agreed to permit the strategy 
to go forward without registration.
    Senator Coleman. What is the hierarchy here? What is your 
relationship with the partner in the PFP, Practice and 
Procedures? Do you have any authority over that person? Are you 
on an equal plane?
    Mr. DeLap. I guess it would be parallel. Washington 
National Tax reported ultimately--I don't remember the exact 
layers, but ultimately to the Vice Chairman Tax. I reported to 
the Vice Chairman Tax.
    Senator Coleman. There was a little discussion--I came in 
at the tail end of it--of confidentiality, having BLIPS clients 
sign a confidentiality agreement. Did you have any problem with 
that?
    Mr. DeLap. At the time a nondisclosure agreement relative 
to tax strategies was common in the profession, so at the time 
I did not have a problem with that as such.
    Senator Coleman. Let me just get to the termination of the 
marketing of BLIPS, which I believe was at the end of 1999?
    Mr. DeLap. Yes, it was, I think in the fall of 1999.
    Senator Coleman. Did you have any involvement with KPMG's 
decision to terminate the marketing of BLIPS?
    Mr. DeLap. When I approved BLIPS from a policy standpoint, 
I set forth a list of conditions under which it would need to 
be offered. One of those conditions was that it would be 
offered to a limited number of individuals who were individuals 
who understood the investment and tax risk involved, and that 
Doug Ammerman and I would discuss at which point the marketing 
should be terminated. I believe that we had that discussion, I 
think in October 1999, maybe November 1999, and determined at 
that time there should be no further approaches to potential 
clients regarding BLIPS.
    Senator Coleman. A cynic might say that the more 
transactions, the greater chance of being on the IRS's radar. 
Any substance to that cynicism?
    Mr. DeLap. The way--I viewed it somewhat differently. I 
expected that the transactions, being large transactions, would 
be picked up on audit. My concern was that if there were an 
unlimited number of taxpayers entering into similar 
transactions, that the likelihood that a court would invoke the 
Step Transaction Doctrine, would go way up. So I thought it was 
important relative to the overall analysis that there be a 
limited number.
    Senator Coleman. Thank you. Senator Levin, a short follow-
up round.
    Senator Levin. Thank you, Mr. Chairman.
    I want to go back to the way KPMG's fees were tied to the 
targeted loss, Mr. Eischeid. Those fees were not tied, as I 
understand it, to the total amount of money managed or the 
amount of profit, if any, made by those investments. Is that 
correct?
    Mr. Eischeid. I suppose, Senator, in the same sense that 
it's referenced to the loan premium. You could use as an 
alternative reference the total amount invested in the 
strategic investment fund. You just really adopt a differing 
percentage to derive sort of the shorthand starting point for 
those fee negotiations.
    But to the second point, there was no contingency around 
our fees. Once we had negotiated an amount with the client, it 
was a fixed amount that the client then agreed to pay us.
    Senator Levin. Typically 1.25 percent of the targeted loss; 
is that correct?
    Mr. Eischeid. Generally, yes, sir.
    Senator Levin. Now let us talk about the comments regarding 
netting and the grantor trust. Mr. Watson, who was one of the 
chief technical persons there, testified that netting gains and 
losses in a grantor trust would then allow individual gains and 
losses to be hidden, and that was not proper.
    If you will look at Exhibit 10,\1\ contains some internal 
KPMG e-mails on this matter. At this point KPMG was discussing 
whether its clients should use that method of netting, and Mr. 
Watson reacted strongly to it. If you look at the two comments 
that Watson made, ``When you put the OPIS transaction together 
with this `stealth' reporting approach, the whole thing 
stinks.'' And the last sentence of the second quote of this e-
mail of Mr. Watson, ``I believe we are filing misleading, and 
perhaps false, returns by taking this reporting position.''
---------------------------------------------------------------------------
    \1\ See Exhibit No. 10 which appears in the Appendix on page 428.
---------------------------------------------------------------------------
    Do you agree with Mr. Watson's position, Mr. Eischeid?
    Mr. Eischeid. Senator, before I answer your question, I 
would like to, if I could, clarify the record. In your previous 
question I had agreed to your statement before you had I think 
completed it, and so I just wanted to clarify that my 
affirmative response is with respect to our fee calculation and 
the loan premium amount.
    With respect to this question, no, I don't agree with Mr. 
Watson's characterization.
    Senator Levin. Here is what you wrote in that Exhibit 10. 
``We concluded that each partner must review the WNT memo and 
decide for themselves what position to take on their returns 
after discussing the various pros and cons with their 
clients.''
    What I do not understand is why is the leader of the group, 
on an issue of this magnitude that is raised by the top 
technical professional on the issue, you tell your colleagues 
that they can do as they see fit. Should not a firm adopt a 
standard position on an issue as controversial as this one, and 
particularly one that results in potentially fraudulent 
returns? Why not a standard position in your firm?
    Mr. Eischeid. Senator, first of all, the reference 
memorandum, which I don't necessarily see here, was prepared by 
the head of the Personal Financial Planning Practice within 
National Tax at the time. And so sometime later Mr. Watson 
expressed his view with respect to the issues addressed in that 
opinion. So what you are witnessing here is really that 
spirited debate that I referenced in my initial comments about 
what is simply the right answer? What is the proper 
interpretation of the law? I don't think that any of the 
professionals viewed it as anything more than that, and that my 
partners are tax professionals, and I trusted their judgment to 
analyze the law and arrive at a correct determination.
    Senator Levin. Did any KPMG clients who utilized BLIPS use 
grantor trusts to net out the losses that were received from 
those strategies?
    Mr. Eischeid. Senator, no, not to my knowledge.
    Senator Levin. Did KPMG ever suggest this to them as a 
strategy? Did you ever sell BLIPS or OPIS on the basis of 
netting gains or losses in a grantor trust?
    Mr. Eischeid. Senator, as I indicated, I don't believe that 
any of our BLIPS clients prepared or had tax returns prepared 
that reflected any type of grantor trust netting.
    I must also point out that when--the IRS's position with 
respect to grantor trust netting--emerged, as we discussed 
earlier, in August 2000, we endeavored to approach all of our 
clients to ascertain whether or not this type of netting might 
have occurred on one of their tax returns, and if so, we 
recommended to those clients, given the articulated position of 
the IRS, that they amend those returns.
    Senator Levin. If you take a look at Exhibit 10 at the 
second from the last page, where it says ``up in the 
Northeast,'' the third line there. ``The short answer to your 
inquiry is,'' see that? ``Up in the Northeast, at least, there 
is quite a bit of activity in the trust area where they used to 
not audit many of these kinds of trusts. They are now auditing 
quite a number of them because they have figured out that 
trusts are a common element in some of these shelter deals.'' 
Do you see that, ``trusts are a common element?'' Was that true 
in the case of BLIPS?
    Mr. Eischeid. Senator, I have no basis to answer that 
question.
    Senator Levin. You are not familiar with this KPMG 
document?
    Mr. Eischeid. I have seen this KPMG document, yes, sir.
    Senator Levin. Is it true that trusts are a common element 
in some of these shelter deals?
    Mr. Eischeid. That would not be my understanding, no, 
Senator.
    Senator Levin. This was a call that you made, as I 
understand, asking a colleague if that colleague had spoken 
with a client whose name is redacted here; is that right?
    Mr. Eischeid. No, Senator, I don't think I had anything to 
do with this particular document.
    Senator Levin. Take a look at the next page. It is a memo 
from you. ``Did you have your `netting' discussions with'' 
blank and blank, redacted because they are clients, ``I need 
copies of the memos of oral advice.'' That is your memo.
    Mr. Eischeid. Yes, Senator.
    Senator Levin. This is the answer to it. So how can you say 
you are unaware of it?
    Mr. Eischeid. My impression, Senator, is that these are two 
totally unrelated documents, separated by 6 months or more.
    Senator Levin. The memorandum here of May 24 is not a 
response to your October document; they are not related?
    Mr. Eischeid. No, Senator. I think the second memorandum 
that you are referring to----
    Senator Levin. Which is the second one, the one on top of--
--
    Mr. Eischeid. October 20 is really referencing those kinds 
of client discussions that I just testified to. After Notice 
2044 came out, and we went back to our clients to ascertain 
whether or not some type of netting activity had been 
undertaken.
    Senator Levin. So whether or not the top document was a 
response to the earlier one or not, you were interested in 
knowing whether there were netting discussions; is that 
correct? And it related to FLIP; is that correct?
    Mr. Eischeid. This particular, the dialogue between myself 
and another of our partners related to a FLIP transaction, yes, 
Senator.
    Senator Levin. The short answer is yes. My question is, 
that that document asking your colleague whether you had 
netting discussions, related to FLIP; is that correct? And the 
answer is yes, is it not?
    Mr. Eischeid. Yes, this related to FLIP, correct.
    Senator Levin. Mr. Manth--well, let me ask Mr. Wiesner. I 
have a little time left. You are the partner in charge of the 
Washington National Tax Office during the BLIPS review. Exhibit 
65 \1\ is a May 7, 1999 e-mail from Mr. DeLap. He forwards an 
e-mail from Mark Watson, who reports that based on new 
information he had just learned at a meeting with Presidio on 
BLIPS that he is no longer comfortable with the BLIPS product 
because there is only a remote possibility of making a profit, 
and the bank controls the loan proceeds, so it is doubtful it 
is not even a real loan. He also reports that another technical 
reviewer at WNT is concerned about who is the borrower, and Mr. 
DeLap recommends not moving forward until these issues are 
resolved.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 65 which appears in the Appendix on page 623.
---------------------------------------------------------------------------
    Then, Mr. Wiesner, on May 7 and May 10 you meet with Mr. 
Rosenthal and Mr. Watson to discuss their concerns. You 
announce that the decision was made to move forward. You 
overruled your technical people on this, did you not?
    Mr. Wiesner. Senator, what was reflected here was on--when 
we started our discussions of whether or not we could arrive at 
a more likely than not opinion in January. After 2 months of 
deliberation, I had believed, because I thought I had received 
everyone's sign-off, that we had arrived at a more likely than 
not conclusion. Mr. DeLap then began his review of the 
transaction, and there were some follow up e-mails and 
memorandums such as this memorandum on Friday, May 14.
    To the extent that there were issues raised that were new 
issues raised concerning the transaction, yes, we took those 
very seriously.
    Senator Levin. One of the issues is whether or not the 
representations which are material to your firm's tax opinion 
are credible; is that correct?
    Mr. Wiesner. Yes, sir, that is correct.
    Senator Levin. Whether those representations are credible. 
If you take a look at Exhibit 7,\2\ you wrote this memo on 
February 7.
---------------------------------------------------------------------------
    \2\ See Exhibit No. 7 which appears in the Appendix on page 415.
---------------------------------------------------------------------------
    ``Last, an issue that I am somewhat reluctant to raise, but 
I believe is very important going forward concerns the 
representations that we are relying on in order to render our 
tax opinion on BLIPS I. In each of the 66 or more deals that 
were done last year, our clients represented that they 
`independently' reviewed the economics and had a reasonable 
opportunity to earn a pre-tax profit. Also, they had no 
`agreement' to complete the transaction in any predetermined 
manner, i.e., close out the deal on 12/31 and trigger the 
embedded tax loss.''
    Now your writing. ``As I understand the facts, all 66 
closed out by year-end and triggered the tax loss. Thus, while 
I continue to believe that we can issue the tax opinions on 
BLIPS I, the issue going forward is can we continue to rely on 
the representations in any subsequent deals if we go down that 
road?''
    Now, when you were confronted with that evidence--66 out of 
66, that is not a coincidence--what did you do? Did you 
evaluate whether KPMG should rely on the client's 
representations for these BLIPS deals?
    Mr. Wiesner. Senator, in the memorandum we are referring 
to, the e-mail which was February 24, the first paragraph of 
the e-mail was my conclusion that we still could issue a more 
likely than not tax opinion. We had considered----
    Senator Levin. Is this for the ones that existed, or for a 
new one?
    Mr. Wiesner. This was for the 66 transactions that we were 
talking about for 1999.
    Senator Levin. Let us separate those out for the moment. 
You said later on in that memo, going forward, the issue is 
whether we can continue to rely on the representations made.
    Mr. Wiesner. Yes, I did, Senator, because after I made my 
conclusion based on an evaluation of the law, and that is that 
the fact that the 66 people got in and got out, that does not, 
per se, result in the transactions of each individual not 
meeting the economic substance doctrine. But then, looking 
forward and worrying as a professional about the sort of--the 
types of representations we are looking for here and the 
reasonableness of the representations, I had a concern from a 
business point of view of whether we could continue to rely on 
the representations.
    Senator Levin. But you did continue, did you not?
    Mr. Wiesner. I am not sure on that, Senator, but if in fact 
we did, a determination was--my----
    Senator Levin. You are not sure whether you continued to 
sell BLIPS deals?
    Mr. Wiesner. Senator, this memorandum really was my last 
involvement in the BLIPS transaction.
    Senator Levin. Well, let me tell you, you did continue to 
sell BLIPS deals. Now, does that trouble you?
    Mr. Wiesner. Well, Senator, I would have to look and 
examine the issue as we did for the 1999 deals and determine, 
again, whether there was a reasonable basis for each of the 
individuals to make their representation. And that was an issue 
for 1999 as well as going forward that I and Washington 
National Tax wasn't in a position to make.
    What I did to follow up was talk to Mr. Eischeid and to 
make sure that Mr. Eischeid and the people in the field who 
were dealing with the clients would explore the issues.
    Senator Levin. I don't see how in heaven's name as a tax 
professional you raise an issue, 66 out of 66 representations 
turn out not to be accurate. And you raise first the question 
as to whether you ought to issue the opinions that you 
subsequently issued. But then you say going forward. Going 
forward. Now you raise an issue. What about future deals? 
Should we continue to sell this? Should we continue to rely on 
these representations that are unanimously disproved by the 
facts?
    These are not credible representations. You put them in 
your client's mouth. You folks write the representations. There 
is no prospect of a profit on the investment. Sixty-six times 
out of 66 that turns out to be the case. You raise the 
question, and then you continue to go forward as a firm anyway. 
You continue to sell this tax deal.
    Mr. Eischeid. Senator, I am certain that I don't agree with 
your characterization. We don't believe that the 
representations that our clients made to us were false and that 
it is----
    Senator Levin. It turned out not to be true 66 out of 66 
times. Would you agree with that?
    Mr. Eischeid. No, Senator, I would not. I think the 
representation that we're speaking to is that the client at the 
time that they entered into the transaction believed that they 
had a reasonable opportunity to make a profit from their 
investment transaction. I think that's the representation and--
--
    Senator Levin. Mr. Wiesner, you said, ``My recommendation 
is that we deliver the tax opinions in BLIPS I and close the 
book on BLIPS and spend our best efforts on alternative 
transactions.'' The firm did not do that. They did not follow 
your advice. Should they have?
    Mr. Wiesner. Senator, my responsibility was, again, as a 
technical reviewer of the transaction and coming to my 
conclusion with respect to the transaction and what we should 
do. I made the recommendation from my own personal view and in 
my own judgment, and--but I was not the person who would 
ultimately make the decision.
    Senator Levin. Does it trouble you the firm went forward 
and continued to sell BLIPS? You were troubled when you wrote 
the memo. Are you troubled now when I tell you the firm went 
ahead and sold BLIPS, more BLIPS? Does that bother you?
    Does anything bother you? Now I am asking you a direct 
question. You made a recommendation, Mr. Wiesner. You are a 
professional. You recommended to your firm that they stop 
selling BLIPS. They didn't. My question: Does that bother you?
    Mr. Wiesner. Senator, I was--again, in the context of the 
situation, I was making my own personal recommendation in terms 
of what I thought was a course of action. This is an area of 
very complex, difficult interpretation of the law, application 
of the facts to the law, and I made my best determination and 
made my recommendation.
    Mr. Eischeid. And, Senator, I might point out----
    Senator Levin. Could you answer my question?
    Mr. Eischeid. I am sorry.
    Senator Levin. Are you going to answer my question? I know 
it was a personal recommendation of yours. That is my question. 
Are you personally bothered by the fact that your 
recommendation was not followed?
    Mr. Wiesner. Would I have preferred that my recommendation 
were followed?
    Senator Levin. Yes.
    Mr. Wiesner. Yes.
    Senator Levin. Thank you, Mr. Chairman.
    Senator Coleman. Thank you. We will excuse the panel and 
now call our next panel.
    Senator Levin. Mr. Chairman, I do have questions for the 
record for the witnesses that I did not get to, and I am 
wondering if the record can be kept open for those witnesses.
    Senator Coleman. Without objection.
    Senator Levin. Thank you.
    Senator Coleman. I would now like to welcome our third 
panel to today's hearing: Richard Berry, Jr., Senior Partner 
with Pricewaterhouse Coopers, New York City; Mark Weinberger, 
Vice Chair of Tax Services for Ernst & Young, Washington, DC; 
and, finally, Richard H. Smith, Jr., Vice Chair of Tax Services 
for KPMG LLP, New York City.
    Again, I want to thank you for your attendance at today's 
hearing, and I look forward to hearing your testimony.
    Before we begin, pursuant to Rule VI, all witnesses who 
testify before the Subcommittee are required to be sworn. At 
this time I would ask you to please stand and raise your right 
hand. Do you swear that the testimony you are about to give 
before this Subcommittee is the truth, the whole truth, and 
nothing but the truth, so help you, God?
    Mr. Berry. I do.
    Mr. Weinberger. I do.
    Mr. Smith. I do.
    Senator Coleman. As I have indicated to witnesses before in 
the other panels, I would like you to confine your testimony to 
5 minutes in a statement but that your entire written testimony 
will be entered into the record.
    We will start with Mr. Berry, who will go first, followed 
by Mr. Weinberger and finish up with Mr. Smith. And after we 
have heard all the testimony, we will turn to questions.
    Mr. Berry, you may proceed.

  TESTIMONY OF RICHARD J. BERRY, JR.,\1\ SENIOR TAX PARTNER, 
        PRICEWATERHOUSE COOPERS LLP, NEW YORK, NEW YORK

    Mr. Berry. Thank you. Good afternoon, Chairman Coleman and 
Senator Levin. I am Rick Berry, and I serve as the national 
leader of Pricewaterhouse Coopers tax practice. I am pleased to 
be here today to discuss the important topic of abusive tax 
shelters.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Berry appears in the Appendix on 
page 303.
---------------------------------------------------------------------------
    Let me say right at the outset that we share the 
Subcommittee's concerns about the impact that abusive shelters 
have on our tax system. I welcome the opportunity to discuss 
our own experience with the Subcommittee. I know you have had a 
long day so far, so I will briefly summarize my written 
testimony.
    From 1997 to 1999, we had a small group of less than 10 
people who worked on three tax shelters known as FLIP, CDS, and 
BOSS. The BOSS transaction triggered widespread public 
attention and controversy in the fall of 1999. As a result, we 
decided that we had made a regrettable mistake being in this 
business. Our reputation was hurt, our clients and people were 
embarrassed, and it was incompatible with our core business.
    We got out of this business immediately. We established an 
independent and centralized quality control group. We 
strengthened our procedures to ensure that we would never again 
engage in this type of activity. We decided the appropriate 
course of action was to shut down the BOSS transactions and 
refund all the fees we had received.
    Not one of the BOSS transactions was ever completed. We 
also never, I repeat, never did any of the so-called Son of 
BOSS transactions. We stopped doing FLIP and CDS as well. We 
have now been out of this business for almost 4 years.
    Not long after this, the IRS contacted our firm to review 
our compliance with the registration and list maintenance 
requirements of the tax law. The next step to putting this 
behind us was to work with the IRS to resolve any issues 
relating to our registration and list maintenance obligations. 
We fully cooperated with the Service. We reached a closing 
agreement in June 2002 and made a settlement payment. We agreed 
to provide the IRS with over 130 tax planning strategies for 
their review. They are in the final stages of this review, and 
no issues have been raised.
    The IRS also reviewed our quality control procedures and 
told us they were comprehensive, thorough, and effective. We 
continue to cooperate with the Service and fully abide by the 
terms of our agreement.
    Our experience almost 4 years ago served as a wake-up call 
to our tax practice. Our partners were adamant that we get out 
of this business immediately. We took the unusual step of 
shutting down the largest transaction and returning all of our 
fees. We settled with the IRS. We implemented comprehensive 
quality control procedures to ensure that the firm would never 
again be involved with potentially abusive tax products. We 
take responsibility for our actions, and we have learned from 
our mistakes. As a result, our tax practice is once again 
dedicated to the core values on which our firm was founded.
    Thank you for the opportunity to testify before you today. 
I look forward to your questions.
    Senator Coleman. Thank you, Mr. Berry. Mr. Weinberger.

 TESTIMONY OF MARK A. WEINBERGER,\1\ VICE CHAIR, TAX SERVICES, 
               ERNST & YOUNG LLP, WASHINGTON, DC

    Mr. Weinberger. Good afternoon, Chairman Coleman and 
Senator Levin. My name is Mark Weinberger, and I am 
representing Ernst & Young. I appreciate the opportunity to 
participate in addressing the important matters being 
considered by your Subcommittee.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Weinberger appears in the 
Appendix on page 309.
---------------------------------------------------------------------------
    The subject of tax shelters is complex, and the complexity 
begins with the definition of tax shelters. When I discuss tax 
shelters, I am referring to products that have been widely 
marketed that are intended to generate tax benefits 
substantially in excess of any anticipated economic and 
business benefits, generally to shelter income from other 
sources. Beginning in the mid-1990's, these products were 
marketed with increasing frequency by investment banks, law 
firms, financial service firms, accounting firms, and other 
professional service firms, including ours.
    The stock market boom and the proliferation of the stock 
awards in the 1990's created an unprecedented number of 
individual taxpayers with large gains and significant potential 
tax liabilities. Initially, in an effort to be responsive to 
client needs, we and other firms looked for legitimate tax 
planning to try and meet their needs. Perhaps reflecting the 
tenor of the times, these efforts rapidly evolved into 
competitive and widespread marketing of those ideas.
    Selling and marketing are essential parts of any business, 
but we should not allow any part of our tax practice to be 
dominated by a sales mentality. Our past involvement in the 
type of activities that are the focus of this Subcommittee's 
attention is not reflective of our--and we believe your--
expectations of our role as professionals. Ernst & Young has 
more than 23,000 employees in the United States. That number 
includes more than 6,000 professionals in the tax practice who 
provide a wide range of tax services to more than 22,000 tax 
clients. The revenues derived from the work under scrutiny by 
this Subcommittee never accounted for more than one-half of 1 
percent of our firm's revenues. Our core tax practice was and 
is assisting our clients in their efforts to comply with the 
tax laws and reduce their tax liability in a manner that is 
appropriate and consistent with the tax law. We are committed 
to doing business in ways that embody the highest professional 
standards.
    To make sure that we stay true to who we are as a firm, 
since I have assumed responsibilities, we have implemented a 
host of policy, procedural, and organizational reforms designed 
to create the highest quality professional environment. In 
addition, we have entered into a settlement agreement with the 
IRS regarding tax shelter registration and list maintenance 
requirements. And we have disbanded the group that had been 
involved in developing and marketing of tax products of the 
type at issue. This has nothing to do with the merits of the 
transactions; it has to do with who we want to be as a firm.
    We have made a number of organizational changes that are 
relevant in the context of this hearing. Ernst & Young has 
established a new full-time position called Americas Director 
for Tax Quality, who is a senior serving client representative 
who now has full-time responsibility just to look over all of 
our quality initiatives; established a Tax Technical Review 
Committee for each of our key functional areas in tax to 
provide detailed technical reviews of significant issues and 
help assure consistency in interpretation of the tax law; 
established a new tax review board, with members that include 
senior executives from outside the tax practice from our 
general counsel's office and our quality department, to provide 
a firm-level view with respect to tax practices, services, and 
relationships; and established a new tax practice hotline to 
allow employees to provide anonymous input on any matter about 
which they may have concerns.
    In addition to our most recent initiatives, we continue to 
adhere to our policies under which we do not recommend 
transactions that have been listed by the IRS as potentially 
abusive or substantially similar; and, furthermore, we do not 
enter into confidentiality agreements with our clients for tax 
services.
    Finally, as part of our efforts to move forward, earlier 
this year Ernst & Young executed a closing agreement with the 
Internal Revenue Service resolving all issues regarding tax 
shelter rules and regulations. A key aspect of that agreement 
is our commitment to implement a quality and integrity program 
to promote the highest standards of practice and ongoing 
compliance with laws and regulations.
    The agreement includes a significant investment by our firm 
in education, data collection, national review, and annual 
audits of our practices across the country. This will ensure 
consistent quality for our firm and our clients.
    In closing, we believe these initiatives, individually and 
collectively, will foster the highest standards of 
professionalism within Ernst & Young. We believe these policies 
are the right course for our firm and our clients.
    That said, in the years ahead, there surely will be 
disagreements between the IRS and taxpayers. Our tax laws are 
enormously complex, and there is more than ample room for 
disagreement on any number of issues. Where the Service and the 
taxpayers disagree, those differences should reflect well-
reasoned and good-faith interpretations of the rules as applied 
to a particular taxpayer's facts and circumstances.
    Let me assure you that we know who we are and who we want 
to be. We have taken, and are taking, numerous steps to ensure 
that quality and professionalism are the touchstones for 
everything we do.
    Thank you again for the opportunity to discuss our positive 
changes with you, Mr. Chairman and Senator Levin, and I will 
answer the Subcommittee's questions at the appropriate time.
    Senator Coleman. Thank you, Mr. Weinberger. Mr. Smith.

 TESTIMONY OF RICHARD H. SMITH, JR., VICE CHAIR, TAX SERVICES, 
                  KPMG LLP, NEW YORK, NEW YORK

    Mr. Smith. Thank you, Mr. Chairman.
    Mr. Chairman, Senator Levin, my name is Richard Smith. I am 
the Vice Chair of Tax Services for KPMG. While today's hearing 
is focused on certain tax strategies KPMG presented to clients 
in the past, I would like to describe how KPMG's policies and 
practices have changed since then.
    The business and regulatory environment are markedly 
different today than at the time KPMG and its competitors 
presented such strategies, and KPMG has moved forward as well. 
KPMG has no higher priority than restoring public trust in the 
accounting profession. It is no longer enough to say that a 
strategy complies with the law or meets technical standards. 
Today, the standard by which we judge our conduct is whether 
any action could in any way risk the reputations of KPMG or our 
clients. If it could, we will not do it. Our reputation, our 
integrity, and our credibility are simply too important to put 
at risk.
    Some of the more significant changes and new procedures in 
place at KPMG include:
    One, we have substantially changed KPMG's tax services and 
offerings. Today, KPMG offers our clients tax services that are 
tailored to address their distinct business objectives and tax 
planning needs. We no longer offer or implement aggressive 
look-alike tax strategies. In particular, we no longer offer or 
implement FLIP, OPIS, BLIPS, or SC2, or any similar 
transactions. Additionally, KPMG does not and will not accept 
any new engagements for advice and opinions on tax shelters 
that have been listed and deemed abusive by the Internal 
Revenue Service.
    Two, over the past 3 years, KPMG has developed an 
increasingly more rigorous and formal review and oversight 
procedure within our tax practice. All tax strategies must 
undergo three levels of review and approval.
    First, we have created the new position of Partner in 
Charge of Tax Risk and Regulatory Affairs. This partner 
analyzes each tax strategy proposed by the firm to determine if 
it could in any way put KPMG or our clients at risk.
    Second, the partner in charge of our Washington National 
Tax Practice must sign off on the technical merits of all 
significant tax strategies.
    Finally, the Department of Professional Practice-Tax 
reviews all tax strategies to ensure that they are in 
compliance with the firm's policies and procedures. Each of 
these partners has veto power over any tax strategy proposed 
and operate independently from our operations and business 
development functions. If any tax strategy puts KPMG or our 
clients at risk, is not technically correct and defensible, or 
is inconsistent with our policies or procedures, it will not be 
approved.
    Three, we have also revised our procedures with respect to 
list maintenance and registration obligations under the 
Internal Revenue Code. In early 2000, KPMG established a 
practice, procedure, and administration group in Washington 
National Tax as the contact point for analysis of disclosure, 
list maintenance, and registration issues. KPMG's procedures 
and training programs have been updated continuously since that 
time, tracking developments in the law and fine-tuning our 
compliance processes.
    Four, practices and positions focused on look-alike 
strategies are no longer part of this firm. In 2002, two 
practices in particular, Stratecon and Innovative Solutions, 
were eliminated. Many of the partners who were part of these 
practices are no longer with the firm. We have abolished 
positions such as national deployment champions and area 
deployment champions, which were charged with marketing these 
strategies to our clients. We also eliminated the Tax 
Innovation Center, which was responsible for supporting the 
marketing of look-alike tax strategies.
    Five, our tax training program now focuses on technical 
developments rather than marketing strategies. We have 
discontinued weekly tax partner calls, training programs, and 
other activities that primarily focus on marketing. Tax 
partners calls and training now concentrate on changes in the 
law and technical tax developments.
    Six, in 2002, KPMG implemented a firm-wide compliance and 
ethics hotline. This hotline is designed to encourage anyone 
within KPMG to report their concerns about any potentially 
unethical, improper, or illegal conduct within the firm, and is 
in addition to long-standing channels for employee 
communication.
    Seven, we have put in place more stringent rules about 
offering tax services to executives at our SEC audit clients. 
Under the Sarbanes-Oxley Act, the audit committees of our SEC 
audit clients must preapprove all services provided by KPMG, 
including tax services. We have applied this disclosure and 
approval discipline to tax advice offered to executives of SEC 
audit clients.
    Eight, we are constantly looking at additional steps we can 
take to improve and enforce compliance with these policies and 
practices.
    Senator Coleman. If you would just summarize?
    Mr. Smith. I will just sum up and move forward. Thank you, 
Senator.
    Senator Coleman. Thank you.
    Mr. Smith. We encourage anyone at KPMG to bring to our 
attention immediately any actions that are inconsistent with 
these guiding principles and procedures and to suggest 
additional policies or procedures that would help ensure that 
we are providing the highest quality tax services and advice to 
our clients.
    KPMG looks forward to being part of the solution and wants 
to work with Congress as well as the IRS and other policymakers 
as you consider sound and responsible approaches to better 
define what tax strategies are allowable under the law and to 
further strengthen the enforcement of the tax code.
    Thank you, and I look forward to your questions.
    Senator Coleman. Thank you, Mr. Smith.
    First, let me say that I applaud the efforts that you have 
taken and the commitment that you have made to apply the 
highest standards, the sensitivity that we are hearing today 
regarding the impact this has on the reputation of firms and 
the industry. So I want to put on the record my appreciation 
for that.
    At the same time, obviously, as we look back, the past is 
not a pretty past, and part of the concern, as we sit here, our 
job is to figure out where we go from here. Was the past just 
simply a product of the booming 1990's and being awash in cash? 
And the sense I get, gentlemen, is that--and, by the way, not 
just PWC and Ernst & Young and KPMG. We could have had the 
table lined up with everybody in the business, it seems, 
looking for ways to figure out how to wash out profit and to 
limit liability. I mean, that is the reality.
    So the question is: How do we make sure it does not happen 
again? How do we make sure that these statements today that you 
make saying, hey, we have changed our process, we have cleaned 
up our act, will be the reality should this economic engine 
start booming again? And that is a concern.
    I do not think we need to have an IRS agent sitting there 
next to you as you make your policy decisions. But as we look 
at the past, clearly, there is a very sorrowful record, I 
think.
    Mr. Berry, I would take it that you would agree that these 
FLIP, BOSS, CDS things, as you look back, lacked economic 
substance.
    Mr. Berry. Mr. Chairman, with respect to the BOSS 
transaction, which we did not do, that in my judgment is an 
abusive shelter, or would have been.
    With respect to FLIP and CDS, if not abusive, they come 
very close to that line. They do not meet our quality 
standards. We regret that we ever got involved in those 
transactions, and we would not do them today.
    Senator Coleman. Would you have an opinion on BLIPS?
    Mr. Berry. I am not familiar with those transactions. We 
never did them.
    Senator Coleman. We talked about registering a little bit, 
and perhaps, Mr. Weinberger, on that issue. My concern is the 
lack of registration service as the way to keep things under 
the radar. Would you agree with that?
    Mr. Weinberger. Senator, I agree that transparency and the 
ability for the IRS to be able to identify transactions quickly 
and respond is absolutely a cornerstone to being able to deal 
with this process going forward. And that involves registration 
on the part of promoters. It involves disclosure by taxpayers. 
And it involves the list maintenance rules that the IRS also 
passed.
    Senator Coleman. How do we ensure that there is 
transparency on a regular basis? Is it going to require more 
legislation?
    Mr. Weinberger. Well, Senator, since the original 
transactions that were discussed today and others that are out 
there have occurred, there have been significant regulatory 
changes, and there are legislative changes before the Senate 
Finance Committee. The environment has changed in many ways, 
not the least of which is the disclosure rules are now more 
aligned with the registration and list maintenance rules, which 
creates a web so that not only will individuals have to 
disclose transactions, but the promoters are supposed to 
register them and maintain lists as a mechanism to be able to 
give the IRS the information to be able to actually know when 
those transactions occur and to respond appropriately.
    Senator Coleman. Mr. Smith, does KPMG have internal 
controls regarding to ensure that IRS registration requirements 
are met?
    Mr. Smith. Yes. Certainly over the years, we have improved 
our policies and procedures to reflect not only the changes 
that have taken place in the law and regulations, as Mr. 
Weinberger described, the changes in the disclosure rules as 
well as the listing requirements. But we have put in policies 
and procedures that go beyond those particular rules that I 
think are helpful in addressing the concerns that you are 
talking about today.
    For example, for us we think transparency is so important 
that we are going to err on the side of registration beyond 
what might be required in the law and regulations.
    Senator Coleman. One of the areas of questioning that was 
generated by my distinguished Ranking Member, Senator Levin, 
had to do with the fee structure. To me, why not base fees on 
profits that would be generated by a transaction, if you really 
believe that, versus fees that are being generated due to the 
amount of loss you are going to take? I mean, it is clear that 
that was the standard.
    Is that something that needs to be dealt with 
legislatively?
    Mr. Smith. I think that there are a number of different 
ways that fees could be structured, and I think there have been 
some significant changes that have occurred over the past 
couple of years.
    Mr. DeLap talked about the changes with regard to 
contingent fees. We think that those were good changes and 
certainly have focused on how do we bring transparency to our 
fees as well as bring transparency for the government into the 
transactions in which we are involved.
    Senator Coleman. And, again, to note from an industry-wide 
perspective, I take it, Mr. Weinberger, that Ernst & Young also 
used a fee system based on taxes avoided under the shelters in 
the past. Is that correct?
    Mr. Weinberger. Senator, we had fixed fees that were based 
on investments which were attributable to the losses.
    Senator Coleman. Has that process been changed today?
    Mr. Weinberger. Yes, the AICPA and the SEC have rules on 
contingent fees, and obviously we need as an industry to comply 
with all of those. The vast majority of work that our firm does 
is hourly based. There are certain circumstances where they are 
specifically allowed to have value-billing based on the 
complexities of different transactions or the investment 
involved.
    Senator Coleman. And my last question, because I am trying 
to figure out where we go from here, and I could spend a lot of 
time getting very angry, as my colleague, I think justifiably, 
from Michigan has been as he has looked at the amounts of tax 
avoidance as a result of these schemes and the impact that it 
has.
    Gentlemen, I would like you all to respond. Talk to me 
about the lessons you have learned what the industry as a whole 
should take from what we have discussed today, and where does 
the tax adviser industry go from here? Where do we go from a 
legislative perspective as well as from an internal 
perspective? And I take it your statements of the controls you 
set in place perhaps have answered that, but I would like your 
sense. Is there more legislation that we are going to have to 
enact in order to keep the reins on this thing and ensure that 
people meet the highest quality ethical standards? Mr. Berry.
    Mr. Berry. Yes, my firm is very supportive of additional 
legislation, particularly in the areas of increased disclosure, 
both on the part of the taxpayer and the tax preparer, and 
definitely increased penalties.
    Senator Coleman. Mr. Weinberger.
    Mr. Weinberger. Senator, I think that legislation will 
never solely prevent individuals, if they do not step up to the 
plate and do the right thing. So I think it takes our part as a 
professional service firm. I think it does take the IRS 
following up on the transactions they identify. I think the 
transparency and disclosure rules are crucial. We have an 
incredibly complex tax code. I am not Pollyanna-ish enough to 
think that we are going to simplify it, but that would 
certainly be a huge benefit to dealing with those who want to 
aggressively use the tax code in ways that take advantage of 
the complexity. And like Mr. Berry, I do think the cost/benefit 
analysis of looking at whether or not when you give advice you 
are following the rules, it should be further analyzed, 
absolutely.
    Senator Coleman. Mr. Smith.
    Mr. Smith. Yes, I think all of the component pieces of the 
system are important to improving compliance with the tax code. 
The IRS, clients, tax advisers, Congress--I think all of those 
are important in terms of the policies that they set.
    At the end of the day, it is how a professional feels about 
themselves and how they feel that they should conduct 
themselves, and that is part of setting the tone at the top 
within each of those organizations and institutions. And it is 
about executing on setting the highest professional standards 
and making sure that we live up to those.
    So I think the internal controls and changes that have been 
made by certainly the three firms before you right now, as well 
as the changes with regard to listing and disclosure that apply 
to the firms and apply to the taxpayers, are important 
developments in the entire system.
    We certainly support anything that relates to further 
transparency and enforcement of that transparency.
    Senator Coleman. Thank you, Mr. Smith. Senator Levin.
    Senator Levin. Thank you, Mr. Chairman.
    I am glad one of you mentioned the need to increase 
penalties. The current penalty for promoting an abusive tax 
shelter is $1,000. Now, there is no way that that is anything 
other than a parking ticket. And when professionals promote 
abusive tax shelters, it seems to me that the penalty has got 
to be similar to what the penalty is paid by the taxpayer that 
they are advising and putting documents into the hands of. And 
so one of the provisions of the bill which we will be 
introducing will be increased penalties, but they are going to 
be significant because the current penalties of $1,000, I think 
a maximum of $10,000 for a similar violation, is a joke. And it 
is a pitiful joke.
    Mr. Smith, your prepared statement says on page 4 at the 
top that in 2002, KPMG eliminated two tax groups that ``were 
responsible for developing tax strategies specifically designed 
to be presented to multiple clients, Stratecon and Innovative 
Solutions.'' And when did that happen in 2002?
    Mr. Smith. That happened as I came on as the Vice Chair of 
Tax, Senator, which would have been in April.
    Senator Levin. Of last year?
    Mr. Smith. Yes.
    Senator Levin. Well, when you look at Exhibit 89,\1\ if you 
would take a look at your exhibits, this is the organizational 
chart for KPMG for 2003 that your firm supplied to the 
Subcommittee in February of this year in response to the 
subpoena.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 89 which appears in the Appendix on page 680.
---------------------------------------------------------------------------
    Now, we asked for organizational charts for each of several 
years so we could understand the way your firm is organized. 
The 2003 chart still lists Stratecon. How do you explain that?
    Mr. Smith. This organizational chart is inaccurate.
    Senator Levin. Your own organizational chart is inaccurate?
    Mr. Smith. This particular version----
    Senator Levin. Your own organizational chart is inaccurate? 
Is that what your testimony is?
    Mr. Smith. This version that you have is not accurate in 
terms of----
    Senator Levin. This is your document, KPMG 000001. I mean, 
this is what you supplied to us. This is the first document you 
supplied to us in response to a subpoena. Are you testifying 
that the document you supplied us showing your organizational 
makeup for 2003 was inaccurate?
    Mr. Smith. I think it reflects a change in one box in this 
particular organizational chart which has me as the Vice Chair 
of Tax. There are numerous--as I just perused over this 
particular organizational chart before me, there are numerous 
errors in terms of the organization.
    Senator Levin. All right. I just want to make it clear. 
This is the chart that your firm supplied to us. Is that 
correct?
    Mr. Smith. I suspect it is, Senator.
    Senator Levin. Can you get us an accurate chart?
    Mr. Smith. Yes.
    Senator Levin. Because I think the Subcommittee has a right 
to expect when we subpoena documents that you will give us 
accurate documents. Is that a fair expectation, would you say?
    Mr. Smith. I would have expected that you would have 
received something other than a draft organizational chart.
    Senator Levin. Was this a draft that you submitted to us?
    Mr. Smith. Let me restate that, sir. This document that you 
have does not reflect our organization.
    Senator Levin. OK. Now, it also refers to a PFP, Personal 
Financial Planning, as I understand it.
    Mr. Smith. Yes.
    Senator Levin. Innovative Strategies, do you see that?
    Mr. Smith. I don't see----
    Senator Levin. Do you see where it says PFP Inno Strat, J. 
Eischeid? Do you see that, the third column?
    Mr. Smith. I'm sorry. I don't.
    Senator Levin. Excuse me, J. Eischeid.
    Mr. Smith. Oh, I do see it, yes.
    Senator Levin. OK. It doesn't refer to Innovative 
Solutions, which your statement refers to.
    Mr. Smith. Innovative Strategies or Innovative Solutions--
--
    Senator Levin. They are the same?
    Mr. Smith [continuing]. Was a practice that we no longer 
had after I became Vice Chairman, notwithstanding what is 
reflected on this organizational chart.
    Senator Levin. We can't find Innovative Solutions, which 
your testimony referred to, in any of your charts. It is always 
Innovative Strategies.
    Mr. Smith. Well, the two practices, Senator, that I focused 
on when I became Vice Chair in terms of making some changes to 
our focus and to our business were Stratecon and Innovative 
Strategies or Innovative Solutions.
    Senator Levin. To either name, is when you----
    Mr. Smith. Either name from my perspective.
    Senator Levin. I have got you.
    Mr. Smith. It is the practice that was represented by this 
prior organizational chart.
    Senator Levin. OK. I want to ask about another document. 
This is a proprietary document which we are going to put in 
front of you. We did not put it in our documents because it is 
proprietary. It is a long one.
    Mr. Smith. Thank you.
    Senator Levin. It is dated November 26. Do you see that?
    Mr. Smith. Yes, Senator, I do.
    Senator Levin. OK. Now, if you take a look at about the 
eighth line on the left, it still shows Stratecon there. You 
said that you eliminated it in April 2002.
    Mr. Smith. Yes.
    Senator Levin. We have a date, November 26, 2002, which 
still shows Stratecon, and it still shows Solutions in 
Development. How do you explain that?
    Mr. Smith. Yes. As I came in to serve as the Vice Chair of 
Tax, I made very clear that we were going to make changes to 
our structure in terms of the organization and focused on these 
two in particular, and others.
    This document reflects the fact that the systems that we 
had had not yet been changed at the particular point in time 
when this document was produced.
    Senator Levin. I thought you said you terminated--it is 
just very unclear to me. I thought you said you terminated 
Stratecon when you came in in April 2002. And my question is: 
Why does Stratecon still show as having Solutions in 
Development on November 26, 2002? It is a straightforward 
question.
    Mr. Smith. Yes, and----
    Senator Levin. I don't understand your answer.
    Mr. Smith. Let me try to elaborate on it, Senator, and that 
is, we have a number of systems, accounting systems throughout 
our business, and stand-alone databases in various parts of our 
business, and I believe that this particular document reflects 
a database that was not updated based on the changes that we 
made in our practice.
    Senator Levin. So this document is wrong, too. It wasn't 
updated as of November 26? It was incorrect?
    Mr. Smith. Systems changes in terms of databases do take 
some time to implement, so it is reflective that we had had a 
Stratecon practice and that certain things had been worked on, 
yes.
    Senator Levin. There is an e-mail from Mark Watson, Exhibit 
34,\1\ Mr. Smith, on July 22, 1999.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 34 which appears in the Appendix on page 521.
---------------------------------------------------------------------------
    Mr. Smith. That was Exhibit 34, Senator?
    Senator Levin. Yes, Exhibit 34, to you and Mr. Wiesner. 
This is about the BLIPS economic substance issue. It raises 
questions. It says, ``It seems very unlikely that the rate of 
return on the investments purchased with the loan proceeds will 
equal or exceed the interest charged on the loan and the fees 
incurred by the borrower to secure the loan. . . . Before any 
fees are considered, the client would have to generate a 240-
percent annual rate of return on the $2.5 million foreign 
currencies investment in order to break even. If fees are 
considered, the necessary rate of return to break even would be 
even greater.''
    Mr. Watson also noted that the BLIPS client ``has a 
tremendous economic incentive to get out of the loan as soon as 
possible due to the large negative spread.''
    And then he asked you, ``Before I submit our non-economic 
substance comments on the loan documents to Presidio, I want to 
confirm that you are still comfortable with the economic 
substance of this transaction.'' He had told our staff that he 
never heard from you following that memo. Is that correct?
    Mr. Smith. Well, my recollection doesn't serve me back to 
1999, Senator, but let me provide you some insights that might 
be helpful.
    Senator Levin. I just want to know, because in terms of 
time we are running out. Do you remember responding to this 
memo?
    Mr. Smith. I have no particular recollection of responding 
to this memo, but I know what I would do having read this memo 
right now, and that would have been--he talks about a 
commitment that he has, I think for the following day, and so I 
either would have called him or I would have known that that 
deadline was not something that we needed to meet, and I would 
have gotten back to him either in a general meeting about this 
matter or specifically.
    Senator Levin. All right. Now, turn to Exhibit 13,\2\ if 
you would. This is an August 1999 Mark Watson memo. It says 
before BLIPS ``engagement letters are signed and revenue is 
collected, I feel it is important to again note that I and 
several other WNT partners remain skeptical that the tax 
results purportedly generated by a BLIPS transaction would 
actually be sustained by a court if challenged by the IRS. We 
are particularly concerned about the economic substance of the 
BLIPS transaction.''
---------------------------------------------------------------------------
    \2\ See Exhibit No. 13 which appears in the Appendix on page 450.
---------------------------------------------------------------------------
    And then if you look at the top of the page, you will see 
that Steven Rosenthal responded to Mark Watson that very day as 
follows: ``I share your concerns.'' And then a few lines later, 
``I continue to be seriously troubled by these issues, but I 
defer to Phil Wiesner and Richard Smith to assess them.''
    So now your two professionals seriously question the 
economic substance of BLIPS, and they appear to be identifying 
you as well as Mr. Wiesner as individuals who ignored their 
concern and pushed through the approval of BLIPS. You have 
heard Mr. Watson's testimony. How did BLIPS get approved when 
there are such serious questions about its economic substance?
    Mr. Smith. Well, I certainly don't agree with the 
characterization that we ignored their concerns. If we go back 
and look at the entire time line here, you go back to January 
or February 1999, and there was in-depth consideration of all 
of the issues that were implicated within BLIPS. These are a 
couple among those which where the debate continued. Certainly 
it was encouraged that everybody have the opportunity to raise 
concerns that they had throughout the process at any point in 
the process so that those could be concerned--be considered, 
excuse me.
    Senator Levin. If the professionals in their positions 
today had the same problems with the tax product, would you 
proceed with it?
    Mr. Smith. I would say that if people have technical 
concerns with regard to any matters that we have, that we would 
consider them seriously in our discussion. The difference----
    Senator Levin. I am sure that is what your position is, 
that you would seriously consider them. But given what you know 
now--and I think then from these memos--of their concerns, lack 
of economic substance, no real loan. Over and over again they 
were told. This came to you anyway. Would you override their 
concerns today?
    Mr. Smith. I think our process has evolved in terms of how 
we might address this today. One of the things that we have 
learned in terms of how to deal with these types of issues is 
that we put out as our standard that we got to ``more likely 
than not.'' And we believe that we reached that standard.
    The issue with that standard is that it is close to the 
edge of the cliff. You are up to and--you are not to cross that 
edge. But certainly once you go up there, it is often the 
cautious and the right thing to do to back away and not 
approach these types of issues in the same manner.
    So the change in the way that we would go about this would 
be to consider that and assure ourselves that we are not 
conducting ourselves in a way that would have this same level 
of risk associated with it.
    Senator Levin. Over the last 5 years, Mr. Smith, did KPMG 
encourage the sale of its tax products to potential clients?
    Mr. Smith. We are in a business, Senator, and we do talk to 
our clients about tax advice, and we encourage and talk to our 
professionals about making sure that they represent our clients 
and that they think about their industry and the issues that 
face them and work to represent them fully.
    Senator Levin. Well, it is not a response to the question, 
and I want to ask it--I am going to try it again.
    Mr. Smith. Sure.
    Senator Levin. It is a very significant question. It goes 
to the heart of all of the promoting that you did. You have 
given us a list of all the tax products which you developed, 
which were offered for sale. We have seen the marketing plans, 
the telemarketing, the profiles of likely clients for your tax 
products, the internal databases that were used to develop 
potential client lists for some of your tax products; again, 
your telemarketing center in Fort Wayne, Indiana; the 
unsolicited contacts with clients to tell them of KPMG tax 
products and services; the revenue goals that you set for your 
tax groups; your sales opportunity center that was intended to 
help its personnel sell your tax products.
    I just want to talk now about tax products, and my question 
to you, again, is: Have you over the last 5 years encouraged 
the sale or acceptance of tax products to potential clients?
    Mr. Smith. Certainly our encouragement of our professionals 
to serve their clients has extended over the past 5 years as 
well as before that.
    Senator Levin. I have just got to keep asking it. It is my 
last question. I may have to ask it two or three more times. 
Have you encouraged the sale or acceptance of your tax products 
to potential clients?
    Mr. Smith. We have encouraged our tax professionals to 
advise our clients, and we do that, have contact with----
    Senator Levin. Did that include--look, I have got to just 
keep asking this. Did that include encouraging the sale or 
acceptance of your tax products by those clients?
    Mr. Smith. Well, Senator, I think that----
    Senator Levin. It is a straightforward question.
    Mr. Smith. In a number of different components of our 
business, we talk to our clients in many different ways, over 
the telephone and in writing, in meetings face-to-face, and we 
do encourage our tax professionals to meet with our clients and 
talk to them about the complexities of the tax code and to talk 
about their business and the things that they ought to be 
thinking about from a tax perspective, yes. [Laughter.]
    Senator Levin. Is ``yes'' the answer to my question?
    Mr. Smith. I believe that my entire response was the answer 
to your question.
    Senator Levin. But is the ``yes'' at the end of it intended 
to respond to my question? Did KPMG----
    Mr. Smith. I'm trying to----
    Senator Levin. No, I am sorry. See, you come here and you 
are asking us to believe that you have basically changed your 
ways, things are done differently there now for various 
reasons. And, frankly, I am skeptical. And one of the reasons 
which makes me skeptical is I cannot get a straight answer out 
of you to a very direct question, whether or not KPMG 
encouraged the sale or acceptance of its tax products to 
potential clients. There is a mass of evidence that you did, 
but I cannot get you to say, ``Yes, one of the things we did 
was encourage the sale or acceptance of our tax products to 
potential clients.'' I cannot get you to say that.
    Mr. Smith. Well----
    Senator Levin. Even though it is obviously true. It is as 
clear as the nose on your face that it is true.
    Mr. Smith. I think we are in agreement, Senator, because 
what you just said was one of the things that we do is to 
encourage our professionals, yes, to----
    Senator Levin. No. You just say encourage professionals. 
Look, Mr. Smith, I don't want to play a game with you. I want 
to try to get a direct answer, and I will try one more time. 
But you understand the reluctance to give a direct answer to me 
raises questions about what you are saying that you are trying 
to change your ways or you have changed your ways or you are 
going to through a lot of procedures.
    Now, unless I can get a straight answer to a question that 
has overwhelming evidence in support of a yes answer, I 
cannot--I am skeptical about what you are telling us otherwise. 
So let me ask it one last time.
    Over the last 5 years, is one of the things that KPMG did 
was encourage the sale or acceptance of its tax products to 
potential clients? Can you give me a yes or no answer to that?
    Mr. Smith. I can, Senator.
    Senator Levin. And what is it?
    Mr. Smith. Yes.
    Senator Levin. Thank you. Thank you, Mr. Chairman.
    Senator Coleman. Thank you, Senator Levin.
    With that, the hearing record will be kept open for 3 
weeks. The witnesses are reminded that when answering 
supplemental written questions from the Subcommittee, they will 
still be under oath.
    I want to thank the witnesses for appearing before us 
today. This hearing is adjourned.
    [Whereupon, at 1:10 p.m., the Subcommittee was adjourned.]


   U.S. TAX SHELTER INDUSTRY: THE ROLE OF ACCOUNTANTS, LAWYERS, AND 
                        FINANCIAL PROFESSIONALS

                              ----------                              


                      THURSDAY, NOVEMBER 20, 2003

                                       U.S. Senate,
                Permanent Subcommittee on Investigations,  
                  of the Committee on Governmental Affairs,
                                                    Washington, DC.
    The Subcommittee met, pursuant to notice, at 9:05 a.m., in 
room 216, Hart Senate Office Building, Hon. Norm Coleman, 
Chairman of the Subcommittee, presiding.
    Present: Senators Coleman and Levin.
    Staff Present: Raymond V. Shepherd, III, Staff Director and 
Chief Counsel; Joseph V. Kennedy, General Counsel; Mary D. 
Robertson, Chief Clerk; Leland Erickson, Counsel; Mark 
Greenblatt, Counsel; Steven Groves, Counsel; Frank J. Minore, 
Detailee, General Accounting Office; Kristin Meyer, Staff 
Assistant; Steve D'Ettorre, Staff Assistant; Kevin Carpenter 
(Senator Specter); Elise J. Bean, Staff Director/Chief Counsel 
to the Minority; Bob Roach, Counsel and Chief Investigator to 
the Minority; Julie Davis, Professional Staff Member to the 
Minority; Laura Stuber, Counsel to the Minority; Brian Plesser, 
Counsel to the Minority; Christopher Kramer, Professional Staff 
Member to the Minority; Beth Merillat-Bianchi, Detailee, 
Internal Revenue Service; Jim Pittrizzi, Detailee, General 
Accounting Office; Ken Seifert, Intern; Jessilyn Cameron, 
Brookings Fellow; David Berrick (Senator Lieberman); and Rudy 
Broiche (Senator Lautenberg).

              OPENING STATEMENT OF SENATOR COLEMAN

    Chairman Coleman. This hearing of the Permanent 
Subcommittee on Investigations is called to order.
    I want to begin by thanking my distinguished Ranking 
Member, Senator Levin, again for his work in this area and his 
deep concern for taxpayers, his concern for just kind of a 
fundamental sense of right and wrong in business practices. I 
think when we address those concerns, when we clear up things 
that are very problematic, such as we examined last Tuesday and 
which we will address today, I think we all benefit.
    Senator Levin. Thank you, Senator Coleman.
    Chairman Coleman. On Tuesday, this Subcommittee heard 
testimony under oath concerning the role of major accounting 
firms in the development, marketing, and implementation of 
generic tax products with no substantial economic purpose other 
than to reduce tax burdens, the result being to rob the U.S. 
Treasury of billions of dollars annually.
    Let me begin by saying I am troubled by what I heard on 
Tuesday and troubled by what I did not hear. We had accounting 
firm after accounting firm come forward and tell us, ``Mr. 
Chairman, what we did was wrong.'' Yet, I remain troubled that 
it wasn't some revelation that came to them after the fact that 
what they did was wrong. Common sense would dictate that they 
knew what they were doing was wrong when they were doing it.
    Although the various firms gave tortured explanations of 
multiple levels of review and hours of deliberation they 
engaged in before reaching their decisions of more probable 
than not legality, I think the answer is much simpler. It was 
the 1990's. The surge in the market made many awash in cash. 
There were millions of dollars to be made and everybody else 
was doing it. But the bottom line itsthat it was wrong, it was 
unethical, and in some cases was illegal.
    These sham transactions clearly lacked economic substance. 
Some may have believed there was a loophole that supported 
these transactions, but the lure of millions of dollars in fees 
clearly played a role in the decision on the part of tax 
professionals to drive a Brink's truck through any purported 
loophole.
    Last Tuesday shined a light on a dark and shameful period 
for the accounting industry. That was the past and it must 
remain the past. The future is much brighter. I was bolstered 
by the fact that all the firms said these abusive tax shelters 
are a thing of the past. Some admitted their mistakes. All said 
they would sin no more.
    We heard that many of the people involved in these abusive 
tax shelters are no longer working for these companies, that 
they have put in place policies and procedures that will deter 
such practices in the future, and that they have recommitted 
themselves to the highest ethical and business standards.
    It was obvious last Tuesday and it will be demonstrated 
today that accounting firms did not act alone. Others, 
including otherwise reputable investment advisors, banks, and 
law firms were part and parcel of these fraudulent schemes. 
Moreover, they also provided the added benefit of making 
detection by the IRS difficult. These entities provided a 
veneer of legitimacy for abusive tax shelters that were, in 
fact, illusory or sham transactions with little or no economic 
substance driven primarily for favorable tax consequence.
    Based on PSI's investigation, investment advisors were 
essential for developing and implementing the financial 
transactions for these shelters. In fact, investment advisors 
have been deemed to be promoters of tax shelters bought by the 
IRS for certain sheltered transactions, triggering registration 
obligations.
    However, the Permanent Subcommittee has determined that 
Presidio, an investment firm that clearly promoted at least two 
abusive tax shelters, BLIPS and OPIS, did not register these 
shelters with the IRS. By refusing to register these abusive 
tax shelters, it is obvious that KPMG and Presidio attempted to 
conceal their existence from the IRS. There are others who are 
also complicit--lawyers and bankers who made money, lots of 
money, and had to know what they were doing was wrong.
    This Subcommittee was not playing Monday morning 
quarterback when it focused on these transactions. The players 
in these abusive tax shelters had to know there was no economic 
substance to these transactions and that their efforts to avoid 
IRS detection by failing to register them was part of a 
deliberate cover-up. It seems clear to this Senator that 
ethical concerns were gagged and blindfolded by the lure of big 
dollars.
    Major law firms are essential to the tax shelter business. 
They were routinely utilized by the accounting firms to provide 
tax opinions in order to protect taxpayers from penalties if 
challenged by the IRS. Some firms provided hundreds of cookie 
cutter opinions of various tax schemes. The other firms took on 
the additional role of soliciting, developing, and marketing 
tax schemes. In fact, the IRS has targeted at least two 
prominent law firms as promoters of tax shelters.
    As someone who practiced law for 17 years in the Minnesota 
Attorney General's Office, former Solicitor General of the 
State of Minnesota, I am well aware of the ethical standard 
that requires attorneys to avoid even the appearance of 
impropriety. Based on our investigation, it is difficult for me 
to understand how that standard was not violated in these 
cases.
    In addition, the existence of a closed business 
relationship with KPMG also raises concerns about whether any 
independent analysis and advice was provided. I look forward to 
hearing the testimony of the attorneys involved in these 
transactions.
    And the bankers, I know, take great pride in what they do 
and the code of conduct they insist upon for their employees 
and themselves. Most Americans may not think of bankers as 
their friend next door, but for generations, Americans have 
come to expect that banks are a bastion of fiscal 
responsibility in possession of their money, their savings, 
their hopes, and their dreams. In this case, it appears that 
bankers helped facilitate these transactions for the price of 
admission into a tax shelter business that allowed everyone 
involved to profit.
    Prominent banks provided the necessary loans for tax 
shelters. While the banks have traditionally concerned 
themselves primarily with credit risks, these loans were 
critical for generating the artificial paper losses in the tax 
shelter industry. For the banks involved, these schemes were 
merely a vehicle to generate substantial profits.
    Given the evidence that PSI has uncovered in the sworn 
testimony the Subcommittee has heard, it is imperative to 
ensure that the proper regulatory and oversight framework 
exists to address the myriad of participants involved in the 
tax shelter industry.
    On the last panel, we will hear from the agencies charged 
with enforcing the laws. The Internal Revenue Service is 
primarily responsible for interpreting and enforcing the tax 
laws. High rates automatically create a large incentive to find 
loopholes or tax strategies. The complexity of the tax code 
also reduces the transparency of returns, making it very 
difficult for the regulators to follow what is going on in the 
private sector.
    On Tuesday, the Subcommittee heard testimony that 
accounting and investment firms structured deals to 
intentionally conceal their efforts from the IRS. It is 
imperative that Congress not allow the IRS to become the 
toothless paper tiger that is ignored by those involved in the 
tax shelter industry. We must give them the tools, the 
resources, and the direction necessary for the proper 
enforcement of our Nation's tax laws. Congress must not allow 
the IRS to be an irrelevancy.
    After today's hearing, I intend to discuss with Senator 
Levin what follow-up action we need to take in order to address 
the problems exposed by this investigation. A number of 
potential reforms were discussed at Tuesday's hearings. These 
include more expansive and explicit reporting requirements, 
tougher penalties for noncompliance, and more effective 
internal review procedures within the professional firms 
involved in these transactions. The scope of my response will 
depend very much on the behavior of the professional firms and 
the willingness and ability of the regulators to address these 
issues.
    If Congress needs to act in order to provide more resources 
or to simplify tax laws and close loopholes that are being 
upheld by the courts, then we will do so. Let me be very clear, 
however. I am against additional regulation just for the sake 
of more regulation. The preferable way is professionals who 
self-impose a high ethical standard and to consistently act in 
accordance with those standards without requiring Congressional 
review to highlight transgressions.
    But sometimes, regulations such as the Sarbanes-Oxley Act 
are the only way to restore the public trust without which our 
tax and financial systems cannot work. I do intend to see 
public trust in the application of tax laws restored. Congress 
will take the necessary steps to prevent a recurrence or the 
proliferation of abusive tax shelters.
    With that, the distinguished Ranking Member, Senator Levin.

               OPENING STATEMENT OF SENATOR LEVIN

    Senator Levin. Thank you very much, Mr. Chairman. First, 
let me thank you for these hearings, thank you and your staff 
for all the support that you have given to this investigation. 
It has been critical and the country is very much in your debt 
for doing this.
    Today, as you point out, is the second of 2 days of 
hearings on our year-long investigation into the role of 
professional firms, such as accounting firms, banks, investment 
advisors, and law firms, in the development, marketing, and 
implementation of abusive tax shelters.
    The purpose of the transactions that we have been looking 
at and the transactions creating those shelters wasn't to make 
a profit, but it was to produce a tax loss to offset or to 
shelter income. These transactions were a sham, a deception, an 
abuse of honest taxpayers.
    The first day of hearings focused on KPMG, a leading 
accounting firm that for the past 5 years has been heavily 
involved in the development and marketing of generic tax 
products to multiple clients, including some potentially 
abusive or illegal tax shelters. It took some time at the last 
hearing before KPMG would admit that it has been promoting tax 
products, but in the end, they finally did.
    Today's hearing will examine some of the professional firms 
that have joined forces and worked hand-in-glove with KPMG in 
the tax shelter business--banks, investment advisors, and 
lawyers, without which those abusive tax shelters would never 
have polluted so many tax returns and robbed Uncle Sam and 
average taxpayers of billions of dollars of revenues.
    The Subcommittee's investigation is focused on four KPMG 
tax shelters known by their acronyms, BLIPS, FLIP, OPIS, and 
SC2. The first three have already been identified by the 
Internal Revenue Service as potentially abusive or illegal tax 
shelters. The fourth, SC2, is under IRS review. BLIPS, FLIP, 
and OPIS required the participation of a bank, investment 
advisory firm, and law firm to work. Each of the professional 
firms here today had a role in one or more of these tax 
products and helped provide the legal or financial facade of 
economic substance for transactions whose only real purpose was 
to reduce or eliminate the buyer's taxes.
    KPMG sold BLIPS, FLIP, and OPIS to about 300 people. It is 
no accident that the same banks, investment advisors, and law 
firms appear over and over again in connection with the 
transactions needed to implement these tax shelters. In fact, 
KPMG courted and built up relations with each of these 
professional firms because it couldn't implement its tax 
products without them. KPMG also wanted to form business 
alliances with other respected professionals to increase its 
stature in client contacts.
    An internal KPMG memorandum that we just received this 
week, which is Exhibit 137,\1\ lays it all out. In 1997, a 
month before he left the firm to form his own investment 
advisory firm called Presidio, a senior KPMG partner, Robert 
Pfaff, sent a memo to the two top officials in the KPMG tax 
services practice with a number of suggestions for, ``KPMG's 
Tax Advantaged Transaction Practice.'' Among other suggestions, 
the memo argues for the development of ``turnkey'' tax 
products, tax shelters that KPMG clients could use without any 
changes to reduce their taxes.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 137 which appears in the Appendix on page 2735.
---------------------------------------------------------------------------
    The memo also stated that, in most cases, it will be 
``difficult or impossible for KPMG to be the sole provider of a 
tax advantaged product,'' in other words, a tax shelter, ``due 
to restrictions placed on the firm's scope of activities by 
authorities.''
    The memo described KPMG's ``dilemma'' in its words, as 
follows: ``To avoid IRS scrutiny, KPMG had to market its tax 
products as investment strategies, but if it characterized its 
services as providing investment advice to clients, it could 
attract SEC scrutiny and have to comply with Federal securities 
regulations.''
    And this memo, again, which we just received this week, 
explains it as follows: ``It is clear we cannot openly market 
tax results of an investment. Rather, our clients should be 
made aware of investment opportunities that are imbued with 
both commercial reality and favorable tax results. Conversely, 
we cannot offer investments without running afoul of a myriad 
of firm and securities rules. Ultimately, it was this dilemma 
that led me to the conclusion that KPMG needs to align with the 
likes of a Presidio.''
    In other words, KPMG recognized that to make its tax 
products work, KPMG itself could not provide ``investment 
advice.'' It also knew it could not issue loans or provide 
financing. It had no authority to practice law. It needed 
assistance from other professionals with those capabilities to 
carry out its tax schemes and it found them.
    Law firms like Brown and Wood, which later became Sidley 
Austin Brown and Wood, issued favorable, boilerplate legal 
opinion letters for BLIPS, FLIP, and OPIS, issuing more than 
250 opinion letters in all.
    Investment advisory firms like Quellos doing business as 
Quadra, and Presidio helped set up hundreds of BLIPS, FLIP, and 
OPIS transactions.
    Banks like Deutsche Bank, HVB Bank, and others financed 
hundreds of BLIPS, FLIP, and OPIS transactions. Deutsche Bank 
and HVB together provided more than $5 billion in financing for 
these transactions.
    Everyone, of course, got paid lots of fees. For example, in 
BLIPS, clients paid a set fee at 7 percent of the planned tax 
loss. Now think about that. If anything demonstrates that the 
goal of these schemes was to produce paper tax losses, it is 
that the fee was based on the size of the planned tax loss. The 
higher the planned tax loss, the higher the fee.
    In the case of the BLIPS fee, after certain expenses were 
subtracted, the remaining money was divvied up among the firms 
that carried out the client's BLIPS transaction. KPMG and the 
banks each got 1.25 percent, what they called 125 basis points. 
The investment advisor got 2.75 percent, or 275 basis points. 
The law firm generally got $50,000 for each opinion, possibly 
more in cases where the expected tax loss was large.
    Looking at just the four tax products examined by this 
Subcommittee, KPMG brought in fees totalling at least $124 
million. Sidley Austin Brown and Wood, with more than 250 
opinion letters, raked in at least $50,000 per boilerplate 
letter and made more than $12 million. Deutsche Bank hauled in 
about $33 million from its OPIS transactions and expected to 
make the same again from BLIPS. HVB made over $5 million in 
less than 3 months doing BLIPS deals in 1999 and decided on 
doing more in the year 2000, due in part, in its own words, to 
``excellent profitability.''
    Now, what exactly were these fees for? The law firm Sidley 
Austin Brown and Wood provided a so-called independent legal 
opinion letter finding that the tax products complied with the 
law. In fact, the law firm collaborated heavily with KPMG to 
develop the products and write the opinion letters. The banks 
provided financing and nominal currency transactions that acted 
as an investment fig leaf to disguise transactions that were 
really tax driven. The investment advisors provided the design 
and the rhetoric to recast the tax dodges as investment 
strategies.
    The facts echo what this Subcommittee uncovered during its 
Enron investigation: Respected professional organizations 
offering their services and making a lot of money by assisting 
other parties to complete highly structured and deceptive 
transactions. In this case, the transactions were intended to 
help KPMG's clients reduce or eliminate paying their fair share 
of taxes owed to Uncle Sam. By facilitating these tax schemes, 
these organizations also opened themselves up to possible 
violations of the laws against the promoting of abusive tax 
shelters and against aiding or abetting tax evasion.
    Now, relative specifically to the SC2 tax product, we had 
planned to have at today's hearing one of the pension funds 
that KPMG approached and convinced to participate in SC2 
transactions. None of the SC2 tax products could have been sold 
absent a charity willing to accept S Corporation stock 
donations under unusual circumstances. To save time, we asked 
the pension fund to submit a written statement instead of 
appearing here today.
    That statement sets forth these key facts. KPMG initiated 
the contact with the charity. The charity did not know its 28 
benefactors beforehand, and the charity was asked and expected 
to hold the stock it was given ``for several years'' and would 
then ``be able to sell the stock back to the owner and receive 
cash.'' In short, it is clear that SC2 was intended to provide 
only temporary stock donations.
    Also relative to SC2, we did not have time at the last 
hearing to address a number of very troubling statements made 
by the former KPMG tax partner Lawrence Manth, who headed up 
the SC2's sales effort and who claimed that KPMG was selling 
SC2 to benefit police and firefighters. The documents are 
overwhelming in demonstrating the opposite. KPMG was not acting 
altruistically in selling SC2, but again, it was helping its 
clients reduce or eliminate their taxes. If the sole objective 
was to make a charitable donation, SC2 donors could have simply 
donated cash instead of going through the exercise of first 
donating stock, then buying it back for cash, and we plan to 
follow up on those statements with Mr. Manth and others.
    The industry which promotes abusive tax shelters should 
have no place in the business plans of respected legal and 
financial professionals. It is time to put an end to banks, 
investment advisors, and law firms using their talent to 
promote, aid, or abet dubious and abusive tax shelter schemes.
    Finally, we will hear today from three key regulators: The 
IRS, the Federal Reserve, and the newly formed Public Company 
Accounting Oversight Board. Each has a role to play in 
convincing, or if necessary forcing, accounting firms, banks, 
investment advisors, and law firms to get out of the abusive 
tax shelter promotion business. To help those efforts, Congress 
needs to enact stronger penalties for promoting, aiding, or 
abetting abusive tax shelters. The current fines of $1,000 for 
individuals and $10,000 for corporations are useless as 
deterrents.
    We also need more enforcement dollars for the IRS to go 
after tax shelter promoters. We also need to put an end to 
auditor conflicts of interest that arise when accounting firms 
sell tax shelter services to their audit clients and then turn 
around and audit their own handiwork. We need to clarify and 
strengthen the economic substance doctrine.
    We need a coordinated regulators' review to identify 
abusive tax shelter products some accounting firms, banks, 
investment advisors, and law firms are selling, and to stop 
them from assisting the purveyors of abusive tax shelters.
    And, as our Chairman, I think very eloquently pointed out, 
we need the professions themselves to adhere to higher 
standards of conduct.
    Again, my thanks to you, Mr. Chairman, and to your staff 
for all the help you have given me.
    Chairman Coleman. Thank you, Senator Levin.
    I would now like to welcome our first panel to today's 
important hearing: Raymond J. Ruble, a former partner for the 
law firm of Sidley Austin Brown and Wood; Thomas R. Smith, a 
current partner with Sidley Austin Brown and Wood; and finally 
N. Jerold Cohen, a partner with the law firm of Sutherland 
Asbill and Brennan. I thank each of you for your attendance at 
today's hearing and look forward to hearing your testimony.
    Before we begin, pursuant to Rule 6, all witnesses who 
testify before this Subcommittee are required to be sworn. I 
would ask you to each rise and raise your right hand.
    Do you swear that the testimony you are about to give will 
be the truth, the whole truth, and nothing but the truth, so 
help you, God?
    Mr. Ruble. I do.
    Mr. Smith. I do.
    Mr. Cohen. I do.
    Chairman Coleman. Thank you, gentlemen.
    Gentlemen, we do have a timing system. I would ask that you 
keep your statements to 5 minutes. Your fully prepared 
statements will be entered into the official record.
    Mr. Ruble, we will have you go first this morning, followed 
by Mr. Smith and finish up with Mr. Cohen. After we have heard 
all of your testimony, we will turn to questions. Mr. Ruble, I 
understand that you are accompanied by counsel. Counsel, please 
identify yourself for the record.
    Mr. Hoffinger. Jack Hoffinger.
    Chairman Coleman. Thank you. Mr. Ruble, you may begin.

 TESTIMONY OF RAYMOND J. RUBLE, FORMER PARTNER, SIDLEY AUSTIN 
 BROWN AND WOOD, LLP, NEW YORK, NEW YORK, REPRESENTED BY JACK 
                           HOFFINGER

    Mr. Ruble. Thank you, sir. Senator Coleman and Senator 
Levin, my name is R.J. Ruble. I would very much like to respond 
to your questions on the matters that are being discussed today 
and I appreciate your endeavors in this regard. However, I have 
been instructed by my counsel not to testify based on my Fifth 
Amendment constitutional rights.
    Chairman Coleman. Mr. Ruble, I would like to see if I could 
just explore two matters with you. One, if you could just turn 
to Exhibit 116 \1\ in the exhibit book, it appears to be an e-
mail from R.J. Ruble that reads as follows: ``This morning, my 
managing partner, Tom Smith, approved Brown and Wood, LLP, 
working with the newly conformed tax products group at KPMG on 
a joint basis in which we would jointly develop tax products 
and jointly share in the fees, as you and I have discussed.'' 
Is this, in fact, an e-mail that you prepared?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 116 which appears in the Appendix on page 2691.
---------------------------------------------------------------------------
    Mr. Ruble. I must respectfully decline to answer on the 
grounds asserted.
    Chairman Coleman. I would just ask one other question, 
again, for my foundational purposes. You have in the exhibit 
book Exhibits 90a. and 90b.\1\ Exhibit 90a. purports to be an 
opinion by KPMG regarding some of the tax shelters that we 
talked about. Exhibit 90b. purports to be a Brown and Wood 
legal opinion. I would note that both opinions appear to have 
substantially the same language, in fact, almost the exact 
language. I would ask you again if that is a correct assertion.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 90a. and 90b. which appear in the Appendix on 
pages 684 and 781.
---------------------------------------------------------------------------
    Mr. Ruble. I have been instructed to decline to answer on 
the grounds asserted.
    Chairman Coleman. Given the fact that you are asserting 
your Fifth Amendment right against self-incrimination to all 
questions asked of you by the Subcommittee, you are excused, 
Mr. Ruble.
    Mr. Ruble. Thank you very much, sir.
    Chairman Coleman. Mr. Smith.

 TESTIMONY OF THOMAS R. SMITH, JR.,\2\ PARTNER, SIDLEY AUSTIN 
            BROWN AND WOOD, NEW YORK, NEW YORK, LLP

    Mr. Smith. Thank you, Mr. Chairman and Senator Levin. My 
name is Tom Smith. I am a partner in the law firm of Sidley 
Austin Brown and Wood and I am pleased to answer your questions 
to the extent that I can.
---------------------------------------------------------------------------
    \2\ The prepared statement of Mr. Smith appears in the Appendix on 
page 312.
---------------------------------------------------------------------------
    I joined Brown and Wood in 1963 and have spent my career 
there as a securities lawyer. I am not a tax lawyer. But from 
1996 to May 1, 2001, at the time of our merger with Sidley and 
Austin, I was the managing partner of Brown and Wood.
    Mr. Chairman, our firm wants to cooperate with the 
Subcommittee to the maximum extent it can. The area of tax work 
that brings us here today is an area that our firm no longer 
participates in. Unfortunately, my personal files on these 
matters were lost in the destruction of our office in the World 
Trade Center on September 11, and Mr. Ruble, the person in our 
firm most knowledgeable about these matters, is not available 
to you or to us. Thus, we are limited in the information we can 
provide.
    Mr. Ruble is no longer a partner of the firm. He was 
expelled from the partnership on October 24, 2003, for 
activities in violation of the partnership agreement, that is, 
accepting undisclosed compensation and for refusing to explain 
his conduct to the firm.
    As a result, we are not confident that the information Mr. 
Ruble has given us in the past and upon which we have relied is 
accurate, and we have so advised the Subcommittee staff, the 
Internal Revenue Service, and other interested parties.
    That said, let me tell you a bit about the tax practice at 
Brown and Wood. Of the approximately ten tax partners at Brown 
and Wood before the merger, Mr. Ruble was virtually the only 
one who engaged in this practice, although he consulted with 
others on discrete issues. At the time Mr. Ruble began 
providing concurring opinions to individual taxpayers, Brown 
and Wood had an opinion committee and expected partners to seek 
the advice of that committee or of the other colleagues at the 
firm of novel and unsettled legal issues. In addition, Brown 
and Wood required approval of tax opinions by a second tax 
partner, and as a matter of fact, during the period in 1999, we 
expanded that second opinion requirement to all lawyers.
    After the merger, the firm maintained and expanded the size 
of the opinion committee and further enhanced its policies in 
this area. The purpose of this policy was to help ensure the 
quality and consistency of tax advice provided by the firm and 
to provide an electronically maintained library of tax opinions 
that all tax lawyers could access.
    No set of procedures will stop an individual from acting 
improperly if he or she is unwilling to abide by the rules of 
our profession and to engage in blatant acts of deceit and 
concealment. Nevertheless, we have hired a tax attorney whose 
principal responsibility is to monitor our internal procedures 
and our compliance with the evolving requirements of the 
Internal Revenue Service.
    Prior to the merger of Brown and Wood and Sidley and Austin 
and as part of our transition planning, it was decided that the 
combined firm would stop providing individual tax opinions that 
this Subcommittee is considering and we would reorient the tax 
practice to the corporate transactional work that is central to 
both firms' practices. This action reflected the decision of 
Brown and Wood and the combined firm to redirect the efforts of 
the firm to our core tax work and did not and does not reflect 
on the quality of the work performed earlier. I understand that 
no court has decided that Mr. Ruble's tax opinions are wrong, 
much less rendered in bad faith.
    Although Mr. Ruble had confirmed that he had stopped 
issuing opinions of this type, the firm discovered that 
additional opinions had been issued after the merger. When 
confronted with this, Mr. Ruble said that the opinions were the 
last in the typewriter and were being rendered because he had 
pre-merger commitments to provide them to clients. He was told 
to stop issuing such opinions. He assured the firm that he had 
stopped, but in fact, he lied to us. He evaded our controls we 
had in place and he breached the trust we reposed in him.
    We had and have procedures in place designed to ensure that 
all of our lawyers, partners, associates, and others act in 
compliance with applicable laws and the highest ethical 
standards. In a law partnership, the effectiveness of 
procedures of this sort is highly dependent upon the 
trustworthiness of our partners.
    Both Sidley Austin Brown and Wood and I personally want to 
thank you for the open, cooperative, and professional treatment 
we have received from both the Majority and Minority staff.
    Chairman Coleman. Thank you, Mr. Smith.
    Mr. Cohen, before we proceed, I note that you have a 
gentleman with you. For the record, would you please identify 
him.
    Mr. Cohen. A partner, J.D. Fleming, who has come with me.

TESTIMONY OF N. JEROLD COHEN,\1\ PARTNER, SUTHERLAND ASBILL AND 
  BRENNAN, LLP, ATLANTA, GEORGIA, ACCOMPANIED BY J.D. FLEMING

    Mr. Cohen. Mr. Chairman, Senator Levin, thank you very much 
for inviting me to these hearings. I commend you on the 
hearings. I think they are very important. I think if they lead 
to the passage of some of the provisions that were passed in 
the Senate CARE Act or to some of the provisions that are now 
in the JOBS Act, I think that will be very good.
---------------------------------------------------------------------------
    \1\ Letter to Senators Coleman and Levin, dated November 18, 2003, 
with responses to questions appears in the Appendix on page 315.
---------------------------------------------------------------------------
    I am especially pleased to hear both Senators acknowledging 
that the Service needs more resources. Over the last 7 years, 
its workload has gone up over 11 percent and its workforce down 
by over 11 percent. You just can't keep that up and it is 
showing, and it is showing in some of these things.
    First of all, let me say that my firm, Sutherland Asbill 
and Brennan, has not been involved in the development, 
marketing, or implementation, or the promotion, aid, or 
abetment of the tax shelters that you have asked us about. In 
fact, the fourth of the shelters, SC2, I know nothing at all 
about.
    We have been engaged by clients who were under audit by the 
Internal Revenue Service long after they participated in these 
transactions to represent them, and we have been representing 
them in that regard.
    Every time we discuss with a client potential 
representation, we inform them that we cannot--cannot--
participate in any suit against any promoter, whether it is the 
promoter or a firm that has been involved with the transaction, 
that we represent, and we have a litigation group that 
represents all of the major accounting firms, five back then, 
four now, in totally unrelated litigation. We tell them because 
of that, we cannot represent them in any action against anyone 
connected with this, these transactions, and we suggest to them 
that they obtain other counsel to represent them in that 
regard. We tell them that several times and we tell them to 
engage other counsel sooner rather than later because there is 
a statute of limitations problem in any actions that they might 
want to consider.
    Now, having said that, let me also commend the staff for 
the Minority Report. I haven't read the whole thing, it is 
awfully long, but I thought it was very good. I know they 
worked long and hard at that. In fact, I called some of the 
staffers a couple of times and found them working late at night 
on that.
    But after my letter responding to your questions and 
reading the Minority Report, I found that I could make further 
responses to some of your questions. I respect the pressure the 
staff was under and I know that our firm is only discussed in 
three pages of the large report. But I wish they had had time, 
and I know they didn't, to consult with me because there are a 
lot of misstatements in those three pages about my firm's 
activities.
    First of all, it states that KPMG referred over two dozen 
clients to us. That is not true. I am not saying that I would 
not have liked to have had more clients, because we shared the 
costs of our representation among all the clients, and I am 
sure all of the clients would have liked to have had more, but 
we never had two dozen clients referred to us by KPMG to my 
knowledge. I have no idea what KPMG told you. We had clients 
coming in from other clients, from financial advisors, and from 
law firms. In fact, the first clients we had with regard to the 
three transactions, the three products, if you will, that I 
knew about came from law firms.
    Let me also say that I can tell you now that we have in the 
three transactions that we have worked on approximately 40 such 
clients. That is, reading the numbers you have in your report, 
it is not an inconsiderable number to me, but it is a small 
part of the landscape.
    Now, the report suggests that our only disclosure to the 
client was in the engagement letter, which is quite clear. Your 
report does cite the engagement letter stating to the clients 
that we cannot represent them before the accounting firms. It 
suggests that that is all we did, and there is an opinion that 
came out that cannot be correct--because it did not represent 
the facts.
    The facts are that is not all we did. Before undertaking 
any engagement, we spoke to the client or to their financial 
advisor or whoever their advisor was. Some of these clients are 
so wealthy that you don't speak to the clients. They always 
contact the lawyers either through their own in-house lawyer or 
through their financial advisors, and all were advised, 
clients, financial advisors, in-house people, that they needed 
to get another lawyer to--if they contemplated any action 
against anyone in connection with the products. They were told 
to do that right away because there was a statute of 
limitations problem.
    Now, the report also suggests that representing clients 
when another group in my firm represents KPMG is a conflict of 
interest. I will have to tell you, that goes way beyond any 
ethical responsibility I have been aware of in my 42 years of 
practice, way beyond that. And even though there is not a 
conflict there, we, as I said, took care to tell--KPMG knew we 
could not defend them against any of these clients and the 
clients knew we also could not represent them. If there is a 
conflict, I would suggest that there may be a conflict in both 
representing the clients before the IRS and against KPMG. It 
gives you a pretty tight rope to walk in making your arguments.
    Finally, I would like to mention the fact that the report 
suggests that we entered into agreements hiring KPMG. We 
entered into one such so-called Covell agreement. It was 
entered into because the client was already being advised by 
KPMG. We thought we might need to have some advice from KPMG. 
We did not want to waive the client's attorney-client 
privilege, the privilege with respect to our advice, and so we 
entered into the one Covell letter. We never entered into 
another one with connection with these transactions because we 
never used that one, so it was never, ever used.
    Chairman Coleman. I would ask you to summarize the rest of 
your testimony, Mr. Cohen.
    Mr. Cohen. Well, the summary is--I think that I will go 
back to the start. I wish the staff had talked to me a little--
had time to talk to me. I know I am not a big piece of this 
action, and I think I could have corrected these things. Having 
read the rest of the report, I am sure they would have 
corrected the record on that score.
    And once again, I would say the one thing you didn't 
mention, you or Senator Levin, you mentioned that you want more 
disclosure. I think that is badly needed. You mentioned that 
you want more resources for the IRS. I think that is badly 
needed. The one thing you haven't mentioned is the one that I 
think is the most important, and that is an extension of the 
statute of limitations where there is no disclosure. I think 
that will go a lot further. In my experience, penalties have 
not done the job. Back when I was Chief Counsel of the Internal 
Revenue Service, we fought tax shelters on a much broader 
scale, much lower dollars, and the penalties didn't seem to 
stem that tide. Thank you.
    Chairman Coleman. Thank you, Mr. Cohen, and I do want to 
thank you for your testimony. It has been very clarifying. I 
will tell you up front that on first blush, our concerns had to 
do with potential conflicts of interest with KPMG and you have 
gone a long way to explaining that and helping us understand it 
better, so I do thank you for that.
    Let me just make sure that I do understand. First, did KPMG 
refer tax audit cases to you?
    Mr. Cohen. I think they did, but not in the----
    Chairman Coleman. You said you never had two dozen. Do you 
know what the number was?
    Mr. Cohen. No, I do not at this time. I can try to find 
that out and submit that number to your staff. But I would say 
I have no idea whether KPMG thought that they referred more 
clients to us than they actually referred, but the references--
frequently, clients come in from a number of sources. Most of 
our references came from law firms, from financial advisors, 
from the clients themselves who had talked to other clients.
    Chairman Coleman. And I take it KPMG has an ongoing 
relationship with Sutherland Asbill and Brennan?
    Mr. Cohen. The firm continues to defend in malpractice 
cases, other than cases involving tax shelters, KPMG and the 
other three of the remaining large accounting firms.
    Chairman Coleman. Could you tell us the approximate amount 
of attorney fees that KPMG generated?
    Mr. Cohen. I haven't the slightest idea.
    Chairman Coleman. Could you provide that to us after----
    Mr. Cohen. If under our professional responsibility we are 
allowed to and we can go to KPMG and get that authorization, 
that waiver, we would be more than happy to do so.
    Chairman Coleman. I would appreciate that.
    Did KPMG ever tell you they would knowingly refer clients 
to your firm when the subject matter was a tax scheme/shelter 
that they were deeply involved in?
    Mr. Cohen. Never.
    Chairman Coleman. In referring the cases that they did 
refer to you, my question has to do with whether you then 
turned around and retained KPMG to serve as consultants in the 
case? You indicated in your testimony that happened one time.
    Mr. Cohen. One Covell letter, that's right.
    Chairman Coleman. And then you----
    Mr. Cohen. That's it.
    Chairman Coleman [continuing]. Indicated that not again?
    Mr. Cohen. Not again, and let me mention this. I never--I 
don't recall a client that came in just--KPMG said, go to me. 
My understanding was that they gave the clients a choice of 
firms.
    Chairman Coleman. Thank you, Mr. Cohen.
    Mr. Smith, according to IRS pleadings filed against Brown 
and Wood, Brown and Wood issued approximately 600 opinion 
letters regarding these 13 different tax avoidance products 
during Mr. Ruble's tenure. Can you give me a sense of kind of 
the knowledge, how it worked in Brown and Wood, whether folks 
would know about what Mr. Ruble was doing, whether they would 
know kind of the volume of what he was doing, the type of 
things that he was doing? How did that work? How did that 
supervision oversight work?
    Mr. Smith. Senator Coleman, I will, but let me just 
caution, I am sure you can tell, and I am very outraged, I can 
tell you what we were told and what our understanding was and I 
can go through that with you.
    Mr. Ruble's practice in this area, I think, to the best of 
my understanding, really started in 1997. You referred to an e-
mail in which there was a discussion--it said that there was a 
discussion with me. The first I knew about that e-mail was when 
I read it in the Wall Street Journal several weeks ago. I knew 
nothing about that. We had never been told that there was any 
sort of an alliance or proposed alliance with KPMG or anyone 
else. Had he had that conversation with me, I would have 
immediately talked to our executive committee about it, that I 
was basically the chairman of that, and this has never happened 
and we never approved any sort of an alliance with KPMG. That 
would have required a lot of analysis on our part and it just 
never happened.
    Chairman Coleman. That e-mail is Exhibit 116,\1\ I think, 
in the books in front of you, if you turn to Tab 116, the large 
black book right there.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 116 which appears in the Appendix on page 2691.
---------------------------------------------------------------------------
    Mr. Smith. Yes.
    Chairman Coleman. And as I indicated before, the bottom of 
that e-mail, ``Subject, Joint Projects; Author, R.J. Ruble; 
Date, 12/15/97, 11:08 a.m. This morning, my managing partner 
Tom Smith--''
    Mr. Smith. Yes.
    Chairman Coleman. ``--approved Brown and Wood, LLP, working 
with the newly conformed tax products group at KPMG on a joint 
basis in which we would jointly develop and market tax products 
and jointly share in the fees as you and I have discussed.'' 
You indicate that that e-mail is not true, not accurate?
    Mr. Smith. We never--I never saw this and it is totally 
untrue.
    Chairman Coleman. Are you aware of any agreement or effort 
to market tax products with KPMG?
    Mr. Smith. No.
    Chairman Coleman. Can you help me understand? Is that 
something that would be unusual for a law firm to do?
    Mr. Smith. It would be unusual for Sidley Austin Brown and 
Wood to do, and at that time Brown and Wood. I would be happy 
to tell you what our understanding was that we were doing. When 
you asked----
    Chairman Coleman. Please. I would appreciate that.
    Mr. Smith. Yes. You asked how we handled this at the firm. 
In 1998, the revenues increased materially in this area and as 
the chairman, as the managing partner, I undertook and the 
executive committee undertook to see if we could get a better 
handle on what these opinions were, was this a business we 
should be in, what sort of exposure to risks that we had 
because of these opinions, and exactly what our role was in 
supplying these opinions. And I called the practice group head, 
Tom Humphries, and asked him, who was aware of what was 
happening here but really had not been involved with these 
opinions. Some of the partners had been involved with certain 
discrete issues, but not with the total product. That was a 
total opinion.
    I looked at those opinions and read them. They were more 
likely than not based on factual representation opinions. Quite 
frankly, sir, I was really not in a position to pass on the 
validity of those opinions. I think we had four or five of our 
tax partners read those opinions and advise us, and the advice 
we got was that they were valid opinions under the then law.
    We discussed with Mr. Ruble and with our tax partners 
exactly what our role was in this and we were told that our 
role was to provide concurring opinions to taxpayers, and a lot 
of times to their financial advisors, and Mr. Cohen testified 
that you do this, and that KPMG wanted an outside law firm to 
do this, that KPMG would designate to help the financial 
advisors understood this.
    We understood his role to be not involved in the design of 
these products, but that KPMG would come to him with the 
product and ask him if he could render the concurring opinion. 
Now, to do that, Mr. Ruble had to do a thorough analysis of 
what was in there. It was my understanding we inquired about 
this, that he would perhaps make suggestions so that he could 
render his opinion and perhaps he might--I guess if he saw 
something there to improve the product, he might have passed 
that on. That is just an assumption on my part. We thought he 
was being given the product and just saying if--rendering his 
opinion on them, more likely than not based on the factual 
assumptions.
    Chairman Coleman. My concern is, first, he issued 
approximately 600 opinions, so I take it he is generating a 
substantial amount of fees which I would then suspect is not 
under the radar screen of Brown and Wood?
    Mr. Smith. Absolutely not.
    Chairman Coleman. He is generating volume here?
    Mr. Smith. Absolutely not.
    Chairman Coleman. If he is generating that volume, I am 
just again trying to understand the internal mechanism. He was 
generating a lot of money in a tax area?
    Mr. Smith. Right.
    Chairman Coleman. I take it he is not operating solely by 
himself?
    Mr. Smith. Well, that is a good question. We have all of 
this under review. I think in large measure, what we most fear 
in a law firm, he was a lone wolf, and this is----
    Senator Levin. What?
    Mr. Smith. A lone wolf, Senator Levin, not to mention a 
rogue partner, which is your greatest fear.
    Chairman Coleman. And you understand, though, again, having 
been in the profession for a number of decades and 
understanding there are lone wolves but understanding the 
structure of law firms, you have a guy generating a lot of 
fees----
    Mr. Smith. Correct.
    Chairman Coleman [continuing]. And complex issues that when 
looked at are pretty clear. You look at these issues and you 
have on the BLIPS cases, I believe there were 66 investors. 
These are supposed to be 7-year investment schemes. Every one 
of them gets out after 60 days. You look at this thing and you 
can see it is being created for generating tax loss. That is 
what it is about. I am still troubled by the sense that it is 
just Mr. Ruble.
    Mr. Smith. Well, it was Mr. Ruble who was rendering the 
opinions and dealing with the clients. I know of no instance in 
my understanding where any other tax lawyer at Brown and Wood 
were involved in the dealings with the clients.
    We had the other tax partners in the group, in a highly 
esteemed group, I think we had four or five of them review 
these opinions and advise us as to whether or not they were 
appropriate. And as I say, I am a securities lawyer and I have 
to rely on their advice in this regard.
    Chairman Coleman. Senator Levin.
    Senator Levin. The IRS has alleged in court that Sidley 
Austin Brown and Wood issued about 600 opinion letters on 13 
potentially abusive or illegal tax shelters, and it is our 
understanding that about half of those letters, perhaps 250 to 
300, were issued in connection with BLIPS, FLIP, and OPIS. 
Would that be about right?
    Mr. Smith. Yes, we did render approximately 600, and I 
think it was 13 different transactions. I just don't know the 
answer as to how many applied to which.
    Senator Levin. You don't have any idea about how many were 
issued in conjunction with BLIPS, FLIP, and OPIS?
    Mr. Smith. No, sir. I can get you that----
    Senator Levin. Well, we will tell you. Let us assume that 
our information is correct, and if you would----
    Mr. Smith. I would assume, yes.
    Senator Levin [continuing]. For the purpose of discussion 
say about 300. Now, we understand that your firm charged 
substantially the same fee, $50,000, for each letter provided 
to BLIPS, FLIP, and OPIS clients.
    Mr. Smith. It was a fixed fee. I think it started at 
$50,000. There may have been different amounts in different 
instances.
    Senator Levin. Possibly a little more----
    Mr. Smith. Yes.
    Senator Levin [continuing]. If the tax loss was more?
    Mr. Smith. No, I don't think it was--it was my 
understanding it was never based on the size of the 
transaction.
    Senator Levin. Well, we will get to that later in terms of 
the fees.
    Mr. Smith. Yes.
    Senator Levin. So you got $50,000 for each letter, 
approximately?
    Mr. Smith. Approximately, that is my understanding in this.
    Senator Levin. Now, these letters were drafted after the 
initial prototype, is that correct? In other words, there was 
an initial letter on each of these and then the following 
letters, follow-up letters, were virtually identical to the 
prototype letter, is that not correct?
    Mr. Smith. Could you help me with what you mean by 
prototype?
    Senator Levin. The first letter that you wrote approving 
BLIPS, for instance, was followed by dozens and dozens of other 
letters----
    Mr. Smith. That is correct.
    Senator Levin [continuing]. And so the first letter was the 
prototype.
    Mr. Smith. OK. I understand.
    Senator Levin. And then all the successive letters, 50 or 
100 on each, BLIPS, FLIP, and OPIS, were then basically cookie 
cutter opinions following that prototype opinion, is that 
correct?
    Mr. Smith. Yes. To my understanding, yes. I could not tell 
you to what extent they varied based on the facts. It could 
have been.
    Senator Levin. All right. It could have been----
    Mr. Smith. But that was my basic understanding of it.
    Senator Levin. All right.
    Mr. Smith. Pretty similar, basically similar, Senator, to--
--
    Senator Levin. Virtually identical? Basically the same, but 
use your words. Now, the clients' names were changed. In how 
many cases were there client consultations?
    Mr. Smith. I couldn't answer that question, Senator.
    Senator Levin. Is it possible that in most cases, there 
were no client consultations, you simply submitted the letter?
    Mr. Smith. I couldn't answer that question.
    Senator Levin. All right.
    Mr. Smith. That is a question we would be interested in. We 
would be interested in the answer to that question.
    Senator Levin. I would hope so.
    Mr. Smith. Yes.
    Senator Levin. Who was your client?
    Mr. Smith. Well, we were rendering these opinions to the 
taxpayer. I don't think we--and that was--hopefully, we had 
engagement letters with respect to this which explain this and 
explain our role. But these opinions were being rendered--I 
don't think we rendered more than one opinion to any taxpayer, 
and that was the sole piece of legal work we did for those 
taxpayers, these concurring opinions.
    Senator Levin. Right.
    Mr. Smith. KPMG as a national tax group were also rendering 
an opinion, to my understanding.
    Senator Levin. The taxpayer was supposed to be your client. 
You don't know whether there was any personal contact with 
those taxpayers in most cases or not, do you, for instance, in 
the BLIPS transactions? Do you have any idea?
    Mr. Smith. It was my understanding that Mr. Ruble was 
available to consult, primarily with the financial advisors of 
these taxpayers. I have no idea.
    Senator Levin. You have no idea. Did you ever ask Mr. 
Ruble, in all your conversations with Mr. Ruble, about this 
matter, as to whether he ever met with your clients?
    Mr. Smith. The tax partners would have.
    Senator Levin. Did you ask your tax partners whether there 
was ever any connection?
    Mr. Smith. I did not, sir.
    Senator Levin. Is that not an important question for a law 
firm, as to whether you have any contact with your client or 
not?
    Mr. Smith. I think it is an important question.
    Senator Levin. But you didn't ask that of these tax 
partners of yours?
    Mr. Smith. I don't recall asking that, yes.
    Senator Levin. On the question of fees, according to the 
American Bar Association Model Rule 1.5, a lawyer ``shall not 
make an agreement for, charge, or collect an unreasonable 
fee,'' and then cites the factors to be considered in setting a 
fee amount as the time and labor required, the novelty and 
difficulty of the questions involved, and the skill requisite 
to perform the legal service properly.
    It used to be that legal opinions were written for one 
client on a particular set of facts, but mass marketed tax 
products are accompanied by mass production of legal opinion 
letters with boilerplate language, and this is what happened 
here, according to your own testimony, and as a matter of fact, 
that is what happened with these tax shelters, BLIPS, FLIP, and 
OPIS. Virtually all the costs associated with the letters are 
attached, therefore, to drafting the first prototype opinion, 
which would be labor intensive. But after that, with the cookie 
cutter follow-ups by the hundreds, the firm has very limited 
costs since it used that boilerplate language to produce the 
later letters and rarely even consulted with the client, or you 
don't even know whether the clients were consulted.
    Now, my question has to do with the fees that were charged 
on these letters. Did your firm estimate in advance about how 
many opinion letters would be issued for a shelter?
    Mr. Smith. It is my understanding that we had no idea how 
many taxpayers would be investing in these structured products.
    Senator Levin. And would be referred to your firm?
    Mr. Smith. That would be referred to our firm.
    Senator Levin. So now how would you decide on the fee? How 
can you charge $50,000 for a cookie cutter opinion letter when 
you don't know if you are going to issue 1, 5, 50, 100, or 200 
of those letters, same fee, $50,000? How do you decide on that 
fee? What is it based on?
    Mr. Smith. We would have to ask Mr. Ruble how he----
    Senator Levin. Well, you asked Mr. Ruble. I am sure you had 
these conversations. You ended up firing him. What did he say 
when you asked him, how do you base a fee?
    Mr. Smith. I never asked him how he would base the fee or--
--
    Senator Levin. But you knew you were getting $50,000 for 
each piece of paper that your firm was issuing?
    Mr. Smith. That would be part of his----
    Senator Levin. And you have an ethical obligation to charge 
your clients, who you probably never even saw, a reasonable 
fee. How do you base a $50,000 fee?
    Mr. Smith. That would be part of the arrangement that he 
would have made in the first instance, what the fees would 
cost, and we had no idea whether or not we were going to make 
money on this or not. If we were going to get $50,000 a 
transaction and we only had two or three, we are clearly going 
to lose a lot of money.
    Senator Levin. So you did figure out that if there were 
only two or three of these, you would lose money.
    Mr. Smith. Well, obviously we would. The time would be 
greater than that.
    Senator Levin. So what was your break-even point?
    Mr. Smith. I have no idea, Senator.
    Senator Levin. Does your firm have any idea?
    Mr. Smith. I can sort of do an analysis of that. I doubt if 
we had much of an idea as to what the break-even point would 
be, because going into this, you wouldn't know how much 
research was going to be involved. You wouldn't know--I assume 
that there was--Mr. Ruble was conferring with his clients or 
the advisors of his clients to a certain extent. I can't tell 
you to what extent.
    Senator Levin. Do you know how many hours? Was there a 
billing kept for this kind of----
    Mr. Smith. Yes.
    Senator Levin. About how many----
    Mr. Smith. I do not have that with me. I would be happy to 
provide you with that.
    Senator Levin. So you did keep track of about how many 
hours went into the preparation of that opinion?
    Mr. Smith. Yes.
    Senator Levin. All right. You will submit that to the 
Subcommittee?
    Mr. Smith. Yes.
    Senator Levin. But you decided--were you involved in this 
decision that no matter how many opinions were issued, they 
were all going to be about $50,000 a crack?
    Mr. Smith. I was not involved in that decision.
    Senator Levin. Who was, besides Mr. Ruble?
    Mr. Smith. Well, at this point, I am just perplexed as to 
answer any of these questions. I will see what I can find out 
on that.
    Senator Levin. Let me turn now to Exhibit 117.\1\ This is a 
KPMG employee stating that, ``Our deal with Brown and Wood is 
that if their name is used in selling the strategy, they will 
get a fee. We have decided as a firm that B&W opinions,'' that 
is your law firm, ``should be given in all deals.'' They are 
deciding that your opinion is going to be given to presumably 
your client. Isn't that astounding, that some outside company 
is going to decide that your opinion is going to be given to 
folks who are supposed to receive independent advice and be 
your clients?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 117 which appears in the Appendix on page 2692.
---------------------------------------------------------------------------
    Mr. Smith. Senator Levin, this was not our understanding. 
It was our understanding on these transactions that the 
taxpayer was going to be given a choice of two or three firms.
    Senator Levin. So this comes as a surprise to you?
    Mr. Smith. Oh, absolutely.
    Senator Levin. There was no deal with Brown and Wood, 
right?
    Mr. Smith. Well, certainly not to my knowledge, or the 
knowledge of the executive committee.
    Senator Levin. And did you ask Mr. Ruble whether he had 
made a deal on your behalf with KPMG?
    Mr. Smith. Well, I don't know that we asked him if he had 
made a deal, having had--but we inquired heavily throughout 
this as to exactly what his role was.
    Senator Levin. Did you ask him whether he had made a deal 
with KPMG?
    Mr. Smith. I didn't.
    Senator Levin. Did anybody ask, as far as you know, on 
behalf of your firm? Did we have some kind of an arrangement 
with KPMG? Did anybody ask him that question?
    Mr. Smith. Well, the arrangement----
    Senator Levin. Since you got hundreds of referrals at 
$50,000 a crack, did anybody ask Ruble in your presence or 
otherwise whether there was an arrangement with KPMG and your 
firm?
    Mr. Smith. Well, as----
    Senator Levin. As far as you know, did anybody----
    Mr. Smith. There is an arrangement implicit in what I 
described.
    Senator Levin. Did anyone ask Mr. Ruble explicitly whether 
or not there was a deal between your firm and KPMG that the 
users of these tax shelters would be given your letter?
    Mr. Smith. I have no knowledge of anyone asking him if 
there was a deal.
    Senator Levin. Or an agreement?
    Mr. Smith. Agreement.
    Senator Levin. My time is up, thank you.
    Chairman Coleman. Thank you, Mr. Levin.
    Let me continue and make sure I understand. The client is 
the taxpayer, is that correct?
    Mr. Smith. That is correct, Senator Coleman.
    Chairman Coleman. Not KPMG. So how did the client come to 
your attention or to Mr. Ruble's attention?
    Mr. Smith. They would--it was our understanding, in 
connection with KPMG marketing these investment products that 
they would give the taxpayer the choice of two or three firms 
and that is how we would be approached thereafter.
    Chairman Coleman. So KPMG is supposed to give the taxpayer 
a number of firms and it is your testimony you are not aware of 
any arrangement, marketing arrangements or the other type of 
interconnecting relationships that the Ruble e-mails reflect?
    Mr. Smith. It was our understanding that there was 
absolutely no efforts on our part to market or promote these 
products.
    Chairman Coleman. In Exhibits 90a. and 90b.\1\--I think 
really have the first pages, but there are many page----
---------------------------------------------------------------------------
    \1\ See Exhibits No. 90a. and 90b. which appear in the Appendix on 
pages 684 and 781.
---------------------------------------------------------------------------
    Mr. Smith. This would be in the other book?
    Chairman Coleman [continuing]. Opinions. Yes. If you look 
at Exhibit 90a., it would be just the first page, 90a. is on 
the stationery of KPMG. I believe Exhibit 90b. would be--you 
have just the first page of the opinion from Brown and Wood. So 
KPMG, as I would understand it, is providing an opinion to the 
taxpayer, right, and then Brown and Wood is supposed to provide 
an independent analysis, is that correct?
    Mr. Smith. That is correct.
    Chairman Coleman. And if one looks at these opinions, the 
language is in substantial portion exactly the same. Do you 
work with the tax firms in developing your opinions?
    Mr. Smith. It was our understanding that he--his role was 
to review the product and determine whether he could give a 
concurring opinion, and really the only input that he would 
have would be whether or not there needed to be modifications 
so that he could opine.
    Chairman Coleman. Again, these opinions are being reviewed 
by others in the firm?
    Mr. Smith. There was a second signer requirement throughout 
this provision.
    Chairman Coleman. And so if the others in the firm are 
seeing kind of the exact duplications of opinions and opinion 
after opinion after opinion, would that shine a light or would 
that raise a concern to anybody?
    Mr. Smith. That, with respect to a product, the opinions 
are going to be basically the same. I don't know that that 
would shine a light. I must add that in terms of this second 
opinion requirement, among the many things that we are looking 
at is to what extent that was observed.
    Chairman Coleman. I am concerned about the relationship 
with KPMG, whether----
    Mr. Smith. Right.
    Chairman Coleman. Where is the independence in this? I can 
tell you from where we are sitting, Mr. Smith, there doesn't 
seem to be a heck of a lot of independence. From where we are 
sitting, as a matter of fact, there isn't. Let us lay that out. 
Now, the question is, is it Mr. Ruble or did it go beyond Mr. 
Ruble and that is what we are trying to understand.
    Mr. Smith. That what went beyond? I am sorry, Senator.
    Chairman Coleman. The intertwining of relationships between 
a law firm and an accounting firm, the marketing of tax 
products between a law firm and an accounting firm. That is 
what we are trying to understand, and we are looking at stuff 
that says that it has been approved, it has been discussed. We 
are looking at substantial legal opinions that are almost exact 
between the accounting firm and the law firm.
    Mr. Smith. With respect to these products, they would be 
almost exact. I can't really tell you to what extent there 
might be differences, but here again, it is something I can 
find out for you.
    Chairman Coleman. How do you avoid this in the future? What 
is Sidley Austin Brown and Wood doing today to make sure that 
rogue partners don't have the capacity to get involved in sham 
relationships with accounting firms or tax products like this?
    Mr. Smith. Well, I testified that we have strengthened our 
opinion policy. We have been coming up with more of a 
structured opinion policy. Throughout the time that we were 
rendering these opinions, one specific thing that we have done 
is put in--is have a tax attorney whose job is to monitor 
opinions being given in the department. We have an electronic 
library of these opinions, who the second opinion writer is, 
and this is to avoid any tax opinions being rendered that 
hasn't been reviewed.
    But I must caution that law firms operate on a degree of 
trust. As you know, 25 years ago, when I first joined Brown and 
Wood, it was just pretty much a general partnership. We trusted 
each other. Unfortunately, this has been very much eroded in 
this instance.
    We have this situation with Mr. Ruble under review, and as 
part of that review, we are going to consider what additional 
controls we have to have. I am just absolutely apoplectic that 
this happened and embarrassed that this happened.
    Chairman Coleman. Senator Levin.
    Senator Levin. I want you to look again, Mr. Smith, at 
Exhibit 116.\1\ This is a Ruble e-mail. It is dated December 
15, 1997. ``This morning, my managing partner, Tom Smith, 
approved Brown and Wood, LLP, working with the newly conformed 
tax products group at KPMG on a joint basis in which we would 
jointly develop and market tax products and jointly share in 
the fees as you and I have discussed. To the extent it is 
possible, it would be very beneficial from our perspective to 
involve our San Francisco office and I have given Paul Pringle 
and Eric Haueter of that office your name and telephone number. 
Please call me when you have a chance.'' Mr. Smith, did you, in 
fact, approve Brown and Wood working with the newly conformed 
tax products group at KPMG as that e-mail stated?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 116 which appears in the Appendix on page 2691.
---------------------------------------------------------------------------
    Mr. Smith. Absolutely not.
    Senator Levin. Now, there were two other persons from the 
law firm's San Francisco office, Mr. Pringle and Mr. Haueter--
it is a little hard to read, but any rate, Eric Haueter. So 
KPMG writes--Mr. Bickham at KPMG writes Mr. Ritchie at KPMG 
that the B&W initiative is moving ahead, as you can see from 
the attached. Now, if you will look at Exhibit 120.\2\--got it?
---------------------------------------------------------------------------
    \2\ See Exhibit No. 120 which appears in the Appendix on page 2699.
---------------------------------------------------------------------------
    Mr. Smith. Yes.
    Senator Levin. All right. A meeting actually took place 
between KPMG and your two tax professionals.
    Mr. Smith. They were not tax lawyers. Paul Pringle and Eric 
Haueter are securities lawyers, corporate securities.
    Senator Levin. All right.
    Mr. Smith. Corporate securities.
    Senator Levin. Your two lawyers.
    Mr. Smith. Yes.
    Senator Levin. Two lawyers for the B&W law firm. What took 
place at that meeting?
    Mr. Smith. I have no knowledge of that, Senator.
    Senator Levin. Are they still with your firm?
    Mr. Smith. Absolutely.
    Senator Levin. Have you asked them?
    Mr. Smith. No, I haven't, sir.
    Senator Levin. You might do that.
    Mr. Smith. I will.
    Senator Levin. Now, if you will take a look at Exhibit 
112,\1\ it is a memo dated 3 months later. By the way, before I 
go to that exhibit, you say you have not talked to those two 
lawyers----
---------------------------------------------------------------------------
    \1\ See Exhibit No. 112 which appears in the Appendix on page 2678.
---------------------------------------------------------------------------
    Mr. Smith. About that matter.
    Senator Levin. About that matter. Is this the first time 
you learned that those two lawyers were named as having been at 
that meeting with KPMG?
    Mr. Smith. The first time I have learned of that, yes.
    Senator Levin. Right now?
    Mr. Smith. Right now.
    Senator Levin. All right. So now look at Exhibit 112, and 
this is March 13, 1998, and this is from--it is a KPMG memo 
saying that a working group has been formed to work on OPIS, 
and this working group includes R.J. Ruble of Brown and Wood. 
Is that unusual?
    Mr. Smith. Well, I had----
    Senator Levin. That he is part of a working group at KPMG?
    Mr. Smith. I had heard that term working group, and it was 
my understanding that--working group can mean any number of 
things. It was my understanding that his role, as I have 
testified, was to provide these concurring opinions, and to the 
extent that he felt that a modification would be required for 
him to do that, perhaps that was it. When I read working group, 
I just had assumed that it would be something like a mailing 
list or something like that. I have scratched my head as to 
what working group means, but my understanding, I have said 
over and over again what his role was.
    Senator Levin. Now Mr. Cohen----
    Mr. Cohen. Yes, sir?
    Senator Levin. Is it not true that the PSI staff invited 
you to come here to Washington to talk with them, you indicated 
you preferred not to travel here, and that you instead would 
want to talk to the staff by telephone?
    Mr. Cohen. I spoke with the staff about not attending this 
because I had some client conflicts.
    Senator Levin. Right, that you wanted to talk to them by 
phone?
    Mr. Cohen. Yes.
    Senator Levin. OK.
    Mr. Cohen. With respect to this hearing, Senator Levin.
    Senator Levin. And you spoke with our staff by phone on 
several occasions, is that true?
    Mr. Cohen. I did.
    Senator Levin. And is it true that you told the staff that 
your firm was then representing 24 KPMG clients?
    Mr. Cohen. I don't believe--that we were representing 24? 
Not to my recollection, but I will try to get that number for 
you when I return and give that to Ms. Bean.
    Senator Levin. Is it possible you told our staff, as their 
notes indicate, that you were representing 24 KPMG clients?
    Mr. Cohen. Well, of course, anything is possible. To my 
recollection, I did not.
    Senator Levin. Did you say that you were sure that KPMG was 
giving your firm's name to KPMG clients that you got?
    Mr. Cohen. I don't recollect that, but let me say that 
having read the staff's review where Mr. Jones, who heads up 
their controversy practice, was giving out the list of a 
coalition which, by the way, had about 50 lawyers in it, and we 
certainly would have been in that group.
    Senator Levin. But in terms of your stating to our staff 
that you were sure that KPMG was giving your firm's name to 
KPMG clients that you got, you don't remember that?
    Mr. Cohen. I don't recall stating that, but I will tell you 
that I suspect that is true.
    Senator Levin. All right. Now, we interviewed a KPMG client 
that was referred to your firm and he told the Subcommittee 
that he was not repeatedly counseled that your firm represented 
KPMG and that he only understood that for the first time when 
he asked your firm for advice on whether he should sue KPMG.
    Mr. Cohen. Well, he did not ask the firm. He always spoke 
through his financial advisor, Mr. Thornette. Mr. Thornette 
was, in fact, told before the engagement that we represented--
that our litigation team represented KPMG and that his client, 
Mr. Schwartz, should obtain other counsel if he intended to 
pursue any cause with respect to the transaction he went into 
and that he should do that sooner rather than later. And that 
was repeated when Mr. Thornette called us later to say that he 
had now decided to pursue that course.
    Senator Levin. Now, I want you to think about this scenario 
with me.
    Mr. Cohen. Certainly.
    Senator Levin. A client is sold a tax shelter by KPMG that 
turns out to be illegal, or allegedly illegal, and he wants to 
sue KPMG because the IRS is after him. Now, how do you 
undertake that representation to begin with?
    Mr. Cohen. How do we undertake that?
    Senator Levin. Yes. In other words, you had a long 
relationship, did you not, with KPMG? You had defended KPMG 
against malpractice claims. In addition to the malpractice 
claims, you had also represented KPMG against claims that they 
had given bad accounting advice, is that correct?
    Mr. Cohen. In business transactions, yes, that is correct.
    Senator Levin. So now you have a question of whether or not 
a client of yours with whom you had a longstanding relationship 
had sold an illegal tax shelter. When that comes to your 
attention, isn't that something where you would immediately 
say, I can't get involved in that matter because----
    Mr. Cohen. No, that I cannot defend the taxpayer----
    Senator Levin. Yes.
    Mr. Cohen. What comes to my mind--no, I don't see a 
conflict there.
    Senator Levin. In representing a taxpayer?
    Mr. Cohen. No, in a tax proceeding. I could not represent 
that taxpayer in a proceeding against KPMG and I so informed 
the taxpayer and I advised the taxpayer, going beyond my 
ethical responsibilities, to obtain other counsel and to do 
that sooner rather than later.
    Senator Levin. OK. Now take a look at Exhibit 45.\1\
---------------------------------------------------------------------------
    \1\ See Exhibit No. 45 which appears in the Appendix on page 557.
---------------------------------------------------------------------------
    Mr. Cohen. I don't have a copy of the exhibits. Are these 
the exhibits?
    Chairman Coleman. The white volume has Exhibit 45.
    Senator Levin. This is a letter sent in September 2002 by 
KPMG to your firm agreeing to assist the law firm in its 
representation of a KPMG client who had bought BLIPS.
    Mr. Cohen. All right.
    Senator Levin. So you hired KPMG as an expert in this case 
that was brought against him, is that correct?
    Mr. Cohen. We hired--this is a typical Covell letter that 
is used by attorneys to protect their clients' confidential 
communications with them from disclosure and thereby waiver of 
the attorney-client privilege. At the time, as I said, this is 
the only one of these we entered into at the time we thought 
that we would be conferring with the KPMG. They had been 
previously the client's accounting firm. They were providing 
the documents in response to some things called Information 
Document Requests, or IDRs, furnished by the IRS, and we 
thought we might need their advice. We never used their advice 
in this connection and we therefore--we just never entered into 
another Covell arrangement, in connection with these 
transactions. But this is quite common in connection with 
securities, antitrust, business litigation, etc.
    Senator Levin. This was in a firm, however, is that not 
correct, where a client of KPMG was also a client of yours?
    Mr. Cohen. That is correct.
    Senator Levin. And you used KPMG as the expert in the case 
which was brought against your client?
    Mr. Cohen. That is not correct. As I said----
    Senator Levin. That is not correct? This was not a case 
that was brought against your client, the taxpayer?
    Mr. Cohen. We did not use KPMG as an expert. That is the 
part that is not correct.
    Senator Levin. That is the part that----
    Mr. Cohen. That is correct. There is no----
    Senator Levin. You used their services in a case.
    Mr. Cohen. Well, that is actually----
    Senator Levin. Is that accurate?
    Mr. Cohen. Actually, the services that they provided were 
primarily in response to the Information Document Requests of 
the IRS, which they had already started providing to their 
client. It turned out that there was no exchange of information 
that needed protection via the Covell letter. Is that--have I 
explained that enough?
    Senator Levin. Was that the limit of any advice that you 
got, of any assistance that you got from KPMG in that case?
    Mr. Cohen. The limit was----
    Senator Levin. Do you see the problem here? Do you see 
what----
    Mr. Cohen. The limit was the furnishing of documents that 
had to be turned over to the IRS, yes.
    Senator Levin. And you could not get those documents except 
to hire them in that case and to pay them a fee? You could not 
get the documents otherwise, is that what you are telling me?
    Mr. Cohen. Well, we could not get the documents unless KPMG 
was willing--except through one of two sources, the client or 
the client's financial advisor--I guess three sources, or 
through KPMG.
    Senator Levin. Did you have to pay KPMG to get those 
documents?
    Mr. Cohen. No. All----
    Senator Levin. You could have gotten them without hiring 
them to provide services in that case.
    Mr. Cohen. The fees that KPMG received with respect to its 
services to the client were billed to the client.
    Senator Levin. Well, they were also, were they not, going 
to bill you?
    Mr. Cohen. No.
    Senator Levin. Well, what is this engagement letter which 
says our fees for this engagement will be based on the 
complexity of the issues? This is Exhibit 45.
    Mr. Cohen. Our fees in this engagement will be based on the 
complexity----
    Senator Levin. It says here, we are pleased to engage KPMG 
to assist Sutherland--that we are pleased you have engaged 
KPMG.
    Mr. Cohen. Well, since the client was being billed for 
this, this was run by the client's advisor as to whether this 
was the arrangement the client had with KPMG for fees.
    Senator Levin. And so the fees on page 2 that they are 
talking about are fees that they were charging to your joint 
client, is that correct?
    Mr. Cohen. These are fees that they were charging the 
client for their services in responding to Information Document 
Requests and the next paragraph makes it clear that our firm, 
since we are not being--we are not remitting anything to KPMG, 
we will only remit something to KPMG after the client sends a 
check to us.
    Senator Levin. And so the only funds that went to KPMG were 
from your joint client? Is that correct?
    Mr. Cohen. The only funds that went to KPMG were from 
KPMG's client.
    Senator Levin. Who was also your client?
    Mr. Cohen. My client, I was representing this client in 
connection with the audit and the potential settlement of his 
tax matter.
    Senator Levin. So joint client?
    Mr. Cohen. Well, I don't----
    Senator Levin. It was a client of both of yours?
    Mr. Cohen. Yes.
    Senator Levin. OK.
    Mr. Cohen. But that is--in my--normally, Senator, I would 
think of a joint client as someone you are jointly representing 
before the IRS. That is not the case.
    Senator Levin. I understand.
    Mr. Cohen. That is not the case.
    Senator Levin. It was a client of both of yours----
    Mr. Cohen. Well----
    Senator Levin. In different matters?
    Mr. Cohen. That is true, Senator, and I will tell you that 
I have a lot of----
    Senator Levin. I am just asking you if that is accurate.
    Mr. Cohen. That is absolutely accurate. I have a lot of 
clients that are joint clients in that sense.
    Senator Levin. I understand.
    Mr. Cohen. In fact a number of major corporations in the 
country are clients of mine for tax matters and are joint 
clients in that they are clients of KPMG.
    Senator Levin. Thank you.
    Mr. Cohen. Certainly.
    Chairman Coleman. Gentlemen, thank you for your testimony. 
Mr. Smith, I know that you were reading a statement that has 
not been submitted to the Subcommittee. Would you make that 
available to the Subcommittee?
    Mr. Smith. Yes.\1\
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Smith appears in the Appendix on 
page 312.
---------------------------------------------------------------------------
    Chairman Coleman. Thank you. Your testimony has been very 
helpful. Thank you very much.
    I would now like to welcome our second panel to today's 
important hearing: William Boyle, former Vice President of the 
Structured Finance Group of Deutsche Bank; and Domenick 
DeGiorgio, former Vice President of Structured Finance at HVB 
America. I thank each of you for your attendance at today's 
hearing and look forward to hearing your testimony.
    Before we begin, pursuant to Rule 6, all witnesses who 
testify before the Subcommittee are required to be sworn. I 
would ask at this time that you please stand and raise your 
right hand.
    Do you swear that the testimony you are about to give 
before the Subcommittee will be the truth, the whole truth, and 
nothing but the truth, so help you, God?
    Mr. Boyle. I do.
    Mr. DeGiorgio. I do.
    Chairman Coleman. As I indicated, gentlemen, before the 
previous panel, we use a timing system here. Statements should 
be five minutes. If you have a more complete statement, your 
entire statement will be entered into the record.
    Mr. Boyle, we will have you go first, followed by Mr. 
DeGiorgio. After we have heard all the testimony, we will turn 
to questions. Mr. Boyle, you may proceed.

     TESTIMONY OF WILLIAM BOYLE,\2\ FORMER VICE PRESIDENT, 
 STRUCTURED FINANCE GROUP, DEUTSCHE BANK AG, NEW YORK, NEW YORK

    Mr. Boyle. Chairman Coleman, Ranking Member Senator Levin, 
and members of the Subcommittee, thank you for inviting me 
today. My name is William Boyle. I am a former employee of 
Bankers Trust. I joined Deutsche Bank when it acquired Bankers 
Trust. I left Deutsche Bank 2 years ago and am now an 
independent consultant.
---------------------------------------------------------------------------
    \2\ The prepared statement of Mr. Boyle with an attachment appears 
in the Appendix on page 317.
---------------------------------------------------------------------------
    I welcome the opportunity to speak today about a 
transaction called BLIPS. The Subcommittee requested that I 
appear for an interview, which I was pleased to do so last 
week. The Subcommittee also requested that I appear today to 
testify, and I am pleased to do so voluntarily.
    Mr. Chairman, I was not involved in BLIPS at its inception. 
The BLIPS transaction was first proposed to Deutsche Bank in 
early 1999. Deutsche Bank played a banking role in the BLIPS 
transactions. My personal involvement in BLIPS began around 
June 1999, when I became a Vice President in the Structured 
Transactions Group of Deutsche Bank.
    BLIPS was developed for clients of KPMG. I understand it 
was designed for KPMG--I am sorry. I understand it was designed 
by KPMG or Presidio Advisors or both. BLIPS involved interest 
rate swaps and investments in foreign currency option contracts 
and foreign and domestic fixed-income securities.
    As part of BLIPS, Deutsche Bank issued to investors 
approximately 56 loans from September 1999 through October 
1999. The stated principal amount plus premium of these loans 
was approximately $7.8 billion. The average size of the loan 
issued to the BLIPS investor by the bank was approximately $139 
million.
    The bank lent money to investors and it executed 
transactions as directed by investors' investment advisors. As 
a major global bank, Deutsche Bank was able to provide 
financial services for such transactions. These services 
included providing large loans, custody services, foreign 
exchange option trading, and interest rate derivatives.
    The transactions were not designed by Deutsche Bank. The 
bank did not present BLIPS to investors or in any other way 
market, sell, or promote it. Deutsche Bank did not provide any 
tax advice to any of the investors, nor did the bank discuss 
with any investor any potential tax benefits of the investment.
    Deutsche Bank took several risk management steps to assure 
that its actions in the BLIPS transactions were limited to its 
role as the executor of the financial transactions. Let me 
summarize those actions.
    First, before making the loans, Deutsche Bank conducted an 
internal review process. The internal groups that reviewed the 
bank's provision of services were Deutsche Bank Private 
Banking, Global Markets, Tax, Legal, Credit Risk Management, 
Treasury, and Compliance.
    Second, each of the BLIPS investors agreed in writing that 
Deutsche Bank had not provided them with any tax, legal, 
investment, or other advice, and that they had, in fact, 
received such advice from expert professionals. One paragraph 
of that agreement read, ``You have been independently advised 
by your legal counsel and will comply with all Internal Revenue 
laws of the United States.''
    Third, the bank received written representation letters 
from KPMG, Presidio, and each investor that described the 
limited scope of Deutsche Bank's involvement in the BLIPS 
transactions. This was done so that there would be no 
misunderstanding.
    Fourth, Deutsche Bank consulted with a prominent outside 
independent law firm for its counsel. The law firm drafted and 
reviewed the transactional documents pertaining to the bank. It 
also provided Deutsche Bank with a legal opinion, which has 
been provided to the committee. This opinion concluded, among 
other things, that Deutsche Bank is not a promoter or organizer 
of the BLIPS transactions and that Deutsche Bank had no 
responsibility to register the transaction as tax shelters.
    Regarding the tax treatment, Deutsche Bank understood that 
the BLIPS transactions involved potentially favorable income 
tax benefits that could be claimed by investors. In discussing 
the tax issues, it is important to describe the role of the 
bank. Deutsche Bank provides banking services for a 
transaction. As such, it is not customary or appropriate to 
provide legal or tax advice to its clients, nor is it customary 
or appropriate to determine in advance whether a client's tax 
position will later be sustained. Historically, that is not a 
role that banks are authorized to play.
    Deutsche Bank's role as the executor of financial 
transactions meant that the determination of whether the 
investor's tax position would be sustained was outside of its 
banking role. Such a determination was the appropriate 
responsibility of the investor's lawyers and accountants. 
However, Deutsche Bank carefully considered its involvement in 
BLIPS and sought independent legal advice that it was complying 
with its responsibilities.
    Mr. Chairman, that concludes my oral statement and I would 
be pleased to answer questions.
    Chairman Coleman. Thank you very much, Mr. Boyle.
    Mr. DeGiorgio, I notice you have a gentleman with you. 
Would he please identify himself for the record?
    Mr. Skarlatos. Yes, sir. My name is Brian Skarlatos.
    Chairman Coleman. You may proceed, Mr. DeGiorgio.

  TESTIMONY OF DOMENICK DeGIORGIO,\1\ FORMER VICE PRESIDENT, 
  STRUCTURED FINANCE, HVB AMERICA, INC., NEW YORK, NEW YORK, 
                 ACCOMPANIED BY BRIAN SKARLATOS

    Mr. DeGiorgio. Thank you, Mr. Chairman. Chairman Coleman, 
Ranking Member Senator Levin, and members of the Subcommittee, 
my name is Domenick DeGiorgio and I am a Managing Director in 
the New York City office of Bayerische Hypo-und Vereinsbank, 
otherwise known as HVB. I appreciate the Subcommittee's 
invitation to come before you to discuss HVB's limited 
involvement with tax-oriented transactions in the late 1990's.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. DeGiorgio appears in the Appendix 
on page 326.
---------------------------------------------------------------------------
    We agree with the Subcommittee that there are important 
public policy issues raised by the tax shelter phenomenon and 
we support the Subcommittee's investigation into it. We look 
forward to discussing with you in the future the issues it 
raises.
    My written testimony addresses the specific questions asked 
by the staff about HVB's role in any tax-oriented transactions. 
As I point out in that submission, we were only involved in one 
particular series of transactions that the Subcommittee is 
investigating, the so-called BLIPS transactions, and our role 
there was limited to providing traditional banking services, 
such as lending, foreign currency trading, and some interest 
rate derivative trading.
    We did not organize, promote, or market any tax shelter 
transactions and we certainly did not offer tax advice or tax 
opinions or any other kind of financial or investment advice to 
any of the customers. We did not refer any customers to KPMG or 
Presidio and we did not accept, or, for that matter, were 
offered any referral fees. To reiterate, our role was strictly 
as bankers in these transactions.
    The Subcommittee staff has assured us that they agree HVB's 
activities in connection with the BLIPS transactions were legal 
and appropriate. We complied with applicable statutory and 
regulatory obligations. We followed our own cautious and 
conservative internal lending policies and the ``know your 
customer'' requirements.
    However, we recognize that the mass marketing of abusive 
tax shelters is a serious problem and we agree that financial 
institutions should not facilitate these types of products. 
Indeed, we discontinued our participation in the BLIPS 
transactions as soon as the IRS announced its position that 
they were improper. Since then, we have addressed our concerns 
about tax structured transactions by exiting the business 
entirely. We have concluded that tax structured transactions 
require extensive outside expert advice and go beyond our 
expertise as banking professionals.
    The staff has also told us that they appreciate HVB's 
candor and openness in providing information during the 
Subcommittee's investigation. Senator Levin's Minority Report 
released Tuesday makes a note of that fact.
    We have fully cooperated with your inquiries. We have 
produced thousands of pages of documents and have given several 
hours of interviews with the staff, even before my appearance 
here today. We even requested a friendly subpoena before my 
appearance here today so that I would be able under the 
financial privacy laws to discuss any questions or respond to 
any questions you may have.
    As I said, my written testimony addresses the specific 
issues you have asked me to discuss and I will be happy to 
discuss them now.
    Chairman Coleman. Thank you, Mr. DeGiorgio. I apologize. 
Having lived in Brooklyn, New York, and my neighbors were 
Keratanuito, Kalavido, and Camparelli, I should have been able 
to handle DeGiorgio, so---- [Laughter.]
    Mr. DeGiorgio. Mr. Chairman, it happens all the time.
    Chairman Coleman. I apologize for that, and thank you for 
your cooperation.
    Did KPMG, in your discussions with KPMG--first of all, how 
many of these BLIPS transactions was HVB involved in?
    Mr. DeGiorgio. Over the 2-year period, approximately 30 
transactions.
    Chairman Coleman. Did KPMG ever indicate to you this was a 
tax mitigation strategy versus an investment strategy?
    Mr. DeGiorgio. We certainly were aware, as opposed to being 
ignorant, regarding the inherent tax benefits associated with 
the investment strategy.
    Chairman Coleman. Did it ever become clear to you that this 
was not going to be a 7-year collateral premium loan as 
originally laid out, that this was going to be a 60-day deal?
    Mr. DeGiorgio. We certainly recognized soon after the 
funding date that the likelihood of going beyond a 60-day 
period was less probable than the probability of this 
transaction remaining through maturity.
    Chairman Coleman. If I can direct your attention to Exhibit 
111.\1\ This, I believe, is a Presidio credit request, and if 
you look at the second page, I think it is, under background, 
counterparty purpose of transaction, it reads as follows. ``HVB 
will earn a very''--again, let me just back up. If you go to 
page 1, under comments, it says, ``We are seeking an approval 
to fund four 7-year collateralized premium loans.'' That is in 
the box labeled comment. That is on the No. 1 relationship.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 111 which appears in the Appendix on page 2660.
---------------------------------------------------------------------------
    If you then go to box three, it notes that ``HVB will earn 
a very attractive return if the deals run to term. If, however, 
the advances are prepaid within 60 days, and there is a 
reasonable prospect they will be, HVB will earn a return of 
two-point''--I can't read that--a certain percent ``on the 
average balance of the funds advanced, and given the fact that 
our collateral will most likely be cash deposits, at least for 
the early stage of the transaction, we enjoy the possibility of 
earning an infinite ROE,'' presumably return on investment, 
``on these loans.''
    So at what point did somebody tell you these things are 
going to be 60-day deals and not 7-year premium high-risk 
loans?
    Mr. DeGiorgio. The communication regarding the likelihood 
of these transactions or the investors terminating their 
positions prior to the 7-year maturity rate came to the bank 
through the Presidio investment firm. I don't recall the exact 
verbiage used, but it went along the lines of it is likely that 
if the investors do not earn a substantial return on their 
investment during phase one of the investment strategy, they 
are likely to terminate their positions before the end of the 
year.
    Chairman Coleman. I have trouble with--well, let me back it 
up. Out of the 30 BLIPS transactions, how many got out after 60 
days?
    Mr. DeGiorgio. Eleven were funded in 1999 and all 11 
terminated their positions in 1999.
    Chairman Coleman. In 60 days?
    Mr. DeGiorgio. Yes.
    Chairman Coleman. Did that raise any question in your mind 
about whether these were 7-year premium deals or 60-day deals?
    Mr. DeGiorgio. Well, it certainly turned out to be 60-day 
transactions, but I still believe that there was some rational 
explanation and basis for entering into a 7-year facility.
    Chairman Coleman. How did you come to the interest rates on 
these? Do you recall what the interest rate was for these 
loans?
    Mr. DeGiorgio. I thought I would have that information on 
the front page of this exhibit, but I don't seem to see it 
there.
    Chairman Coleman. Well, how do you arrive at something 
generating a premium? What is the basis for that?
    Mr. DeGiorgio. I am sorry, generating a premium?
    Chairman Coleman. Yes. In these loans, you have a base 
loan, right, then you have a premium, how does that happen? 
What kind of conditions do you need for that to happen?
    Mr. DeGiorgio. The rate on the premium, is that what you 
are asking me?
    Chairman Coleman. Yes.
    Mr. DeGiorgio. That is----
    Chairman Coleman. I was told, I believe, by staff that it 
was right around 17 percent.
    Mr. DeGiorgio. Correct.
    Chairman Coleman. Is that a high rate?
    Mr. DeGiorgio. I think it was closer to 18 percent, and 
that is strictly a function of the net present value derived 
between the difference of the loans or the funds advanced and--
over a 7-year term--and the stated or face amount of the loan.
    Chairman Coleman. But again, based on a 7-year term?
    Mr. DeGiorgio. Correct.
    Chairman Coleman. But early on, you are noting that the 
reasonable prospects that this is going to be 60 days.
    Mr. DeGiorgio. Well, we certainly had some questions as to 
whether or not the investors could make a substantial return on 
their investment.
    Chairman Coleman. What kind of credit risk was there with 
these loans?
    Mr. DeGiorgio. The credit risk was nominal.
    Chairman Coleman. And that is----
    Mr. DeGiorgio. As I am sure you see, most of the 
transactions were over-collateralized.
    Chairman Coleman. Is that unusual?
    Mr. DeGiorgio. Not necessarily. In many situations where 
trading activities or underlying investments are the motives or 
basis for taking down a loan, the collateral coverage is rather 
high.
    Chairman Coleman. Did you have any knowledge whatsoever 
that by getting out after 60 days, with the premiums that these 
generated, that you were generating a tax loss for an investor?
    Mr. DeGiorgio. Again, we certainly were not ignorant of the 
resultant tax benefits. It is part of our due diligence.
    Chairman Coleman. And you realize our concern that these 
resulting tax benefits couldn't have come about unless you 
participate in this.
    Mr. DeGiorgio. Well, we certainly also recognized that a 
loan needed to be funded and you needed banks to fund those 
loans. But I think with permission, I would like to just 
elaborate on that for a moment and make it clear to the 
Subcommittee that for the tax advice and the tax analysis and 
the tax aspects of this transaction, our due diligence included 
understanding what support or level of support firms such as 
KPMG could and was willing to provide to its client base. And 
having received a copy of the draft of the opinion that was 
authored by KPMG, we certainly felt comfortable that based on 
the letter of the law and the analysis, that the opinion was 
well reasoned and it was supported by case study and we had no 
expertise or ability to challenge the conclusions reached in 
that opinion.
    Chairman Coleman. Mr. Boyle, let me get back to this issue 
about getting out in 60 days. Did Deutsche Bank expect that the 
taxpayers would likely terminate the BLIPS after only 60 days, 
even though the stated term of the loan was 7 years?
    Mr. Boyle. I think that Deutsche Bank understood there was 
a strong likelihood of that happening, and, in fact, it did 
happen.
    Chairman Coleman. I think strong likelihood may be an 
understatement. Will you turn to Exhibit 69,\1\ please. By the 
way, how many BLIPS transactions did Deutsche Bank process?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 69 which appears in the Appendix on page 644.
---------------------------------------------------------------------------
    Mr. Boyle. I believe approximately 56.
    Chairman Coleman. How many is that?
    Mr. Boyle. I believe 56.
    Chairman Coleman. Fifty-six. Exhibit 69 is from Presidio 
Advisors.
    Mr. Boyle. OK.
    Chairman Coleman. And it is to John Rolfes at Deutsche 
Bank. Can you identify who John Rolfes is?
    Mr. Boyle. John Rolfes, I believe, is a Managing Director 
in the Private Bank.
    Chairman Coleman. And this says, ``John, further to our 
Friday phone conversation, I would like to describe the 
necessary financing steps the BLIPS program will require,'' and 
it lays it out. Day one, investor borrows a certain amount for 
7 years, 16 percent annual rate. On day two, and I'm going to 
go now to the fourth paragraph, excuse me, day 7. On day 60, 
investor exits partnership and unwinds all trades in 
partnership. So Deutsche Bank up front knew that even though 
you were issuing what was a 7-year loan with an interest rate 
predicated on that, in fact, this was a 60-day deal.
    Mr. Boyle. Well, clearly, the credit agreement was 7 years, 
but you can see everyone got out of the loans we were involved 
in in a 60-day period, yes.
    Chairman Coleman. And again with Deutsche Bank, as with 
HVB, collateral here was more than the amount of the loan and 
the premium combined, is that correct?
    Mr. Boyle. Yes.
    Chairman Coleman. Deutsche Bank didn't have much risk in 
this.
    Mr. Boyle. Deutsche Bank had risk depending upon what the 
underlying assets were. I believe in the first stage, as you 
had seen, they elected to invest them in kind of short-term 
money market fund-type investments, so those were fairly very 
low risk, yes.
    Chairman Coleman. And didn't Deutsche Bank insist that if 
collateral ever dipped below the 100 percent--101 percent 
figure, Deutsche Bank would be entitled to get its money back 
immediately?
    Mr. Boyle. Yes. Well, I think that is a normal provision. I 
don't think that provision itself is unusual because your 
recourse is to the assets that are there, so you want to ensure 
that you can dispose of the assets and repay the loan, yes.
    Chairman Coleman. So tell me again the reason for the 16 
percent interest. How do you arrive at that figure?
    Mr. Boyle. My understanding is the client requested a 
premium loan, and once again, you determine the 16 percent rate 
would--you would basically discount that back and ensure that 
you received all the payments----
    Chairman Coleman. So the client requests a premium loan and 
it is a premium loan that feeds into the tax consequences, the 
opportunity to get a tax loss, is that correct?
    Mr. Boyle. That is my understanding, yes.
    Chairman Coleman. And that is what happened in all of these 
situations?
    Mr. Boyle. Yes.
    Chairman Coleman. Senator Levin.
    Senator Levin. Mr. DeGiorgio, looking at this straight, 
would you not agree that this was basically intended to be a 
tax deal for the taxpayer? Just to cut through all this stuff 
before--I am going to go through all of it with you anyway----
    Mr. DeGiorgio. OK.
    Senator Levin [continuing]. To prove it, but---- 
[Laughter.]
    In your heart of hearts, is this not clearly intended to be 
a tax deal?
    Mr. DeGiorgio. I think to dispute the notion that there 
were inherent and significant tax benefits is ridiculous. 
However, the investment strategy was described to us as a 
significant motive for these investors to enter into this 
transaction.
    Senator Levin. Could there be any profit in this 
transaction? I mean, is there any way? Just take a look at it. 
The only thing which was at risk was 7 percent of the premium, 
correct?
    Mr. DeGiorgio. During phase one, which is the first 60-day 
period?
    Senator Levin. Right.
    Mr. DeGiorgio. Correct.
    Senator Levin. The only thing that was at risk, and they 
all bailed out after 60 days----
    Mr. DeGiorgio. Right.
    Senator Levin [continuing]. And we will go through that 
just to show that is what the intention was. That is what the 
plan was, to finish at 60 days and then collect your tax loss. 
So assuming that is what happened, the only possible money that 
had any risk attached to it was that 7 percent that the 
taxpayer put up to pay all the fees, is that correct?
    Mr. DeGiorgio. Again, at least initially during phase one--
--
    Senator Levin. During the 60 days.
    Mr. DeGiorgio. Yes.
    Senator Levin. OK. Is that correct?
    Mr. DeGiorgio. Yes.
    Senator Levin. All right. Now, within 1 week after this 
loan was taken out by the taxpayer, the loan was assigned to an 
investment fund, right?
    Mr. DeGiorgio. Correct.
    Senator Levin. And you were aware of that fact?
    Mr. DeGiorgio. Yes.
    Senator Levin. Why wasn't the loan just made to the 
investment fund?
    Mr. DeGiorgio. That, I don't know. I am not sure why there 
was a two-tiered fund.
    Senator Levin. Why there was an assignment?
    Mr. DeGiorgio. Correct.
    Senator Levin. You don't know why these loans were just not 
made to the investment fund? Would there have been a tax 
advantage if it had been made to the investment fund?
    Mr. DeGiorgio. There probably was, if I recall some of the 
aspects of the KPMG opinion, it did refer to a shifting of 
liability from one entity to another.
    Senator Levin. Assignment of----
    Mr. DeGiorgio. Being correlated with the tax benefit.
    Senator Levin. Of course. From what you now know, would you 
agree the only way that the tax benefit, the tax loss, would be 
created is if the loan originally went to the taxpayer and then 
was almost immediately assigned to that so-called investment 
fund? Is that what you now are aware of?
    Mr. DeGiorgio. I am--the only way is a strong statement and 
I probably couldn't make that. But I can certainly ascertain 
that it is one way of creating a tax loss.
    Senator Levin. All right. If you could think of the other 
reason for doing that, let the Subcommittee know, will you, for 
the record?
    Mr. DeGiorgio. Sure.
    Senator Levin. We haven't been able to find one yet, but if 
you can find one, let us know.
    Now, did you eventually come to understand, at least, that 
BLIPS was primarily a tax avoidance scheme?
    Mr. DeGiorgio. No, I did not.
    Senator Levin. Let us go to Exhibit 107.\1\ Is it Alex 
Nouvakhov--am I pronouncing his name correctly?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 107 which appears in the Appendix on page 2646.
---------------------------------------------------------------------------
    Mr. DeGiorgio. Very close.
    Senator Levin. All right. He is with your bank?
    Mr. DeGiorgio. Yes, he is.
    Senator Levin. Now, he acknowledged to us that he knew that 
BLIPS was a tax shelter and here is what his notes read, if you 
could take a look at his notes. They are a little bit hard to 
read, but you will see on the right-hand side, right in the 
middle where there is a 7 percent and then there is an arrow 
up. Do you see that?
    Mr. DeGiorgio. I am with you.
    Senator Levin. OK. It says, ``Seven percent fee equity paid 
by the investor for tax sheltering.'' Do you see that?
    Mr. DeGiorgio. Yes, I do.
    Senator Levin. Well, he was aware of it, then, right?
    Mr. DeGiorgio. Well, certainly--I certainly was present at 
the meeting where this presentation was made.
    Senator Levin. Is that an accurate note?
    Mr. DeGiorgio. The note reflects the cost and how Presidio 
had intended on charging its investors for participating in the 
investment structure.
    Senator Levin. He didn't say investment structure. He says 
tax sheltering. Was that an accurate note or wasn't it?
    Mr. DeGiorgio. Actually, what Alex Nouvakhov thought at the 
point in time, I don't recall Presidio mentioning or referring 
to this as a tax shelter, but they certainly described to us 
how the calculation of the cost to the investor was being made.
    Senator Levin. Did you understand it basically to be a tax 
sheltering effort?
    Mr. DeGiorgio. I am sorry, can you repeat that, Senator?
    Senator Levin. Did you understand this at that point, then, 
to be basically a tax sheltering effort?
    Mr. DeGiorgio. No. I still referred to this----
    Senator Levin. I know you referred to it. I am talking 
about what you understand as a knowledgeable business person. 
Mr. Nouvakhov referred to it as a tax shelter and that the 7 
percent fee was for that purpose. Now I am asking you, under 
oath, did you understand this to be and believe it to be 
basically a tax sheltering effort?
    Mr. DeGiorgio. No, I did not. I still viewed it as an 
investment strategy with inherent tax benefits.
    Senator Levin. Now take a look at Exhibit 124.\1\ This is 
an HVB document. This begins on day 48. And then if you look at 
the second line on page one, it says, ``Day 48, ten business 
days prior to the withdrawal date.'' That is your document, 
right?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 124 which appears in the Appendix on page 2705.
---------------------------------------------------------------------------
    Mr. DeGiorgio. Yes, it is.
    Senator Levin. So it was obvious to you when you prepared 
this document that the withdrawal was going to occur on day 60, 
was it not?
    Mr. DeGiorgio. Not exactly.
    Senator Levin. What does it mean, ten business days prior 
to withdrawal date? It doesn't say possible withdrawal date. It 
says withdrawal date, right? Are you familiar with this 
document?
    Mr. DeGiorgio. Absolutely.
    Senator Levin. Does it say prior to withdrawal date? Am I 
reading it right, or is this something subject to 
interpretation like Mr. Nouvakhov's notes?
    Mr. DeGiorgio. No, not at all. I can explain it fully.
    Senator Levin. All right.
    Mr. DeGiorgio. Given the time of year, obviously it was 
fourth quarter 1999 going into a Y2K event, we as an 
institution--since we had reasonable expectations that the 
transactions would terminate within a 60-day period--prepared 
our back office and operations teams for the reasonable 
expectation of an unwind.
    Senator Levin. Within 60 days?
    Mr. DeGiorgio. Within 60 days. But I have to say, Senator, 
if this were a different time of the year, in other words, if 
these transactions were funded in January and the 60-day period 
occurred within the first quarter of that year, this process 
would never have been put in place. It was simply a function of 
year-end constraints in addition to the Y2K events.
    Senator Levin. To summarize your testimony, you had the 
reasonable expectation that the withdrawal would occur by day 
60 and then that happened in every case?
    Mr. DeGiorgio. Correct.
    Senator Levin. There was a theoretical possibility that it 
wouldn't occur within 60 days, is that correct?
    Mr. DeGiorgio. Theoretical possibility.
    Senator Levin. And your bank could force it to end at 60 
days, couldn't it?
    Mr. DeGiorgio. No.
    Senator Levin. You didn't have the power to end it at 60 
days?
    Mr. DeGiorgio. No, unless there were violations in the 
collateral ratio.
    Senator Levin. And the collateral ratio was 100 percent-
plus, right?
    Mr. DeGiorgio. Hundred-and-one-point-two-five.
    Senator Levin. Pretty solid collateral there?
    Mr. DeGiorgio. Absolutely.
    Senator Levin. No risk for the bank?
    Mr. DeGiorgio. No credit risk. Plenty of execution and 
operational and administrative risks.
    Senator Levin. There were operational risks. Didn't you 
control the fund? Wasn't it in your custody?
    Mr. DeGiorgio. The funds were not necessarily at risk 
because you are absolutely correct. The funds remained in an 
account under the customer's name at the bank.
    Senator Levin. At your bank?
    Mr. DeGiorgio. Correct. The risks I am referring to, again, 
are operational regarding the trading activities----
    Senator Levin. Which was limited to the 7 percent that the 
customer put up, right?
    Mr. DeGiorgio. During the first 60 days, correct.
    Senator Levin. And you had the reasonable expectation when 
it would end, right?
    Mr. DeGiorgio. Yes. I said that.
    Senator Levin. I now want you to say it, though, in 
connection with this point, which is that since there was an 
expectation that it would end within 60 days and there was no 
risk to the bank of its funds at all within that 60 days, 
because you were more than fully collateralized, that therefore 
the reasonable expectation was there would never be a risk to 
the bank.
    Mr. DeGiorgio. Certainly the likelihood of there being 
credit risk to the bank was low, as we have ensured to protect 
ourselves with the over-collateralization measures.
    Senator Levin. And if you look at Exhibit 125,\1\ you have 
a chart showing that all the loan proceeds--not the equity, not 
that 7 percent, the taxpayer's equity--is converted into Euros 
and will be converted back 30 days later. So this is a Euro 
account. This is not the loan, the premium loan or the basic 
loan. This is just the 7 percent, is that correct, or is this 
the whole loan?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 125 which appears in the Appendix on page 2711.
---------------------------------------------------------------------------
    Mr. DeGiorgio. This is the whole loan proceeds.
    Senator Levin. This is the loan proceeds?
    Mr. DeGiorgio. Right.
    Senator Levin. So the so-called loan, and there is a great 
question as to whether there was a loan here at all since, for 
all the reasons that have been given the other day, but 
basically it was in your control, fully collateralized, and 
expected to be terminated at 60 days during which there was no 
risk, but in any event, during that period, there was a deposit 
into a Euro account, is that basically correct?
    Mr. DeGiorgio. That is correct.
    Senator Levin. Were any of the loan proceeds during that 
period put at risk during the investment scheme, as part of the 
investment scheme?
    Mr. DeGiorgio. Not during the first 60-day period.
    Senator Levin. That is the period we are talking about, 
right?
    Mr. DeGiorgio. Yes.
    Senator Levin. My time is up. Thank you.
    Chairman Coleman. We will come back to a second round, 
Senator Levin.
    Senator Levin. Thank you.
    Chairman Coleman. Mr. Boyle, on the issue about whether the 
loan was at risk in terms of the Deutsche Bank transactions, 
did Deutsche Bank lay out some requirement that the loan had to 
be invested in certain types of securities?
    Mr. Boyle. There was a list of permitted investments, yes.
    Chairman Coleman. And these, it is my understanding, they 
generate a lower rate of return than the interest that the 
Deutsche Bank was charging?
    Mr. Boyle. I believe that the investment that they chose 
for the first days was an investment that----
    Chairman Coleman. So Deutsche Bank knew up front there was 
going to be no profit generated within this 60-day period.
    Mr. Boyle. To the--you mean with--after----
    Chairman Coleman. Investor.
    Mr. Boyle. After he made the investment, yes.
    Chairman Coleman. And again, at least the Deutsche Bank 
clearly got from Presidio a memo saying this is a 60-day deal.
    Mr. Boyle. Like I said before, there was an expectation 
that it may very well wind up at 60 days, and in fact, did 
unwind.
    Chairman Coleman. I mean, again, expectation. On day 60, 
investor exits partnership and unwinds all trades in 
partnership. That is Exhibit 69. That is not an equivocal 
expectation, is it?
    Mr. Boyle. That language is clearly not, no, sir.
    Chairman Coleman. Exhibit 113.\1\ This is a memo, Deutsche 
Bank Private Bank management committee meeting talking about 
the BLIPS product, is that correct?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 113 which appears in the Appendix on page 2679.
---------------------------------------------------------------------------
    Mr. Boyle. Yes.
    Chairman Coleman. And on page two, it indicates that KGT 
suggests that 25 customers be selected from different 
geographic areas. PKS will ensure that written agreements be 
prepared. Can you help me understand why you would want to 
select 25 customers from different geographic areas?
    Mr. Boyle. I don't know precisely. That was a Private Bank 
recommendation, I guess, to John Rolfes. I don't believe that 
applied to us per se in the Structured Transactions Group.
    Chairman Coleman. Is that unusual, to put those kinds of 
geographic limitations on this?
    Mr. Boyle. I don't know, to be honest with you, sir. No.
    Chairman Coleman. Our concern here, is this an effort to 
keep this under the radar screen?
    Mr. Boyle. I don't know.
    Chairman Coleman. Have you heard of any other similar 
restrictions being placed in any other Deutsche Bank 
transactions?
    Mr. Boyle. Not that I am aware of, no.
    Chairman Coleman. And Deutsche Bank ultimately engaged in 
56 of these deals. Senior management said 25. What is the 
reason for the difference?
    Mr. Boyle. The reason for the difference. A different--
originally, we were focusing on the amount that we may 
potentially loan and we wanted to do things in different stages 
to make sure we were comfortable executing the transactions, 
and I believe the initial stage, we were approached with the 
idea of doing up to 25 investors.
    Chairman Coleman. Again, I go back to this question that 
Senator Levin asked of Mr. DeGiorgio. Looking at this, is there 
any question in your mind that these were tax shelters that 
were going to be used to provide opportunities for taxpayers to 
generate loss and write it off?
    Mr. Boyle. Well, it is very clear from the opinions and 
everything that there were significant tax benefits that the 
investor may report on its return, yes.
    Chairman Coleman. Were you concerned? Is Deutsche Bank 
concerned at all about the reputational risk for being involved 
in this stuff?
    Mr. Boyle. You know, like all investments, we are very 
concerned in terms of reviewing, going through a very thorough 
internal review.
    Chairman Coleman. Have you changed your practices today?
    Mr. Boyle. I am no longer an employee, so--I am certain 
they adjusted everything accordingly, but I am not there 
anymore.
    Chairman Coleman. And Mr. DeGiorgio, you have indicated 
that HVB has, in fact, changed its practices?
    Mr. DeGiorgio. That is correct, and it is DeGiorgio. 
[Laughter.]
    Chairman Coleman. And it changed its practices because 
these are abusive tax shelters?
    Mr. DeGiorgio. Well, when it became abundantly clear to the 
bank that the IRS had issues with the strategy, as was 
reflected, I believe, in a notice in August 2000, we 
immediately discontinued our participation in the transaction.
    Chairman Coleman. And again, it is your testimony here 
today that in spite of the fact that you had--how many BLIPS 
accounts did you have?
    Mr. DeGiorgio. Approximately 30.
    Chairman Coleman. Thirty, that you had 30 BLIPS accounts, 
that all of these were purported to be 7-year loans at 16 
percent interest rate, even though it was clear they were going 
to be exiting in 60 days and they were all exited on 60 days, 
and at the time, you weren't aware that these were abusive tax 
shelters?
    Mr. DeGiorgio. That is correct.
    Chairman Coleman. Senator Levin.
    Senator Levin. Mr. Boyle, take a look at Exhibit 70,\1\ if 
you would. This is a bank document relative to BLIPS. It is 
called a new product committee overview memo. Take a look at 
page three, if you would, and it is point 12. ``It is 
imperative that the transaction be wound up after 45 to 60 days 
and the loan repaid due to the fact that the HNW individual 
will not receive his or her capital loss or tax benefit until 
the transaction is wound up and the loan repaid.'' Is that 
correct?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 70 which appears in the Appendix on page 646.
---------------------------------------------------------------------------
    Mr. Boyle. Excuse me?
    Senator Levin. Is that--did I read that correctly?
    Mr. Boyle. Well, you read it correctly, yes.
    Senator Levin. So it was imperative that this be wound up 
in 45 to 60 days in order that the person get their tax 
benefit? Am I reading it right?
    Mr. Boyle. Well, like I said before, the loan itself was a 
7-year loan that people had the option of repaying at any time 
within that particular 7 years. And based upon the tax opinion, 
if they wanted to potentially take that tax benefit in the 
current year----
    Senator Levin. Not potentially. Forget the potentially.
    Mr. Boyle. OK.
    Senator Levin. If they wanted to get the tax benefit.
    Mr. Boyle. If they wanted to get the tax benefit, they 
would have had to unwind it in the current year, yes.
    Senator Levin. And that was 60 days?
    Mr. Boyle. Yes, sir.
    Senator Levin. OK. Now, in Exhibit 106,\2\ this is your 
PowerPoint presentation about this transaction. This is your 
Structured Transaction Group. That is the group that 
implemented BLIPS. You were part of that group, were you not?
---------------------------------------------------------------------------
    \2\ See Exhibit No. 106 which appears in the Appendix on page 2622.
---------------------------------------------------------------------------
    Mr. Boyle. Yes, sir.
    Senator Levin. Page 7 of the exhibit describes the client 
environment for the group. It says that your group was doing 
``tax driven deals.''
    Mr. Boyle. Those are the words, yes.
    Senator Levin. Is that a lie? Is your own PowerPoint 
presentation a lie?
    Mr. Boyle. No. I mean, the group was involved in complex 
financial transactions in which there were significant tax 
benefits, yes.
    Senator Levin. No. Not significant tax benefits. Let us put 
that aside. We have heard that rhetoric two or three times. We 
are talking about your own PowerPoint that says these were 
``tax driven deals.'' Were those words a lie?
    Mr. Boyle. I did not prepare the document.
    Senator Levin. Were they accurate?
    Mr. Boyle. That there were significant tax benefits?
    Senator Levin. No, that they were tax driven.
    Mr. Boyle. I don't know the precise context that they are 
using tax driven, but clearly, if you believe that----
    Senator Levin. Give me a context for that. These are three 
words, tax driven deals.
    Mr. Boyle. Yes. If you----
    Senator Levin. That doesn't mean some tax benefits. That 
means these were tax driven deals. That is your document. That 
is your bank's document.
    Mr. Boyle. Yes.
    Senator Levin. Was that accurate or not, that these were 
tax driven deals?
    Mr. Boyle. If they are referring to the fact that there 
were significant tax benefits, yes.
    Senator Levin. Otherwise, if they were driven by those 
benefits--driven?
    Mr. Boyle. Well, you have to look at----
    Senator Levin. Driven means that is the principal point. 
That is the driver. You know what the word means.
    Mr. Boyle. Yes, sir.
    Senator Levin. Let us not fiddle around with words. Were 
these tax driven deals?
    Mr. Boyle. I don't know which ones--I don't know which 
deals they were referring to in that----
    Senator Levin. BLIPS.
    Mr. Boyle. BLIPS?
    Senator Levin. Was BLIPS a tax driven deal?
    Mr. Boyle. I am not sure they are referring to BLIPS in 
that transaction.
    Senator Levin. Well, was BLIPS a tax driven deal?
    Mr. Boyle. BLIPS had a very significant tax benefit, yes, 
sir.
    Senator Levin. Yes. And so you are denying it was a tax 
driven deal?
    Mr. Boyle. No, I am saying if tax driven means significant 
tax benefits, yes.
    Senator Levin. And if it means that the principal purpose 
of it was tax benefits, it was not?
    Mr. Boyle. That is something we weren't involved in 
deciding or reviewing.
    Senator Levin. You weren't involved in reviewing? I am 
asking you, you are saying that there were tax benefits. You 
knew that much.
    Mr. Boyle. Yes. We understood that----
    Senator Levin. But you can't say that it was driven by tax 
benefits, is that correct?
    Mr. Boyle. Yes.
    Senator Levin. You are not saying that?
    Mr. Boyle. No. I mean, you are asking me what the 
investors' intentions were. We did not talk to the investors, 
no, sir.
    Senator Levin. I am talking about your chart at your bank, 
your PowerPoint presentation.
    Mr. Boyle. Right.
    Senator Levin. You were part of the committee that prepared 
it. I am asking you, are those words accurate, that you were 
looking at tax driven deals. You are not going to--you are 
going to basically tell me today that if it means something 
that it doesn't mean, then yes. Now I am asking you, if it 
means what it says, is the answer yes or no? Was your bank 
engaged in tax driven deals?
    Mr. Boyle. Like I said before, if it means transactions 
that may have significant tax benefits, yes. And I did not 
prepare this----
    Senator Levin. If it means that the principal purpose was 
tax benefits, then yes or no?
    Mr. Boyle. I don't--I am not aware of that.
    Senator Levin. The other word is ``gain mitigation 
strategies,'' by the way. Take a look now at page 17 of that 
same exhibit. You will see that BLIPS is listed as one of the 
deals implemented by the group.
    Mr. Boyle. Yes.
    Senator Levin. Were you aware of the fact, Mr. Boyle, that 
the premium part of the so-called loan when it was repaid would 
generate a tax loss for the taxpayer?
    Mr. Boyle. I was aware that may be the position they took, 
yes, I was.
    Senator Levin. Thank you. Now, it was designed as a 7-year 
investment program, but I think you indicated that the 
reasonable likelihood was that the taxpayer would get out after 
60 days. Is it not true that it was anticipated that taxpayers 
would get out at 60 days?
    Mr. Boyle. We understood that they made that choice, yes.
    Senator Levin. Was it anticipated the taxpayers would get 
out, not possibly get out, but was it anticipated that they 
would get out at 60 days?
    Mr. Boyle. I would say it was anticipated that they would 
get out, yes.
    Senator Levin. Thank you. You said anticipated they get 
out, yes, you meant, I assume, that they would get out in 60 
days?
    Mr. Boyle. In 60 days, yes, sir.
    Senator Levin. Thank you. Now, was the amount of funds that 
were at risk limited to the funds contributed by the taxpayer, 
that 7 percent?
    Mr. Boyle. No. They had a series of permitted investments 
that they could choose from. In the first stage, my 
understanding is they all invested in what you would refer to 
as low-risk investments.
    Senator Levin. So that if the 60-day period was the limit 
of the loan, then the risk in the foreign currency transactions 
would be limited to the funds contributed by the taxpayer, that 
7 percent?
    Mr. Boyle. I believe so, yes.
    Senator Levin. Was the 7 percent approximately that was 
contributed by the taxpayer in Presidio that was held in your 
bank until the investment fund was closed, is that also true?
    Mr. Boyle. I am sorry?
    Senator Levin. Your bank held the funds?
    Mr. Boyle. I believe so, yes. Well, yes. It went into a 
custody account in the Private Bank.
    Senator Levin. So the funds were held in your custody?
    Mr. Boyle. For the benefit of the client, yes.
    Senator Levin. Yes. And the 7.7 percent was intended to 
cover market risks, transaction costs, and Deutsche Bank fees, 
is that correct?
    Mr. Boyle. Yes.
    Senator Levin. Now, there was an Exhibit 103,\1\ if you 
take a look at that. It is from Mick Wood. He worked at the 
bank?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 103 which appears in the Appendix on page 2615.
---------------------------------------------------------------------------
    Mr. Boyle. Yes.
    Senator Levin. In response to a memo that you wrote to him 
about BLIPS, this is, I think, similar to the question that our 
Chairman raised, and if I am duplicating it exactly, then 
forgive me. I may have missed your exhibit reference here, Mr. 
Chairman. But Exhibit 103 is a reply to a memo that you wrote 
about BLIPS, and he said, ``I would have thought you could 
still ensure that the issues are highlighted by ensuring that 
the papers are prepared and all discussion held in a way which 
makes them legally privileged.'' It sounds like he is 
suggesting that Deutsche Bank should hide the program behind 
the claim of privilege, is that correct?
    Mr. Boyle. You may possibly interpret it that way. My 
understanding--I don't know--I don't recall much of what was 
hidden. I think the only things I recall was trying to limit 
the tax discussion with our attorneys to the appropriate 
professionals in the bank to review that. I think everything 
else is fairly well laid out, including any potential tax 
benefits that the investor may receive from the transaction.
    Senator Levin. You are saying that the purpose for the 
privilege was not to hide this program behind such a claim?
    Mr. Boyle. I think the purpose--I don't remember precisely, 
but I think generally my recollection is that the reference to 
privilege was more to--as you recall, we were advised--not 
advised, but we were counseled by an outside law firm and they 
were preparing a tax opinion with respect to our role in the 
transaction and it was, I believe, to limit the access people 
had internally to that document to the appropriate 
professionals that should be reviewing it.
    Senator Levin. And the purpose of limiting access to the 
document?
    Mr. Boyle. To the tax opinion, yes.
    Senator Levin. The tax opinion?
    Mr. Boyle. Yes.
    Senator Levin. Take a look at Exhibit 104.\1\ This is an e-
mail from Ivor Dunbar----
---------------------------------------------------------------------------
    \1\ See Exhibit No. 104 which appears in the Appendix on page 2618.
---------------------------------------------------------------------------
    Mr. Boyle. Yes.
    Senator Levin. Co-head of your Structured Transaction Group 
who implemented BLIPS, and that again was your group, I gather, 
and here is what he says under point two, privilege.
    Mr. Boyle. Yes.
    Senator Levin. ``This is not easy to achieve, and therefore 
a more detailed description of the tax issues is not 
advisable.'' Don't describe the tax issues.
    Mr. Boyle. Yes.
    Senator Levin. Keep those out of any paper trail.
    Mr. Boyle. Right.
    Senator Levin. Is that right?
    Mr. Boyle. That is clearly what he said there, yes.
    Senator Levin. Yes. Now look at point three in that same e-
mail, reputation risk. ``In this transaction, reputation risk 
is tax related and we have been asked by the tax department not 
to create an audit trail.'' The tax department, don't create an 
audit trail in respect to the bank's tax affairs. ``The tax 
department assumes primary responsibility for controlling tax 
related risks, including reputation risk, and will brief senior 
management accordingly. We are therefore not asking risk and 
resources committee to approve the reputation risk.'' Boy, 
isn't that unusual?
    Mr. Boyle. I don't----
    Senator Levin. Not to approve a reputation risk because we 
want to do this orally?
    Mr. Boyle. I don't believe that is what he was getting at. 
I think what they were doing is in terms of reviewing the tax--
the transaction, they were restricting that to the tax 
professionals, the attorneys, and senior management. I don't 
believe that--when you go through the internal documents in 
terms of the approvals and that, I mean, it was always clear 
that there were tax benefits that may arise to the investor in 
the transaction. I don't believe that was hidden or kept low 
profile at any point in time.
    Senator Levin. No, but it was hidden. Not the tax benefits. 
What was hidden is what you are so unwilling to say but which 
is so obviously true, which is that was the principal purpose 
of the transaction. That is what the effort was. Obviously, 
there are tax impacts of every transaction. But this, the fact 
that this was intended to be a tax shelter, and that was its 
principal purpose, which is obvious from everything, is what 
they didn't want to say there, because there would be a 
reputational risk at that point.
    And let me go on to that reputational risk. By the way, 
would there not be a reputational risk if, in fact, your 
papers--every time your papers say that the principal purpose 
of this was a tax deal, does that not create a reputational 
risk?
    Mr. Boyle. If that is, in fact, true. I don't recall 
anything----
    Senator Levin. Yes, it would create a reputational risk 
every time you would say, this is a tax deal primarily, right? 
You would agree that creates a reputational risk?
    Mr. Boyle. Yes, I would--yes, but I don't recall those 
words out there anywhere in terms of----
    Senator Levin. Well, we have gone through a lot of 
documents which quite clearly talk about this being a tax deal.
    Mr. Boyle. Yes, sir.
    Senator Levin. Having to be wound up in a certain number of 
days and so forth. So what we see here is the tax department at 
Deutsche Bank saying that the reputational risk here was so 
great that it pulled the review of the BLIPS program out of 
your risk and resources committee because there would have been 
a paper trail, as you just indicated, and it instead personally 
briefed Mr. John Ross, who is the CEO of Deutsche Bank 
Americas.
    Now, how many times do you think that that would have 
happened, where there were these kind of tax deals that were 
pulled away from that committee and orally discussed with the 
CEO instead because of a statement that there is a reputational 
risk in having this reviewed by your committee? Do you think 
that happened frequently or would this be unusual?
    Mr. Boyle. No. My understanding is that it was not pulled 
away from that committee because of BLIPS. I think that was a 
general policy that the bank was going through, that the tax 
aspects would be reviewed by the tax professionals and senior 
management.
    Senator Levin. But it says here, though, in Exhibit 104 
again that we are, therefore, not asking risk and resources 
committee to approve reputational risk on BLIPS. This will be 
dealt with directly by the tax department and John Ross. I am 
asking you, was that common?
    Mr. Boyle. With respect to any tax related transaction, 
yes.
    Senator Levin. It was?
    Mr. Boyle. I believe so.
    Senator Levin. OK. I believe that the chairman is covered 
in Exhibit 113,\1\ where that same type of issue was raised--
where it says, John Ross approved the product, however, 
insisted that any customer found to be in litigation be 
excluded from the product, the product be limited to 25 
customers, and that a low profile be kept on these 
transactions. Again, try me on this one. Why a low profile? Why 
limit it to 25?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 113 which appears in the Appendix on page 2679.
---------------------------------------------------------------------------
    Mr. Boyle. My recollection of the conversations, we were 
sitting down and taking Mr. Ross through the transaction, 
particularly our role in the transaction, and because it 
involved a more likely than not opinion for the potential tax 
benefit to the investor, we wanted to make very clear what our 
role was just in terms of banking, that we are not out there 
marketing or providing tax advice and that type of thing. So I 
am--my guess is he was referring to that conversation.
    Senator Levin. My final line of questions, if I ask the 
indulgence of the Chair, who has been very generous in many 
ways. Exhibit 105,\2\ if you take a look at that, is an e-mail 
from you, Mr. Boyle, to John Wadsworth, and this is going to 
take a couple of minutes to work through this.
---------------------------------------------------------------------------
    \2\ See Exhibit No. 105 which appears in the Appendix on page 2619.
---------------------------------------------------------------------------
    Mr. Boyle. Actually, I don't have Exhibit 105. Oh, here it 
is.
    Senator Levin. You have it? OK. Here is what you wrote. 
``During 1999, we executed $2.8 billion of loan premium deals 
as part of BLIPS approval process. At that time, NetWest and 
HVB Bank had executed approximately a half-billion dollars of 
loan premium deals. I understand that we based our limitations 
on concerns regarding reputational risk which were heightened 
in part on the proportion of deals we have executed relative to 
the other banks.'' You had done a lot of this, compared to the 
other banks, and here is what you proposed.
    ``In addition to the execution of the underlying FX 
transactions, we would like to lend an amount of money to HVB 
Bank equal to the amount of money HVB Bank lends to the client. 
We could potentially make a market interest rate loan secured 
by HVB high coupon loan to the client which would be secured by 
the underlying FX transactions. The loan we fund HVB Bank with 
could be differentiated from the underlying loan to the client 
because of the market coupon versus high coupon, the date the 
loans are made, and the fact that we do not face the client as 
HVB Bank does.''
    So in other words, Mr. Boyle, the reputational risk to 
Deutsche Bank for doing additional BLIPS deals was so great 
that the bank is not permitting any additional transactions, 
and in response to that situation, your solution is not to halt 
BLIPS transactions. Rather, you propose to fund and execute 
additional BLIPS transactions through the front of another 
bank, HVB.
    Now, if the reputational risk is that great, shouldn't 
Deutsche Bank stop its participation rather than try to hide 
its involvement in more of these transactions?
    Mr. Boyle. I think we have to put this note in context from 
what I remember. The bank itself had reached the conclusion 
back in November or October 1999 they didn't want to 
participate anymore with these particular transactions. My 
understanding is that there may have been other opportunities 
to do some more. We approached Mr. Wadsworth with respect to 
revisiting this, and he clearly was not interested in doing any 
more of these deals, and it stopped at that point.
    Senator Levin. Mr. DeGiorgio, did Deutsche Bank approach 
HVB about this idea?
    Mr. DeGiorgio. Yes, it did.
    Senator Levin. And did you or HVB accept the idea?
    Mr. DeGiorgio. No, we did not.
    Senator Levin. You rejected it?
    Mr. DeGiorgio. Yes, we did.
    Senator Levin. And why?
    Mr. DeGiorgio. Because we were concerned with the 
operational and execution risks associated with the transaction 
that would not have been alleviated in the structure that had 
been proposed, as you see in this e-mail.
    Senator Levin. Thank you. Thank you, Mr. Chairman.
    Chairman Coleman. Thank you. Mr. DeGiorgio and Mr. Boyle, 
you are excused.
    I would now like to welcome our third panel to today's 
hearing: John Larson, Managing Director of Presidio Advisory 
Services; and Jeffrey Greenstein, Chief Executive Officer of 
Quellos Group, formerly known as Quadra Advisors. I thank each 
of you for your attendance at today's hearing and look forward 
to your testimony.
    Before we begin, pursuant to Rule 6, all witnesses who 
testify before the Subcommittee are required to be sworn. At 
this time, I would ask you to please stand and raise your right 
hand.
    Do you swear that the testimony you are about to give 
before this Subcommittee is the truth, the whole truth, and 
nothing but the truth, so help you, God?
    Mr. Larson. I do.
    Mr. Greenstein. I do.
    Chairman Coleman. Again, as you have seen with the earlier 
panels, I would like testimony to be 5 minutes. Your written 
testimony will be entered into the record in its entirety.
    Mr. Larson, we will have you go first this morning, 
followed by Mr. Greenstein. After we have heard all the 
testimony, we will then turn to questions. Mr. Larson.

TESTIMONY OF JOHN LARSON, MANAGING DIRECTOR, PRESIDIO ADVISORY 
              SERVICES, SAN FRANCISCO, CALIFORNIA

    Mr. Larson. I have no advance statement.
    Chairman Coleman. Mr. Greenstein.

 TESTIMONY OF JEFFREY GREENSTEIN,\1\ CHIEF EXECUTIVE OFFICER, 
  QUELLOS GROUP, LLC, FORMERLY KNOWN AS QUADRA ADVISORS, LLC, 
                      SEATTLE, WASHINGTON

    Mr. Greenstein. Mr. Chairman, Senator Levin, my name is 
Jeff Greenstein and I appreciate the opportunity to be here 
today. I am the Chief Executive Officer of Quellos Group, based 
in Seattle, and since our founding in 1994, we have focused on 
providing both asset management services to institutional and 
private clients worldwide.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Greenstein appears in the 
Appendix on page 334.
---------------------------------------------------------------------------
    We understand and very much respect the Subcommittee's 
responsibility in this area and its interest in ascertaining 
whether there is a need to change public policy.
    You have asked me to address tax advantaged investments or 
strategies with names like BLIPS, SC2, FLIP, and OPIS. With 
respect to BLIPS and SC2, we have no experience in these areas 
whatsoever and, therefore, I cannot comment. With respect to 
the latter two strategies, I am able to discuss the investment 
and structural aspects with the Subcommittee today, although 
let me emphasize that I do not have any tax expertise and thus 
am not able to provide meaningful input on the tax aspects of 
either strategy.
    As you have heard, prior to our involvement, the 
international accounting firm of KPMG developed FLIP in the 
mid-1990's to provide its clients with a tax savings investment 
strategy. In the course of many conversations and meetings, 
KPMG advised us that its senior tax experts, many of whom had 
direct Treasury or IRS experience, had carefully researched the 
existing statutes and regulations and that KPMG's national tax 
office had concluded that these transactions would likely yield 
favorable tax treatment for its investors under the Internal 
Revenue Code.
    By way of history, our introduction to KPMG occurred in 
1995 in a matter completely unrelated to what we are here today 
to discuss. We were working with one of our clients to 
restructure a portion of their portfolio to meet their 
investment objectives. Given the importance of analyzing any 
investment portfolio on an after-tax basis, our client asked to 
review our portfolio recommendations with its tax advisor, 
KPMG, and therefore, at the client's request, we did.
    As a result of this prior interaction, KPMG later contacted 
us to see if we would apply our investment expertise to help 
with the security transactions related to one of its 
strategies. This strategy later became known as FLIP. KPMG 
presented us with a set of predefined criteria that it had 
designed for FLIP and told us that transactions meeting these 
criteria would likely result in favorable tax consequences. Our 
role as investment advisor was to identify, analyze, implement, 
and manage the specific stock and option transactions that were 
required to execute FLIP.
    These transactions gave investors a reasonable prospect of 
earning an economic profit which, in fact, was very real as a 
number of FLIP and OPIS investors did indeed realize an overall 
profit. The profit potential was directly linked to the gradual 
appreciation in the public shares of one of the world's major 
financial institutions. KPMG specifically approved all of the 
stock and option transactions after it had determined that the 
transactions met the criteria for obtaining favorable tax 
consequences.
    Our role as investment advisor was formalized in 1997 with 
an agreement between KPMG and Quadra that defined our different 
roles. In the agreement, KPMG confirmed its responsibility for 
the tax aspects of the strategy while agreeing that Quadra had 
responsibility for only providing investment advice. KPMG was 
and remains an international accounting firm with an excellent 
reputation and deep resources and we relied on its tax 
analysis, conclusions and advice. Additionally, a prominent 
national law firm concurred with their opinion.
    KPMG began introducing FLIP to potential investors during 
1996, and subsequently, Pricewaterhouse Coopers, PWC, developed 
a similar strategy with similar tax attributes. They sought and 
received our assistance in providing investment-related advice 
and execution services. PWC also provided a detailed opinion of 
this strategy which was consistent with KPMG's earlier 
conclusion that the Internal Revenue Code likely afforded 
favorable tax treatment.
    In 1998, we were approached again by KPMG with respect to a 
variation of the FLIP transaction known as OPIS. It was our 
understanding that KPMG had been offering this strategy to its 
clients through another investment advisor, the Presidio Group, 
but that the Presidio Group had exhausted its capacity. At that 
time, KPMG requested our assistance with executing OPIS. For 
OPIS, all of the investment and structural aspects of the 
strategy were fully developed, the nature of the financial 
instruments and security transaction had been fully specified, 
and our role was simply to implement the trades and execute the 
documents required as prescribed by KPMG.
    Chairman Coleman. I would ask you to summarize the rest of 
your testimony, Mr. Greenstein.
    Mr. Greenstein. Thank you. I want to reiterate that our 
focus has been on meeting the financial and investment 
objectives of our clients through thoughtful, sophisticated, 
disciplined, and well-researched portfolio management. This 
presented us with the opportunity to work with some of the most 
respected groups in the industry, and I think it is important 
to note that we have not been working with the accounting firms 
in strategies along these lines for years.
    And with that, that is an abridged version of my prepared 
remarks and I would be happy to address any questions you might 
have.
    Chairman Coleman. Thank you, Mr. Greenstein. Your complete 
remarks will be entered into the record, without objection.
    Mr. Larson, you were originally--at one point, you were 
Senior Manager at KPMG, is that correct?
    Mr. Larson. That is correct, yes.
    Chairman Coleman. And when did you move over to Presidio?
    Mr. Larson. In the summer of 1997.
    Chairman Coleman. And, in fact, were you involved in 
forming Presidio Advisory Services?
    Mr. Larson. I was.
    Chairman Coleman. And was that with another member of KPMG?
    Mr. Larson. Yes, Robert Pfaff.
    Chairman Coleman. So would it be fair to say that you knew 
the ins and outs of these kinds of transactions, you had 
experience and history?
    Mr. Larson. Yes, that would be fair.
    Chairman Coleman. And, in fact, I believe you were involved 
in developing FLIP's transactions?
    Mr. Larson. I was one of the team of developers, yes.
    Chairman Coleman. Now, it is fair to state, Mr. Larson, 
that Presidio knew the BLIPS transaction was specifically 
designed so that investors would exit on day 60 of the 
transaction, regardless of the fact that BLIPS was a financing 
structure as a 7-year loan, is that correct?
    Mr. Larson. I would--I do not agree with that.
    Chairman Coleman. Would you turn to Exhibit 69,\1\ please.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 69 which appears in the Appendix on page 644.
---------------------------------------------------------------------------
    Mr. Larson. The black one or the white one?
    Chairman Coleman. Sixty-nine is in the white one. It is a 
memo, Presidio Advisors Group. It is from Amir Makov. Do you 
know who that is?
    Mr. Larson. Yes. He is my other business partner.
    Chairman Coleman. He is a partner? He has certain authority 
and can speak for Presidio with authority?
    Mr. Larson. Yes, correct.
    Chairman Coleman. And this is a memo to John Rolfes, CEO at 
Deutsche Bank?
    Mr. Larson. John was the Managing Director.
    Chairman Coleman. Managing Director, I am sorry. And in the 
memo, it lays out, ``John, further to our Friday conversation, 
I would like to describe the necessary financing steps the 
BLIPS program will require,'' and it lays out--it starts with 
the day one, investor LLC borrows $100,000, and then principal 
amount for 7 years at 16 percent annual. So 7 years at 16 
percent annual. And then you go down, day 7 and the last 
paragraph, beginning of the last paragraph on that page, ``On 
day 60, investor exits partnership and unwinds all trades in 
partnership.'' Is that what the document states?
    Mr. Larson. That is what it states, yes, sir.
    Chairman Coleman. And is there anything equivocal about 
saying that the investor exits the partnership and unwinds all 
trades in partnership?
    Mr. Larson. No, that is what it says.
    Chairman Coleman. So Presidio understood this was a 60-day, 
get out in 60-day deal?
    Mr. Larson. What Presidio understood, even as the two 
previous speakers said, that there was a significant likelihood 
that investors would want to exit after 60 days, but in no way 
did we understand that this was unequivocally a 60-day 
investment.
    Chairman Coleman. In this document, there is no indication 
of significant likelihood. It says, ``on day 60, investor exits 
partnership and unwinds all trades in partnership,'' not 
significant possibility.
    Mr. Larson. I agree that that is what it says.
    Chairman Coleman. Can you tell me what step transactions 
are?
    Mr. Larson. Well, there is a tax doctrine which you might 
be referring to called the step transaction doctrine.
    Chairman Coleman. Is there a prohibition in the tax code 
against step transactions designed to produce artificial 
losses?
    Mr. Larson. I am not quite sure what you are referring to.
    Chairman Coleman. In testimony on Tuesday, we heard that 
there was a remote chance--remote chance--that BLIPS investors 
would make a profit of a transaction because they were 
structuring it, and I believe if you turn to Exhibit 80,\1\ 
that testimony came from Mark Watson, who appeared under 
subpoena before this Subcommittee. He says, ``According to 
Presidio, the probability of making a profit from this strategy 
is remote.'' Was that a fair representation of Presidio's 
conversations with Mr. Watson?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 80 which appears in the Appendix on page 664.
---------------------------------------------------------------------------
    Mr. Larson. No, it is not.
    Chairman Coleman. So did Mr. Watson make this up?
    Mr. Larson. I think Mr. Watson may have misunderstood the 
presentation and information that was provided to him.
    Chairman Coleman. Can you tell me how many BLIPS 
transactions Presidio was involved in?
    Mr. Larson. My recollection is 65 to 70.
    Chairman Coleman. Do you know if anyone made a profit?
    Mr. Larson. No, the trades were not profitable.
    Chairman Coleman. So Mr. Watson is saying Presidio says 
there is a remote possibility. You are saying zero. Of all you 
were involved in, zero transactions made a profit.
    Mr. Larson. That is correct, although I am also saying that 
it was our view at the time when we were planning the program 
and executing it that, in fact, there was a significant 
possibility of profit. That did not come to pass, but I think 
we had a well-reasoned view that our strategies could be highly 
profitable.
    Chairman Coleman. Was the market in trouble at that time?
    Mr. Larson. We were--under our--the trading strategies that 
we were implementing were foreign currency transactions, so I 
guess I am not sure what market you are referring to.
    Chairman Coleman. I am just trying to understand how you 
have every transaction in which you are involved, none makes a 
profit, but you are saying there was a reasonable possibility 
for profit.
    Mr. Larson. The trading strategies, the primary ones that 
we were implementing were, I guess, based on our expectation 
that a specific event would take place in the market, and by 
that, what I mean is the largest positions that we took in the 
BLIPS trades, we were shorting the Argentina peso and we were 
shorting the Hong Kong dollar and we were taking positions of 
very significant size. By taking those positions, what we were 
speculating was that one or both of those currencies would be 
forced to break its trading peg and devalue, and if that took 
place, then we had an expectation that, in particular that with 
Argentina, that Argentina was likely--in fact, we thought very 
nearly certain--to devalue its currency. Had that happened 
while our trades were open, the profits would have been 
extremely significant.
    Chairman Coleman. And what percentage of the loans were at 
risk, of the loans that were involved in these transactions?
    Mr. Larson. The expected risk, but not the certain risk, 
was approximately equal to the equity invested by the 
investors. However, there was always a possibility of a 
catastrophic loss in any of the partnerships.
    Chairman Coleman. Let me ask the question this way. An 
investor took out a $15 million loan--a $20 million loan from 
Deutsche Bank, or a $50 million loan from Deutsche Bank. How 
much of that was at risk? How much of that was involved in the 
risk of loss?
    Mr. Larson. The most likely scenarios and the ones that 
came to pass was that amount would not be at significant risk 
during the initial part of the trade.
    Chairman Coleman. Sixty days?
    Mr. Larson. Yes. That was the most likely.
    Chairman Coleman. The period in which they got out.
    Mr. Larson. Yes. However, what I would go on to say is that 
there was also a possibility, not a likelihood by any means, 
but a possibility that if our foreign currency trades had moved 
against us, and in particular if the value of the either Hong 
Kong or Argentina currencies had gone up, then there could have 
been very significant losses which would have hit the 
collateral.
    Chairman Coleman. So the standard now is not a likelihood.
    Mr. Larson. Standard--I am sorry.
    Chairman Coleman. You were saying that there was not a 
likelihood of profit being made.
    Mr. Larson. I am sorry, could you repeat the question?
    Chairman Coleman. I am trying to use the phrase there. I 
was trying to understand what the expectation was during 60 
days. In other words, how much of a $50 million loan, how much 
was at risk? A very minimal amount. What was then the 
likelihood of the investor suffering any loss?
    Mr. Larson. Using your example, during the initial 60-day 
period of our trading program, it was unlikely that there would 
be any loss that would affect the $50 million of collateral.
    Chairman Coleman. Let me ask you one other question. I will 
pursue this line of questioning afterwards. According to the 
testimony of KPMG's Lawrence DeLap on Tuesday, he was of the 
view that BLIPS transactions should be registered and Presidio 
should have registered the transactions. Did Presidio register 
their BLIPS transactions?
    Mr. Larson. We did not.
    Chairman Coleman. Mr. Greenstein, did Quadra--at that time, 
you were Quadra--did you register the FLIP transactions with 
Pricewaterhouse Coopers?
    Mr. Greenstein. Yes, we did. We took registration very 
seriously and followed the advice of the tax advisor.
    Chairman Coleman. Mr. Larson, did Presidio do some FLIP 
transactions?
    Mr. Larson. Yes, we did.
    Chairman Coleman. Did you register those?
    Mr. Larson. We did not.
    Chairman Coleman. I will turn the questioning over to 
Senator Levin at this time, but there will be a second round.
    Senator Levin. Thank you. If you take a look at Exhibit 
137,\1\ Mr. Larson, this is the memo that was written by Mr. 
Pfaff shortly before he left KPMG. When he wrote that memo, he 
went, as you have indicated, to join you at Presidio. You were 
partners with him. This is the road map that KPMG followed in 
its efforts to mass market tax shelters, or as Mr. Pfaff notes, 
develop a turnkey package tax product business and that 
Presidio was the instrument to do that.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 137 which appears in the Appendix on page 2735.
---------------------------------------------------------------------------
    Now, Mr. Larson, was there a ``Tax Advantaged Transaction 
Practice'' at KPMG at the time that this memo was written, in 
July 1997? Do you see that? There was a ``Tax Advantaged 
Transaction Practice''?
    Mr. Larson. I do. There may have been an informal group 
that used that acronym, but I am not certain.
    Senator Levin. Well, you were there, weren't you?
    Mr. Larson. Yes, but I think this was written 6 or 7 years 
ago.
    Senator Levin. So you are saying that--was it called TAT?
    Mr. Larson. KPMG loved acronyms and----
    Senator Levin. Was it called TAT?
    Mr. Larson. I am not sure whether I remember a TAT group, 
although I see it referred to here.
    Senator Levin. All right. Were you part of a Tax Advantaged 
Transaction Practice, formal or informal, at KPMG?
    Mr. Larson. I was certainly part of a tax products--some 
informal groups, yes.
    Senator Levin. But you are not familiar with the term Tax 
Advantaged Transaction Practice? That is not something you 
remember participating in at KPMG?
    Mr. Larson. I was personally assigned to the international 
tax services group during virtually my entire career.
    Senator Levin. Was there also this informal or formal group 
called Tax Advantaged Transaction Practice that you were part 
of?
    Mr. Larson. I may have seen this acronym or name before or 
not. I don't really recall.
    Senator Levin. All right. Were you part of the effort to 
complete the FLIP tax opinion before you left KPMG to go with 
Presidio?
    Mr. Larson. I was one of the people that worked on the 
initial opinion, yes.
    Senator Levin. Was FLIP designed primarily for tax 
reduction?
    Mr. Larson. I would say the FLIP was designed with two 
purposes in mind, one for the significant expected tax 
benefits, and second, to make money, for the investment 
possibility.
    Senator Levin. And was that true with other products, 
including BLIPS?
    Mr. Larson. Yes, that was.
    Senator Levin. The question then becomes as to whether the 
primary purpose was the tax loss that was created or the 
possibility, which was indicated as remote, of making a profit, 
and that becomes, of course, the whole issue.
    Now, take a look at page three of that Exhibit 137. 
``Logically,'' Mr. Pfaff wrote, ``we would simply issue an 
edict that any client with an imminent gain of a threshold 
amount,'' large enough, in other words, ``should contact the 
Tax Advantaged Transaction Practice. However,'' he wrote, 
``after reading this case called Colgate Palmolive, it appears 
that we cannot openly market tax results of an investment. 
Rather, our clients should be made aware of investment 
opportunities that are imbued with both commercial reality and 
favorable tax results. Conversely, we cannot offer investments 
without running afoul of a myriad of firm and security rules. 
Ultimately, it was this dilemma that led me to the conclusion 
that I was in the wrong industry to play the role I enjoy the 
most, and hence, the firm's need to align with the likes of a 
Presidio.''
    Now, this clearly shows that Mr. Pfaff and others at KPMG 
knew they were marketing tax advantaged products, that key 
court cases said that you can't market tax shelters as such, so 
KPMG had to create a facade of investment around the tax 
advantaged products. And the investments that were part of 
these products were back-fitted, then, into the transactions 
after the tax schemes were worked out, simply to try to make it 
look like there was an investment purpose to them.
    Now, if you take a look at Exhibit 137 from Mr. Pfaff, 
again, your partner, which you received a copy of, he talked 
about approaching only clients who had an ``imminent gain.'' 
Now, if this is an investment strategy, why would you limit it 
to approaching clients that were confronting a gain? If its 
purpose, any significant purpose, was to make a profit, why 
wouldn't you approach folks who would want to make a profit?
    Mr. Larson. I would say that that is consistent with the 
dual purpose of the transaction in that since we understood 
that one of the valuable aspects of this product was the hoped-
for tax benefits, it would make sense that logical people to 
talk to about the combined package would be those who might be 
receptive to tax planning.
    Senator Levin. But making a profit would run the other 
direction. Then they would have to be sold another tax product 
to create a tax loss.
    Mr. Larson. I think that the two can certainly be 
reconciled, but you are correct that to the extent that you 
make a profit on one of these transactions, then your tax 
benefit shrinks, so I agree with that.
    Senator Levin. You had two cross-purposes here.
    Mr. Larson. To a degree.
    Senator Levin. Now, let us look at the financing of the 
BLIPS deals. This is Exhibit 1Aa.,\1\ but there is a chart 
which I think we can put on here, page 7, that contains a 
typical BLIPS deal. You were the principal marketer of BLIPS, 
is that not correct?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 1a. which appears in the Appendix on page 371.
---------------------------------------------------------------------------
    Mr. Larson. I am sorry, which exhibit?
    Senator Levin. That is Exhibit 1a., page 7.
    Mr. Larson. Excuse me.
    Senator Levin. Do I have that right? Is that the right 
number?
    Chairman Coleman. It is in the white book.
    Senator Levin. I am sorry, yes, in the white book.
    Mr. Larson. I don't think the pages are numbered, so I am 
not sure what page you are on.
    Senator Levin. Well, just go through them and----
    Mr. Larson. Yes. I see.
    Senator Levin. Now, you were a principal marketer of BLIPS, 
is that not correct?
    Mr. Larson. I was.
    Senator Levin. Now, why was it that the loan was initially 
taken out by the taxpayer? This so-called loan, this purported 
loan was initially taken out by the taxpayer and almost 
immediately assigned to this other entity. Why was the loan 
just not made to the investment group directly?
    Mr. Larson. I think it could have been.
    Senator Levin. Well, the tax advantages would have been 
lost, wouldn't they?
    Mr. Larson. Certainly one way of structuring this for the 
tax advantage was to have the loan drawn down the way it was 
outside the partnership.
    Senator Levin. But if the loan were made directly to the 
partnership instead of to the taxpayer, there wouldn't have 
been the tax benefit, right? There wouldn't have been that 
premium.
    Mr. Larson. That is correct.
    Senator Levin. OK. So it had to go that way. Now, that is 
for tax reasons. The taxpayer's capital contribution was 7 
percent of the loss that was planned to be generated by the 
BLIPS transaction, is that correct?
    Mr. Larson. That was normally the case.
    Senator Levin. And if you look at Exhibit 67,\1\ this is a 
page from the Deutsche Bank PowerPoint presentation on the 
BLIPS program. If you look at the last three lines on that 
page, it reads as follows. ``Seven-point-seven percent of the 
premium amount will be held in full by Deutsche Bank until the 
LLC account is closed and the Deutsche Bank has a legal claim 
on that amount in the credit agreement.'' Then it says the 
following. ``The 7.7 percent will cover market risks, 
transaction costs, and DBSI fees.''
---------------------------------------------------------------------------
    \1\ See Exhibit No. 67 which appears in the Appendix on page 632.
---------------------------------------------------------------------------
    I think that is fairly clear. So the 7.7 percent put in by 
the taxpayer in Presidio was the amount set aside and held by 
Deutsche Bank to cover the risks associated with any currency 
trades, transaction costs, and Deutsche Bank fees. Now, would 
you not agree that within that 60-day period that the risk was 
limited to the capital funds put up by the investor?
    Mr. Larson. Not exactly, no.
    Senator Levin. Was it true what you told our staff on 
October 3, that the intent was that the maximum amount put at 
risk was the cash that the investor had contributed? Was that 
the intent?
    Mr. Larson. That was the expectation, but what I also told 
the staff, and I would say here now, is that there was always 
the possibility which we in the banks were aware of that 
something could go wrong and that there could be a catastrophic 
trading loss on the FX positions in excess of that amount.
    Senator Levin. In the absence of a catastrophe, that was 
the intention. Did that ever happen, that catastrophe?
    Mr. Larson. It did not.
    Senator Levin. And in the case of every BLIPS transaction, 
the loss was no more than the amount that was put up by the 
taxpayer, is that correct?
    Mr. Larson. That is correct.
    Senator Levin. My time is up. Are we going to have another 
round?
    Chairman Coleman. Thank you, Senator Levin.
    Mr. Greenstein, according to your statement, Quadra is an 
investment advisor in clients referred to you by KPMG?
    Mr. Greenstein. Pardon me?
    Chairman Coleman. Clients referred to you by KPMG in 
connection with the transactions known as FLIP and OPIS, is 
that correct?
    Mr. Greenstein. They were referred, and in many cases, KPMG 
was their financial advisor based on a power of attorney that 
the client had executed.
    Chairman Coleman. It is very clear that advisors cannot be 
involved in abusive tax shelters, you understood that? There is 
no question about that?
    Mr. Greenstein. Yes.
    Chairman Coleman. You have KPMG advising a client, issuing 
opinions, and you are relying on those. Did Quadra ever take 
any steps to have an independent, uninterested account review 
the transactions to ensure that you were not engaging in 
anything that ran afoul of the tax laws?
    Mr. Greenstein. At that point, we knew of multiple 
unrelated premier tax advisory groups, both two accountants and 
two nationally recognized law firms, that had concluded the 
same tax issue, and at that point in time, KPMG and 
Pricewaterhouse Coopers, had tens--potentially tens of 
thousands of tax professionals and we respected the opinion and 
the work that they did, and there was no need for us to look 
elsewhere.
    Chairman Coleman. What is your understanding of the 
requirement that a promoter of a tax shelter register such 
transactions with the IRS?
    Mr. Greenstein. My understanding is very limited, and on 
that issue, we deferred aggressively to the tax advisor, be it 
KPMG or Pricewaterhouse, for their conclusion on the matter.
    Chairman Coleman. Did you consider yourself to be a 
promoter of FLIP and OPIS under your understanding of the term?
    Mr. Greenstein. I don't understand the legal definition of 
the term, and I know there is one. We were certainly involved 
on certain marketing aspects, but I would say we were not the 
primary promoter.
    Chairman Coleman. You were involved in marketing?
    Mr. Greenstein. We were involved in describing the 
investment and structural aspects, yes.
    Chairman Coleman. Now, for some or all of the FLIP and OPIS 
transactions that you engaged in with Pricewaterhouse Coopers, 
I think you indicated that you registered those transactions, 
is that correct?
    Mr. Greenstein. I believe that to be the case, yes.
    Chairman Coleman. But it is my understanding that for the 
same transactions that Quadra engaged in with KPMG, Quadra did 
not register those transactions.
    Mr. Greenstein. That is correct, under the guidance of 
KPMG.
    Chairman Coleman. Did you ever talk to KPMG and say, hey, 
we are doing it for Pricewaterhouse, why not you?
    Mr. Greenstein. We did, yes.
    Chairman Coleman. And the response?
    Mr. Greenstein. We have done our analysis and it is our 
opinion that it does not need to be registered and we will not 
be registering it, they told us.
    Chairman Coleman. You weren't uncomfortable with that?
    Mr. Greenstein. We weren't uncomfortable because it was 
common certainly in the investment world for two well-respected 
organizations to reach different conclusions on the same 
matter, and we had respect for the work that they did in this 
regard.
    Chairman Coleman. You know by not registering them, you are 
not bringing it to the attention of the IRS, right?
    Mr. Greenstein. I was aware of that, and again, I would 
stress how seriously we took the issue, because when PWC told 
us to register, we did register immediately.
    Chairman Coleman. But felt you didn't have to do it with 
KPMG because they told you that they didn't want to do it?
    Mr. Greenstein. They told us that they concluded it did not 
need to be registered as a tax shelter.
    Chairman Coleman. Are you still involved in tax shelter 
transactions now, and that would be under, what is it, Quellos, 
because Quadra is no longer in existence?
    Mr. Greenstein. We always focus on maximizing a client's 
after-tax investment objectives, so in some cases, a simple 
shelter could be using municipal bonds. So that term, broadly 
defined, we are always trying to do that. But in terms of the 
types of strategies that we are talking about here today, no, 
we are not involved.
    Chairman Coleman. Help me understand. I have to say, with 
Presidio, it is very clear. They knew BLIPS was a 60-day 
transaction. It was very clear what the purpose was. I don't 
have the paper trail, I must say, Mr. Greenstein, with you, but 
I have got to believe at the time you were doing this, was 
there any red light that went on? Pricewaterhouse says register 
and KPMG says don't register. Isn't there any red light that 
went on and said, hey, we may be involved in something here 
that is just not right?
    Mr. Greenstein. Again, from our perspective, it was not 
uncommon for two well-respected firms, after thorough research, 
to come to different conclusions and we would see that all the 
time in the investment world where one well-respected group 
might say a stock is going up and someone else is saying it is 
going down, looking at the same facts. So no, it was not 
unusual to receive different opinions.
    Chairman Coleman. Senator Levin.
    Senator Levin. Mr. Larson, I think you have already 
testified that none of the BLIPS taxpayers, the folks who 
bought BLIPS, made a profit, is that correct?
    Mr. Larson. That is correct.
    Senator Levin. Is it then true that it was unlikely, based 
on that experience, that investors would earn a pre-tax profit?
    Mr. Larson. Based on our expectation and observation of the 
foreign currency markets, and in particular the situation in 
1999 with Argentina, we were expecting a devaluation of the 
Argentina peso at any time and, hence, it was our expectation 
that very significant profits would be forthcoming. Did we know 
exactly when Argentina was going to devalue? No, we did not, 
although within about 12 months, after additional support by 
the International Monetary Fund eventually failed, Argentina 
did, in fact, devalue. But we were a little ahead of ourselves.
    Senator Levin. So that taxpayers who bought BLIPS--taxpayer 
after taxpayer after taxpayer--how many were there?
    Mr. Larson. I believe we did about 65----
    Senator Levin. Sixty-five----
    Mr. Larson [continuing]. Or 70.
    Senator Levin. And every single one of them did not get a 
profit on the investment. They all made out as they should not 
have made out in terms of the tax loss, that they made huge 
gains in terms of their tax losses. But in terms of that 
investment of that 7 percent, over 60 in a row did not make a 
profit, right?
    Mr. Larson. Many of those were going on simultaneously.
    Senator Levin. But 60 of them did not make a profit?
    Mr. Larson. That is correct.
    Senator Levin. And yet you represented that there was still 
the reasonable opportunity to make a profit?
    Mr. Larson. Yes, we did.
    Senator Levin. Now finally, in terms of your fee, Exhibit 
121 \1\ has at the bottom an e-mail from Kerry Bratton at 
Presidio. The title of the e-mail message here is, ``Regarding 
BLIPS, seven percent.'' And as her message states--is Kerry 
Bratton a man or a woman?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 121 which appears in the Appendix on page 2701.
---------------------------------------------------------------------------
    Mr. Larson. She is a she.
    Senator Levin. As her message states, the e-mail shows how 
in a typical BLIPS deal the 7 percent put in by the taxpayer 
gets divided up, and here is what the typical deal does. Ten 
percent of the taxpayer's money, 0.7 percent, in other words, 
went to currency trading losses. Most of the 7 percent, as a 
matter of fact, 5.5 percent of the 7 percent, went to the 
fees--your fees, the bank's fees, KPMG's fees. So only a small 
part of the taxpayer's funds went to the currency transactions, 
is that correct, went to pay the losses on the currency 
transactions? Most of that 7 percent went for fees?
    Mr. Larson. In her example, yes.
    Senator Levin. Not in her example, typically. They were 
typical.
    Mr. Larson. Yes.
    Senator Levin. OK. So that was the typical breakdown of the 
7 percent? Was she right?
    Mr. Larson. Actually, I think she left out the financing 
cost on the loan.
    Senator Levin. Well, it says here the breakout for a 
typical deal is as follows. Do you see that in the middle of 
that page----
    Mr. Larson. I do.
    Senator Levin. OK. Was this a typical breakout?
    Mr. Larson. I would say yes.
    Senator Levin. OK. Now, the bottom line, then, is this, 
that the greater the loss, the greater the fees that you would 
receive, is that true?
    Mr. Larson. Correct.
    Senator Levin. Your fee wasn't part of the profit. It 
wasn't based on profit.
    Mr. Larson. Actually, excuse me. Greater--which loss, the 
tax loss or----
    Senator Levin. Yes. Is that right? The greater the loss 
that this taxpayer had in this deal, this paper loss, the 
greater your fee, is that correct?
    Mr. Larson. I think our--the advisory fee, I believe was 
charged as a percentage of the assets under management inside 
the strategic investment funds.
    Senator Levin. And that typically was the premium?
    Mr. Larson. Yes, correct.
    Senator Levin. All right. And that premium was the same as 
the loss, is that correct, to the taxpayer?
    Mr. Larson. It would be close----
    Senator Levin. Close enough?
    Mr. Larson. Yes.
    Senator Levin. And the greater that loss would be, the 
greater your premium would be, the greater your fee would be, 
is that not correct?
    Mr. Larson. That is correct.
    Senator Levin. Your fee was not based on profit from an 
investment, is that correct?
    Mr. Larson. That is correct.
    Senator Levin. Your fee was based on what that loss would 
be to the taxpayer, is that correct?
    Mr. Larson. Correct.
    Senator Levin. And the greater the loss, the greater your 
fee?
    Mr. Larson. I agree.
    Senator Levin. If anything demonstrates the purpose of this 
whole transaction simply--I think all these other documents 
prove it as well--but it is that the whole structure of the 
fees that went to the folks who cooked up this tax transaction 
was that the tax loss which the taxpayer achieved would 
determine the fee, and the greater the loss, the greater your 
fee. That, it seems to me, dramatizes what this is all about.
    I am not going to ask you to respond because I think you 
would probably give me some rhetoric about profit was possible 
and there was always a possibility that something would happen. 
But just strip away all of the gobbledy-gook and just take a 
look at how the fees of the folks who designed this tax shelter 
were achieved, and the fees were based on the loss to the 
taxpayer and the fees increased as the losses increased. They 
weren't related to the profit for obvious reasons. There were 
no profits. None were expected. In fact, if it were based on 
profits, there wouldn't have been any fees.
    I just have one more question of Mr. Greenstein, Mr. 
Chairman. I don't know if you want to----
    Chairman Coleman. No, we are not going to have another 
round. I was going to make a comment, and I would give you an 
opportunity to make the last comment, the last question, 
Senator. I just wanted to make sure--I never did too well in 
math and I just want to make sure we understand this, because 
we have talked a lot about the taxpayer didn't make a profit 
and generated a loss, and so if you are short-selling Argentine 
pesos and there isn't a catastrophe, in fact, none of these 
taxpayers made a profit. They made a loss.
    But the loss we are talking about here is not the loss in 
the transactions about pesos. The loss is when you set this 
deal up, if you got a $50 million loan, you got a $20 million 
premium. The loss is the loss you are going to write off when 
you cash out after 60 days of $20 million. So I don't want to 
be confused then, right. The loss is not the loss that the 
transaction--your fee is not a percentage of what was lost in 
the Argentina peso transaction. Your fee is a percentage of 
what the taxpayer was able to write off, is that correct?
    Senator Levin. Is that a yes?
    Chairman Coleman. Is that a yes?
    Mr. Larson. Yes.
    Chairman Coleman. Senator Levin.
    Senator Levin. Just one question, Mr. Greenstein. I don't 
have the exhibit handy. Perhaps my staff can get it. But you 
basically were told, were you not, by KPMG that whether or not 
you registered the FLIP was your decision?
    Mr. Greenstein. They did mention that to us and we deferred 
again to their decision, viewing them as the primary promoter, 
that if they decided that it did not need to be registered for 
themselves that we would go with that assessment.
    Senator Levin. And then you wrote them in Exhibit 135,\1\ I 
believe, on the last page--excuse me, they wrote you. Gregg 
Ritchie wrote you that the analysis of the tax shelter 
registration requirements which may be applicable to Quadra 
must be made by your firm in conjunction with your own tax 
counsel. You didn't do that, did you?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 135 which appears in the Appendix on page 2729.
---------------------------------------------------------------------------
    Mr. Greenstein. We did not, and I think this letter was--
they had communicated other things to us different than what 
this letter said and I think this was to absolve them of any 
liability that they may have for our decision.
    Senator Levin. Do you know what CYA means?
    Mr. Greenstein. Yes, sir. [Laughter.]
    Senator Levin. Was this a CYA letter, in your judgment?
    Mr. Greenstein. I believe it was.
    Senator Levin. Thank you, Mr. Chairman.
    Chairman Coleman. Thank you. The witnesses are excused.
    I would now like to welcome our last panel to today's 
important hearing: The Honorable Mark Everson, Commissioner at 
the Internal Revenue Service; William McDonough, Chairman of 
the Public Company Accounting Oversight Board; and Richard 
Spillenkothen, Director of Banking Supervision and Regulation 
of the Federal Reserve. I thank each of you for your attendance 
at today's hearing and look forward to hearing your testimony.
    Before we begin, pursuant to Rule 6, all witnesses who 
testify before the Subcommittee are required to be sworn. At 
this time, I would ask you to please stand and raise your right 
hand.
    Do you swear that the testimony you give before the 
Subcommittee will be the truth, the whole truth, and nothing 
but the truth, so help you, God?
    Mr. Everson. I do.
    Mr. McDonough. I do.
    Mr. Spillenkothen. I do.
    Chairman Coleman. As you would have heard from the earlier 
panels, we would like all statements to be 5 minutes. Your 
entire written statement will be entered as part of the 
permanent record.
    Mr. Everson, we will have you go first this morning, 
followed by Mr. McDonough, and finish up with Mr. 
Spillenkothen. After we have heard all your testimony, we will 
proceed to questions. You may proceed, Mr. Everson.

 TESTIMONY OF MARK EVERSON,\1\ COMMISSIONER, INTERNAL REVENUE 
                    SERVICE, WASHINGTON, DC

    Mr. Everson. Thank you. Good morning, Mr. Chairman and 
Senator Levin. I commend you for your interest in this 
important subject of abusive tax shelters.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Everson with an attached chart 
appears in the Appendix on page 338.
---------------------------------------------------------------------------
    Abusive tax avoidance transactions have a corrosive 
influence on our tax administration system and the very rule of 
law itself. Senator Grassley recently noted, ``The IRS should 
be able to enforce the tax code and respect taxpayer rights at 
the same time. We can't have people abusing the tax code and we 
can't have the IRS abusing taxpayers. It is as simple as 
that.''
    I agree. The IRS must demonstrate and execute a balanced 
approach of service and enforcement if taxpayers are to remain 
faithful to our system of self-assessment, and we can't allow 
manipulation of the tax system through abusive shelters to 
undermine taxpayers' faith that if they pay their share of 
taxes, others will, as well.
    I would like to mention four factors which I believe have 
contributed to the proliferation of abusive tax shelters and 
are depicted on that chart.\2\
---------------------------------------------------------------------------
    \2\ Chart entitled ``Son of Boss Promoter Relationships'' attached 
to Commissioner Everson's prepared statement which appears in the 
Appendix on page 348.
---------------------------------------------------------------------------
    First, the complexity of the tax code. Abusive tax 
avoidance transactions are designed to take advantage of the 
complexity of the tax code to obtain benefits that Congress 
never intended. Complexity becomes the shelter promoters' 
camouflage. Promoters hope that both the taxpayer and the IRS 
will be confused by a shelter's complexity, while the 
transaction's apparent viability is bolstered by legal opinions 
secured from reputable law firms.
    To address this complexity, the Treasury Department and the 
IRS have significantly increased and accelerated the issuance 
of published guidance concerning potentially abusive 
transactions and the IRS has vigorously pursued compliance with 
the promoter registration, list maintenance, and disclosure 
rules. These measures complement our increased examinations of 
tax shelters in taxpayer returns.
    Second, the cozy relationship among sophisticated 
promoters. You have identified the relationships that exist 
among the various promoters and facilitators who peddle abusive 
tax transactions. I would like to draw your attention to this 
chart, which depicts promoter relationships for just one type 
of transaction, in this case, the Son of Boss.
    The chart shows the reinforcing network of commercial 
interests that design, develop, and market these sophisticated 
products, including investment advisors, CPA firms, law firms, 
banks, and brokers. At the bottom, the chart indicates the 
linkages of these players to other tax shelter products of 
concern to the IRS.
    The IRS is currently investigating over 100 promoters, 
including accounting firms, law firms, and financial 
institutions. Most have complied with our request for 
documents, but some have not, so in the last 6 months, the 
Department of Justice has filed summons enforcement actions 
against six of these promoters, including accounting firms and, 
for the first time, law firms. In addition, we are auditing 
thousands of individuals and corporations who have entered into 
questionable transactions.
    Third, the erosion in professional ethics. At my 
confirmation hearing last March, I stated that attorneys and 
accountants should be the pillars of our system of taxation, 
not the architects of its circumvention. Based on what I have 
seen while on the job since May and what you have uncovered in 
your own investigation, I believe as strongly as ever in that 
statement.
    As you have learned some organizations have decided to turn 
away from the promotion of abusive tax shelters, have reached 
agreements with the IRS, and are moving on. That is good news. 
I believe it reflects a reassessment by these firms and an 
improvement in their professional ethics. Others, such as KPMG 
and Jenkens and Gilchrist, remain in litigation with the IRS 
and have not yet complied with our legitimate document 
requests.
    Fourth, nominal penalties undermine the regulation of 
abusive transactions. The penalties that are currently on the 
books with respect to the promotion of abusive tax transactions 
constitute a nominal cost of doing business to organizations 
determined to generate large fees by promoting abusive tax 
avoidance transactions. De minimis penalties are no more than a 
speed bump on a single-minded road to professional riches.
    Legislative proposals were announced in March 2002 to 
establish meaningful penalties for failure to comply with the 
promoter registration, disclosure, and list maintenance 
requirements of the code. We need significantly increased 
penalties to hit the promoters who don't get the message where 
it counts, in their wallets.
    Mr. Chairman, I want to assure you and Senator Levin that 
the problem of abusive tax transactions is and will remain a 
high priority for the IRS. Thank you.
    Chairman Coleman. Thank you very much, Commissioner. 
Chairman McDonough.

TESTIMONY OF WILLIAM J. McDONOUGH,\1\ CHAIRMAN, PUBLIC COMPANY 
           ACCOUNTING OVERSIGHT BOARD, WASHINGTON, DC

    Mr. McDonough. Chairman Coleman, Ranking Member Senator 
Levin, and Members of the Subcommittee, I am pleased to appear 
before you today on behalf of the Public Company Accounting 
Oversight Board, and I would like to begin by commending the 
Subcommittee's investigation of the role of professional firms, 
including accounting firms, in the development and marketing of 
abusive tax shelters. Indeed, the evidence you have accumulated 
has served as a wake-up call that we all, whether corporate 
leader, legislator, or regulator, must heed.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. McDonough appears in the Appendix 
on page 349.
---------------------------------------------------------------------------
    The financial scandals at Enron, Adelphia, WorldCom, 
HealthSouth, and elsewhere left the impression that public 
company financial reporting is not to be trusted and that 
professional advisors, including investment bankers, lawyers, 
and even a company's independent auditors, will help 
unscrupulous executives cook the books.
    Congress responded to that breach of trust by enacting the 
Sarbanes-Oxley Act of 2002. That Act established the PCAOB and 
charged it with ``oversee[ing] the audit of public companies 
that are subject to the securities laws, and related matters, 
in order to protect the interests of investors and further the 
public interest in the preparation of informative, accurate, 
and independent audit reports.''
    To carry out that charge, the Act gives the Board 
significant powers over the practice of auditing the financial 
statements of public companies, including: To register public 
accounting firms that audit public companies; to inspect the 
audits and quality controls of such firms; to conduct 
investigations and disciplinary proceedings; and to establish 
auditing quality control, ethics, independence, and other 
standards relating to the preparation of audit reports or 
issuers.
    Now, of course, much of the tax work done by accounting 
firms falls outside of the audit-oriented focus that Congress 
has assigned to the PCAOB. Nevertheless, the PCAOB has a 
variety of tools that may help address some of the problems 
caused by those abusive tax shelters that are designed to make 
financial statements look better.
    First, the Board will be conducting a program of annual 
inspections of the largest registered firms' audits of public 
companies' financial statements and triennial inspections of 
smaller registered firms. In those inspections, we will conduct 
reviews of engagement work papers, which will put us in a 
position to identify and examine how firms audit questionable, 
tax-oriented transactions that are reflected in public 
companies' financial statements. We will also look for 
auditors' involvement in structuring such transactions for 
public company audit clients.
    Because we are only beginning our inspections program, we 
cannot today assess the current extent of promotion and use of 
corporate tax shelters and products to public company audit 
clients. We will, however, scrutinize the accounting and 
presentation of the transactions that we discover through our 
inspections program, specifically through our reviews of 
selected audit engagements.
    In addition, by looking at auditor compensation, promotion, 
and retention, our inspections will identify a firm's policies 
and practices that create incentives for firm audit personnel 
to promote such transactions to their public company clients.
    Therefore, while existing laws and regulations may not ban 
auditors from promoting and giving tax opinions on such 
transactions to their audit clients, both auditors and public 
companies should expect heightened scrutiny of such 
transactions. The prospect of that scrutiny may give pause to 
corporate management, audit committees, and auditors that may 
consider such transactions.
    Second, through our authority to discipline registered 
firms and associated persons, we may impose stiff penalties for 
failing to adequately and impartially audit such transactions 
undertaken by public companies.
    Finally, the Board has the authority to commence a 
standard-setting project to address at least a part of the 
problem. Specifically, the Board has authority to add to the 
statutory list of non-audit services that a registered firm may 
not provide to audit clients. Such regulation, of course, would 
not prohibit a registered firm from selling tax shelters to 
non-audit clients.
    The Board also has the authority to develop and impose 
additional auditing procedures. While ferreting out tax 
avoidance is not directly within our purview, auditors ought to 
follow appropriate standards for identifying and auditing 
transactions whose main purpose is to create the impression of 
enhanced earnings in the financial statements.
    Congress gave the PCAOB the responsibility and the tools to 
build a new future for auditing through independent standard 
setting, registration inspection, investigations, and 
discipline. As we move forward to employ those tools in the 
public interest, my fellow Board members and I look forward to 
a long and constructive relationship with this Subcommittee. 
Thank you.
    Chairman Coleman. Thank you, Chairman McDonough. Mr. 
Spillenkothen.

 TESTIMONY OF RICHARD SPILLENKOTHEN,\1\ DIRECTOR, DIVISION OF 
   BANKING SUPERVISION AND REGULATION, THE FEDERAL RESERVE, 
                         WASHINGTON, DC

    Mr. Spillenkothen. I, too, thank you, Mr. Chairman, for the 
opportunity to testify today on the Federal Reserve's 
continuing efforts to advance corporate governance, risk 
management, and internal controls at banking organizations.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Spillenkothen appears in the 
Appendix on page 361.
---------------------------------------------------------------------------
    Numerous corporate governance and legal compliance failings 
over the last 2 years, including those delineated by this 
Subcommittee, highlight once again the critical need for 
effective risk management and internal controls to guide 
firms', both banks' and commercial firms', business practices 
and activities.
    Federal Reserve staff have not reviewed the specific tax 
structures that I understand to be the focus of today's 
hearings, and as you know, bank supervisors are not tax experts 
nor are they responsible for the oversight of tax compliance by 
banking organizations or their customers.
    However, I appreciate the opportunity to talk to you today 
about our supervisory requirements and expectations for banks 
involved in complex transactions and about some of the steps we 
have taken to address banks' risk management and internal 
control infrastructures.
    At the outset, I should point out that the primary focus of 
the Federal Reserve's supervision is promoting an institution's 
safety and soundness, as well as compliance with banking and 
consumer laws and regulations in a way that protects 
depositors, the FDIC insurance fund, and the rights of 
consumers.
    Some basic principles and expectations for banking 
organizations guide our work in assessing business activities 
and risks, including banks' involvement in complex structured 
transactions.
    First, and obviously most important, banking organizations 
must obey the law. They must have policies and procedures in 
place to ensure compliance with all laws and regulations and 
that they are not knowingly facilitating illegal activities by 
their customers or business associates. Banks should not engage 
in borderline transactions that are likely to result in 
significant reputational or operational risk to the 
organization.
    Second, banks should perform thorough due diligence on the 
transactions or business activities that they are involved in 
and check with key legal, accounting, and tax authorities 
within their organizations, as well as independent third party 
experts, when appropriate. Banking organizations ordinarily 
should not be held legally responsible for the judgments, 
actions, or malfeasance of their customers or third party 
professional advisors. Such an expectation would require banks 
to assume management responsibilities outside their span of 
control, create potential legal liabilities that would 
compromise their ability to perform as financial 
intermediaries, or threaten their safety and soundness, and 
place additional significant cost on banking organizations.
    Finally, banking organizations must recognize that although 
they are not directly accountable for the actions of their 
customers or third party legal and accounting professionals, to 
the extent that their names or products are implicitly 
associated with misconduct by those parties, additional legal 
and reputational risks may arise.
    With these principles in mind and in light of recent events 
of the last couple of years, the Federal Reserve has taken 
steps to enhance the supervision of complex structured 
transactions and refine its supervisory programs.
    During the past year, we have conducted special reviews of 
banking organizations engaged in complex structured 
transactions. Where we have found deficiencies, we have been 
clear on the need for banks to develop effective internal 
controls that comprehensively assess the risks associated with 
legal compliance. Formal Enron-related supervisory enforcement 
actions taken publicly by the Federal Reserve last summer 
underscore the expectations of bank supervisors on the need for 
banks to address internal weaknesses relating to complex 
structured transactions.
    In addition to these efforts, we are working with our 
colleagues at the other bank agencies and the SEC to develop 
supervisory guidance on appropriate controls and risk 
management systems pertaining to complex structured 
transactions, including those that may have a tax component or 
dimension. During this period, we have increased our 
supervisory emphasis on the management of legal and 
reputational risks.
    We are focusing increased attention on the adequacy of new 
product approval processes, the management of large or highly 
profitable customer relationships, and controls over the use of 
special purpose entities. Examiners are also stepping up 
efforts to review corporate governance and internal control 
infrastructures, including board and management oversight, 
corporate-wide compliance activities, and internal audit 
functions.
    Banks appear to be responding to the lessons of recent 
years and the actions of supervisors. They are implementing 
better processes for subjecting transactions with heightened 
risk profiles to additional levels of scrutiny. This includes 
more thorough written policies and procedures, as well as 
processes for due diligence reviews by appropriate internal 
control functions, including accounting, legal, tax, prior to 
the execution of more complex or risky transactions. Most 
organizations have established new or reconstituted senior-
level review committees and have fortified their new product 
approval processes.
    Firms have also increased staff training around the 
identification and control of legal and reputational risks. 
Where necessary, banks should continue to strengthen these 
systems and bank management must work to ensure that the new 
processes are effective over time.
    In closing, supervisors will continue to focus on risk 
management and control processes in order to foster safety and 
soundness, financial stability, and compliance with applicable 
laws and regulations. Supervisory activities will reinforce 
recent actions taken by banks to address weaknesses, and where 
necessary, supervisors will take appropriate corrective and 
enforcement action.
    Of course, no system of official oversight is failsafe and 
supervisors cannot detect and prevent all control or management 
failures. However, strong and effective supervision, including 
the use of supervisory enforcement tools, management steps to 
strengthen corporate governance, risk management, and internal 
control infrastructures, and the incentives provided by 
marketplace discipline can contribute to better compliance and 
continued improvements in management of legal and reputational 
risks.
    Chairman Coleman. I would ask you to summarize.
    Mr. Spillenkothen. Thank you. I am finished, Mr. Chairman, 
and I would be happy to attempt to answer any questions you 
have.
    Chairman Coleman. Thank you very much, Mr. Spillenkothen.
    Let me just kind of go in reverse order here. Did you have 
a chance, Mr. Spillenkothen, to listen to the testimony today?
    Mr. Spillenkothen. I did not have a chance to listen to all 
of it, Mr. Chairman. I tried to stay involved in some of it, 
but not all of it.
    Chairman Coleman. If I can do a very brief summary, 
basically we have a situation where banks are issuing loans for 
these BLIPS, FLIP, and OPIS transactions, issuing loans 
ostensibly for 7-year periods but clearly being informed that 
these folks are getting out in 60 days. There is a premium 
piece in the loan structure, that when it is then part of an 
investment package, of which, by the way, very little is at 
risk, when it is pulled out, the investor claims loss. So you 
have folks, in effect, putting in very little. And, by the way, 
all these bank loans are collateralized at 101 percent.
    So these are clearly tax shelters. There is no question 
about them. These are not 7-year high-interest loans, they are 
60-day deals, in and out. And yet the banks' basic assertion 
is, well, we are not tax experts. We relied upon the KPMGs of 
the world.
    Do you see any problems with that kind of operation?
    Mr. Spillenkothen. Mr. Chairman, I have not had a chance to 
look at the specifics of these transactions and so I would be 
reluctant to try to opine on them.
    Chairman Coleman. I am not asking you to opine on the 
transaction. I am asking you to opine on the actions of the 
bank. I mean, how much more do they have to know?
    Mr. Spillenkothen. I think banks, as I tried to say, need 
to have internal systems to make sure that they are in 
compliance with all laws, including tax laws. I think the 
lesson of the last couple of years, which I think many banks 
have learned in part through the assistance of this 
Subcommittee and other market events, is that banks should 
avoid borderline transactions or transactions that have a high 
probability of resulting in legal problems or significant 
reputational risk. Banks need to ensure that they have systems 
in place to comply with the law, and ensure that they are not 
facilitating illegal activities by outside third parties.
    Chairman Coleman. One of the kind of common denominators of 
all these transactions is that they are not registered. In some 
cases, they are limiting the scope of them. They are 
geographically distributing them, keeping everything below the 
radar. Talk to me about expanding reporting requirements in a 
way that would allow IRS to identify loans that are being used 
for questionable tax shelters. Can you talk to me about that 
imposing burdensome additional costs? How would you evaluate 
the efficacy and cost impact of such requirements? Mr. 
Spillenkothen.
    Mr. Spillenkothen. Well, I think whenever you impose 
additional reporting requirements, there is potential burden, 
but one of the things that you have to do when you are 
developing reporting requirements is to be able to define what 
you are trying to collect information on. You have to be able 
to define the activity or transactions that you are trying to 
collect information on. I would leave it to my colleagues at 
other agencies, the IRS, to describe and deal with how you 
would define some of these things, but a clearly important 
element of getting reporting is to be able to define what 
activities one is trying to collect information on.
    Chairman Coleman. Commissioner Everson, how do you react to 
the IRS being described as a toothless paper tiger?
    Mr. Everson. I am sure that everyone who has come before 
this Subcommittee or before the Finance Committee in the 
hearing several weeks ago would not agree with that 
characterization, given their current problems. But I think 
what you are perhaps suggesting is that there has been concern 
that we need to have increased tools to do our job and perhaps 
more resources.
    I will comment on both of these areas, I have mentioned the 
penalties. I think the penalties are central to assuring that 
we learn what is going on in this whole arena. The question you 
just asked to my colleague gets to getting information from yet 
another source. If we can just get the information from the 
practitioners and from the taxpayers themselves, I think that 
will be very helpful.
    In terms of the resource question, I would point out both 
you and Senator Levin have spoken to this question most 
recently in your speech in New York. We are not an agency that 
gets topped up in the appropriations process. Yet again, we are 
sitting with a mark before the Senate right now that is $245 
million below the President's request, and this is something 
that has happened under Republican Presidents, Democratic 
Presidents, Republican Congresses, and Democratic Congresses. 
We tend to fall short.
    This is compounded in this case, because some 70 percent of 
our costs are personnel related and the pay raise is 2 percent 
greater than was budgeted. So we are more squeezed. And if 
there is an across-the-board non-defense, non-homeland recision 
of a percent or two on discretionary spending, that will cause 
further problems that are very significant for us.
    So in this area, the first thing I would like to see is for 
the funding request to be honored.
    Chairman Coleman. I think one of the concerns in dealing 
with the IRS is always about focus. I know you have the server, 
the wait person who worried about getting audited for her tips. 
You have the small business person worried about getting 
audited for whatever. And we are sitting at this hearing here 
and we are hearing about, over 6 years, $80-something billion 
potentially lost to taxpayers and the IRS being a toothless 
paper tiger in regard to these kinds of transactions. So I 
would say the issue is focus and what the policy makers would 
want to say is, yes, we are going to focus on those things that 
generate maximum return for the people who are massively 
committing tax fraud.
    Mr. Everson. I agree with that 100 percent, and in fact, if 
you look at the request that the President made for the 2004 
budget, he did provide for additional funds particularly in 
this area. The first priority of the budget request was to 
devote more enforcement resources to high-end taxpayers and to 
address these corporate shelters, and we are prioritizing.
    We have shifted over a lot of our resources into this area, 
as the GAO and others have noted, in tracking all of our 
efforts, which include, as I mentioned, accelerating guidance. 
It includes enhancement of audits. We have got thousands of 
audits working right now for the taxpayers, businesses, and 
individuals alike in this area, including criminal 
investigations.
    We are also extending our leverage and our reach. We have 
reached an agreement with 42 States around the country. I think 
you heard testimony from the State of California about this 
agreement. We are sharing information, jointly managing the 
caseload. Already, California has given us information, for 
instance, that gave us new participants in one of the shelters 
we are investigating. So we are really trying to provide the 
focus to this subject that you have suggested is appropriate.
    Chairman Coleman. Just for me to try to get a sense of the 
scope of this, from your perspective, there was an article, I 
believe, in American Lawyer entitled ``Still in the Shadows,'' 
October 1, 2003. It says, ``as of June 2002, according to the 
IRS, 186 people had avoided $4.4 billion in taxes from BLIPS 
transactions. Another 57 people had avoided $1.4 billion from 
FLIP and OPIS.'' Are these numbers accurate, to the best of 
your knowledge?
    Mr. Everson. I won't comment on particular numbers because 
the way some of these transactions are tracked by the 
originator of the transaction are a little bit different from 
the way we track them, sir. But overall, clearly, this problem 
runs into the billions of dollars.
    The difficulty here, if you will, is that there are 
potentially abusive transactions, families of transactions that 
we have identified. We have already listed over two dozen of 
them. There are general criteria based on the amount of tax 
avoided vis-a-vis the investment, the same kinds of questions 
you have been asking, that also compel disclosure. And clearly, 
some of those disclosure requirements are now just coming into 
effect for the tax year, calendar year 2003. We will see a lot 
of that information next year. But this problem runs into the 
billions of dollars.
    Chairman Coleman. And there are a range of these, COBRA, 
BOSS, Son of Boss, and other things that you laid out.
    Mr. Everson. Yes, sir.
    Chairman Coleman. One other question and then I will turn 
it over to my colleague, and there will be a second round. I 
have other questions I want to get to.
    I am concerned about the finger pointing that we saw here 
in regard to reporting, almost as if there was some lack of 
clear, common definition. Ernst & Young says, or PWC says we 
should report FLIP, but KPMG doesn't. And then the advisors 
say, well, we are advised by these big accounting firms. It 
just seems obvious that the purpose of reporting--the ethical 
thing, the right thing to do is to give you notice and then 
people can make judgments about that. But there appears to be 
some legal basis or question, however questionable, that says 
you don't have to report. How do you clarify that to make sure 
it is very clear that these kind of transactions have to be 
reported?
    Mr. Everson. I am not sure we need to clarify it. I do 
believe we need to increase the penalties so that the guidance 
which is already out there and in law is taken seriously.
    Chairman Coleman. Switch, being the switch that you may use 
to hit somebody, that kind of switch.
    Mr. Everson. I hate to say it, but not everybody has 
approached this from a point of view of the first objective 
which is to comply with the law.
    Chairman Coleman. I appreciate that. Senator Levin.
    Senator Levin. Let me first join you in welcoming our 
witnesses, thanking you for your work. It is critically 
important, and that is dramatized every day, but in 2 days of 
hearings here by what has been presented, pretty shocking, 
disturbing, sorry testimony.
    I also would urge you, if you haven't had a chance, to read 
our staff report. It is an extraordinary report. I think 
perhaps your staffs have already had a chance to look at it, 
but in any event, we would be interested in your comments on 
the factual material which is set forth in that report. Perhaps 
for the record, Mr. Chairman, if it is appropriate, I would ask 
that they give us a comment about what they read in that report 
after they or their staffs have had a chance to do so.
    Chairman Coleman. That request will be made and the answers 
will become part of the official record.
    Senator Levin. I thank you.
    First, Mr. Everson, the fines that you made reference to, I 
couldn't agree with you more. The current fine structure is 
really absurd, a $1,000 fine. It is not even a slap on the 
wrist. It is a slap on the finger or a slap on a nail on the 
finger. It is nothing. It is not even a cost of doing business. 
It is nothing compared to the rip-off that is going on and the 
amount of money that is made by those rip-offs.
    So just looking here at Section 6700, a person who 
organizes or assists in the organization of a partnership, any 
investment plan, causes to make another person to make or 
furnish an arrangement which the person knows or has reason to 
know is false or fraudulent shall pay a penalty equal to 
$1,000. It might as well not be here. In fact, I would prefer 
it not be there.
    Mr. Everson. It is chump change.
    Senator Levin. Yes. What we have got to do is find a way to 
move in the direction that you have talked about, and I will be 
introducing a bill to do exactly that which will even go beyond 
what Senator Grassley and others have done, because what they 
do is take away part or all of the rip-off amount, but they 
don't penalize people.
    So if somebody makes money they should not have made, a fee 
of $50 million, to say that you have to give back part of what 
you improperly got, or even all as the maximum penalty, which 
is what is in the other bill, seems to me isn't truly a 
penalty. It just says, give part of your ill-begotten gain back 
to us, or pay it to the government. It seems to me there has 
got to be a real penalty above and beyond what that person got 
improperly if we are going to really have a deterrent.
    But in any event, I welcome the comment that you made, 
because we are going to need support to go at least as far as 
the Grassley bill and, I hope, beyond that. I happen to believe 
that, for instance, the promoter of these illegal schemes 
should pay the same as the taxpayer to whom they sold the 
illegal scheme, and if the taxpayer has to pay Uncle Sam $40 
million because that is what they cheated Uncle Sam of, that 
the promoter of that tax scheme that resulted in that cheating 
pay the same amount. That will be a deterrent if we can go that 
far. That is a real deterrent.
    Again, I won't ask you to comment on specific penalties, 
but I do hope you will take a look at these various approaches 
to penalties.
    Now, Commissioner Everson, let me ask you this question 
relative to the enforcement problems that exist. Let us assume 
that the IRS gets wind of an illegal tax shelter, one that does 
not comply with Federal law, and it finds out that it is being 
promoted by a certain bank, a certain accounting firm, a 
certain investment advisory firm. Can the IRS tell the Federal 
Reserve about the bank's involvement?
    Mr. Everson. Senator, one of the very important premises of 
the tax code is the confidentiality of taxpayer information. We 
respect that and we think that is very important. One of the 
results of that standard is that we are precluded from sharing 
information with others unless it reaches a point where we take 
it over, say, to the Justice Department because it becomes a 
full-fledged criminal matter.
    Senator Levin. If it is a crime that there is evidence of, 
you can take it to the FBI or the Justice Department, is that 
correct?
    Mr. Everson. We have a Criminal Investigations Division. If 
you may remember, they took care of Al Capone some decades ago.
    Senator Levin. Right.
    Mr. Everson. They would do the work and then they would 
bring it over. After it is ready, it goes over to the Tax 
Division at Justice and they look at it and they make the 
determination, and we do work with other agencies, yes, exactly 
as we did in the Scruchie indictment last week in corporate 
governance.
    Senator Levin. But you cannot, for instance, share 
information about civil violations----
    Mr. Everson. That is correct.
    Senator Levin [continuing]. With, for instance, the SEC 
relative to an investment advisor. You can't do it with the 
Public Company Accounting Oversight Board relative to an 
accounting firm's involvement, and you can't do it with the 
Federal Reserve relative to a bank's involvement, even though 
you think the law has been violated, is that correct?
    Mr. Everson. That is correct. To use one of your examples, 
if my fellow panelist, Chairman of the Public Company 
Accounting Oversight Board, if we are working on one of the 
firms, the accounting firms, and we have discovered or we 
believe that there is a pattern of abuse in this area, I can't 
turn to Bill and say, you ought to consider this in your risk 
assessment and your approach as to how you are governing the 
agency.
    Likewise, we audit thousands of companies every year, and 
if we determine that 10 or 20 or whatever, some small 
percentage, are operating at the edge from a corporate 
governance point of view in the tax arena, we cannot originate 
a discussion with the SEC.
    I do believe that what you are putting your finger on is an 
important subject that merits discussion because it is a gap in 
the governance structure. I want to make clear, however, that I 
do not believe in the routine sharing of individual tax return 
information. But in the case of some of these large 
corporations or the firms that you are discussing, I believe 
that there is a gap there that should be considered to be 
addressed.
    Senator Levin. I think we would welcome any thoughts, 
further comments that you have on that subject, and the same 
from our other witnesses. It is a very important subject. I 
agree with you. You don't want any routine sharing here or else 
we are going to lose the great benefit, it seems to me, of our 
tax system, which is that we have got the confidence of 
taxpayers that they can pay their taxes and not worry about 
being turned over to the SEC, generally, unless they are 
committing a crime, in which case they will be turned over to 
the FBI. But short of that, there is an understanding among our 
taxpayers that is important to maintain. On the other hand, you 
point out there is a gap here, which perhaps can be addressed 
in an appropriate way.
    The Federal Reserve has done a review of financial products 
and I just am wondering, who should be doing the same kind of 
review here of these tax shelters that you did of the financial 
products? It requires a review here, and I think if you have 
any of your staff that were here during this hearing or the 
Finance Committee hearings, I think you probably got more than 
a drift as to how deep and significant a problem that we have.
    I am just wondering, who would be the appropriate agency to 
do the same kind of review of these kind of tax shelters, the 
ones that do not have a business purpose but whose primary 
purpose is to create a tax deduction? Would that be the Federal 
Reserve, would it be the Oversight Board, or would it be the 
IRS, or all three of you, or the SEC?
    Mr. McDonough. Senator, we at the PCAOB would certainly 
think that we have a piece of the action. Anything that an 
accounting firm is doing vis-a-vis its audit clients, we feel 
would fall within our purview and we would be, through our 
inspection process, pursuing it very aggressively.
    Even in the area which is not our direct responsibility, 
that is, the activities of accounting firms with their non-
audit clients, what we are saying to them is that their real 
task is to restore the faith of the American people in their 
profession, and if you are running a firm, well, the place to 
start is in restoring public confidence in your firm.
    What we are saying as a Board, and what I am saying as a 
rather outspoken Chairman of the Board, is if you really want 
the American people to restore their confidence in your 
profession, you should be very thoughtful about what kinds of 
products you are offering, and if it is likely to hurt the 
reputation of your firm or not rebuild the reputation of your 
firm, you shouldn't be doing it, even if it is legal.
    Senator Levin. OK. Mr. Spillenkothen, can you make a 
commitment to us that you would work with the Accounting Board 
and with the IRS to make a thorough review of these kinds of 
transactions which spawn these abusive tax shelters? Could you 
give us that kind of commitment?
    Mr. Spillenkothen. Senator Levin, we have, as you 
indicated, in the last year looked at bank involvement in 
complex structured transactions, a subset of which is 
transactions that have a tax component. We have, in doing that, 
focused on the banks' internal controls and systems for 
identifying risky or suspect transactions; for having internal 
checks and balances that involve review by independent tax 
accounting, and legal people; for escalating questionable 
transactions to appropriate decisionmakers, and for ensuring 
adequate documentation and controls. As I indicated in my 
statement, where we found some deficiencies, we have given 
feedback to organizations. We have also taken some formal 
enforcement actions.
    So we have endeavored to focus on the risk management and 
internal controls of these organizations and I think we have 
already reviewed these transactions and we have worked into our 
ongoing supervisory processes procedures to focus on complex 
structured transactions. So I think we have tried to do that. 
We are working, as I indicated, on additional guidance that 
would provide risk management guidance on structured 
transactions, including those that have a tax dimension to 
them.
    So we have focused on complex structured transactions. 
Obviously, our expertise is not taxes and our focus is on 
safety and soundness and internal controls for compliance with 
all laws and regulations.
    Chairman Coleman. Thank you, Mr. Spillenkothen.
    Mr. McDonough, just a few things I would like to focus on. 
First, I totally agree in this post-Enron world, restoring 
confidence is absolutely critical. It is critical for the 
economy, critical obviously just on a personal level, you would 
think, for the firms involved. The question is, how do we do 
that and how do we ensure it and what role?
    My question, in part, is for you. The Public Company 
Accounting Oversight Board gets set up. Principally, you are 
looking at the quality of company audits, and the issues here 
that affect the reputation of these companies go beyond the 
audits.
    Mr. McDonough. Sure.
    Chairman Coleman. And I think we need more hands on deck in 
order to deal with this. I would hope that you would give some 
thought to how you can play a greater role in this. You have 
the bully pulpit, and that is important. You can remind people 
again and again. But beyond that, I just think the non-audit 
role of accounting firms today has certainly been called into 
great question, and though we have received a number--and I was 
certainly pleased to hear the companies come forth and say, we 
have changed our practice and changed our standards and changed 
personnel, but is that enough? So I would just hope that you 
would give that thought.
    The other question, and I think you addressed it somewhat 
in your testimony but I would like to kind of go back over it, 
Senator Levin raised questions about the degree to which 
accounting firms should be allowed to offer tax advice to the 
offices and the directors of the companies they audit. We have 
got this whole issue of you are auditing and you are offering 
tax advice. Could you describe the Board's current views on 
that subject?
    Mr. McDonough. Right. Well, as you are aware and as you 
have just said, Mr. Chairman, the accounting firms have long 
provided tax advice to their audit clients and both the 
Sarbanes-Oxley Act and what the SEC had to say in January in a 
rule continue to make that possible.
    But having said that, we will use our inspections to do as 
much as we conceivably can. We will watch for whenever firms 
put pressure on auditors to sell non-audit services, including 
tax services, to executives. We will get at this issue through 
our examination of auditor compensation and promotion 
practices, and when we find inappropriate influences that may 
have an effect on audit quality, we will call the firm to bear 
on it.
    Essentially, what we are trying to say is we want audit 
firms to reward really good, tough auditors for being good 
tough auditors, not for other stuff. If we see that they are 
rewarding auditors or getting a little tax advice work or 
anything else, we will be very heavy-handed in our discussions 
with them.
    Chairman Coleman. Getting back to one other of the kind of 
the non-audit functions that came into question here, and that 
is fee generated by the percentage of loss that could be 
written off, is there anything inherently questionable about 
that? Perhaps, Commissioner, you might want to address this. 
Clearly, it raised red flags, it should have for the banks, it 
should have for the advisors, and certainly for the accounting 
firms. But is there anything inherently questionable about that 
and how would you deal with that issue in the future?
    Mr. Everson. One of the things that the Subcommittee 
report, and I have had a chance to read at least the summary of 
it, correctly highlights is the revision in fee structures over 
time at the accounting firms, which I think has very much 
contributed to this decline in ethics. That is to say that 
instead of billing for time, they bill for value added. That is 
a change in the professional construct.
    When I started out in accounting, you had the investment 
banks. They took fees and they had a stake in the action and 
they took, in many of these transactions, commercial risk, 
whereas the lawyers and the accountants were compensated based 
on time. That has drifted and changed over the decades so that 
the incentive, if you will, to gain riches as a professional is 
to change the value creation for the client. The last witness 
you had, the discussion you were having, in this case, it is 
not really value creation, it is value destruction from the 
government's interest. That is a different construct for 
lawyers and accountants than what it once was and I don't think 
it is a healthy one.
    Chairman Coleman. Chairman McDonough, would you respond to 
that?
    Mr. McDonough. Yes. I think it is clearly completely 
inappropriate for such arrangements to exist between an 
accounting firm and its audit clients. You mentioned earlier 
that we have the bully pulpit to deal with the accounting firms 
in areas which do not involve audit clients. That is being 
used, if I may say so, Mr. Chairman, very broadly and very 
effectively.
    I was down in Atlanta, Georgia, last night talking to the 
Georgia State Society of CPAs. I am spending a lot of my time 
out and I can tell you the message is very direct and it is not 
very subtle. It is, ``we will have to have the accounting 
profession reach a new standard of culture, ethics, 
responsibility so they regain the confidence of the American 
people, and they can either do it voluntarily, which is the 
best way, or if they don't do it voluntarily, we will make them 
do it.'' That is pretty direct.
    Chairman Coleman. I appreciate those efforts, Mr. 
McDonough. Senator Levin.
    Senator Levin. Thank you. Mr. McDonough, you have indicated 
you are looking at adopting a national rule prohibiting the 
contingent fee. Is that where you are at?
    Mr. McDonough. I believe that all of the rules necessary to 
prohibit contingent fees for audit clients already exist. I 
will do a double-check and if they don't, you can be very sure 
that we will be looking at any new audit standard setting or 
rulemaking we will need in the area, but I think it is already 
there.
    Senator Levin. I think most States have it, but I don't 
know that there is a national rule. But in any event, if you 
could double-check that----
    Mr. McDonough. We will do that.
    Senator Levin [continuing]. And your commitment that it 
should be a national prohibition is helpful.
    Mr. McDonough. Yes.
    Senator Levin. Now, Senators Baucus, McCain, and I have 
introduced S. 1767, which would ban auditors from providing tax 
shelter services to clients that they audit. I am wondering 
whether you have had a chance to examine that legislation, and 
if so, what your reaction is to it.
    Mr. McDonough. Senator, I haven't had an opportunity to 
review the legislation, but based on just the brief description 
you gave of it, it seems to me that it is highly unlikely that 
an accounting firm could be giving an audit client tax shelter 
advice and not flunk the independence test. Independence, as 
you know, is an absolute requirement for an auditor to maintain 
in order to carry out his or her professional responsibilities.
    But even if permitted by the audit committee, which all tax 
work really has to be and should be, if it came into the area 
of actually recommending and advising tax shelters, I think it 
would be quite clear. We would have to look at it in the 
individual case, but generically, that auditor would be 
evaluating his or her own work and that would flunk the 
independence test.
    Senator Levin. That is what we are trying to get at and 
trying to prohibit--that exact activity, where the accountant 
is auditing his own product, his own work product. If you could 
take a look at that bill and give us a response to it, that 
would be very helpful.
    The only thing I really want to say in conclusion, if I 
could just take a minute here, Mr. Chairman, is that basically, 
Uncle Sam is getting ripped off by the promoters of sham 
transactions which produce tax deductions and tax losses as 
their principal goal. These are abusive. They are costing us 
perhaps $10 or $15 billion a year.
    We have had really an extraordinary staff report, and I 
want to thank my staff, and your staff has been very 
supportive, Mr. Chairman, and I want to thank them for that 
support.
    The report that we have issued is probably the most 
detailed report on these sham transactions that we are aware 
of. In any event, it is a very disturbing picture. I think if 
the average taxpayer out there could somehow or other get 
through these complicated machinations, that the level of 
disgust and abhorrence would be so high that you as regulators 
and we as legislators would be forced to take very strong, very 
urgent action against the people who promote these shelters.
    They are aided and abetted in that process by 
professionals. It is similar to what happened with Enron. Enron 
was the engine, but professionals, including banks, 
stockbrokers, and lawyers, aided and abetted Enron. It could 
not have happened without them.
    In this case, we have the aiders and abetters. We also have 
the engine here being the designers of the tax shelters who are 
professional people.
    So we are going to do, I hope, everything that we can do 
legislatively to tighten up the law on economic substance, if 
necessary--there is a bill which does that which has passed the 
Senate--to adopt penalties, I won't say stricter penalties 
because I consider the ones that are in existence a joke and, 
for all intents and purposes, nonexistent, so adopt really 
tough penalties and real penalties for people who aid and abet 
these sham transactions which produce these tax shelters.
    The regulatory agencies that you represent are playing a 
critical role and we need you to work together to coordinate 
better, to use your resources in a targeted way, as I think our 
Chairman pointed out.
    But we also, frankly, need the professions to help clean up 
their own act. This is a pretty shameful exposition that we 
have witnessed here of professional failure. If it is a true 
profession, the immorality that we have seen, the shocking 
testimony of purposeful deceptive transactions which have no 
real purpose other than to create a tax deduction should really 
shake up our professions. But I don't think we can count on 
that, unhappily. Even if the top-level folks who run these 
professions adopt good codes of ethics and enforce them, there 
are still going to be those folks who will try to evade those 
codes of ethics, and for that we need regulators, and for that, 
we need tough penalties.
    I am determined to do whatever I can, and I know our 
Chairman joins me in this, to do whatever we can to put an end 
to the kind of abuses that we have seen dramatized this week.
    Thank you, Mr. Chairman.
    Chairman Coleman. Thank you, Senator Levin. Senator Levin, 
I want to also reiterate my commitment to doing what we need to 
do to make sure that these sham abusive transactions are a 
thing of the past.
    I do want to thank our staffs, and thank my staff for all 
the work they have done to catch up with all the work that your 
staff did. They did an extraordinary job. These are complex 
transactions and that is one of the challenges certainly the 
IRS has in dealing with them. But they are also pretty simple. 
I mean, you don't need to be a rocket scientist to figure out 
if somebody made $20 million and somebody comes up to you and 
says, hey, we will get that as a loss and then you will not 
have to pay taxes, limit tax liability on it. The complexity is 
how you get from A to Z, but the concept is very simple.
    What struck me, Senator Levin, as I listened, where 
otherwise very bright, smart people, not just in the accounting 
firms but all the others involved who just turned a blind eye 
to what was so obvious, and to me, it was obvious. I think 
everybody knew what they were doing and what they did was 
wrong, and it is not just Uncle Sam that gets ripped off. It is 
the little guy. The fact that there is $85 billion less being 
paid into the government coffers over 6 years means that those 
folks who are paying the taxes, doing the right thing, working 
hard, they are the ones who are really suffering and we have 
got to make sure that doesn't happen.
    You have a lot of responsibility. You have a lot of 
challenges. We will certainly work with you and support your 
efforts. Clearly, I look forward to working with you, Senator 
Levin, on your legislation and some of the recommendations 
proposed by the Commissioner.
    Hopefully, what we saw was a thing of the past. I think we 
have a responsibility to make sure it doesn't happen again. I 
fear that, in part, we are nowhere out of the high-flying 
1990's. We are not generating just barrels of cash anymore from 
all these transactions, and in part, that may be why the 
activity has slowed up. I do accept the statements from the 
firms involved they have changed their ways, but the climate is 
different.
    I just want to make sure that--and I hope we get back to 
the economy rolling. I don't want to get back to the ethical 
standards or the lack thereof, but when we get back to the 
economy rolling, I just want to make sure that if that should 
happen, that we don't face the same problems. That is our 
challenge and we will do everything we can to make sure it 
doesn't happen and still do the things we can to promote growth 
and promote economy and promote opportunity in this country.
    Before adjourning, I would like to add for the record a 
written statement submitted by Tom Lopez, the Chief Investment 
Officer with the Fire and Police Pension System of Los 
Angeles.\1\
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Lopez appears in the Appendix as 
Exhibit No. 153 on page 3016.
---------------------------------------------------------------------------
    With that, this hearing is adjourned.
    [Whereupon, at 1:10 p.m., the Subcommittee was adjourned.]


                            A P P E N D I X


                       U.S. TAX SHELTER INDUSTRY:
                   THE ROLE OF ACCOUNTANTS, LAWYERS,
                      AND FINANCIAL PROFESSIONALS

                              ----------                              


       FOUR KPMG CASE STUDIES: FLIP, OPIS, BLIPS, AND SC2

I. Introduction

    In 2002, the U.S. Senate Permanent Subcommittee on 
Investigations of the Committee on Governmental Affairs, at the 
direction of Senator Carl Levin, then its Chairman, initiated 
an in-depth investigation into the development, marketing, and 
implementation of abusive tax shelters by professional 
organizations such as accounting firms, banks, investment 
advisors, and law firms. The information in this Report is 
based upon the ensuing bipartisan investigation conducted 
jointly by the Subcommittee's Democratic and Republican staffs, 
with the support of Subcommittee Chairman Norm Coleman.
    During the course of its investigation, the Subcommittee 
issued numerous subpoenas and document requests, and the 
Subcommittee staff reviewed over 235 boxes, and several 
electronic compact disks, containing hundreds of thousands of 
pages of documents, including tax product descriptions, 
marketing material, transactional documents, manuals, 
memoranda, correspondence, and electronic mail. The 
Subcommittee staff also conducted numerous, lengthy interviews 
with representatives of accounting firms, banks, investment 
advisory firms, and law firms. In addition, the Subcommittee 
staff reviewed numerous statutes, regulations, legal pleadings, 
reports, and legislation, dealing with federal tax shelter law. 
The staff consulted with federal and state agencies and various 
accounting, tax and financial experts, including the U.S. 
Department of the Treasury, U.S. Internal Revenue Service 
(IRS), Public Company Accounting Oversight Board (PCAOB), 
California Franchise Tax Board, tax experts on the staffs of 
the Joint Commission on Taxation, Senate Committee on Finance, 
and House Committee on Ways and Means, various tax 
professionals, and academic experts, and other persons with 
relevant information.
    The evidence reviewed by the Subcommittee establishes that 
the development and sale of potentially abusive and illegal tax 
shelters have become a lucrative business in the United States, 
and professional organizations like major accounting firms, 
banks, investment advisory firms, and law firms have become 
major developers and promoters. The evidence also shows that 
respected professional firms are spending substantial 
resources, forming alliances, and developing the internal and 
external infrastructure necessary to design, market, and 
implement hundreds of complex tax shelters, some of which are 
illegal and improperly deny the U.S. Treasury of billions of 
dollars in tax revenues.
    The term ``tax shelter'' has come to be used in a variety 
of ways depending upon the context. In the broadest sense, a 
tax shelter is a device used to reduce or eliminate the tax 
liability of the tax shelter user. Some tax shelters are 
specific tax benefits explicitly enacted by Congress to advance 
a legitimate endeavor, such as the low income housing tax 
credit. Those types of legitimate tax shelters are not the 
focus of this Report. The tax shelters under investigation by 
the Subcommittee are complex transactions used by corporations 
or individuals to obtain significant tax benefits in a manner 
never intended by the tax code. These transactions have no 
economic substance or business purpose other than to reduce or 
eliminate a person's tax liability. These abusive tax shelters 
can be custom-designed for a single user or prepared as a 
generic ``tax product'' available for sale to multiple clients. 
The Subcommittee investigation focuses on the abusive tax 
shelters sold as generic tax products available to multiple 
clients.
    Under current law, generic tax shelters are not illegal per 
se; they are potentially illegal depending upon how purchasers 
actually use them and calculate their tax liability on their 
tax returns. Over the last 5 years, the IRS has begun 
publishing notices identifying certain generic tax shelters as 
``potentially abusive'' and warning taxpayers that use of such 
``listed transactions'' may lead to an audit and assessment of 
back taxes, interest, and penalties for using an illegal tax 
shelter. As used in this Report, ``potentially abusive'' tax 
shelters are those that come within the scope of an IRS 
``listed transaction,'' while ``illegal'' tax shelters are 
those with respect to which the IRS has taken actual 
enforcement action against taxpayers for violating federal tax 
law.
    The Subcommittee investigation perceives an important 
difference between selling a potentially abusive or illegal tax 
shelter and providing routine tax planning services. None of 
the transactions examined by the Subcommittee derived from a 
request by a specific corporation or individual for tax 
planning advice on how to structure a specific business 
transaction in a tax-efficient way; rather all of the 
transactions examined by the Subcommittee involved generic tax 
products that had been affirmatively developed by a firm and 
then vigorously marketed to numerous, in some cases thousands, 
of potential buyers. There is a bright line difference between 
responding to a single client's tax inquiry and aggressively 
developing and marketing a generic tax shelter product. While 
the tax shelter industry of today may have sprung from the 
former, it is now clearly driven by the latter.
    In order to gain a deeper understanding of the issues, the 
Subcommittee conducted four in-depth case studies examining tax 
products sold by a leading accounting firm, KPMG, to 
individuals or corporations to help them reduce or eliminate 
their U.S. taxes. KPMG is one of the largest accounting firms 
in the world, and it had built a reputation as a respected 
auditor and expert tax advisor. KPMG vigorously denies being a 
tax shelter promoter, but the evidence obtained as a result of 
the Subcommittee investigation is overwhelming in demonstrating 
KPMG's active and, at times, aggressive role in promoting and 
profiting from generic tax products sold to individuals and 
corporations, including tax products later determined by the 
IRS to be potentially abusive or illegal tax shelters.
    Earlier this year, KPMG informed the Subcommittee that it 
maintained an inventory of over 500 ``active tax products'' 
designed to be offered to multiple clients for a fee. The four 
KPMG case studies featured in this Report are the Bond Linked 
Issue Premium Structure (BLIPS), Foreign Leveraged Investment 
Program (FLIP), Offshore Portfolio Investment Strategy (OPIS), 
and the S-Corporation Charitable Contribution Strategy (SC2). 
KPMG sold these four tax products to more than 350 individuals 
from 1997 to 2001. All four generated significant fees for the 
firm, producing total revenues in excess of $124 
million.1 The IRS later determined that three of the 
products, BLIPS, FLIP, and OPIS, were potentially abusive or 
illegal tax shelters, while the fourth, SC2, is still under 
review. As of June 2002, an IRS analysis of just some of the 
tax returns associated with BLIPS, FLIP, and OPIS had 
identified 186 people who had used BLIPS to claim losses on 
their tax returns totaling $4.4 billion, and 57 people who had 
used FLIP or OPIS to claim tax losses of $1.4 billion, for a 
grand total of $5.8 billion.2 Evidence made 
available to the Subcommittee suggests that lost tax revenues 
are also significant, including documents which show that, for 
169 out of 186 BLIPS participants for which information was 
recorded, federal tax revenues were reduced by $1.4 billion.
---------------------------------------------------------------------------
    \1\ Letter dated 9/12/03, from KPMG's legal counsel, Wilkie Farr & 
Gallagher, to the Subcommittee, at 2. According to KPMG information 
provided to the Subcommittee in this letter and a letter dated 8/8/03, 
FLIP was sold to 80 persons, in 63 transactions, and produced total 
gross revenues for the firm of about $17 million over a 4-year period, 
1996-1999. OPIS was sold to 111 persons in 79 transactions, and 
produced about $28 million over a 2-year period, 1998-1999. BLIPS, the 
largest revenue generator, was sold to 186 persons in 186 transactions, 
and produced about $53 million over a 1-year period from about October 
1999 to about October 2000. SC2 was sold to 58 S corporations in 58 
transactions, and produced about $26 million over an 18-month period 
from about March 2000 to about September 2001. Other information 
presented to the Subcommittee suggests these revenue figures may be 
understated and that, for example, BLIPS generated closer to $80 
million in fees for the firm, OPIS generated over $50 million, and SC2 
over $30 million.
    \2\ United States v. KPMG, Case No. 1:02MS00295 (D.D.C. 7/9/02), 
``Declaration of Michael A. Halpert,'' Internal Revenue Agent, at para. 
37.
---------------------------------------------------------------------------
    Some members of the U.S. tax profession are apparently 
claiming that the worst tax shelter abuses are already over, so 
there is no need for investigations, reforms, or stronger laws. 
The Subcommittee investigation, however, indicates just the 
opposite: while a few tax shelter promoters have ended their 
activities, the tax shelter industry as a whole remains active, 
developing new products, marketing dubious tax shelters to 
numerous individuals and corporations, and continuing to 
wrongfully deny the U.S. Treasury billions of dollars in 
revenues, leaving average U.S. taxpayers to make up the 
difference.

II. Findings

    Based upon its investigation to date, the Subcommittee 
Minority staff recommends that the Subcommittee make the 
following findings of fact.

        (1)  The sale of potentially abusive and illegal tax 
        shelters has become a lucrative business in the United 
        States, and some professional firms such as accounting 
        firms, banks, investment advisory firms, and law firms 
        are major participants in the mass marketing of generic 
        ``tax products'' to multiple clients.

        (2)  Although KPMG denies being a tax shelter 
        promoter, the evidence establishes that KPMG has 
        devoted substantial resources to, and obtained 
        significant fees from, developing, marketing, and 
        implementing potentially abusive and illegal tax 
        shelters that U.S. taxpayers might otherwise have been 
        unable, unlikely or unwilling to employ, costing the 
        Treasury billions of dollars in lost tax revenues.

        (3) KPMG devotes substantial resources and maintains 
        an extensive infrastructure to produce a continuing 
        supply of generic tax products to sell to multiple 
        clients, using a process which pressures its tax 
        professionals to generate new ideas, move them quickly 
        through the development process, and approve, at times, 
        potentially abusive or illegal tax shelters.

        (4) KPMG uses aggressive marketing tactics to sell 
        its generic tax products, including by turning tax 
        professionals into tax product salespersons, pressuring 
        its tax professionals to meet revenue targets, using 
        telemarketing to find clients, using confidential 
        client tax data to identify potential buyers, targeting 
        its own audit clients for sales pitches, and using tax 
        opinion letters and insurance policies as marketing 
        tools.

        (5) KPMG is actively involved in implementing the tax 
        shelters which it sells to its clients, including by 
        enlisting participation from banks, investment advisory 
        firms, and tax exempt organizations; preparing 
        transactional documents; arranging purported loans; 
        issuing and arranging opinion letters; providing 
        administrative services; and preparing tax returns.

        (6) Some major banks and investment advisory firms 
        have provided critical lending or investment services 
        or participated as essential counter parties in 
        potentially abusive or illegal tax shelters sold by 
        KPMG, in return for substantial fees or profits.

        (7) Some law firms have provided legal services that 
        facilitated KPMG's development and sale of potentially 
        abusive or illegal tax shelters, including by providing 
        design assistance or collaborating on allegedly 
        ``independent'' opinion letters representing to clients 
        that a tax product would withstand an IRS challenge, in 
        return for substantial fees.

        (8) Some charitable organizations have participated 
        as essential counter parties in a highly questionable 
        tax shelter developed and sold by KPMG, in return for 
        donations or the promise of future donations.

        (9) KPMG has taken steps to conceal its tax shelter 
        activities from tax authorities and the public, 
        including by refusing to register potentially abusive 
        tax shelters with the IRS, restricting file 
        documentation, and using improper tax return reporting 
        techniques.

III. Executive Summary

    The Subcommittee's investigation into the role of 
professional organizations in the tax shelter industry has 
identified two fundamental, relatively recent changes in how 
the industry operates.
    First, the investigation has found that the tax shelter 
industry is no longer focused primarily on providing 
individualized tax advice to persons who initiate contact with 
a tax advisor. Instead, the industry focus has expanded to 
developing a steady supply of generic ``tax products'' that can 
be aggressively marketed to multiple clients. In short, the tax 
shelter industry has moved from providing one-on-one tax advice 
in response to tax inquiries to also initiating, designing, and 
mass marketing tax shelter products.
    Secondly, the investigation has found that numerous 
respected members of the American business community are now 
heavily involved in the development, marketing, and 
implementation of generic tax products whose objective is not 
to achieve a business or economic purpose, but to reduce or 
eliminate a client's U.S. tax liability. Dubious tax shelter 
sales are no longer the province of shady, fly-by-night 
companies with limited resources. They are now big business, 
assigned to talented professionals at the top of their fields 
and able to draw upon the vast resources and reputations of the 
country's largest accounting firms, law firms, investment 
advisory firms, and banks.
    The four case studies featured in this Report examine tax 
products developed by KPMG, a respected auditor and tax expert 
and one of the top four accounting firms in the United States. 
In the latter half of the 1990's, according to KPMG employees 
interviewed by Subcommittee staff, KPMG's Tax Services Practice 
underwent a fundamental change in direction by embracing the 
development of generic tax products and pressing its tax 
professionals to sell them. KPMG now maintains an inventory of 
more than 500 active tax products and routinely presses its tax 
professionals to participate in tax product marketing 
campaigns.
    Three of the tax products examined by the Subcommittee, 
FLIP, OPIS, and BLIPS, are similar in nature. In fact, BLIPS 
was developed as a replacement for OPIS which was developed as 
a replacement for FLIP.3 All three tax products 
function as ``loss generators,'' meaning they generate large 
paper losses that the purchaser of the product then uses to 
offset other income, and shelter it from taxation.4 
All three products have generated hundreds of millions of 
dollars in phony paper losses for taxpayers, using a series of 
complex, orchestrated transactions involving shell 
corporations, structured finance, purported multi-million 
dollar loans, and deliberately obscure investments.5 
All three also generated substantial fees for KPMG, with BLIPS 
and OPIS winning slots among KPMG's top ten revenue producers 
in 1999 and 2000, before sales were discontinued. All three tax 
products are also covered by the ``listed transactions'' that 
the IRS has published and declared to be potentially abusive 
tax shelters.6 In all three cases, the IRS has 
already begun requiring taxpayers who used these products to 
pay back taxes, interest, and penalties. Over a dozen taxpayers 
penalized by the IRS for using these tax products have 
subsequently filed suit against KPMG for selling them an 
illegal tax shelter.7
---------------------------------------------------------------------------
    \3\ See, e.g., document dated 5/18/01, ``PFP Practice 
Reorganization Innovative Strategies Business Plan--DRAFT,'' authored 
by Jeffrey Eischeid, Bates KPMG 0050620-23, at 1.
    \4\ Id. See also document dated 7/21/99, entitled ``Action 
Required,'' authored by Jeffrey Eischeid, Bates KPMG 0006664 (In the 
case of BLIPS, ``a key objective is for the tax loss associated with 
the investment structure to offset/shelter the taxpayer's other, 
unrelated, economic profits.'').
    \5\ See Appendix A for a more detailed explanation of BLIPS.
    \6\ FLIP and OPIS are covered by IRS Notice 2001-45 (2001-33 IRB 
129) (8/13/01); while BLIPS is covered by IRS Notice 2000-44 (2000-36 
IRB 255) (9/5/00). See also United States v. KPMG, Case No. 1:02MS00295 
(D.D.C. 9/6/02).
    \7\ See, e.g., Jacoboni v. KPMG, Case No. 6:02-CV-510 (M.D. Fla. 4/
29/02) (OPIS); Swartz v. KPMG, Case No. C03-1252 (W.D. Wash. 6/6/03) 
(BLIPS); Thorpe v. KPMG, Case No. 5-030CV-68 (E.D.N.C. 1/27/03) (FLIP/
OPIS).
---------------------------------------------------------------------------
    The fourth tax product, SC2, is described by KPMG as a 
``charitable contribution strategy.'' 8 It is 
directed at individuals who own profitable corporations 
organized under Chapter S of the tax code (hereinafter ``S 
corporations''), which means that the corporation's income is 
attributed directly to the corporate owners and taxable as 
personal income. SC2 is intended to generate a tax deductible 
charitable donation for the corporate owner and, more 
importantly, to defer and reduce taxation of a substantial 
portion of the income produced by the S corporation, 
essentially by ``allocating'' but not actually distributing 
that income to a tax exempt charity holding the corporation's 
stock. Like BLIPS, FLIP, and OPIS, SC2 requires a series of 
complex, orchestrated transactions to obtain the promised tax 
benefits. Among other measures, these transactions involve the 
issuance of non-voting stock and warrants, a corporate non-
distribution resolution, and a stock redemption agreement; a 
temporary donation of the non-voting stock to a charity; and 
various steps to ``allocate'' but not distribute corporate 
income to the tax exempt charity.9 Early in its 
development, KPMG tax professionals referred to SC2 as ``S-
CAEPS,'' pronounced ``escapes.'' The name was changed after a 
senior tax official pointed out: ``I think the last thing we or 
a client would want is a letter in the files regarding a tax 
planning strategy for which the acronym when pronounced sounds 
like we are saying `escapes.' '' 10 In 2000 and 
2001, SC2 was one of KPMG's top ten revenue producers. SC2 is 
not covered by one of the ``listed transactions'' issued by the 
IRS, but is currently undergoing IRS review.11
---------------------------------------------------------------------------
    \8\ The formal title of the tax product is the S-Corporation 
Charitable Contribution Strategy.
    \9\ See Appendix B for a more detailed explanation of SC2.
    \10\ Email dated 3/24/00, from Mark Springer to multiple KPMG tax 
professionals, ``RE: S-corp Product,'' Bates KPMG 0016515. See also 
email dated 3/24/00, from Mark Springer to multiple KPMG tax 
professionals, ``Re: S-corp Product,'' Bates 0016524 (suggesting 
replacing ``all S-CAEPS references with something much more benign'').
    \11\ See email dated 4/10/02, from US-Tax Innovation Center to 
multiple KPMG tax professionals, ``IRS Summons Information Request for 
SC2,'' Bates XX 001433 (``The IRS has requested certain information 
from the Firm related to SC2.''); undated KPMG document entitled, 
``April 18 IRS Summons Response.''
---------------------------------------------------------------------------
    Together, these four case histories, BLIPS, FLIP, OPIS, and 
SC2, provide an in-depth portrait of how a professional 
organization like KPMG, and the professional organizations it 
allies itself with, end up developing, marketing, and 
implementing highly questionable or illegal tax products. The 
evidence also sheds light on the critical roles played by other 
professional organizations to make suspect tax products work.

A. Developing New Tax Products

    The Subcommittee investigation has found that the tax 
product development and approval process used at KPMG was 
deeply flawed and led, at times, to the approval of tax 
products that the firm knew were potentially abusive or 
illegal. Among other problems, the evidence shows that the KPMG 
approval process has been driven by market considerations, such 
as consideration of a product's revenue potential and ``speed 
to market,'' as well as by intense pressure that KPMG 
supervisors have placed on subordinates to ``sign-off'' on the 
technical merits of a proposed product even in the face of 
serious questions about its compliance with the law.
    The case of BLIPS illustrates the problems. Evidence 
obtained by the Subcommittee discloses an extended, unresolved 
debate among KPMG tax professionals over whether BLIPS met the 
technical requirements of federal tax law. In 1999, the key 
KPMG technical reviewer resisted approving BLIPS for months, 
despite repeated expressions of dismay from superiors. He 
finally agreed to withdraw his objections to the product in 
this email sent to his supervisor: ``I don't like this product 
and would prefer not to be associated with it [but] I can 
reluctantly live with a more-likely-than-not opinion being 
issued for the product.'' This assessment is not exactly the 
solid endorsement that might be expected for a tax product sold 
by a major accounting firm.
    The most senior officials in KPMG's Tax Services Practice 
exchanged emails which frankly acknowledged the problems and 
reputational risks associated with BLIPS, but nevertheless 
supported putting it on the market for sale to clients. One 
senior tax professional summed up the pending issues with two 
questions:

        ``(1) Have we drafted the opinion with the appropriate 
        limiting bells and whistles . . . and (2) Are we being 
        paid enough to offset the risks of potential litigation 
        resulting from the transaction? . . . My own 
        recommendation is that we should be paid a lot of money 
        here for our opinion since the transaction is clearly 
        one that the IRS would view as falling squarely within 
        the tax shelter orbit.''

    No one challenged the analysis that the risky nature of the 
product justified the firm's charging ``a lot of money'' for a 
tax opinion letter predicting it was more likely than not that 
BLIPS would withstand an IRS challenge. When the same KPMG 
official observed, ``I do believe the time has come to shit and 
get off the pot,'' the second in command at the Tax Services 
Practice responded, ``I believe the expression is shit OR get 
off the pot, and I vote for shit.''
    BLIPS, like its predecessors OPIS and FLIP, was sold by 
KPMG to numerous clients before the IRS issued notices 
declaring them potentially abusive tax shelters that did not 
meet the requirements of federal tax law. Other professional 
firms have also sold potentially abusive or illegal tax 
products such as the Currency Options Brings Reward 
Alternatives (COBRA) and Contingent Deferred Swap (CDS) sold by 
Ernst & Young, the FLIP tax product and Bond and Option Sales 
Strategy (BOSS) sold by PricewaterhouseCoopers, the Customized 
Adjustable Rate Debt Facility (CARDS) sold by Deutsche Bank, 
the FLIP tax product sold by Wachovia Bank, and the Slapshot 
tax product sold by J.P. Morgan Chase.12 The sale of 
these abusive tax shelters by other firms clearly demonstrates 
that flawed approval procedures are not confined to a single 
firm or a single profession. Many other professional firms are 
also developing and selling dubious tax products.
---------------------------------------------------------------------------
    \12\ Slapshot is an abusive tax shelter that was examined in a 
Subcommittee hearing last year. See ``Fishtail, Bacchus, Sundance, and 
Slapshot: Four Enron Transactions Funded and Facilitated by U.S. 
Financial Institutions,'' S. Prt. 107-82 (107th Congress 1/2/03).
---------------------------------------------------------------------------

B. Mass Marketing Tax Products

    A second striking aspect of the Subcommittee investigation 
was the discovery of the substantial effort KPMG has expended 
to market its tax products to potential buyers. The 
investigation found that KPMG maintains an extensive marketing 
infrastructure to sell its tax products, including a market 
research department, a Sales Opportunity Center that works on 
tax product ``marketing strategies,'' and even a full-fledged 
telemarketing center staffed with people trained to make cold 
calls to find buyers for specific tax products. When 
investigating SC2, the Subcommittee discovered that KPMG used 
its telemarketing center in Fort Wayne, Indiana, to contact 
literally thousands of S corporations across the country and 
help elevate SC2 to one of KPMG's top ten revenue-producing tax 
products.
    The evidence also uncovered a corporate culture in KPMG's 
Tax Services Practice that condoned placing intense pressure on 
the firm's tax professionals--CPAs and lawyers included--to 
sell the firm's generic tax products. Numerous internal emails 
by senior KPMG tax professionals exhorted colleagues to 
increase their sales efforts. One email thanked KPMG tax 
professionals for a team effort in developing SC2 and then 
instructed these professionals to ``SELL, SELL, SELL!!'' 
Another email warned KPMG partners: ``Look at the last partner 
scorecard. Unlike golf, a low number is not a good thing. . . . 
A lot of us need to put more revenue on the board.'' A third 
email asked all partners in KPMG's premier technical tax group, 
Washington National Tax (WNT), to ``temporarily defer non-
revenue producing activities'' and concentrate for the ``next 5 
months'' on meeting WNT's revenue goals for the year. The email 
stated: ``Listed below are the tax products identified by the 
functional teams as having significant revenue potential over 
the next few months. . . . Thanks for help in this critically 
important matter. As [the Tax Services Practice second in 
command] said, `We are dealing with ruthless execution--hand to 
hand combat--blocking and tackling.' Whatever the mixed 
metaphor, let's just do it.''
    The four case studies featured in this Report provide 
detailed evidence of how KPMG pushed its tax professionals to 
meet revenue targets, closely monitored their sales efforts, 
and even, at times, advised them to use questionable sales 
techniques. For example, in the case of SC2, KPMG tax 
professionals were directed to contact existing clients about 
the product, including KPMG's own audit clients. In a written 
document offering sales advice on SC2, KPMG advised its 
employees, in some cases, to make misleading statements to 
potential buyers, such as claiming that SC2 was no longer 
available for sale, even though it was, apparently hoping that 
reverse psychology would then cause the client to want to buy 
the product. KPMG also utilized confidential and sensitive 
client data in an internal database containing information used 
by KPMG to prepare client tax returns in order to identify 
potential targets for its tax products.
    KPMG also used opinion letters and insurance policies as 
selling points to try to convince uncertain buyers to purchase 
a tax product. For example, KPMG tax professionals were 
instructed to tell potential buyers that opinion letters 
provided by KPMG and Sidley Austin Brown & Wood would protect 
the buyer from certain IRS penalties, if the IRS were later to 
invalidate the tax product. In the case of SC2, KPMG tax 
professionals were instructed to tell buyers that, ``for a 
small premium,'' they could buy an insurance policy from AIG, 
Hartford Insurance, or another firm that would reimburse the 
buyer for any back taxes or penalties actually assessed by the 
IRS for using the tax product. These selling points suggest 
KPMG was trying to present its tax products as a risk free 
gambit for its clients. They also suggest that KPMG was 
pitching its tax products to persons with limited interest in 
the products and who likely would not have used them to avoid 
paying their taxes, absent urging by KPMG to do so.

C. Implementing Tax Products

    Developing and selling a tax product to a client did not, 
in many cases, end KPMG's involvement with the product, since 
the product often required the purchaser to carry out complex 
financial and investment activities in order to realize the 
promised tax benefits. In the four cases examined by the 
Subcommittee, KPMG enlisted a bevy of other professionals, 
including lawyers, bankers, investment advisors and others, to 
carry out the required transactions. In the case of SC2, KPMG 
actively found and convinced various charitable organizations 
to participate. Charities told the Subcommittee staff that KPMG 
had contacted the organizations ``out of the blue,'' convinced 
them to participate in SC2, facilitated interactions with the 
SC2 ``donors,'' and supplied drafts of the transactional 
documents.
    The Subcommittee investigation found that BLIPS, OPIS, 
FLIP, and SC2 could not have been executed without the active 
and willing participation of the law firms, banks, investment 
advisory firms, and charitable organizations that made these 
products work. In the case of BLIPS, OPIS, and FLIP, law firms 
and investment advisory firms helped draft complex 
transactional documents. Major banks, such as Deutsche Bank, 
HVB, UBS, and NatWest, provided purported loans for tens of 
millions of dollars essential to the orchestrated transactions. 
Wachovia Bank initially provided client referrals to KPMG for 
FLIP sales, then later began its own efforts to sell FLIP to 
clients. Two investment advisory firms, Quellos Group LLC 
(``Quellos'') and Presidio Advisory Services (``Presidio''), 
participated directly in the FLIP, OPIS, or BLIPS transactions, 
even entering into partnerships with the clients. In the case 
of SC2, several pension funds agreed to accept corporate stock 
donations and sign redemption agreements to ``sell'' back the 
stock to the corporation after a specified period of time. In 
all four cases, Sidley Austin Brown & Wood agreed to provide a 
legal opinion letter attesting to the validity of the relevant 
tax product. Other law firms, such as Sherman and Sterling, 
prepared transactional documents and helped carry out specific 
transactions. In return, each of the professional firms was 
paid lucrative fees.
    In the case of BLIPS, documents and interviews showed that 
banks and investment advisory firms knew the BLIPS transactions 
and ``loans'' were structured in an unusual way, had no 
reasonable potential for profit, and were designed instead to 
achieve specific tax aims for KPMG clients. For example, the 
BLIPS transactions required the bank to lend, on a non-recourse 
basis, tens of millions of dollars to a shell corporation with 
few assets and no ongoing business, to give the same shell 
corporation an unusual ``loan premium'' providing additional 
tens of millions of dollars, and to enter into interest rate 
swaps that, in effect, reduced the ``loan's'' above-market 
interest rate to a much lower floating market rate.
    Documents and interviews also disclosed that the funds 
``loaned'' by the banks were never really put at risk. The so-
called loan proceeds were instead deemed ``collateral'' for the 
``loan'' itself under an ``overcollateralization'' provision 
that required the ``borrower'' to place 101% of the loan 
proceeds on deposit with the bank. The loan proceeds serving as 
cash collateral were then subject to severe investment 
restrictions and closely monitored by the bank. The end result 
was that only a small portion of the funds in each BLIPS 
transaction was ever placed at risk in true investments. 
Moreover, the banks were empowered to unilaterally terminate a 
BLIPS ``loan'' under a variety of circumstances including, for 
example, if the cash collateral were to fall below the 101% 
requirement. The banks and investment advisory firms knew that 
the BLIPS loan structure and investment restrictions made 
little economic sense apart from the client's tax objectives, 
which consisted primarily of generating huge paper losses for 
KPMG clients who then used those losses to offset other income 
and shelter it from taxation.
    Documents and interviews showed that the same circumstances 
existed for the FLIP and OPIS transactions--banks and 
investment advisory firms financed and participated in 
structured and tightly controlled financial transactions and 
``loans'' primarily designed to generate tax losses on paper 
for clients, while protecting bank assets.
    A professional organization that knowingly participates in 
an abusive tax shelter with no real economic substance violates 
the tax code's prohibition against aiding or abetting tax 
evasion.13 A related issue is whether and to what 
extent lawyers, bankers, investment advisors, tax exempt 
organizations, and others have an obligation to evaluate the 
transactions they are asked to carry out and refrain from 
participating in potentially abusive or illegal tax shelters. 
Another issue is whether professional organizations that 
participate in these types of transactions qualify as tax 
shelter promoters and, if so, are obliged under U.S. law to 
register the relevant transactions as tax shelters and maintain 
client lists.
---------------------------------------------------------------------------
    \13\ 26 U.S.C. 6701.
---------------------------------------------------------------------------
    These issues are particularly pressing for several 
professional firms involved in the KPMG transactions that may 
be tax shelter promoters in their own right. For example, 
Sidley Austin Brown & Wood is under investigation by the IRS 
for issuing more than 600 legal opinion letters supporting 13 
questionable tax products, including BLIPS, FLIP, and 
OPIS.14 Deutsche Bank has sponsored a Structured 
Transactions Group that, in 1999, offered an array of tax 
products to U.S. and European clients seeking to ``execute tax 
driven deals'' or ``gain mitigation'' strategies.15 
Internal bank documents indicate that Deutsche Bank was 
aggressively marketing its tax products to large U.S. 
corporations and individuals, and planned to close billions of 
dollars worth of transactions.16 At least two of the 
tax products being pushed by Deutsche Bank, BLIPS and the 
Customized Adjustable Rate Debt Facility (CARDS), were later 
determined by the IRS to be potentially abusive tax shelters.
---------------------------------------------------------------------------
    \14\ See ``Declaration of Richard E. Bosch,'' IRS Revenue Agent, In 
re John Doe Summons to Sidley Austin Brown & Wood (N.D. Ill. 10/16/03).
    \15\ Email dated 4/3/02, from Viktoria Antoniades to Brian McGuire 
and other Deutsche Bank personnel, ``US GROUP 1 Pres,'' DB BLIPS 6329-
52, attaching a presentation dated 11/15/99, entitled ``Structured 
Transactions Group North America,'' at 6336.
    \16\ Id. at 6345-46.
---------------------------------------------------------------------------
    Another set of issues arising from KPMG's enlistment of 
other professionals to implement its tax products involves the 
role played by tax opinion letters. A tax opinion letter, 
sometimes called a legal opinion letter when issued by a law 
firm, is intended to provide written advice to a client on 
whether a particular tax product is permissible under the law 
and, if challenged by the IRS, how likely it would be that the 
challenged product would survive court scrutiny. Traditionally, 
such opinion letters were supplied by an independent tax expert 
with no financial stake in the transaction being evaluated, and 
an individualized letter was sent to a single client. The mass 
marketing of tax products to multiple clients, however, has 
been followed by the mass production of opinion letters by a 
professional firm that, for each letter sent to a client, is 
paid a handsome fee. The attractive profits available from such 
an arrangement have placed new pressure on the independence of 
the tax opinion letter provider.
    In the four case histories featured in this Report, the 
Subcommittee investigation uncovered disturbing evidence 
related to how tax opinion letters were being developed and 
used in connection with KPMG's tax products. In each of the 
four case histories, the Subcommittee investigation found that 
KPMG had drafted its own prototype tax opinion letter 
supporting the product and used this prototype as a template 
for the letters it actually sent to its clients. In addition, 
in all four case histories, KPMG arranged for an outside law 
firm to provide a second favorable opinion letter. Sidley 
Austin Brown & Wood, for example, issued hundreds of opinion 
letters supporting BLIPS, FLIP, and OPIS.17 The 
evidence indicates that KPMG either directed its clients to 
Sidley Austin Brown & Wood to obtain the second opinion letter, 
or KPMG itself obtained the client's opinion letter from the 
law firm and delivered it to the client, apparently without the 
client's actually speaking to any of the lawyers at the firm.
---------------------------------------------------------------------------
    \17\ In the case of SC2, KPMG also arranged for Bryan Cave to issue 
a legal opinion supporting the tax product, but it is unclear whether 
Bryan Cave ever issued one.
---------------------------------------------------------------------------
    The evidence raises serious questions about the independent 
status of Sidley Austin Brown & Wood in issuing the legal 
opinion letters supporting the KPMG tax products. The evidence 
indicates, for example, that KPMG collaborated with the law 
firm ahead of time to ensure it would supply a favorable 
opinion letter. In the case of BLIPS, KPMG and Sidley Austin 
Brown & Wood actually exchanged copies of their drafts, 
eventually issuing two, allegedly independent opinion letters 
that contain numerous, virtually identical paragraphs. 
Moreover, Sidley Austin Brown & Wood provided FLIP, OPIS, and 
BLIPS clients with nearly identical opinion letters that 
included no individualized legal advice. In many cases, the law 
firm apparently issued its letter without ever speaking with 
the client to whom the tax advice was directed. By routinely 
directing its clients to Sidley Austin Brown & Wood to obtain a 
second opinion letter, KPMG produced a steady stream of income 
for the law firm, further undermining its independent status. 
One document even indicates that Sidley Austin Brown & Wood was 
paid a fee in every case in which a client was told during a 
FLIP sales pitch about the availability of a second opinion 
letter from an outside law firm, whether or not the client 
actually purchased the letter. This type of close, ongoing, and 
lucrative collaboration raises serious questions about the 
independence of both parties and the value of their opinion 
letters in light of the financial stake that both firms had in 
the sale of the tax product being analyzed.
    A second set of issues related to the tax opinion letters 
involves the accuracy and reliability of their factual 
representations. The tax opinion letters prepared by KPMG and 
Sidley Austin Brown & Wood in BLIPS, FLIP, and OPIS typically 
included a set of factual representations made by the client, 
KPMG, the participating investment advisory firm, and the 
participating bank. These representations were critical to the 
accounting firm's analysis upholding the validity of the tax 
product. In all three cases, the Subcommittee investigation 
discovered that KPMG had itself drafted the factual 
representations attributed to other parties. The evidence shows 
that prior to attributing factual representations to other 
professional firms involved in the transactions, KPMG presented 
draft statements to the parties beforehand and negotiated the 
wording. But in the case of the factual representations 
attributed to its client, the evidence indicates KPMG did not 
consult with the client beforehand and, in some cases, even 
refused, despite client objections, to allow the client to 
alter the KPMG-drafted representations.
    Equally disturbing is that some of the key factual 
representations that KPMG made or attributed to its clients 
appear to contain false or misleading statements. For example, 
KPMG wrote in the prototype BLIPS opinion letter that the 
client ``has represented to KPMG . . . [that the client] 
independently reviewed the economics underlying the [BLIPS] 
Investment Fund before entering into the program and believed 
there was a reasonable opportunity to earn a reasonable pre-tax 
profit from the transactions.'' In fact, it is doubtful that 
many BLIPS clients ``independently reviewed'' or understood the 
complicated BLIPS transactions or the ``economics'' underlying 
them. In addition, KPMG knew there was only a remote 
possibility--not a reasonable possibility--of a client's 
earning a pre-tax profit in BLIPS. Nevertheless, since the 
existence of a reasonable opportunity to earn a reasonable 
profit was central to BLIPS' having economic substance and 
complying with federal tax law, KPMG included the client 
representation in its BLIPS tax opinion letter.

D. Avoiding Detection

    In addition to the many development, marketing, and 
implementation problems just described, the Subcommittee 
investigation uncovered disturbing evidence of measures taken 
by KPMG to hide its tax product activities from the IRS and the 
public. Despite its 500 active tax product inventory, KPMG has 
never registered, and thereby disclosed to the IRS the 
existence of, a single one of its tax products. KPMG has 
explained this failure by claiming that it is not a tax 
promoter and does not sell any tax products that have to be 
registered under the law. The evidence suggests, however, that 
KPMG's failure to register may not be attributable to a good 
faith analysis of the technical merits of the tax products.
    Five years ago, in 1998, a senior KPMG tax professional 
advocated in very explicit terms that, for business reasons, 
KPMG ought to ignore federal tax shelter requirements and not 
register the OPIS tax product with the IRS, even if required by 
law. In an email sent to several senior colleagues, this KPMG 
tax professional explained his reasoning. In that email, he 
assumed that OPIS qualified as a tax shelter, and then 
explained why the firm should not, even in this case, register 
it with the IRS as required by law. Among other reasons, he 
observed that the IRS was not vigorously enforcing the 
registration requirement, the penalties for noncompliance were 
much less than the potential profits from selling the tax 
product, and ``industry norms'' were not to register any tax 
products at all. The KPMG tax professional coldly calculated 
the penalties for noncompliance compared to potential fees from 
selling OPIS: ``Based upon our analysis of the applicable 
penalty sections, we conclude that the penalties would be no 
greater than $14,000 per $100,000 in KPMG fees. . . . For 
example, our average [OPIS] deal would result in KPMG fees of 
$360,000 with a maximum penalty exposure of only $31,000.'' The 
senior tax professional also warned that if KPMG were to comply 
with the tax shelter registration requirement, this action 
would place the firm at such a competitive disadvantage in its 
sales that KPMG would ``not be able to compete in the tax 
advantaged products market.'' In short, he urged KPMG to 
knowingly, purposefully, and willfully violate the federal tax 
shelter law.
    The evidence obtained by the Subcommittee indicates that, 
over the following 5 years, KPMG rejected several internal 
recommendations by tax professionals to register a tax product 
as a tax shelter with the IRS. For example, the Subcommittee 
investigation learned that, on at least two occasions, the head 
of KPMG's Department of Professional Practice, a very senior 
tax official, had recommended that BLIPS and OPIS be registered 
as tax shelters, only to be overruled each time by the head of 
the entire Tax Services Practice.
    Instead of registering tax products with the IRS, KPMG 
instead apparently devoted resources to devising rationales for 
not registering them. For example, a fiscal year 2002 draft 
business plan for a KPMG tax group described two tax products 
that were under development, but not yet approved, in part due 
to tax shelter registration issues. With respect to the first 
product, POPS, the business plan stated: ``We have completed 
the solution's technical review and have almost finalized the 
rationale for not registering POPS as a tax shelter.'' With 
respect to the second product, described as a ``conversion 
transaction . . . that halves the taxpayer's effective tax rate 
by effectively converting ordinary income to long term capital 
gain,'' the business plan states: ``The most significant open 
issue is tax shelter registration and the impact registration 
will have on the solution.''
    KPMG's concealment efforts did not stop with its years-long 
refusal to register any tax shelter with the IRS. KPMG also 
appears to have used improper reporting techniques on client 
tax returns to minimize the return information that could alert 
the IRS to the existence of its tax products. For example, in 
the case of OPIS and BLIPS, some KPMG tax professionals advised 
their clients to participate in the transactions through 
``grantor trusts'' and then file tax returns in which all of 
the capital gains and losses from the transactions were 
``netted'' at the grantor trust level, instead of each gain or 
loss being reported individually on the return. The intended 
result was that only a single, small net capital gain or loss 
would appear on the client's personal income tax return.
    A key KPMG tax expert objected to this netting approach 
when it was first suggested within the firm in 1998, writing to 
his colleagues in one email: ``When you put the OPIS 
transaction together with this `stealth' reporting approach, 
the whole thing stinks.'' He wrote in a separate email: ``You 
should all know that I do not agree with the conclusion . . . 
that capital gains can be netted at the trust level. I believe 
we are filing misleading, and perhaps false, returns by taking 
this reporting position.'' Despite these strongly worded emails 
from the KPMG tax professional with authority over this tax 
return issue, several KPMG tax professionals apparently went 
ahead and prepared client tax returns using grantor trust 
netting. In September 2000, in the same notice that declared 
BLIPS to be a potentially abusive tax shelter, the IRS 
explicitly warned against grantor trust netting: ``In addition 
to other penalties, any person who willfully conceals the 
amount of capital gains and losses in this manner, or who 
willfully counsels or advises such concealment, may be guilty 
of a criminal offense.'' In response, KPMG apparently contacted 
some OPIS or BLIPS clients and advised them to re-file their 
returns.
    KPMG used a variety of tax return reporting techniques in 
addition to grantor trust netting to avoid detection of its 
activities by the IRS. In addition, in the four cases examined 
by the Subcommittee, KPMG required some potential purchasers of 
the tax products to sign ``nondisclosure agreements'' and 
severely limited the paperwork used to explain the tax 
products. Client presentations were done on chalkboards or 
erasable whiteboards, and written materials were retrieved from 
clients before leaving a meeting. Another measure taken by 
senior KPMG tax professionals was to counsel staff not to keep 
certain revealing documentation in their files or to clean out 
their files, again, to limit detection of firm activity. Still 
another tactic discussed in several KPMG documents was 
explicitly using attorney-client or other legal privileges to 
limit disclosure of KPMG documents. For example, one 
handwritten document by a KPMG tax professional discussing OPIS 
issues states under the heading, ``Brown & Wood'': ``Privilege 
B&W can play a big role at providing protection in this area.'' 
None of these actions to conceal its activities seems 
consistent with what should be the practices of a leading 
public accounting firm.

E. Disregarding Professional Ethics

    In addition to all the other problems identified in the 
Subcommittee investigation, troubling evidence emerged 
regarding how KPMG handled certain professional ethics issues, 
including issues related to fees and auditor independence. The 
fees charged to KPMG clients raise several concerns. Some 
appear to be ``contingency fees,'' meaning fees which are paid 
only if a client obtains specified results from the services 
offered, such as achieving specified tax savings. More than 20 
states prohibit the payment of contingency fees to accountants, 
and SEC, AICPA, and other rules constrain their use in various 
ways. Internal KPMG documents suggest that, in at least some 
cases, KPMG deliberately manipulated the way it handled certain 
tax products to circumvent contingency fee prohibitions. A 
document discussing OPIS fees, for instance, identifies the 
states that prohibit contingency fees and, then, rather than 
prohibit OPIS transactions in those states or require an 
alternative fee structure, directs KPMG tax professionals to 
make sure the OPIS engagement letter is signed, the engagement 
is managed, and the bulk of services is performed ``in a 
jurisdiction that does not prohibit contingency fees.''
    In the case of BLIPS, clients were charged a single fee 
equal to 7% of the ``tax losses'' to be generated by the BLIPS 
transactions. The client fee was typically paid to Presidio, an 
investment advisory firm, which then apportioned the fee amount 
among various firms according to certain factors. The fee 
recipients typically included KPMG, Presidio, a participating 
bank, and Sidley Austin Brown & Wood. This fee splitting 
arrangement may violate restrictions on contingency fees, 
client referral fees, and fees paid jointly to lawyers and non-
lawyers.
    KPMG's tax products also raise auditor independence issues. 
Three of the banks involved in BLIPS, FLIP, and OPIS (Deutsche 
Bank, HVB, and Wachovia Bank), employ KPMG to audit their 
financial statements. SEC rules state that auditor independence 
is impaired when an auditor has a direct or material indirect 
business relationship with an audit client. KPMG apparently 
attempted to address the auditor independence issue by giving 
its clients a choice of banks to use in the transactions, 
including at least one bank that was not a KPMG audit client. 
It is unclear, however, whether individuals actually could 
choose what bank to use. Moreover, it is unclear how providing 
clients with a choice of banks alleviated KPMG's conflict of 
interest, since it still had a direct or material, indirect 
business relationship with a bank whose financial statements 
were certified by KPMG auditors.
    A second set of auditor independence issues involves KPMG's 
decision to market tax products to its own audit clients. By 
engaging in this marketing tactic, KPMG not only took advantage 
of its auditor-client relationship, but also created a conflict 
of interest in those cases where it successfully sold a tax 
product to an audit client. The conflict of interest arises 
when the KPMG auditor reviewing the client's financial 
statements is required, as part of that review, to examine the 
client's tax return and its use of unusual tax strategies. In 
such situations, KPMG is, in effect, auditing its own work.
    A third set of professional ethics issues involves conflict 
of interest concerns related to the legal representation of 
clients who, after purchasing a tax product from KPMG, have 
come under IRS scrutiny. The issues include whether KPMG should 
be referring these clients to a law firm that represents KPMG 
itself on unrelated matters, and whether a law firm that has a 
longstanding, close, and ongoing relationship with KPMG, 
representing it on unrelated matters, should also represent 
KPMG clients. While KPMG and the client have an immediate joint 
interest in defending the tax product that KPMG sold and the 
client purchased, their interests could quickly diverge if the 
suspect tax product is found to be in violation of federal tax 
law. This divergence in interests has been demonstrated 
repeatedly since 2002, as growing numbers of KPMG clients have 
filed suit against KPMG seeking a refund of past fees they paid 
to the firm and additional damages for KPMG's selling them an 
illegal tax shelter.
    The following pages provide more detailed information about 
these and other problems uncovered during the Subcommittee 
investigation into the role of professional firms in the tax 
shelter industry.
    The tax products featured in this Report were developed, 
marketed, and executed by highly skilled professionals in the 
fields of accounting, law, and finance. Historically, such 
professionals have been distinguished by their obligation to 
meet a higher standard of conduct in business than ordinary 
occupations. When it came to decisions by these professionals 
on whether to approve a questionable tax product, employ 
telemarketers to sell tax services, or omit required 
information from a tax return, one might have expected a 
thoughtful discussion or analysis of the firm's fiduciary 
duties, its ethical and professional obligations, or what 
should be done to protect the firm's good name. Unfortunately, 
evidence of those thoughtful discussions was virtually non-
existent, and considerations of professionalism seem to have 
had little, if any, effect on KPMG's mass marketing of its tax 
products.

IV. Recommendations

    Based upon its investigation to date and the above 
findings, the Subcommittee Minority staff recommends that the 
Subcommittee make the following policy recommendations.

        (1) Congress should enact legislation to increase 
        penalties on promoters of potentially abusive and 
        illegal tax shelters, clarify and strengthen the 
        economic substance doctrine, and bar auditors from 
        providing tax shelter services to their audit clients.

        (2) Congress should increase funding of IRS 
        enforcement efforts to stop potentially abusive and 
        illegal tax shelters, and the IRS should dramatically 
        increase its enforcement efforts against tax shelter 
        promoters.

        (3) The IRS and PCAOB should conduct a joint review of 
        tax shelter activities by accounting firms, and take 
        steps to clarify and strengthen federal and private 
        sector procedures and prohibitions to prevent 
        accounting firms from aiding or abetting tax evasion, 
        promoting potentially abusive or illegal tax shelters, 
        or engaging in related unethical or illegal conduct. 
        The PCAOB should consider banning public accounting 
        firms from providing tax shelter services to their 
        audit clients and others.

        (4) The IRS and federal bank regulators should conduct 
        a joint review of tax shelter activities at major 
        banks, clarify and strengthen bank procedures and 
        prohibitions to prevent banks from aiding or abetting 
        tax evasion, promoting potentially abusive or illegal 
        tax shelters, or engaging in related unethical or 
        illegal conduct.

        (5) The U.S. Department of Justice and IRS should 
        conduct a joint review of tax shelter activities at 
        major law firms, and take steps to clarify and 
        strengthen federal and private sector rules to prevent 
        law firms from aiding or abetting tax evasion, 
        promoting potentially abusive or illegal tax shelters, 
        or engaging in related unethical or illegal conduct. 
        The U.S. Treasury Department should clarify and 
        strengthen professional standards of conduct and 
        opinion letter requirements in Circular 230 and 
        explicitly address tax shelter issues.

        (6) Federal and private sector regulators should 
        clarify and strengthen federal and private sector rules 
        related to opinion letters advising on tax products, 
        including setting standards for letters related to mass 
        marketed tax products, requiring fair and accurate 
        factual representations, and barring collaboration 
        between a tax product promoter and a firm preparing an 
        allegedly independent opinion letter.

        (7) The American Institute of Certified Public 
        Accountants (AICPA), American Bar Association, and 
        American Bankers Association should establish standards 
        of conduct and procedures to prevent members of their 
        professions from aiding or abetting tax evasion, 
        promoting abusive or illegal tax shelters, or engaging 
        in related unethical or illegal conduct, including by 
        requiring a due diligence review of any tax-related 
        transaction in which a member is asked to participate. 
        Tax exempt organizations should adopt similar standards 
        of conduct and procedures.

        (8) The AICPA, American Bar Association, and American 
        Bankers Association should strengthen professional 
        standards of conduct and ethics requirements to stop 
        the development and mass marketing of tax products 
        designed to reduce or eliminate a client's tax 
        liability, and should prohibit their members from using 
        aggressive sales tactics to market tax products, 
        including by prohibiting use of cold calls and 
        telemarketing, explicit revenue goals, and fees 
        contingent on projected tax savings.

        (9) The AICPA and American Bar Association should 
        strengthen professional standards of conduct and ethics 
        requirements to prohibit the issuance of an opinion 
        letter on a tax product when the independence of the 
        author has been compromised by providing accounting, 
        legal, design, sales, or implementation assistance 
        related to the product, by having a financial stake in 
        the tax product, or by having a financial stake in a 
        related or similar tax product.

V. Overview of U.S. Tax Shelter Industry

  A. Summary of Current Law on Tax Shelters

    The definition of an abusive tax shelter has changed and 
expanded over time to encompass a wide variety of illegal or 
potentially illegal tax evasion schemes. Existing legal 
definitions are complex and appear in multiple sections of the 
tax code.18 These tax shelter definitions refer to 
transactions, partnerships, entities, investments, plans, or 
arrangements which have been devised, in whole or significant 
part, to enable taxpayers to eliminate or understate their tax 
liability. The General Accounting Office (GAO) recently 
summarized these definitions by describing ``abusive shelters'' 
as ``very complicated transactions promoted to corporations and 
wealthy individuals to exploit tax loopholes and provide large, 
unintended tax benefits.'' 19
---------------------------------------------------------------------------
    \18\ See, e.g., 26 U.S.C. Sec. Sec. 461(i)(3) (defining tax shelter 
for certain tax accounting rules); 6111(a), (c) and (d) (defining tax 
shelter for certain registration and disclosure requirements); and 
6662(d)(2)(C)(iii) (defining tax shelter for application of 
understatement penalty).
    \19\ ``Challenges Remain in Combating Abusive Tax Shelters,'' 
testimony by Michael Brostek, Director, Tax Issues, GAO, before the 
U.S. Senate Committee on Finance, No. GAO-04-104T (10/21/03) 
(hereinafter ``GAO Testimony'') at 1.
---------------------------------------------------------------------------
    Over the past 10 years, Federal statutes and regulations 
prohibiting illegal tax shelters have undergone repeated 
revision to clarify and strengthen them. Today, key tax code 
provisions not only prohibit tax evasion by taxpayers, but also 
penalize persons who knowingly organize or promote illegal tax 
shelters 20 or who knowingly aid or abet the filing 
of tax return information that understates a taxpayer's tax 
liability.21 Additional tax code provisions now 
require taxpayers and promoters to disclose to the IRS 
information about certain potentially illegal tax 
shelters.22
---------------------------------------------------------------------------
    \20\ 26 U.S.C. Sec. 6700.
    \21\ 26 U.S.C. Sec. 6701.
    \22\ See, e.g., 26 U.S.C. Sec. Sec. 6011 (taxpayer must disclose 
reportable transactions); 6111 (organizers and promoters must register 
potentially illegal tax shelters with IRS), 6112 (promoters must 
maintain lists of clients who purchase potentially illegal tax shelters 
and, upon request, disclose such client lists to the IRS).
---------------------------------------------------------------------------
    Recently, the IRS issued regulations to clarify and 
strengthen the law's definition of a tax shelter promoter and 
the law's requirements for tax shelter disclosure.23 
For example, these regulations now make it clear that tax 
shelter promoters include ``persons principally responsible for 
organizing a tax shelter as well as persons who participate in 
the organization, management or sale of a tax shelter'' and any 
person who is a ``material advisor'' on a tax shelter 
transaction.24 Disclosure obligations, which apply 
to both taxpayers and tax shelter promoters, require disclosure 
to the IRS, under certain circumstances, of information related 
to six categories of potentially illegal tax shelter 
transactions. Among others, these disclosures include any 
transaction that is the same or similar to a ``listed 
transaction,'' which is a transaction that the IRS has formally 
determined, through regulation, notice, or other published 
guidance, ``as having a potential for tax avoidance or 
evasion'' and is subject to the law's registration and client 
list maintenance requirements.25 The IRS has stated 
in court that it ``considers a `listed transaction' and all 
substantially similar transactions to have been structured for 
a significant tax avoidance purpose'' and refers to them as 
``potentially abusive tax shelters.'' 26 The IRS has 
also stated in court that ``the IRS has concluded that 
taxpayers who engaged in such [listed] transactions have failed 
or may fail to comply with the internal revenue laws.'' 
27 As of October 2003, the IRS had published 27 
listed transactions.
---------------------------------------------------------------------------
    \23\ See, e.g., Treas. Reg. Sec. 301.6112-1 and Sec. 1.6011-4, 
which took effect on 2/28/03.
    \24\ Petition dated 10/14/03, ``United States' Ex Parte Petition 
for Leave to Serve IRS `John Doe' Summons on Sidley Austin Brown & 
Wood,'' (D.N.D. Ill.), at para. 8.
    \25\ Id. at para. 11. See also ``Background and Present Law 
Relating to Tax Shelters,'' Joint Committee on Taxation (JCX-19-02), 3/
19/02 (hereinafter ``Joint Committee on Taxation report''), at 33; GAO 
Testimony at 7. The other five categories of transactions subject to 
disclosure are transactions offered under conditions of 
confidentiality, including contractual protections to the ``investor'', 
resulting in specific amounts of tax losses, generating a tax benefit 
when the underlying asset is held only briefly, or generating 
differences between financial accounts and tax accounts greater than 
$10 million. GAO Testimony at 7.
    \26\ Petition dated 10/14/03, ``United States' Ex Parte Petition 
for Leave to Serve IRS `John Doe' Summons on Sidley Austin Brown & 
Wood,'' (D.N.D. Ill.), at para.para. 11-12.
    \27\ Id. at para. 16.
---------------------------------------------------------------------------
    In addition to statutory and regulatory requirements and 
prohibitions, federal courts have developed over the years a 
number of common law doctrines to identify and invalidate 
illegal tax shelters, including the economic 
substance,28 business purpose,29 
substance-over-form,30 step 
transaction,31 and sham transaction 32 
doctrines. A study by the Joint Committee on Taxation concludes 
that ``[t]hese doctrines are not entirely distinguishable'' and 
have been applied by courts in inconsistent ways.33
---------------------------------------------------------------------------
    \28\ See, e.g., Gregory v. Helvering, 293 U.S. 465 (1935); ACM 
Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998), cert. denied 
526 U.S. 1017 (1999); Bail Bonds by Marvin Nelson, Inc. v. 
Commissioner, 820 F.2d 1543, 1549 (9th Cir. 1987) (``The economic 
substance factor involves a broader examination of . . . whether from 
an objective standpoint the transaction was likely to produce economic 
benefits aside from a tax deduction.'').
    \29\ See, e.g., Gregory v. Helvering, 293 U.S. 465 (1935); 
Commissioner v. Transport Trading & Terminal Corp., 176 F.2d 570, 572 
(2nd Cir. 1949), cert. denied 339 U.S. 916 (1949) (Judge Learned Hand) 
(``The doctrine of Gregory v. Helvering . . . means that in construing 
words of a tax statute which describe commercial or industrial 
transactions we are to understand them to refer to transactions entered 
upon for commercial or industrial purposes and not to include 
transactions entered upon for no other motive but to escape 
taxation.'')
    \30\ See, e.g., Weiss v. Stearn, 265 U.S. 242, 254 (1924) 
(``Questions of taxation must be determined by viewing what was 
actually done, rather than the declared purpose of the participants; 
and when applying the provisions of the Sixteenth Amendment and income 
laws . . . we must regard matters of substance and not mere form.'')
    \31\ See, e.g., Commissioner v. Court Holding Co., 324 U.S. 331, 
334 (1945) (``The transaction must be viewed as a whole, and each step, 
from the commencement of negotiations to the consummation of the sale, 
is relevant. A sale by one person cannot be transformed for tax 
purposes into a sale by another using the latter as a conduit through 
which to pass title.''); Palmer v. Commissioner, 62 T.C. 684, 692 
(1974).
    \32\ See, e.g., Gregory v. Helvering, 293 U.S. 465 (1935); Rice's 
Toyota World v. Commissioner, 752 F.2d 89, 91-92 (4th Cir. 1985); 
United Parcel Service of America, Inc. v. Commissioner, 78 T.C.M. 262 
at n. 29 (1999), rev'd 254 F.3d 1014 (11th Cir. 2001) (``Courts have 
recognized two basic types of sham transactions. Shams in fact are 
transactions that never occur. In such shams, taxpayers claim 
deductions for transactions that have been created on paper but which 
never took place. Shams in substance are transactions that actually 
occurred but which lack the substance their form represents.'').
    \33\ Joint Committee on Taxation report at 7.
---------------------------------------------------------------------------
    Bipartisan legislation to clarify and strengthen the 
economic substance and business purpose doctrines, as well as 
other aspects of federal tax shelter law, has been developed by 
the Senate Finance Committee. This legislation has been twice 
approved by the Senate during the 108th Congress, but has yet 
to become law.34
---------------------------------------------------------------------------
    \34\ See, e.g., S. 476, the CARE Act of 2003 (108th Congress, first 
session), section 701 et seq.
---------------------------------------------------------------------------

  B. U.S. Tax Shelter Industry and Professional Organizations

          LFinding: The sale of potentially abusive and illegal 
        tax shelters has become a lucrative business in the 
        United States, and some professional firms such as 
        accounting firms, banks, investment advisory firms, and 
        law firms are major participants in the mass marketing 
        of generic ``tax products'' to multiple clients.

    Illegal tax shelters sold to corporations and wealthy 
individuals drain the U.S. Treasury of billions of dollars in 
lost tax revenues each year. According to GAO, a recent IRS 
consultant estimated that for the 6-year period, 1993-1999, the 
IRS lost on average between $11 and $15 billion each year from 
abusive tax shelters.35 In actual cases closed 
between October 1, 2001, and May 6, 2003, involving just 42 
large corporations, GAO reports that the IRS proposed abusive 
shelter-related adjustments for tax years, 1992 to 2000, 
totaling more than $10.5 billion.36 GAO reports that 
an IRS database tracking unresolved, abusive tax shelter cases 
over a number of years estimates potential tax losses of about 
$33 billion from listed transactions and another $52 billion 
from nonlisted abusive transactions, for a combined total of 
$85 billion.37
---------------------------------------------------------------------------
    \35\ GAO Testimony at 12.
    \36\ Id. at 11.
    \37\ Id. at 10.
---------------------------------------------------------------------------
    GAO has also reported that IRS data provided in October 
2003, identified about 6,400 individuals and corporations that 
had bought abusive tax shelters and other abusive tax planning 
products, as well as almost 300 firms that appear to have 
promoted them.38 According to GAO, as of June 2003, 
the IRS had approved investigations of 98 tax shelter 
promoters, including some directed at accounting or law 
firms.39
---------------------------------------------------------------------------
    \38\ Id. at 11.
    \39\ Id. at 16.
---------------------------------------------------------------------------
    IRS Commissioner Mark Everson testified at a recent Senate 
Finance Committee hearing that: ``A significant priority in the 
Service's efforts to curb abusive transactions is our focus on 
promoters.'' 40 He stated, ``The IRS has focused its 
attention in the area of tax shelters on accounting and law 
firms, among others. The IRS has focused on these firms because 
it believes that, in the instances in which the IRS has acted, 
these firms were acting as promoters of tax shelters, and not 
simply as tax or legal advisers.''
---------------------------------------------------------------------------
    \40\ Testimony of Mark Everson, IRS Commissioner, before the Senate 
Committee on Finance, ``Tax Shelters: Who's Buying, Who's Selling and 
What's the Government Doing About It?'' (10/21/03), at 7.
---------------------------------------------------------------------------
    Mr. Everson also described the latest generation of abusive 
tax shelters as complex, difficult-to-detect transactions 
developed by extremely sophisticated people:

        ``The latest generation of abusive tax transactions has 
        been facilitated by the growth of financial products 
        and structures whose own complexity and non-
        transparency have provided additional tools to allow 
        those willing to design transactions intended to 
        generate unwarranted tax benefits. . . . [A]busive 
        transactions that are used by corporations and 
        individuals present formidable administrative 
        challenges. The transactions themselves can be 
        creative, complex and difficult to detect. Their 
        creators are often extremely sophisticated, as are many 
        of their users, who are often financially prepared and 
        motivated to contest the Service's challenges.'' 
        41
---------------------------------------------------------------------------
    \41\ Id. at 2.

    The Commissioner stated that due to the ``growth in the 
volume of abusive transactions'' and ``a disturbing decline in 
corporate conduct and governance,'' among other factors, the 
IRS has enhanced its response to abusive transactions in 
general, and abusive tax shelters in particular.42 
He said that the Office of Tax Shelter Analysis (OTSA), first 
established in February 2000 within the Large and Mid-Size 
Business Division, is continuing to lead IRS tax shelter 
efforts. He stated that, ``OTSA plans, centralizes and 
coordinates LMSB's tax shelter operations and collects, 
analyzes, and distributes within the IRS information about 
potentially abusive tax shelter activity.'' 43 Mr. 
Everson described a number of ongoing IRS tax shelter 
initiatives including efforts to increase enforcement 
resources, conduct promoter audits, enforce IRS document 
requests against accounting and law firms, implement global 
settlements for persons who used certain illegal tax shelters, 
develop proposed regulations to improve tax opinion letters and 
ethics rules for tax professionals appearing before the IRS, 
and issue additional notices to identify illegal tax shelters.
---------------------------------------------------------------------------
    \42\ Id. at 3.
    \43\ Id. at 8.
---------------------------------------------------------------------------
    The Commissioner warned:

        ``[A]busive transactions can and will continue to pose 
        a threat to the integrity of our tax administration 
        system. We cannot afford to tolerate those who 
        willfully promote or participate in abusive 
        transactions. The stakes are too high and the effects 
        of an insufficient response are too corrosive.'' 
        44
---------------------------------------------------------------------------
    \44\ Id. at 16.

    Professional organizations like accounting firms, banks, 
investment advisers, and law firms are now key participants in 
the tax shelter industry. These firms specialize in producing 
tax shelters that utilize complex structured finance 
transactions, multi-million dollar loans, novel tax code 
interpretations, and expensive professional services requiring 
highly skilled professionals. These firms routinely enlist 
assistance from other respected professional firms and 
financial institutions to provide the accounting, investment, 
financing or legal services needed for the tax shelters to 
work.
    During the past 10 years, professional firms active in the 
tax shelter industry have expanded their role, moving from 
selling individualized tax shelters to specific clients, to 
developing generic tax products and mass marketing them to 
existing and potential clients. No longer content with 
responding to client inquiries, these firms are employing the 
same tactics employed by disreputable, tax shelter hucksters: 
churning out a continuing supply of new and abusive tax 
products, marketing them with hard sell techniques and cold 
calls; and taking deliberate measures to hide their activities 
from the IRS.

VI. Four KPMG Case Histories

  A. KPMG In General

    KPMG International is one of the largest public accounting 
firms in the world, with over 700 offices in 152 
countries.45 In 2002, it employed over 100,000 
people and had worldwide revenues of $10.7 billion. KPMG 
International is organized as a Swiss ``non-operating 
association,'' functions as a federation of partnerships around 
the globe, and maintains its headquarters in Amsterdam.
---------------------------------------------------------------------------
    \45\ The general information about KPMG is drawn from KPMG 
documents produced in connection with the Subcommittee investigation; 
Internet websites maintained by KPMG LLP and KPMG International; and a 
legal complaint filed by the U.S. Securities and Exchange Commission 
(SEC) in SEC v. KPMG LLP, Civil Action No. 03-CV-0671 (D.S.D.N.Y. 1/29/
03), alleging fraudulent conduct by KPMG and certain KPMG audit 
partners in connection with audits of certain Xerox Corporation 
financial statements.
---------------------------------------------------------------------------
    KPMG LLP (hereinafter ``KPMG'') is a U.S. limited liability 
partnership and a member of KPMG International. KPMG is the 
third largest accounting firm in the United States, and 
generates more than $4 billion in annual revenues. KPMG was 
formed in 1987, from the merger of two long-standing accounting 
firms, Peat Marwick and Klynveld Main Goerdeler, along with 
their individual member firms. KPMG maintains its headquarters 
in New York and numerous offices in the United States and other 
countries. KPMG is run by a ``Management Committee'' made up of 
15 individuals drawn from the firm's senior management and 
major divisions.46 KPMG's Chairman and CEO is Eugene 
O'Kelly, who joined KPMG in 1972, became partner in 1982, and 
was appointed Chairman in 2002. KPMG's Deputy Chairman is 
Jeffrey M. Stein, who was also appointed in 2002. From 2000 
until 2002, Mr. Stein was the Vice Chairman for Tax heading 
KPMG's Tax Services Practice, and prior to that he served as 
head of operations, or second in command, of the Tax Services 
Practice.
---------------------------------------------------------------------------
    \46\ The 15 Management Committee members are the Chairman, Deputy 
Chairman, Chief Financial Officer, General Counsel, head of the 
Department of Professional Practice, head of the Department of 
Marketing and Communications, head of the Department of Human 
Resources, the two most senior officials in the Tax Services Practice, 
the two most senior officials in the Assurance Practice, and the most 
senior official in each of four industry-related ``lines of business,'' 
such as telecommunications and energy. Subcommittee interview of 
Jeffrey Stein (10/31/03).
---------------------------------------------------------------------------
    KPMG's Tax Services Practice is a major division of KPMG. 
It provides tax compliance, tax planning, and tax return 
preparation services. The Tax Services Practice employs more 
than 10,300 tax professionals and generates approximately $1.2 
billion in annual revenues for the firm. These revenues have 
been increasing rapidly in recent years, including a 45% 
cumulative increase over 4 years, from 1998 to 
2001.47 The Tax Services Practice is headquartered 
in New York, has 122 U.S. offices, and maintains additional 
offices around the world. The current head of the Tax Service 
is Vice Chairman for Tax, Richard Smith.
---------------------------------------------------------------------------
    \47\ Internal KPMG presentation dated 7/19/01, by Rick Rosenthal 
and Marsha Peters, entitled ``Innovative Tax Solutions,'' Bates XX 
001340-50. A chart included in this presentation tracks increases in 
the Tax Service's gross revenues from 1998 until 2001, showing a 
cumulative increase of more than 45% over the 4-year period, from 1998 
gross revenues of $830 million to 2001 gross revenues of $1.24 billion.
---------------------------------------------------------------------------
    The Tax Services Practice has over two dozen subdivisions, 
offices, ``practices'' or ``groups'' which over the years have 
changed missions and personnel. Many have played key roles in 
developing, marketing, or implementing KPMG's generic tax 
products, including the four products featured in this Report. 
One key group is the Washington National Tax Practice (WNT) 
which provides technical tax expertise to the entire KPMG firm. 
A WNT subgroup, The Tax Innovation Center, leads KPMG's efforts 
to develop new generic tax products. Another key group is the 
Department of Professional Practice (DPP) for Tax, which, among 
other tasks, reviews and approves all new KPMG tax products for 
sale to clients. KPMG's Federal Tax Practice addresses federal 
tax compliance and planning issues. KPMG's Personal Financial 
Planning (PFP) Practice focuses on selling ``tax-advantaged'' 
products to high net worth individuals and large 
corporations.48 Through a subdivision known as the 
Capital Transaction Services (CaTS) Practice, later renamed the 
Innovative Strategies (IS) Practice, PFP led KPMG's efforts on 
FLIP, OPIS, and BLIPS.49 KPMG's Stratecon Practice, 
which focuses on ``business based'' tax planning and tax 
products, led the firm's efforts on SC2. Innovative Strategies 
and Stratecon were disbanded in 2002, and their tax 
professionals assigned to other groups.50
---------------------------------------------------------------------------
    \48\ Minutes dated 11/30/00, Monetization Solutions Task Force 
Teleconference, Bates KPMG 0050624-29, at 50625.
    \49\ Document dated 5/18/01, ``PFP Practice Reorganization 
Innovative Strategies Business Plan--DRAFT,'' Bates KPMG 0050620-23, at 
1.
    \50\ Stratecon appears to have been very active until its 
dissolution. See, e.g., email dated 4/8/02, from Larry Manth to 
multiple KPMG tax professionals, ``Stratecon Final Results for March 
2002,'' Bates XX 001732 (depicting Stratecon's March 2002 revenues and 
operating expenses).
---------------------------------------------------------------------------
    Several senior KPMG tax professionals interviewed by the 
Subcommittee staff, when asked to describe KPMG's overall 
approach to tax services, indicated that the firm made a 
significant change in direction in the late 1990's, when it 
made a formal decision to begin devoting substantial resources 
to developing and marketing tax products that could be sold to 
multiple clients. The Subcommittee staff was told that KPMG 
made this decision, in part, due to the success other 
accounting firms were experiencing in selling tax products; in 
part, due to the large revenues earned by the firm from selling 
a particular tax product to banks; 51 and, in part, 
due to new tax leadership that was enthusiastic about 
increasing tax product sales. Among other actions to carry out 
this decision, the firm established the Tax Innovation Center 
which was dedicated to generating new generic tax products. One 
senior KPMG tax professional told the Subcommittee staff that 
some KPMG partners considered it ``important'' for the firm to 
become an industry leader in producing generic tax products. He 
said that, of the many new products KPMG developed, some were 
``relatively plain vanilla,'' while others were ``aggressive.'' 
He said that the firm's policy was to offer only tax products 
which met a ``more likely than not'' standard, meaning the 
product had a greater than 50 percent probability of 
withstanding a challenge by the IRS, and that KPMG deliberately 
chose a higher standard than required by the AICPA, which 
permits firms to offer tax products with a ``realistic 
possibility of success,'' or a one-in-three chance of 
withstanding an IRS challenge.52
---------------------------------------------------------------------------
    \51\ For information about this tax product, see Appendix C, ``Sham 
Mutual Fund Investigation.''
    \52\ KPMG's policy is included in the KPMG Tax Services Manual--
U.S., May 2002, KPMG Accounting & Reporting Publication, (hereinafter 
``KPMG Tax Services Manual''), Sec. 24.5.2, at 24-3.
---------------------------------------------------------------------------
    In recent years, KPMG has become the subject of IRS, SEC, 
and state investigations and enforcement actions in the areas 
of tax, accounting fraud, and auditor 
independence.53 These enforcement actions include 
ongoing litigation by the IRS to enforce tax shelter related 
document requests and a tax promoter audit of the firm; SEC, 
California, and New York investigations into a potentially 
abusive tax shelter involving at least 10 banks that are 
allegedly using sham mutual funds established on KPMG's advice; 
SEC and Missouri investigations or enforcement actions related 
to alleged KPMG involvement in accounting fraud at Xerox 
Corporation or General American Mutual Holding Co.; and auditor 
independence concerns leading to an SEC censure of KPMG for 
investing in AIM mutual funds while AIM was an audit client, 
and to an ongoing SEC investigation of tax product client 
referrals from Wachovia Bank to KPMG while Wachovia was a KPMG 
audit client. In addition, a number of taxpayers have filed 
suit against KPMG for allegedly selling them an illegal tax 
shelter or improperly involving them in work on illegal tax 
shelters.
---------------------------------------------------------------------------
    \53\ Brief summaries of some of these matters are included in 
Appendix C.
---------------------------------------------------------------------------

  B. KPMG's Tax Shelter Activities

          LFinding: Although KPMG denies being a tax shelter 
        promoter, the evidence establishes that KPMG has 
        devoted substantial resources to, and obtained 
        significant fees from, developing, marketing, and 
        implementing potentially abusive and illegal tax 
        shelters that U.S. taxpayers might otherwise have been 
        unable, unlikely or unwilling to employ, costing the 
        Treasury billions of dollars in lost tax revenues.

    KPMG has repeatedly denied being a tax shelter promoter. 
KPMG has denied it in court when opposing IRS document requests 
for information related to tax shelters,54 and 
denied it in response to Subcommittee questions. KPMG has never 
registered any tax product with the IRS as a potentially 
abusive tax shelter.
---------------------------------------------------------------------------
    \54\ See United States v. KPMG, Case No. 1:02MS00295 (D.D.C. 9/6/
02), ``Answer to Petition to Enforce Internal Revenue Summonses,'' at 
para. 1 (``KPMG asserts that it is not a tax shelter organizer, but a 
professional firm whose tax professionals provide advice and counseling 
on a one-on-one basis to clients and prospective clients concerning the 
clients' tax situations.'')
---------------------------------------------------------------------------
    KPMG does not refer to any of its tax products as ``tax 
shelters'' and objects to using that term to describe its tax 
products. Instead, KPMG refers to its tax products as ``tax 
solutions'' or ``tax strategies.'' The KPMG Tax Services Manual 
defines a ``tax solution'' as ``a tax planning idea, structure, 
or service that potentially is applicable to more than one 
client situation and that is reasonable to believe will be the 
subject of leveraged deployment,'' meaning sales to multiple 
clients.55
---------------------------------------------------------------------------
    \55\ KPMG Tax Services Manual, Sec. 24.1.1, at 24-1.
---------------------------------------------------------------------------
    In response to a Subcommittee inquiry, KPMG provided the 
Subcommittee with a list of over 500 ``active tax products'' 
designed to be offered to multiple clients for a 
fee.56 When the Subcommittee asked KPMG to identify 
the ten tax products that produced the most revenue for the 
firm in 2000, 2001, and 2002, KPMG denied having the ability to 
reliably track revenues associated with individual tax products 
and thus to identify with certainty its top revenue 
producers.57 To respond to the Subcommittee's 
request, KPMG indicated that it had ``undertaken a good faith, 
reasonable effort to estimate the tax strategies that were 
likely among those generating the most revenues in the years 
requested.'' 58 KPMG identified a total of 19 tax 
products that were top revenue-producers for the firm over the 
3-year period.
---------------------------------------------------------------------------
    \56\ Untitled document, produced by KPMG on 2/10/03, Bates KPMG 
0000009-91.
    \57\ See chart entitled, ``Good Faith Estimate of Top Revenue-
Generating Strategies,'' attached to letter dated 4/22/03, from KPMG's 
legal counsel to the Subcommittee, Bates KPMG 0001801 (``[B]ecause each 
tax strategy is tailored to a client's particular circumstances, the 
firm does not maintain any systematic, reliable method of recording 
revenues by tax product on a national basis, and therefore is unable to 
provide any definitive list or quantification of revenues for a `top 
ten tax products', as requested by the Subcommittee.'').
    \58\ Id.
---------------------------------------------------------------------------
    The Subcommittee staff's preliminary review of these 19 top 
revenue-producing tax products determined that six, OPIS, 
BLIPS, 401(k)ACCEL, CARDS, CLAS, and CAMPUS, are either within 
the scope of ``listed transactions'' already determined by the 
IRS to be potentially abusive tax shelters or within the scope 
of IRS document requests in an ongoing IRS review of KPMG's tax 
shelter activities.59 The Subcommittee determined 
that many, if not all, of the 19 tax products were designed to 
reduce the tax liability of corporations or individuals, and 
employed features such as structured transactions, complex 
accounting methods, and novel tax law interpretations, often 
found in illegal tax shelters. The Subcommittee staff briefly 
reviewed a number of other KPMG tax products as well 
60 and found that they, too, carried indicia of a 
potentially abusive tax shelter.
---------------------------------------------------------------------------
    \59\ Compare 19 tax products listed in the chart produced by KPMG 
on 8/8/03, Bates KPMG 0001801, to the tax products identified in United 
States v. KPMG, Case No. 1:02MS00295 (D.D.C. 7/9/02), ``Petition to 
Enforce Internal Revenue Service Summonses.''
    \60\ These tax products included OTHELLO, TEMPEST, RIPSS, and 
California REIT.
---------------------------------------------------------------------------
    KPMG insists that all of its tax products are the result of 
legitimate tax planning services. In legal pleadings seeking 
KPMG documents, however, the IRS has stated that a number of 
KPMG's tax products appear to be ``tax shelters'' and requested 
related documentation to determine whether the firm is 
complying with federal tax shelter laws.61 The IRS 
specifically identified as ``tax shelters'' FLIP, OPIS, BLIPS, 
TRACT, IDV, 401(k) ACCEL, Contested Liabilities, Economic 
Liability Transfer, CLAS, CAMPUS, MIDCO, certain ``Tax Treaty'' 
transactions, PICO, and FOCUS.62 The IRS also 
alleged that, according to information from a confidential 
source, ``KPMG continues to hide from the IRS information about 
tax shelters it is now developing and marketing'' and ``KPMG 
continues to develop and aggressively market dozens of possibly 
abusive tax shelters.'' 63
---------------------------------------------------------------------------
    \61\ United States v. KPMG, Case No. 1:02MS00295 (D.D.C. 7/9/02), 
``Petition to Enforce Internal Revenue Service Summonses.''
    \62\ Id.
    \63\ United States v. KPMG, Case No. 1:02MS00295 (D.D.C. 7/9/02), 
``Declaration of Michael A. Halpert,'' Internal Revenue Agent, at para. 
38.
---------------------------------------------------------------------------
    The Subcommittee staff selected three of KPMG's 19 top 
revenue producing tax products for more intensive study, OPIS, 
BLIPS and SC2, as well as an earlier tax product, FLIP, which 
KPMG had stopped selling after 1999, but which was the 
precursor to OPIS and BLIPS, and the subject of lawsuits filed 
in 2002 and 2003, by persons claiming KPMG had sold them an 
illegal tax shelter. All four of these tax products were 
explicitly designed to reduce or eliminate the tax liability of 
corporations or individuals. Three, FLIP, OPIS, and BLIPS, have 
already been determined by the IRS to be illegal or potentially 
abusive tax shelters, and the IRS has penalized taxpayers for 
using them. A number of these taxpayers have, in turn, sued 
KPMG for selling them illegal tax shelters.64 It is 
these four products that are featured in this Report.
---------------------------------------------------------------------------
    \64\ See, e.g., Jacoboni v. KPMG, Case No. 6:02-CV-510 (M.D. Fla. 
4/29/02) (OPIS); Swartz v. KPMG, Case No. C03-1252 (W.D. Wash. 6/6/03) 
(BLIPS); Thorpe v. KPMG, Case No. 5-030CV-68 (E.D.N.C. 1/27/03) (FLIP/
OPIS). In addition, a KPMG tax professional has sued KPMG for 
defamation in ``retaliation for the Plaintiff's refusal to endorse or 
participate in [KPMG's] illegal activities and for his cooperation with 
government investigators.'' Hamersley v. KPMG, Case No. BC297905 (Los 
Angeles Superior Court 6/23/03).
---------------------------------------------------------------------------
    The dispute over whether KPMG sells benign ``tax 
solutions'' or illegal ``tax shelters'' is more than a 
linguistic difference; it goes to the heart of whether 
respected institutions like this one have crossed the line of 
acceptable conduct. Shedding light is a memorandum prepared 5 
years ago, in 1998, by a KPMG tax professional advising the 
firm not to register what was then a new tax product, OPIS, as 
a ``tax shelter'' with the IRS.65 Here is the advice 
this tax professional gave to the second most senior Tax 
Services Practice official at KPMG:
---------------------------------------------------------------------------
    \65\ Memorandum dated 5/26/98, from Gregg Ritchie to Jeffrey Stein, 
then head of operations in the Tax Services Practice, ``OPIS Tax 
Shelter Registration,'' Bates KPMG 0012031-33. Emphasis in original.

        ``For purposes of this discussion, I will assume that 
        we will conclude that the OPIS product meets the 
---------------------------------------------------------------------------
        definition of a tax shelter under IRC section 6111(c).

        ``Based on this assumption, the following are my 
        conclusions and recommendations as to why KPMG should 
        make the business/strategic decision not to register 
        the OPIS product as a tax shelter. My conclusions and 
        resulting recommendation [are] based upon the immediate 
        negative impact on the Firm's strategic initiative to 
        develop a sustainable tax products practice and the 
        long-term implications of establishing . . . a 
        precedent in registering such a product.

        ``First, the financial exposure to the Firm is minimal. 
        Based upon our analysis of the applicable penalty 
        sections, we conclude that the penalties would be no 
        greater than $14,000 per $100,000 in KPMG fees. . . . 
        For example, our average deal would result in KPMG fees 
        of $360,000 with a maximum penalty exposure of only 
        $31,000.

        ``This further assumes that KPMG would bear 100 percent 
        of the penalty. In fact . . . the penalty is joint and 
        several with respect to anyone involved in the product 
        who was required to register. Given that, at a minimum, 
        Presidio would also be required to register, our share 
        of the penalties could be viewed as being only one-half 
        of the amounts noted above. If other OPIS participants 
        (e.g., Deut[s]che Bank, Brown & Wood, etc.) were also 
        found to be promoters subject to the registration 
        requirements, KPMG's exposure would be further 
        minimized. Finally, any ultimate exposure to the 
        penalties are abatable if it can be shown that we had 
        reasonable cause. . . .

        ``To my knowledge, the Firm has never registered a 
        product under section 6111. . . .

        ``Third, the tax community at large continues to avoid 
        registration of all products. Based upon my knowledge, 
        the representations made by Presidio and Quadra, and 
        Larry DeLap's discussions with his counterparts at 
        other Big 6 firms, there are no tax products marketed 
        to individuals by our competitors which are registered. 
        This includes income conversion strategies, loss 
        generation techniques, and other related strategies.

        ``Should KPMG decide to begin to register its tax 
        products, I believe that it will position us with a 
        severe competitive disadvantage in light of industry 
        norms to such degree that we will not be able to 
        compete in the tax advantaged products market.

        ``Fourth, there has been (and, apparently, continues to 
        be) a lack of enthusiasm on the part of the Service to 
        enforce section 6111. In speaking with KPMG individuals 
        who were at the Service . . . the Service has 
        apparently purposefully ignored enforcement efforts 
        related to section 6111. In informal discussions with 
        individuals currently at the Service, WNT has confirmed 
        that there are not many registration applications 
        submitted and they do not have the resources to 
        dedicate to this area.

        ``Finally, the guidance from Congress, the Treasury, 
        and the Service is minimal, unclear, and extremely 
        difficult to interpret when attempting to apply it to 
        `tax planning' products. . . .

        ``I believe the rewards of a successful marketing of 
        the OPIS product . . . far exceed the financial 
        exposure to penalties that may arise. Once you have had 
        an opportunity to review this information, I request 
        that we have a conference with the persons on the 
        distribution list . . . to come to a conclusion with 
        respect to my recommendation. As you know, we must 
        immediately deal with this issue in order to proceed 
        with the OPIS product.''

    This memorandum assumes that OPIS qualifies as a tax 
shelter under federal law and then advocates that KPMG not 
register it with the IRS as required by law. The memorandum 
advises KPMG to knowingly violate the law requiring tax shelter 
registration, because the IRS is not vigorously enforcing the 
registration requirement, the penalties for noncompliance are 
much less than the potential profits from the tax product, and 
``industry norms'' are not to register any tax products at all. 
The memorandum warns that if KPMG were to comply with the tax 
shelter registration requirement, this action would place the 
firm at such a competitive disadvantage that KPMG would ``not 
be able to compete in the tax advantaged products market.''
    The Subcommittee has learned that some KPMG tax 
professionals agreed with this analysis,66 while 
other senior KPMG tax professionals provided the opposite 
advice to the firm.67 but the head of the Tax 
Services Practice, the Vice Chairman for Tax, ultimately 
decided not to register the tax product as a tax shelter. KPMG 
authorized the sale of OPIS in the fall of 1998.68 
Over the next 2 years, KPMG sold OPIS to more than 111 
individuals. It earned fees in excess of $28 million, making 
OPIS one of KPMG's top ten tax revenue producers in 2000. KPMG 
never registered OPIS as a tax shelter with the IRS. In 2001, 
the IRS issued Notice 2001-45 declaring tax products like OPIS 
to be potentially abusive tax shelters.
---------------------------------------------------------------------------
    \66\ See, e.g., email dated 5/26/98, from Mark Springer to multiple 
KPMG tax professionals, ``Re: OPIS Tax Shelter Registration,'' Bates 
KPMG 0034971 (``I would still concur with Gregg's recommendation. . . . 
I don't think we want to create a competitive DISADVANTAGE, nor do we 
want to lead with our chin.'' Emphasis in original.)
    \67\ Lawrence DeLap, then DPP head, told the Subcommittee he had 
advised the firm to register OPIS as a tax shelter. Subcommittee 
interview of Lawrence DeLap (10/30/03).
    \68\ See email dated 11/1/98, from Larry DeLap to William Albaugh 
and other KPMG tax professionals, ``OPIS,'' Bates KPMG 0035702.
---------------------------------------------------------------------------
    The following sections of this Report describe the systems, 
procedures, and corporate culture behind KPMG's efforts to 
develop, market, and implement its tax products, as well as 
steps KPMG has taken to avoid detection of its activities by 
tax authorities and others. Each of these sections includes 
specific evidence drawn from the BLIPS, SC2, OPIS, and FLIP 
case histories. Appendices A and B provide more detailed 
descriptions of how BLIPS and SC2 worked.

  (1) Developing New Tax Products

          LFinding: KPMG devotes substantial resources and 
        maintains an extensive infrastructure to produce a 
        continuing supply of generic tax products to sell to 
        multiple clients, using a process which pressures its 
        tax professionals to generate new ideas, move them 
        quickly through the development process, and approve, 
        at times, potentially abusive or illegal tax shelters.

    KPMG prefers to describe itself as a tax advisor that 
responds to client inquiries seeking tax planning services to 
structure legitimate business transactions in a tax efficient 
way. The Subcommittee investigation has determined, however, 
that KPMG has also developed and supports an extensive internal 
infrastructure of offices, programs, and procedures designed to 
churn out a continuing supply of new tax products unsolicited 
by a specific client and ready for mass marketing.
    Drive to Produce New Tax Products. In 1997, KPMG 
established the Tax Innovation Center, whose sole mission is to 
push the development of new KPMG tax products. Located within 
the Washington National Tax (WNT) Practice, the Center is 
staffed with about a dozen full-time employees and assisted by 
others who work for the Center on a rotating basis. A 2001 KPMG 
overview of the Center states that ``[t]ax [s]olution 
development is one of the four priority activities of WNT'' and 
``a significant percentage of WNT resources are dedicated to 
[t]ax [s]olution development at any given time.'' 69
---------------------------------------------------------------------------
    \69\ ``Tax Innovation Center Overview,'' Solution Development 
Process Manual (4/7/01), prepared by the KPMG Tax Innovation Center 
(hereinafter ``TIC Manual''), at i.
---------------------------------------------------------------------------
    Essentially, the Tax Innovation Center works to get KPMG 
tax professionals to propose new tax product ideas and then 
provides administrative support to develop the proposals into 
approved tax products and move them successfully into the 
marketing stage. As part of this effort, the Center maintains a 
``Tax Services Idea Bank'' which it uses to drive and track new 
tax product ideas. The Center asks KPMG tax professionals to 
submit new ideas for tax products on ``Idea Submission Forms'' 
or ``Tax Knowledge Sharing'' forms with specified information 
on how the proposed tax product would work and who would be 
interested in buying it.70 The Idea Submission Form 
asks the submitter to explain, for example, ``how client 
savings are achieved,'' ``the tax, business, and financial 
statement benefits of the idea,'' and ``the revenue potential 
of this idea,'' including ``key target markets,'' ``the typical 
buyer,'' and an estimated ``average tax fee per engagement.''
---------------------------------------------------------------------------
    \70\ ``TIC Solution Development Process,'' TIC Manual at 6.
---------------------------------------------------------------------------
    In recent years, the Center has established a firm-wide, 
numerical goal for new tax idea submissions and applied ongoing 
pressure on KPMG tax professionals to meet this goal. For 
example, in 2001, the Center established this overall 
objective: ``Goal: Deposit 150 New Ideas in Tax Services Idea 
Bank.'' 71 On May 30, 2001, the Center reported on 
the Tax Services' progress in meeting this goal as part of a 
larger power-point presentation on ``year-end results'' in new 
tax solutions and ideas development. For each of 12 KPMG 
``Functional Groups'' within the Tax Services Practice, a one-
page chart shows the precise number of ``Deposits,'' ``Expected 
Deposits,'' and ``In the Pipeline'' ideas which each group had 
contributed or were expected to contribute to the Tax Services 
Idea Bank. For example, the chart reports the total number of 
new ideas contributed by the e-Tax Group, Insurance Group, 
Passthrough Group, Personal Financial Planning Group, State and 
Local Tax (SALT) Group, Stratecon, and others. It shows that 
SALT had contributed the most ideas at 32, while e-Tax had 
contributed the least, having deposited only one new idea. It 
shows that, altogether, the groups had deposited 122 new ideas 
in the idea bank, with 38 more expected, and 171 ``in the 
pipeline.''
---------------------------------------------------------------------------
    \71\ KPMG presentation dated 5/30/01, ``Tax Innovation Center 
Solution and Idea Development--Year-End Results,'' Bates XX 001755-56, 
at 4.
---------------------------------------------------------------------------
    In addition to reporting on the number of new ideas 
generated during the year, the Center reported on its efforts 
to measure and improve the profitability of the tax product 
development process. The year-end presentation reported, for 
example, on the Tax Innovation Center's progress in meeting its 
goal to ``Measure Solution Profitability,'' noting that the 
Center had developed software systems that ``captured solution 
development costs and revenue'' and ``[p]repared quarterly 
Solution Profitability reports.'' It also discussed progress in 
meeting a goal to ``Increase Revenue from Tax Services Idea 
Bank.'' Among other measures, the Center proposed to ``[s]et 
deployment team revenue goals for all solutions.''
    Development and Approval Process. Once ideas are deposited 
into the Tax Services Idea Bank, KPMG has devoted substantial 
resources to transforming the more promising ideas into generic 
tax products that could be sold to multiple clients.
    KPMG's development and approval process for new tax 
products is described in its Tax Services Manual and Tax 
Innovations Center Manual.72 Essentially, the 
process consists of three stages, each of which may overlap 
with another. In the first stage, the new tax idea undergoes an 
initial screening ``for technical and revenue potential.'' 
73 This initial analysis is supposed to be provided 
by a ``Tax Lab'' which is a formal meeting, arranged by the Tax 
Innovations Center, of six or more KPMG tax experts 
specializing in the tax issues or industry affected by the 
proposed product.74 Promising proposals are also 
assigned one or more persons, sometimes referred to as 
``National Development Champions'' or ``Development Leaders,'' 
to assist in the proposal's initial analysis and, if warranted, 
shepherd the proposal through the full KPMG approval process. 
For example, the lead tax professional who moved BLIPS through 
the development and approval process was Jeffrey Eischeid, 
assisted by Randall Bickham, while for SC2, the lead tax 
professional was Lawrence Manth, assisted by and later 
succeeded by Andrew Atkin.
---------------------------------------------------------------------------
    \72\ KPMG Tax Services Manual, Chapter 24, pages 24-1 to 24-7.
    \73\ TIC Manual at 5.
    \74\ The TIC Manual states that a Tax Lab is supposed to evaluate 
``the technical viability of the idea, the idea's revenue generation 
potential above the Solution Revenue threshold, and a business case for 
developing the solution, including initial target list, marketing 
considerations, and preliminary technical analysis.'' TIC Manual at 5.
---------------------------------------------------------------------------
    If a proposal survives the initial screening, in the second 
stage, it must undergo a thorough review by the Washington 
National Tax Practice (``WNT review''), which is responsible 
for determining whether the product meets the technical 
requirements of existing tax law.75 WNT personnel 
often spend significant time identifying and searching for ways 
to resolve problems with how the proposed product is structured 
or is intended to be implemented. The WNT review must also 
include analysis of the product by the WNT Tax Controversy 
Services group ``to address tax shelter regulations issues.'' 
76 WNT must ``sign-off'' on the technical merits of 
the proposal for it to be approved for sale to clients.
---------------------------------------------------------------------------
    \75\ In an earlier version of KPMG's tax product review and 
approval procedure, WNT did not have a formal role in the development 
and approval process, according to senior tax professionals interviewed 
by the Subcommittee. This prior version of the process, which was 
apparently the first, firm-wide procedure established to approve new 
generic tax products, was established in 1997, and operated until mid 
1998. In it, a three-person Tax Advantaged Product Review Board, whose 
members were appointed by and included the head of DPP-Tax, conducted 
the technical review of new proposals. In 1998, when this 
responsibility was assigned to the WNT, the Board was disbanded. The 
earlier process was used to approve the sale of FLIP and OPIS, while 
the existing procedure was used to approve the sale of BLIPS and SC2. 
Subcommittee interview of Lawrence DeLap (10/30/03).
    \76\ KPMG Tax Services Manual, Sec. 24.4.1, at 24-2.
---------------------------------------------------------------------------
    In the third and final stage, the product must undergo 
review and approval by the Department of Practice and 
Professionalism (``DPP review''). The DPP review must determine 
that the product not only complies with the law, but also meets 
KPMG's standards for ``risk management and professional 
practice.'' 77 This latter review includes 
consideration of such matters as the substantive content of 
KPMG tax opinion and client engagement letters, disclosures to 
clients of risks associated with a tax product, the need for 
any confidentiality or marketing restrictions, how KPMG fees 
are to be structured, whether auditor independence issues need 
to be addressed, and the potential impact of a proposed tax 
product on the firm's reputation.78
---------------------------------------------------------------------------
    \77\ Id., Sec. 24.5.2, at 24-3.
    \78\ Subcommittee interview of Lawrence DeLap (10/30/03). The 
Subcommittee staff was told that, since 1997, DPP-Tax has had very 
limited resources to conduct its new product reviews. Until 2002, for 
example, DPP-Tax had a total of less than ten employees; in 2003, the 
number increased to around or just above 20. In contrast, DPP-
Assurance, which oversees professional practice issues for KPMG audit 
activity, has well over 100 employees.
---------------------------------------------------------------------------
    Each of the three stages takes time, and the entire 
development and approval process can consume 6 months or 
longer. The process is labor-intensive, since it requires tax 
professionals to examine the suggested product, which is often 
quite complex, identify various tax issues, and suggest 
solutions to problems. The process often includes consultations 
with outside professionals, not only on tax issues, but also on 
legal, investment, accounting, and finance issues, since many 
of the products require layers of corporations, trusts, and 
special purpose entities; complex financial and securities 
transactions using arcane financial instruments; and multi-
million-dollar lending transactions, all of which necessitate 
expert guidance, detailed paperwork, and logistical support.
    The KPMG development and approval process is intended to 
encourage vigorous analysis and debate by the firm's tax 
experts over the merits of a proposed tax product and to 
produce a determination that the product complies with current 
law and does not impose excessive financial or reputational 
risk for the firm. All KPMG personnel interviewed by the 
Subcommittee indicated that the final approval that permitted a 
new tax product to go to market was provided by the head of the 
DPP. KPMG's Tax Services Manual states that the DPP ``generally 
will not approve a solution unless the appropriate WNT 
partner(s)/principal(s) conclude that it is at least more 
likely than not that the desired tax consequences of the 
solution will be upheld if challenged by the appropriate taxing 
authority.'' 79 KPMG defines ``more likely than 
not'' as a ``greater than 50 percent probability of success if 
[a tax product is] challenged by the IRS.'' 80 KPMG 
personnel told the Subcommittee that the WNT's final sign-off 
on the technical issues had to come before the DPP would 
provide its final sign-off allowing a new tax product to go to 
market.
---------------------------------------------------------------------------
    \79\ KPMG Tax Services Manual, Sec. 24.5.2, at 24-3.
    \80\ Id., Sec. 41.19.1, at 41-10.
---------------------------------------------------------------------------
    Once approved, KPMG procedures required a new tax product 
to be accompanied by a number of documents before its release 
for sale to clients, including an abstract summarizing the 
product; a standard engagement letter for clients purchasing 
the product; an electronic powerpoint presentation to introduce 
the product to other KPMG tax professionals; and a 
``whitepaper'' summarizing the technical tax issues and their 
resolution.81 In addition, to ``launch'' the new 
product within KPMG, the Tax Innovation Center is supposed to 
prepare a ``Tax Solution Alert'' which serves ``as the official 
notification'' that the tax product is available for sale to 
clients.82 This Alert is supposed to include a 
``digest'' summarizing the product, a list of the KPMG 
``deployment team'' members responsible for ``delivering'' the 
product to market, pricing information, and marketing 
information such as a ``Solution Profile'' of clients who would 
benefit from the tax product and ``Optimal Target 
Characteristics'' and the expected ``Typical Buyer'' of the 
product. The four case histories demonstrated that KPMG 
personnel sometimes, but not always, complied with the 
paperwork required by its procedures. For example, while SC2 
was the subject of a ``Tax Solution Alert,'' BLIPS was not.
---------------------------------------------------------------------------
    \81\ Id., Sec. 24.4.2, at 24-2. See also TIC Manual at 10.
    \82\ TIC Manual at 10.
---------------------------------------------------------------------------
    In addition to or in lieu of the required ``whitepaper'' 
explaining KPMG's position on key technical issues, KPMG often 
prepared a ``prototype'' tax opinion letter laying out the 
firm's analysis and conclusions regarding the tax consequences 
of the new tax product.83 KPMG defines a ``tax 
opinion'' as ``any written advice on the tax consequences of a 
particular issue, transaction or series of transactions that is 
based upon specific facts and/or representations of the client 
and that is furnished to the client or another party in a 
letter, a whitepaper, a memorandum, an electronic or facsimile 
communication, or other form.'' 84 The tax opinion 
letter includes, at a minimum under KPMG policy, a statement of 
the firm's determination that, if challenged by the IRS, it was 
``more likely than not'' that the desired tax consequences of 
the new tax product would be upheld in court. The prototype tax 
opinion letter is intended to serve as a template for the tax 
opinion letters actually sent by KPMG to specific clients for a 
fee.
---------------------------------------------------------------------------
    \83\ KPMG Tax Services Manual, Sec. 41.17.1, at 41-8.
    \84\ Id., Sec. 41.15.1, at 41-8. A KPMG tax opinion often addresses 
all of the legal issues related to a new tax product and provides an 
overall assessment of the tax consequences of the new product. See, 
e.g., KPMG tax opinion on BLIPS. Other KPMG tax opinions address only a 
limited number of issues related to a new tax product and may provide 
different levels of assurance on the tax consequences of various 
aspects of the same tax product. See, e.g., KPMG tax opinions related 
to SC2.
---------------------------------------------------------------------------
    In addition to preparing its own tax opinion letter, in 
some cases KPMG seeks an opinion letter from an outside party, 
such as a law firm, to provide an ``independent'' second 
opinion on the validity of the tax product. KPMG made 
arrangements to obtain favorable legal opinion letters from an 
outside law firm in each of the case studies examined by the 
Subcommittee.
    The tax product development and approval process just 
described is the key internal procedure at KPMG today to 
determine whether the firm markets benign tax solutions that 
comply with the law or abusive tax shelters that do not. The 
investigation conducted by the Subcommittee found that, in the 
case of FLIP, OPIS, BLIPS, and SC2, KPMG tax professionals were 
under pressure not only to develop the new products quickly, 
but also to approve products that the firm's tax experts knew 
were potentially illegal tax shelters. In several of these 
cases, top KPMG tax experts participating in the review process 
expressed repeated concerns about the legitimacy of the 
relevant tax product. Despite these concerns, all four products 
were approved for sale to clients.
    BLIPS Development and Approval Process. The development and 
approval process resulting in the marketing of the BLIPS tax 
product to 186 individuals illustrates how the KPMG process 
works.85 BLIPS was first proposed as a KPMG tax idea 
in late 1998, and the generic tax product was initially 
approved for sale in May 1999. The product was finally approved 
for sale in August 1999, after the transactional documentation 
required by the BLIPS transactions was completed. One year 
later, in September 2000, the IRS issued Notice 2000-44, 
determining that BLIPS and other, similar tax products were 
potentially abusive tax shelters and taxpayers who used them 
would be subject to enforcement action.86 After this 
notice was issued, KPMG discontinued sales of the product.
---------------------------------------------------------------------------
    \85\ See Appendix A for more information about BLIPS.
    \86\ IRS Notice 2000-44 (2000-36 IRB 255) (9/5/00).
---------------------------------------------------------------------------
    Internal KPMG emails disclose an extended, unresolved 
debate among WNT and DPP tax professionals over whether BLIPS 
met the technical requirements of federal tax law, a debate 
which continued even after BLIPS was approved for sale. Several 
outside firms were also involved in BLIPS' development 
including Sidley Austin Brown & Wood, a law firm, and Presidio 
Advisory Services, an investment advisory firm run by two 
former KPMG tax partners. Key documents at the beginning and 
during a key 2-week period of the BLIPS approval process are 
instructive.
    BLIPS was first proposed in late 1998, as a replacement 
product for OPIS, which had earned KPMG substantial fees. From 
the beginning, senior tax leadership put pressure on KPMG tax 
professionals to quickly approve the new product for sale to 
clients. For example, after being told that a draft tax opinion 
on BLIPS had been sent to WNT for review and ``we can 
reasonably anticipate `approval' in another month or so,'' 
87 the head of the entire Tax Services Practice 
wrote:
---------------------------------------------------------------------------
    \87\ Email dated 2/9/99, from Jeffrey Eischeid to John Lanning, 
Doug Ammerman, Mark Watson and Larry DeLap, ``BLIPS,'' Bates MTW 0001.

        ``Given the marketplace potential of BLIPS, I think a 
        month is far too long--especially in the spirit of 
        `first to market'. I'd like for all of you, within the 
        bounds of good professional judgement, to dramatically 
        accelerate this timeline. . . . I'd like to know how 
        quickly we can get this product to market.'' 
        88
---------------------------------------------------------------------------
    \88\ Email dated 2/10/99, from John Lanning to multiple KPMG tax 
professionals, ``RE: BLIPS,'' Bates MTW 0001. See also memorandum dated 
2/11/99, from Jeffrey Zysik of TIC to ``Distribution List,'' Bates MTW 
0002 (``As each of you is by now aware, a product with a very high 
profile with the tax leadership recently was submitted to WNT/Tax 
Innovation Center. We are charged with shepherding this product through 
the WNT `productization' and review process as rapidly as possible.'')

    Five days later, the WNT technical expert in charge of 
Personal Financial Planning (PFP) tax products--who had been 
assigned responsibility for moving the BLIPS product through 
the WNT review process and was under instruction to keep the 
head of the Tax Services Practice informed of BLIPS' status--
wrote to several colleagues asking for a ``progress report.'' 
He added a postcript: ``P.S. I don't like this pressure any 
more than you do.'' 89
---------------------------------------------------------------------------
    \89\ Email dated 2/15/99, from Mark Watson to multiple KPMG tax 
professionals, ``BLIPS Progress Report,'' Bates MTW 0004.
---------------------------------------------------------------------------
    A few days later, on February 19, 1999, almost a dozen WNT 
tax experts held an initial meeting to discuss the technical 
issues involved in BLIPS.90 Six major issues were 
identified, the first two of which posed such significant 
technical hurdles that, according to the WNT PFP technical 
reviewer, most participants, including himself, left the 
meeting thinking the product was ``dead.'' 91 Some 
of the most difficult technical questions, including whether 
the BLIPS transactions had economic substance, were assigned to 
two of WNT's most senior tax partners who, despite the 
difficulty, took just 2 weeks to determine, on March 5, that 
their technical concerns had been resolved. The WNT PFP 
technical reviewer continued to work on other technical issues 
related to the project. Almost 2 months later, on April 27, 
1999, he sent an email to the head of DPP stating that, with 
respect to the technical issues assigned to him, he would be 
comfortable with WNT's issuing a more-likely-than-not opinion 
on BLIPS.
---------------------------------------------------------------------------
    \90\ ``Meeting Summary'' for meeting held on 2/19/99, Bates MTW 
0009.
    \91\ Subcommittee interview of Mark Watson (11/4/03).
---------------------------------------------------------------------------
    Three days later, at meetings held on April 30 and May 1, a 
number of KPMG tax professionals working on BLIPS attended a 
meeting with Presidio to discuss how the investments called for 
by the product would actually be carried out. The WNT PFP 
technical reviewer told the Subcommittee staff that, at these 
meetings, the Presidio representative made a number of 
troubling comments that led him to conclude that the review 
team had not been provided all of the relevant information 
about how the BLIPS transactions would operate, and re-opened 
concerns about the technical merits of the product. For 
example, he told the Subcommittee staff that a Presidio 
representative had commented that ``the probability of actually 
making a profit from this transaction is remote'' and the bank 
would have a ``veto'' over how the loan proceeds used to 
finance the BLIPS deal would be invested. In his opinion, these 
statements, if true, meant the investment program at the heart 
of the BLIPS product lacked economic substance and business 
purpose as required by law.
    On May 4, 1999, the WNT PFP technical reviewer wrote to the 
head of the DPP expressing doubts about approving BLIPS:

        ``Larry, while I am comfortable that WNT did its job 
        reviewing and analyzing the technical issues associated 
        with BLIPS, based on the BLIPS meeting I attended on 
        April 30 and May 1, I am not comfortable issuing a 
        more-likely-than-not opinion letter [with respect to] 
        this product for the following reasons:

          ``. . . [T]he probability of actually making a 
        profit from this transaction is remote (possible, but 
        remote);

          ``The bank will control how the `loan' proceeds are 
        invested via a veto power over Presidio's investment 
        choices; and

          ``It appears that the bank wants the `loan' repaid 
        within approximately 60 days. . . .

        ``Thus, I think it is questionable whether a client's 
        representation [in a tax opinion letter] that he or she 
        believed there was a reasonable opportunity to make a 
        profit is a reasonable representation. Even more 
        concerning, however, is whether a loan was actually 
        made. If the bank controls how the loan proceeds are 
        used and when they are repaid, has the bank actually 
        made a bona fide loan?

        ``I will no doubt catch hell for sending you this 
        message. However, until the above issues are resolved 
        satisfactorily, I am not comfortable with this 
        product.'' 92
---------------------------------------------------------------------------
    \92\ Email dated 5/4/99, from Mark Watson to Larry DeLap, Bates 
KPMG 0011916.

    The DPP head responded: ``It is not clear to me how this 
comports with your April 27 message [expressing comfort with 
BLIPS], but because this is a PFP product and you are the chief 
PFP technical resource, the product should not be approved if 
you are uncomfortable.'' 93 The WNT PFP technical 
reviewer responded that he had learned new information about 
how the BLIPS investments would occur, and it was this 
subsequent information that had caused him to reverse his 
position on issuing a tax opinion letter supporting the 
product.94
---------------------------------------------------------------------------
    \93\ Email dated 5/5/99, from Larry DeLap to Mark Watson, Bates 
KPMG 0011916.
    \94\ Email dated 5/5/99, from Mark Watson to Larry DeLap, Bates 
KPMG 0011915-16. Mr. Watson was not the only KPMG tax professional 
expressing serious concerns about BLIPS. See, e.g., email dated 4/6/99, 
from Steven Rosenthal to Larry DeLap, ``RE: BLIPS,'' Bates MTW 0024; 
email dated 4/26/99, from Steven Rosenthal to Larry DeLap, ``RE: BLIPS 
Analysis,'' Bates MTW 0026; email dated 5/7/99, from Steven Rosenthal 
to multiple KPMG professionals, ``Who Is the Borrower in the BLIPS 
transaction,'' Bates MTW 0028; email dated 8/19/99, from Steven 
Rosenthal to Mark Watson, Bates SMR 0045.
---------------------------------------------------------------------------
    On May 7, 1999 the head of DPP forwarded the WNT PFP 
technical expert's email to the leadership of the tax group and 
noted: ``I don't believe a PFP product should be approved when 
the top PFP technical partner in WNT believes it should not be 
approved.'' 95
---------------------------------------------------------------------------
    \95\ Email dated 5/7/99, from Larry Delap to three KPMG tax 
professionals, with copies to John Lanning, Vice Chairman of the Tax 
Services Practice, and Jeffrey Stein, second in command of the Tax 
Services Practice, Bates KPMG 0011905. In the same email he noted that 
another technical expert, whom he had asked to review critical aspects 
of the project, had ``informed me on Tuesday afternoon that he had 
substantial concern with the `who is the borrower' issuer [sic].'' 
Later that same day, May 7, the two WNT technical reviewers expressing 
technical concerns about BLIPS met with the two senior WNT partners who 
had earlier signed off on the economic substance issue, to discuss the 
issues.
---------------------------------------------------------------------------
    On May 8, 1999, the head of KPMG's Tax Services Practice 
wrote: ``I must say that I am amazed that at this late date 
(must now be six months into this process) our chief WNT PFP 
technical expert has reached this conclusion. I would have 
thought that Mark would have been involved in the ground floor 
of this process, especially on an issue as critical as profit 
motive. What gives? This appears to be the antithesis of `speed 
to market.' Is there any chance of ever getting this product 
off the launching pad, or should we simply give up???'' 
96
---------------------------------------------------------------------------
    \96\ Email dated 5/8/99, from John Lanning to four KPMG tax 
professionals, Bates KPMG 0011905.
---------------------------------------------------------------------------
    On May 9, one of the senior WNT partners supporting BLIPS 
sent an email to one of the WNT technical reviewers objecting 
to BLIPS and asked him: ``Based on your analysis . . . do you 
conclude that the tax results sought by the investor are NOT 
`more likely than not' to be realized?'' The technical reviewer 
responded: ``Yes.'' 97
---------------------------------------------------------------------------
    \97\ Email exchange dated 5/9/99, between Richard Smith and Steven 
Rosenthal, Bates SMR 0025 and SMR 0027.
---------------------------------------------------------------------------
    On May 10, the head of the WNT sent an email to five WNT 
tax professionals:

        ``Gentlemen: Please help me on this. Over the weekend 
        while thinking about WNT involvement in BLIPS I was 
        under the impression that we had sent the transaction 
        forward to DPP Tax on the basis that everyone had 
        signed off on their respective technical issues(s) and 
        that I had signed off on the overall more likely than 
        not opinion. If this impression is correct, why are we 
        revisiting the opinion other than to beef up the 
        technical discussion and further refine the 
        representations on which the conclusions are based. I 
        am very troubled that at this late date the issue is 
        apparently being revisited and if I understand 
        correctly, a prior decision changed on this technical 
        issue?! Richard, in particular, jog my memory on this 
        matter since I based my overall opinion on the fact 
        that everyone had signed off on their respective 
        areas.?'' 98
---------------------------------------------------------------------------
    \98\ Email dated 5/10/99, from Philip Wiesner to multiple WNT tax 
professionals, Bates MTW 0031.

    A few hours later, the head of WNT sent eight senior KPMG 
tax professionals, including the Tax Services Practice head, 
DPP head, and the WNT PFP technical reviewer, a long email 
---------------------------------------------------------------------------
message urging final approval of BLIPS. He wrote in part:

        ``Many people have worked long and hard to craft a tax 
        opinion in the BLIPS transaction that satisfies the 
        more likely than not standard. I believed that we in 
        WNT had completed our work a month ago when we 
        forwarded the [draft] opinion to Larry. . . .

        ``[T]his is a classic transaction where we can labor 
        over the technical concerns, but the ultimate 
        resolution--if challenged by the IRS--will be based on 
        the facts (or lack thereof). In short, our opinion is 
        only as good as the factual representations that it is 
        based upon. . . . The real `rubber meets the road' will 
        happen when the transaction is sold to investors, what 
        the investors' actual motive for investing the 
        transaction is and how the transaction actually 
        unfolds. . . . Third, our reputation will be used to 
        market the transaction. This is a given in these types 
        of deals. Thus, we need to be concerned about who we 
        are getting in bed with here. In particular, do we 
        believe that Presidio has the integrity to sell the 
        deal on the facts and representations that we have 
        written our opinion on?! . . .

        ``Having said all the above, I do believe the time has 
        come to shit and get off the pot. The business 
        decisions to me are primarily two: (1) Have we drafted 
        the opinion with the appropriate limiting bells and 
        whistles . . . and (2) Are we being paid enough to 
        offset the risks of potential litigation resulting from 
        the transaction? . . . My own recommendation is that we 
        should be paid a lot of money here for our opinion 
        since the transaction is clearly one that the IRS would 
        view as falling squarely within the tax shelter orbit. 
        . . .'' 99
---------------------------------------------------------------------------
    \99\ Email dated 5/10/99, from Philip Wiesner to John Lanning and 
eight other KPMG tax professionals, ``RE: BLIPS,'' Bates KPMG 0011904. 
See also email response dated 5/10/99, from John Lanning to Philip 
Wiesner and other KPMG tax professionals, ``RE: BLIPS,'' Bates MTW 0036 
(``you've framed the issues well'').

    Later the same day, the Tax Services operations head wrote 
in response to the email from the WNT head: ``I think it's shit 
OR get off the pot. I vote for shit.'' 100
---------------------------------------------------------------------------
    \100\ Email dated 5/10/99, from Jeffrey Stein to Philip Weisner and 
others, Bates KPMG 0011903.
---------------------------------------------------------------------------
    The same day, the WNT PFP technical reviewer wrote to the 
head of the Tax Services Practice: ``John, in my defense, my 
change in heart about BLIPS was based on information Presidio 
disclosed to me at a meeting on May 1. This information raised 
serious concerns in my mind about the viability of the 
transaction, and indicated that WNT had not been given complete 
information about how the transaction would be structured. . . 
. I want to make money as much as you do, but I cannot ignore 
information that raises questions as to whether the subject 
strategy even works. Nonetheless, I have sent Randy Bickham 
four representations that I think need to be added to our 
opinion letter. Assuming these representations are made, I am 
prepared to move forward with the strategy.'' 101
---------------------------------------------------------------------------
    \101\ Email dated 5/10/99, from Mark Watson to John Lanning and 
others, ``FW: BLIPS,'' Bates MTW 0039 (Emphasis in original.).
---------------------------------------------------------------------------
    A meeting was held on May 10, to determine how to proceed. 
The WNT head, the senior WNT partner, and the two WNT technical 
reviewers decided to move forward on BLIPS, and the WNT head 
asked the technical reviewers to draft some representations 
that, when relied upon, would enable the tax opinion writers to 
reach a more likely than not opinion. The WNT head reported the 
outcome of the meeting in an email:

        ``The group of Wiesner, R Smith, Watson and Rosenthal 
        met this afternoon to bring closure to the remaining 
        technical tax issues concerning the BLIPS transaction. 
        After a thorough discussion of the profit motive and 
        who is the borrower issue, recommendations for 
        additional representations were made (Mark Watson to 
        follow up on with Jeff Eischeid) and the decision by 
        WNT to proceed on a more likely than not basis 
        affirmed. Concern was again expressed that the critical 
        juncture will be at the time of the first real tax 
        opinion when the investor, bank and Presidio will be 
        asked to sign the appropriate representations. Finally, 
        it should be noted that Steve Rosenthal expressed his 
        dissent on the who is the investor issue, to wit, 
        `although reasonable people could reach an opposite 
        result, he could not reach a more likely than not 
        opinion on that issue'.'' 102
---------------------------------------------------------------------------
    \102\ Email dated 5/10/99, from Philip Wiesner to multiple KPMG tax 
professionals, Bates KPMG 0009344.

    After receiving this email, the DPP head sent an email to 
the WNT PFP technical reviewer asking whether he would be 
comfortable with KPMG's issuing a tax opinion supporting BLIPS. 
The WNT PFP technical reviewer wrote: ``Larry, I don't like 
this product and would prefer not to be associated with it. 
However, if the additional representations I sent to Randy on 
May 9 and 10 are in fact made, based on Phil Wiesner's and 
Richard Smith's input, I can reluctantly live with a more-
likely-than-not opinion being issued for the product.'' 
103
---------------------------------------------------------------------------
    \103\ Email dated 5/11/99, from Mark Watson, WNT, to Lawrence 
DeLap, Bates KPMG 0011911.
---------------------------------------------------------------------------
    The DPP head indicated to the Subcommittee staff that he 
did not consider this tepid endorsement sufficient for him to 
sign off on the product. He indicated that he then met in 
person with his superior, the head of the Tax Services 
Practice, and told the Tax Services Practice head that he was 
not prepared to approve BLIPS for sale. He told the 
Subcommittee staff that the Tax Services Practice head was 
``not pleased'' and instructed him to speak again with the 
technical reviewer.104
---------------------------------------------------------------------------
    \104\ Subcommittee interview of Lawrence DeLap (10/30/03).
---------------------------------------------------------------------------
    The DPP head told the Subcommittee staff that he then went 
back to the WNT PFP technical reviewer and telephoned him to 
discuss the product. The DPP head told the Subcommittee staff 
that, during this telephone conversation, the technical 
reviewer made a much clearer, oral statement of support for the 
product, and it was only after obtaining this statement from 
the technical reviewer that, on May 19, 1999, the DPP head 
approved BLIPS for sale to clients.105 The WNT PFP 
technical reviewer, however, told the Subcommittee staff that 
he did not remember receiving this telephone call from the DPP 
head. According to him, he never, at any time after the May 1 
meeting, expressed clear support for BLIPS' approval. He also 
stated that an oral sign-off on this product contradicted the 
DPP head's normal practice of requiring written product 
approvals.106
---------------------------------------------------------------------------
    \105\ Id.
    \106\ Subcommittee interview of Mark Watson (11/4/03).
---------------------------------------------------------------------------
    Over the course of the next year, KPMG sold BLIPS to 186 
individuals and obtained more than $50 million in fees, making 
BLIPS one of its highest revenue-producing tax products to 
date.
    The events and communications leading to BLIPS' approval 
for sale are troubling and revealing for a number of reasons. 
First, they show that senior KPMG tax professionals knew the 
proposed tax product, BLIPS, was ``clearly one that the IRS 
would view as falling squarely within the tax shelter orbit.'' 
Second, they show how important ``speed to market'' was as a 
factor in the review and approval process. Third, they show the 
interpersonal dynamics that, in this case, led KPMG's key 
technical tax expert to reluctantly agree to approve a tax 
product that he did not support or want to be associated with, 
in response to the pressure exerted by senior Tax Services 
professionals to approve the product for sale.
    The email exchange immediately preceding BLIPS' approval 
for sale also indicates a high level of impatience by KPMG tax 
professionals in dealing with new, troubling information about 
how the BLIPS investments would actually be implemented by the 
outside investment advisory firm, Presidio. Questions about 
this outside firm's ``integrity'' and how it would perform were 
characterized as questions of risk to KPMG that could be 
resolved with a pricing approach that provided sufficient funds 
``to offset the risks of potential litigation.'' Finally, the 
email exchange shows that the participants in the approval 
process--all senior KPMG tax professionals--knew they were 
voting for a dubious tax product that would be sold in part by 
relying on KPMG's ``reputation.'' No one challenged the 
analysis that the risky nature of the product justified the 
firm's charging ``a lot of money'' for a tax opinion letter 
predicting it was more likely than not that BLIPS would 
withstand an IRS challenge.
    Later documents show that key KPMG tax professionals 
continued to express serious concerns about the technical 
validity of BLIPS. For example, in July, 2 months after the DPP 
gave his approval to sell BLIPS, one of the WNT technical 
reviewers, objecting to the tax product, sent an email to his 
superiors in WNT noting that the loan documentation 
contemplated very conservative instruments for the loan 
proceeds and it seemed unlikely the rate of return on the 
investments would equal or exceed the loan and fees incurred by 
the borrower. He indicated that his calculations showed the 
planned foreign currency transactions would ``have to generate 
a 240% annual rate of return'' to break even. He also pointed 
out that, ``Although the loan is structured as a 7-year loan, 
the client has a tremendous economic incentive to get out of 
loan as soon as possible due to the large negative spread.'' He 
wrote: ``Before I submit our non-economic substance comments on 
the loan documents to Presidio, I want to confirm that you are 
still comfortable with the economic substance of this 
transaction.'' 107 His superiors indicated that they 
were.
---------------------------------------------------------------------------
    \107\ Email dated 7/22/99, from Mark Watson to Richard Smith and 
Phil Wiesner, Bates MTW 0078.
---------------------------------------------------------------------------
    A month later, in August, after completing a review of the 
BLIPS transactional documents, the WNT PFP technical reviewer 
again expressed concerns to his superiors in WNT:

        ``However before engagement letters are signed and 
        revenue is collected, I feel it is important to again 
        note that I and several other WNT partners remain 
        skeptical that the tax results purportedly generated by 
        a BLIPS transaction would actually be sustained by a 
        court if challenged by the IRS. We are particularly 
        concerned about the economic substance of the BLIPS 
        transaction, and our review of the BLIPS loan documents 
        has increased our level of concern.

        ``Nonetheless, since Richard Smith and Phil Wiesner--
        the WNT partners assigned with the responsibility of 
        addressing the economic substance issues associated 
        with BLIPS--have concluded they think BLIPS is a 
        ``more-likely-than-not'' strategy, I am prepared to 
        release the strategy once we complete our second review 
        of the loan documents and LLC agreement and our 
        comments thereon (if any) have been incorporated.'' 
        108
---------------------------------------------------------------------------
    \108\ Email dated 8/4/99, from Mark Watson to David Brockway, Mark 
Springer, and Doug Ammerman, Bates SMR 0039.

---------------------------------------------------------------------------
    The other technical reviewer objecting to BLIPS wrote:

        ``I share your concerns. We are almost finished with 
        our technical review of the documents that you gave us, 
        and we recommend some clarifications to address these 
        technical concerns. We are not, however, assessing the 
        economic substance of the transaction (ie., is there a 
        debt? Who is the borrower? What is the amount of the 
        liability? Is there a reasonable expectation of 
        profit?) I continue to be seriously troubled by these 
        issues, but I defer to Phil Wiesner and Richard Smith 
        to assess them.'' 109
---------------------------------------------------------------------------
    \109\ Email dated 8/4/99, from Steven Rosenthal to Mark Watson and 
others, Bates SMR 0039.

---------------------------------------------------------------------------
The senior partners in WNT chose to go forward with BLIPS.

    About 6 months after BLIPS tax products had begun to be 
sold to clients, an effort was begun within KPMG to design a 
modified ``BLIPS 2000.'' 110 One of the WNT 
technical reviewers who had objected to the original BLIPS 
again expressed his concerns:
---------------------------------------------------------------------------
    \110\ Senior KPMG tax professionals, again, put pressure on its tax 
experts to quickly approve the BLIPS 2000 product. See, e.g., email 
dated 1/17/00, from Jeff Stein to Steven Rosenthal and others, ``BLIPS 
2000,'' Bates SMR 0050 (technical expert is urged to analyze new 
product ``so we can take this to market. Your attention over the next 
few days would be most appreciated.'').

        ``I am writing to communicate my views on the economic 
        substance of the Blips, Grandfathered Blips, and Blips 
        2000 strategies. Throughout this process, I have been 
        troubled by the application of economic substance 
        doctrines . . . and have raised my concerns repeatedly 
        in internal meetings. The facts as I now know them and 
        the law that has developed, has not reduced my level of 
---------------------------------------------------------------------------
        concern.

        ``In short, in my view, I do not believe that KPMG can 
        reasonably issue a more-likely-than-not opinion on 
        these issues.'' 111
---------------------------------------------------------------------------
    \111\ Email dated 3/6/00, from Steven Rosenthal to David Brockway, 
``Blips I, Grandfathered Blips, and Blips 2000,'' Bates SMR 0056. See 
also memorandum dated 3/28/00, to David Brockway, ``Talking points on 
significant tax issues for BLIPS 2000,'' Bates SMR 0117-21 (identifying 
numerous problems with BLIPS).

    When asked by Subcommittee staff whether he had ever 
personally concluded that BLIPS met the technical requirements 
of the federal tax code, the DPP head declined to say that he 
had. Instead, he said that, in 1999, he approved BLIPS for sale 
after determining that WNT had ``completed'' the technical 
approval process.112 A BLIPS power point 
presentation produced by the Personal Financial Planning group 
in June, a few weeks after BLIPS' approval for sale, advised 
KPMG tax professionals to make sure that potential clients were 
``willing to take an aggressive position with a more likely 
than not opinion letter.'' The presentation characterized BLIPS 
as having ``about a 10 risk on [a] scale of 1-10.'' 
113
---------------------------------------------------------------------------
    \112\ Subcommittee interview of Lawrence DeLap (10/30/03).
    \113\ Power point presentation dated June 1999, by Carol Warley, 
Personal Financial Planning group, ``BLIPS AND TRACT,'' Bates KPMG 
0049639-45, at 496340. Repeated capitalizations in original text not 
included.
---------------------------------------------------------------------------
    In September 2000, the IRS identified BLIPS as a 
potentially abusive tax shelter. The IRS notice characterized 
BLIPS as a product that was ``being marketed to taxpayers for 
the purpose of generating artificial tax losses. . . . [A] loss 
is allowable as a deduction . . . only if it is bona fide and 
reflects actual economic consequences. An artificial loss 
lacking economic substance is not allowable.'' 114 
The IRS' disallowance of BLIPS has not yet been tested in 
court. Rather than defend BLIPS in court, KPMG and many BLIPS 
purchasers appear to be engaged in settlement negotiations with 
the IRS to reduce penalty assessments.
---------------------------------------------------------------------------
    \114\ IRS Notice 2000-44 (2000-36 IRB 255) (9/5/00) at 255.
---------------------------------------------------------------------------
    OPIS and FLIP Development and Approval Process. OPIS and 
FLIP were the predecessors to BLIPS. Like BLIPS, both of these 
products were ``loss generators'' intended to generate paper 
losses that taxpayers could use to offset and shelter other 
income from taxation,115 but both used different 
mechanisms than BLIPS to achieve this end. Because they were 
developed a number of years ago, the Subcommittee has more 
limited documentation on how OPIS and FLIP were developed. 
However, even this limited documentation establishes KPMG's 
awareness of serious technical flaws in both tax products.
---------------------------------------------------------------------------
    \115\ See document dated 5/18/01, ``PFP Practice Reorganization 
Innovative Strategies Business Plan--DRAFT,'' Bates KPMG 0050620-23, at 
1.
---------------------------------------------------------------------------
    For example, in the case of OPIS, which was developed 
during 1998, a senior KPMG tax professional wrote a 7-page 
memorandum filled with criticisms of the proposed tax 
product.116 The memorandum states: ``In OPIS, the 
use of debt has apparently been jettisoned. If we can not 
structure a deal without at least some debt, it strikes me that 
all the investment banker's economic justification for the deal 
is smoke and mirrors.'' At a later point, it states: ``The only 
thing that really distinguishes OPIS (from FLIPS) from a tax 
perspective is the use of an instrument that is purported to be 
a swap. . . . However, the instrument described in the opinion 
is not a swap under I.R.C. Sec. 446. . . . [A] fairly strong 
argument could be made that the U.S. investor has nothing more 
than a disguised partnership interest.''
---------------------------------------------------------------------------
    \116\ Memorandum dated 2/23/98, from Robert Simon to Gregg Ritchie, 
Randy Bickham, and John Harris, concerning OPIS, Bates KPMG 0010729.
---------------------------------------------------------------------------
    The memorandum goes on:

        ``If, upon audit, the IRS were to challenge the 
        transaction, the burden of proof will be on the 
        investor. The investor will have to demonstrate, among 
        other things, that the transaction was not consummated 
        pursuant to a firm and fixed plan. Think about the 
        prospect of having your client on the stand having to 
        defend against such an argument. The client would have 
        a difficult burden to overcome. . . . The failure to 
        use an independent 3rd party in any of the transactions 
        indicates that the deal is pre-wired.''

It also states: ``If the risk of loss concepts of Notice 98-5 
were applied to OPIS, I doubt that the investor's ownership 
interest would pass muster.'' And: ``As it stands now, the 
Cayman company remains extremely vulnerable to an argument that 
it is a sham.'' And: ``No further attempt has been made to 
quantify why I.R.C. Sec. 165 should not apply to deny the loss. 
Instead, the argument is again made that because the law is 
uncertain, we win.'' The memorandum observes: ``We are the firm 
writing the [tax] opinions. Ultimately, if these deals fail in 
a technical sense, it is KPMG which will shoulder the blame.''
    This memorandum was written in February 1998. OPIS was 
approved for sale to clients around September 1998. KPMG sold 
OPIS to 111 individuals, conducting 79 OPIS transactions on 
their behalf in 1998 and 1999.
    In the case of FLIP, an email written in March 1998, by the 
Tax Services Practice's second in command, identifies a host of 
significant technical flaws in FLIP, doing so in the course of 
discussing which of two tax offices in KPMG deserved credit for 
developing its replacement, OPIS.117 The email 
states that efforts to find a FLIP alternative ``took on an air 
of urgency when [DPP head] Larry DeLap determined that KPMG 
should discontinue marketing the existing product.'' The email 
indicates that, for about 6 weeks, a senior KPMG tax 
professional and a former KPMG tax professional employed at 
Presidio worked ``to tweak or redesign'' FLIP and ``determined 
that whatever the new product, it needed a greater economic 
risk attached to it'' to meet the requirements of federal tax 
law.
---------------------------------------------------------------------------
    \117\ Email dated 3/14/98, from Jeff Stein to Robert Wells, John 
Lanning, Larry DeLap, Gregg Ritchie, and others, ``Simon Says,'' 
concerning FLIP, Bates 638010, filed by the IRS on June 16, 2003, as an 
attachment to Respondent's Requests for Admission, Schneider Interests 
v. Commissioner, U.S. Tax Court, Docket No. 200-02.
---------------------------------------------------------------------------
    Among other criticisms of FLIP, the email states: ``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. . . . It was clear, we needed the option to be treated 
as an option for Section 302 purposes, and yet in truth the 
option [used in FLIP] was 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.'' The email states: 
``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.'' The email also observes: ``[I]t was 
Greg who stated in writing to I believe Bob Simon that the `the 
OPIS product was developed in response to your and DPP tax's 
concerns over the FLIP strategy. We listened to your input 
regarding technical concerns with respect to the FLIP product 
and attempt to work solutions into the new product. . . .' ''
    This email was written in March 1998, after the bulk of 
FLIP sales, but it shows that the firm had been aware for some 
time of the product's technical problems. After the email was 
written, KPMG sold FLIP to ten more customers in 1998 and 1999, 
earning more than $3 million in fees for doing so. In August 
2001, the IRS issued a notice finding both FLIP and OPIS to be 
potentially abusive tax shelters.118 The IRS has 
since audited and penalized numerous taxpayers for using these 
illegal tax shelters.119
---------------------------------------------------------------------------
    \118\ IRS Notice 2001-45 (2001-33 IRB 129) (8/13/01).
    \119\ See ``Settlement Initiative for Section 302/318 Basis-
Shifting Transactions,'' IRS Announcement 2002-97 (2002-43 IRB 757) 
(10/28/02).
---------------------------------------------------------------------------
    SC2 Development and Approval Process. The Subcommittee 
investigation also obtained documentation establishing KPMG's 
awareness of flaws in the technical merits of 
SC2.120
---------------------------------------------------------------------------
    \120\ See Appendix B for more detailed information on SC2.
---------------------------------------------------------------------------
    Documents proceeding the April 2000 decision by KPMG to 
approve SC2 for sale reflect vigorous analysis and discussion 
of the product's risks if challenged by the IRS. The documents 
also reflect, as in the BLIPS case, pressure to move the 
product to market quickly. For example, one month before SC2's 
final approval, an email from a KPMG professional in the Tax 
Innovation Center stated: ``As I was telling you, this Tax 
Solution is getting some very high level (Stein/Rosenthal) 
attention. Please review the whitepaper as soon as possible. . 
. .'' 121
---------------------------------------------------------------------------
    \121\ Email dated 3/13/00, from Phillip Galbreath to Richard 
Bailine, ``FW: S-CAEPS,'' Bates KPMG 0046889.
---------------------------------------------------------------------------
    On April 11, 2000, in the same email announcing SC2's 
approval for sale, the head of the DPP wrote:

        ``This is a relatively high risk strategy. You will 
        note that the heading to the preapproved engagement 
        letter states that limitation of liability and 
        indemnification provisions are not to be waived. . . . 
        You will also note that the engagement letter includes 
        the following statement: You acknowledge receipt of a 
        memorandum discussing certain risks associated with the 
        strategy. . . . It is essential that such risk 
        discussion memorandum (attached) be provided to each 
        client contemplating entering into an SC2 engagement.'' 
        122
---------------------------------------------------------------------------
    \122\ Email dated 4/11/00, from Larry DeLap to Tax Professional 
Practice Partners, ``S-Corporation Charitable Contribution Strategy 
(SC2),'' Bates KPMG 0052581-82. One of the KPMG tax partners to whom 
this email was forwarded wrote in response: ``Please do not forward 
this to anyone.'' Email dated 4/25/00, from Steven Messing to Lawrence 
Silver, ``S-Corporation Charitable Contribution Strategy (SC2),'' Bates 
KPMG 0052581.

    The referenced memorandum, required to be given to all SC2 
clients, identifies a number of risks associated with the tax 
product, most related to ways in which the IRS might 
successfully challenge the product's legal validity. The 
---------------------------------------------------------------------------
memorandum states in part:

        ``The [IRS] or a state taxing authority could assert 
        that some or all of the income allocated to the tax-
        exempt organization should be reallocated to the other 
        shareholders of the corporation. . . . The IRS or a 
        state taxing authority could assert that some or all of 
        the charitable contribution deduction should be 
        disallowed, on the basis that the tax-exempt 
        organization did not acquire equitable ownership of the 
        stock or that the valuation of the contributed stock 
        was overstated. . . . The IRS or a state taxing 
        authority could assert that the strategy creates a 
        second class of stock. Under the [tax code], subchapter 
        S corporations are not permitted to have a second class 
        of stock. . . . The IRS or a court might discount an 
        opinion provided by the promoter of a strategy. 
        Accordingly, it may be advisable to consider requesting 
        a concurring opinion from an independent tax advisor.'' 
        123
---------------------------------------------------------------------------
    \123\ Undated KPMG document entitled, ``S Corporation Charitable 
Contribution Strategy[:] Summary of Certain Risks,'' marked ``PRIVATE 
AND CONFIDENTIAL,'' Bates KPMG 0049987-88.

    Internally, KPMG tax professionals had identified even more 
technical problems with SC2 than were discussed in the 
memorandum given to clients. For example, KPMG tax 
professionals discussed problems with identifying a business 
purpose to explain the structure of the transaction--why a 
donor who wanted to make a cash donation to a charity would 
first donate stock to the charity and then buy it back, instead 
of simply providing a straightforward cash 
contribution.124 They also identified problems with 
establishing the charity's ``beneficial ownership'' of the 
donated stock, since the stock was provided on the clear 
understanding that the charity would sell the stock back to the 
donor within a specified period of time.125 KPMG tax 
professionals identified other technical problems as well 
involving assignment of income, reliance on tax indifferent 
parties, and valuation issues.126
---------------------------------------------------------------------------
    \124\ See, e.g., email dated 3/13/00, from Richard Bailene to 
Phillip Galbreath, ``S-CAEPS,'' Bates KPMG 0015744.
    \125\ See, e.g., email dated 3/13/00, from Richard Bailene to 
Phillip Galbreath, ``S-CAEPS,'' Bates KPMG 0015745; KPMG document dated 
3/13/00, ``S-Corporation Charitable Contribution Strategy--Variation 
#1,'' Bates KPMG 0047895 (beneficial ownership is ``probably our 
weakest link in the chain on SC2.''); memorandum dated 3/2/00, from 
William Kelliher to multiple KPMG tax professionals, ``Comments on S-
CAEPS `White Paper,' '' Bates KPMG 0016853-61.
    \126\ See, e.g., email dated 3/13/00, from Richard Bailene to 
Phillip Galbreath, ``S-CAEPS,'' Bates KPMG 0015746, and email from Mark 
Watson, ``S-CAEPS,'' Bates KPMG 0013790-93 (raising assignment of 
income concerns); emails dated 3/21/00 and 3/22/00, from Larry DeLap 
and Lawrence Manth, Bates KPMG 0015739-40 (raising tax indifferent 
party concerns); various emails between 7/28/00 and 10/25/00, among 
KPMG tax professionals, Bates KPMG 0015011-14 (raising tax indifferent 
party concerns); and memorandum dated 2/14/00, from William Kelliher to 
Richard Rosenthal, ``S-Corp Charitable and Estate Planning Strategy 
(`S-CAEPS'),'' Bates KPMG 0047693-95 (raising valuation concerns).
---------------------------------------------------------------------------
    More than a year later, in December 2001, another KPMG tax 
professional expressed concern about the widespread marketing 
of SC2 because, if the IRS ``gets wind of it,'' the agency 
would likely mount a vigorous and ``at least partially 
successful'' challenge to the product:

        ``Going way back to Feb. 2000, when SC2 first reared 
        its head, my recollection is that SC2 was intended to 
        be limited to a relatively small number of large S 
        corps. That plan made sense because, in my opinion, 
        there was (and is) a strong risk of a successful IRS 
        attack on SC2 if the IRS gets wind of it. . . . Call me 
        paranoid, but I think that such a widespread marketing 
        campaign is likely to bring KPMG and SC2 unwelcome 
        attention from the IRS. If so, I suspect a vigorous 
        (and at least partially successful) challenge would 
        result.'' 127
---------------------------------------------------------------------------
    \127\ Email dated 12/20/01, from William Kelliher to David 
Brockway, ``FW: SC2,'' Bates KPMG 0012723.

    Together, the BLIPS, OPIS, FLIP, and SC2 evidence 
demonstrates that the KPMG development process led to the 
approval of tax products that senior KPMG tax professionals 
knew had significant technical flaws and were potentially 
illegal tax shelters. Even when senior KPMG professionals 
expressed forceful objections to proposed products, highly 
questionable tax products received technical and reputational 
risk sign-offs and made their way to market.

  (2) Mass Marketing Tax Products

          LFinding: KPMG uses aggressive marketing tactics to 
        sell its generic tax products, including by turning tax 
        professionals into tax product salespersons, pressuring 
        its tax professionals to meet revenue targets, using 
        telemarketing to find clients, using confidential 
        client tax data to identify potential buyers, targeting 
        its own audit clients for sales pitches, and using tax 
        opinion letters and insurance policies as marketing 
        tools.

    Until recently, accounting firms were seen as traditional, 
professional firms that waited for clients to come to them with 
concerns, rather than affirmatively targeting potential clients 
for sales pitches on tax products. One of the more striking 
aspects of the Subcommittee investigation was discovery of the 
substantial efforts KPMG has expended to market its tax 
products, including extensive efforts to target clients and, at 
times, use high-pressure sales tactics. Evidence in the four 
case studies shows that KPMG compiled and scoured prospective 
client lists, pushed its personnel to meet sales targets, 
closely monitored their sales efforts, advised its 
professionals to use questionable sales techniques, and even 
used cold calls to drum up business. The evidence also shows 
that, at times, KPMG marketed tax shelters to persons who 
appeared to have little interest in them or did not understand 
what they were being sold, and likely would not have used them 
to reduce their taxes without being approached by KPMG.
    Extensive Marketing Infrastructure. As indicated in the 
prior section, KPMG's marketing efforts for new tax products 
normally began long before a product was approved for sale. 
Potential ``revenue analysis'' was part of the earliest 
screening efforts for new products. In addition, when a new tax 
product is launched within the firm, the ``Tax Solution Alert'' 
is supposed to include key marketing information such as 
potential client profiles, ``optimal target characteristics'' 
of buyers, and the expected ``typical buyer'' of the product.
    KPMG typically designates one or more persons to lead the 
marketing effort for a new tax product. These persons are 
referred to as the product's ``National Deployment Champions,'' 
``National Product Champions,'' or ``Deployment Leaders.'' In 
the four case studies investigated by the Subcommittee, the 
National Deployment Champion was the same person who served as 
the product's National Development Champion and shepherded the 
product through the KPMG approval process. For example, the tax 
professional who led the marketing effort for BLIPS was, again, 
Jeffrey Eischeid, assisted by Randall Bickham, while for SC2 it 
was, again, Larry Manth, assisted and succeeded by Andrew 
Atkin.
    National Deployment Champions have been given significant 
institutional support to market their assigned tax product. For 
example, KPMG maintains a national marketing office that 
includes marketing professionals and resources ``dedicated to 
tax.'' 128 Champions can draw on this resource for 
``market planning and execution assistance,'' and to assemble a 
marketing team with a ``National Marketing Director'' and 
designated ``area champions'' to lead marketing efforts in 
various regions of the United States.129 These 
individuals become members of the product's official 
``deployment team.''
---------------------------------------------------------------------------
    \128\ KPMG Tax Services Manual, Sec. 2.21.1, at 2-14.
    \129\ Id.
---------------------------------------------------------------------------
    Champions can also draw on a Tax Services group skilled in 
marketing research to identify prospective clients and develop 
target client lists. This group is known as the Tax Services 
Marketing and Research Support group. Champions can also make 
use of a KPMG ``cold call center'' in Indiana. This center is 
staffed with telemarketers trained to make cold calls to 
prospective clients and set up a phone call or meeting with 
specified KPMG tax or accounting professionals to discuss 
services or products offered by the firm. These telemarketers 
can and, at times, have made cold calls to sell specific tax 
shelters such as SC2.130
---------------------------------------------------------------------------
    \130\ See, e.g., SC2 script dated 6/19 (no year provided, but 
likely 2000) developed for telemarketer calls to identify individuals 
interested in obtaining more information, Bates KPMG 0050370-71. A 
telemarketing script was also developed for BLIPS, but it is possible 
that no BLIPS telemarketing calls were made. BLIPS script dated 7/8/99, 
Bates KPMG 0025670.
---------------------------------------------------------------------------
    In addition to a cadre of expert marketing support 
personnel, National Deployment Champions are supported by 
powerful software systems that help them identify prospective 
clients and track KPMG sales efforts across the country. The 
Opportunity Management System (OMS), for example, is a software 
system that KPMG tax professionals have used to monitor with 
precision who has been contacted about a particular tax 
product, who made the contact on behalf of KPMG, the potential 
sales revenue associated with the sales contact, and the 
current status of each sales effort.
    An email sent in 2000, by the Tax Services operations and 
Federal Tax Practice heads to 15 KPMG tax professionals paints 
a broad picture of what KPMG's National Deployment Champions 
were expected to accomplish:

        ``As National Deployment Champions we are counting on 
        you to drive significant market activity. We are 
        committed to providing you with the tools that you need 
        to support you in your efforts. A few reminders in this 
        regard.

        ``The Tax Services Marketing and Research Support is 
        prepared to help you refine your existing and/or create 
        additional [client] target lists. . . . Working closely 
        with your National Marketing Directors you should 
        develop the relevant prospect profile. Based on the 
        criteria you specify the marketing and research teams 
        can scour primary and secondary sources to compile a 
        target list. This will help you go to market more 
        effectively and efficiently.

        ``Many of you have also tapped into the Practice 
        Development Coordinator resource. Our team of 
        telemarketers is particularly helpful . . . to further 
        qualify prospects [redaction by KPMG] [and] to set up 
        phone appointments for you and your deployment team. . 
        . .

        ``Finally tracking reports generated from OMS are 
        critical to measuring your results. If you don't 
        analyze the outcome of your efforts you will not be in 
        a position to judge what is working and what is not. 
        Toward that end you must enter data in OMS. We will 
        generate reports once a month from OMS and share them 
        with you, your team, Service Line leaders and the [Area 
        Managing Partners]. These will be the focal point of 
        our discussion with you when we revisit your solution 
        on the Monday night call. You should also be using them 
        on your bi-weekly team calls. . . .

        ``Thanks again for assuming the responsibilities of a 
        National Deployment Champion. We are counting on you to 
        make the difference in achieving our financial goals.'' 
        131
---------------------------------------------------------------------------
    \131\ Email dated 8/6/00 from Jeff Stein and Rick Rosenthal to 15 
National Deployment Champions, Bates KPMG 050016.

    In 2002, KPMG opened a ``Sales Opportunity Center'' to make 
it easier for its personnel to make use of the firm's extensive 
marketing resources. An email announcing this Center stated the 
---------------------------------------------------------------------------
following:

        ``The current environment is changing at breakneck 
        speed, and we must be prepared to respond aggressively 
        to every opportunity.

        ``We have created a Sales Opportunity Center to be the 
        `eye of the needle'--a single place where you can get 
        access to the resources you need to move quickly, 
        knowledgeably, and effectively.

        ``This initiative reflects the efforts of Assurance 
        (Sales, Marketing, and the Assurance & Advisory 
        Services Center) and Tax (Marketing and the Tax 
        Innovation Center), and is intended to serve as our 
        `situation room' during these fast-moving times. . . .

        ``The Sales Opportunity Center is a powerful 
        demonstration of the Firm's commitment to giving you 
        what you need to meet the challenges of these momentous 
        times. We urge you to take advantage of this resource 
        as you pursue marketplace opportunities.'' 
        132
---------------------------------------------------------------------------
    \132\ Email dated 3/14/02, from Rick Rosenthal and other KPMG 
professionals, to ``US Management Group,'' Bates XX 000141 (Emphasis in 
original.).

    Corporate Culture: Sell, Sell, Sell. After a new tax 
product has been ``launched'' within KPMG, one of the primary 
tasks of a National Deployment Champion is to educate KPMG tax 
professionals about the new product and motivate them to sell 
it.
    Champions use a wide variety of tools to make KPMG tax 
professionals aware of a new tax product. For example, they 
include product information in KPMG internal newsletters and 
email alerts, and organize conference calls and video 
conferences with KPMG tax offices across the country. Champions 
have also gone on ``road shows'' to KPMG field offices to make 
a personal presentation on a particular product. These 
presentations include how the product works, what clients to 
target, and how to respond to particular concerns. On some 
occasions, a presentation is videotaped and included in an 
office's ``video library'' to enable KPMG personnel to view the 
presentation at a later date.
    Documentation obtained by the Subcommittee shows that 
National Deployment Champions and senior KPMG tax officials 
expend significant effort to convince KPMG personnel to devote 
time and resources to selling new products. Senior tax 
professionals use general exhortations as well as specific 
instructions directed to specific field offices to increase 
their sales efforts. For example, after SC2 was launched, the 
head of KPMG's Federal Practice sent the following an email to 
the SC2 ``area champions'' around the country:

        ``I want to personally thank everyone for their efforts 
        during the approval process of this strategy. It was 
        completed very quickly and everyone demonstrated true 
        teamwork. Thank you! Now let[']s SELL, SELL, SELL!!'' 
        133
---------------------------------------------------------------------------
    \133\ Email dated 2/18/00, from Richard Rosenthal to multiple KPMG 
tax professionals, Bates KPMG 0049236.

    The Federal Tax head also called specific KPMG offices to 
urge them to increase their SC2 sales. This type of instruction 
from a senior KPMG tax official apparently sent a strong 
message to subordinates about the need to sell the identified 
tax product. For example, a tax professional in a KPMG field 
office in Houston wrote the following after participating in a 
conference call on SC2 in which the Federal Tax head and the 
SC2 National Deployment Champion urged the office to improve 
---------------------------------------------------------------------------
its SC2 sales record:

        ``I don't know if you were on Larry Manth's call today, 
        but Rosenthal led the initial discussion. There have 
        been several successes. . . . We are behind.

        ``This is THE STRATEGY that they expect significant 
        value added fees by June 30.

        ``The heat is on. . . .'' 134
---------------------------------------------------------------------------
    \134\ Email dated 4/21/00, from Michael Terracina, KPMG office in 
Houston, to Gary Choate, KPMG office in Dallas, Bates KPMG 0048191.

    In the SC2 case study examined by the Subcommittee, 
National Deployment Champions did not end their efforts with 
phone calls and visits urging KPMG tax professionals to sell 
their tax product, they also produced detailed marketing plans, 
implemented them with the assistance of the ``deployment 
team,'' and pressured their colleagues to increase SC2 sales. 
For example, one email circulated among two members of the SC2 
deployment team and two senior KPMG tax professionals 
---------------------------------------------------------------------------
demonstrates the measures used to push sales:

        ``To memorialize our discussion, we agreed the 
        following:

          ``*LOver the next two weeks, Manth [SC2 National 
        Deployment Champion] will deploy [Andrew] Atkin [on the 
        SC2 deployment team] to call each of the SC2 area 
        solution champions.

          ``*LAndrew will work with the champion to establish a 
        specific action plan for each opportunity. To be at all 
        effective, the plans should [be] very specific as to 
        who is going to do what when. . . . There should be 
        agreement as to when Andrew will next follow-up with 
        them to create a real sense of urgency and 
        accountability.

          ``*LAndrew will involve Manth where he is not getting 
        a response within 24 hours or receiving inappropriate 
        `pushback.' Manth will enlist [David] Jones or Rick 
        [Rosenthal, senior KPMG tax officials,] to help 
        facilitate responsiveness where necessary given the 
        urgency of the opportunity. . . .

          ``*LManth believes inadequate resources are currently 
        deployed to exploit the Midwest SCorp client and target 
        population. Craig Pichette has not yet been able to 
        dedicate enough time to this solution. . . . John 
        Schrier (NE Stratecon) or Councill Leak (SE Stratecon) 
        could be effective. . . .

          ``*LResource[s] will be assigned to adequately 
        address the market opportunity in Florida. . . . Goals 
        must be explicit . . . including a percentage weighting 
        based on expected time commitment. . . .

        ``Manth will explore with Rick the opportunity to form 
        alliances with other accounting firms to drive 
        distribution.'' 135
---------------------------------------------------------------------------
    \135\ Email dated 1/30/01, from David Jones to Larry Manth, Richard 
Rosenthal, and Wendy Klein, ``SC2--Follow-up to 1/29 Revisit,'' Bates 
KPMG 0050389.

    Senior KPMG tax officials also set overall revenue goals 
for various tax groups and urged them to increase their sales 
of designated tax products to meet those goals. For example, in 
an email alerting nearly 40 tax professionals in the 
``Stratecon West'' group to a conference call on a ``Kick Off 
Plan For '01,'' a senior Stratecon professional, who was also 
---------------------------------------------------------------------------
the SC2 National Deployment Champion, wrote:

        ``Hello everyone. We will be having a conference call 
        to kick-off our Stratecon marketing efforts to 
        aggressively pursue closed deals by 6/30/01. The main 
        purpose of the call is to discuss our marketing and 
        targeting strategy and to get everyone acquainted with 
        a number of Stratecon's high-end solutions. If you have 
        clients, at least one of these strategies should be 
        applicable to your client base. As you all know, to 
        reach plan in the West, we must aggressively pursue 
        these high-end strategies.'' 136
---------------------------------------------------------------------------
    \136\ Email dated 12/2/00, from Lawrence Manth to multiple tax 
professionals, Bates XX 000021.

    Two months later, a member of the SC2 deployment team, who 
also worked for Stratecon, sent an email to an even larger 
group of 60 tax professionals, urging them to try a new, more 
appealing version of SC2. In a paragraph subtitled, ``Why 
---------------------------------------------------------------------------
Should You Care?'' he wrote:

        ``In the last 12 months the original SC2 structure has 
        produced $1.25 million in signed engagements for the SE 
        [Southeast]. . . . Look at the last partner scorecard. 
        Unlike golf, a low number is not a good thing. . . . A 
        lot of us need to put more revenue on the board before 
        June 30. SC2 can do it for you. Think about targets in 
        your area and call me.'' 137
---------------------------------------------------------------------------
    \137\ Email dated 2/22/01, from Councill Leak to multiple tax 
professionals, Bates KPMG 0050822-23.

    The steady push for tax product sales continued. For 
example, three weeks later, the Stratecon tax professional sent 
an email to his colleagues stating, ``Due to the significant 
push for year-end revenue, all West Region Federal tax partners 
have been invited to join us on this [conference] call and we 
will discuss our `Quick Hit' strategies and targeting 
criteria.'' 138 Six weeks after that, the same 
Stratecon official announced another conference call urging 
Stratecon professionals to discuss two ``tax minimization 
opportunities for individuals'' which will ``have a quick 
revenue hit for us.'' 139
---------------------------------------------------------------------------
    \138\ Email dated 3/13/01, from Larry Manth to multiple KPMG tax 
professionals, ``Friday's Stratecon Call,'' Bates XX 001439.
    \139\ Email dated 4/25/01, from Larry Manth to multiple KPMG tax 
professionals, ``Friday's Stratecon Call,'' Bates XX 001438.
---------------------------------------------------------------------------
    Stratecon was not alone in the push for sales. For example, 
in 2000, the former head of KPMG's Washington National Tax 
Practice sent an email to all ``US-WNT Tax Partners'' urging 
them to ``temporarily defer non-revenue producing activities'' 
and concentrate for the ``next 5 months'' on meeting WNT's 
revenue goals for the year.140 The email states in 
part:
---------------------------------------------------------------------------
    \140\ Email dated 2/3/00, from Philip Wiesner to US-WNT Tax 
Partners, Bates KPMG 0050888-90.

        ``Listed below are the tax products identified by the 
        functional teams as having significant revenue 
        potential over the next few months. . . . [T]he 
        functional teams will need . . . WNT champions to work 
        with the National Product champions to maximize the 
        revenue generated from the respective products. . . . 
        Thanks for help in this critically important matter. As 
        Jeff said, `We are dealing with ruthless execution--
        hand to hand combat--blocking and tackling.' Whatever 
---------------------------------------------------------------------------
        the mixed metaphor, let's just do it.''

    The evidence is clear that selling tax products was an 
important part of every tax professional's job at KPMG.
    Targeting Clients. KPMG's marketing efforts included 
substantial efforts to identify prospective purchasers for its 
tax products. KPMG developed prospective client lists by 
reviewing both its own client base and seeking new clients 
through referrals and cold calls.
    To review its own client base, KPMG has used software 
systems, including ones known as KMatch and RIA-GoSystem, to 
identify former or existing clients who might be interested in 
a particular tax product. KMatch is ``[a]n interactive software 
program that asks a user a series of questions about a client's 
business and tax situation,'' uses the information to construct 
a ``client profile,'' and then uses the profile to identify 
KPMG tax products that could assist the client to avoid 
taxation.141 KPMG's Tax Innovation Center conducted 
a specific campaign requiring KPMG tax professionals to enter 
client data into the KMatch database so that, when subsequent 
tax products were launched, the resulting client profiles could 
be searched electronically to identify which clients would be 
eligible for and interested in the new product. RIA-GoSystem is 
a separate internal KPMG database which contains confidential 
client data provided to KPMG to assist the firm in preparing 
client tax returns.142 This database of confidential 
client tax information can also be searched electronically to 
identify prospective clients for new tax products and was 
actually used for that purpose in the case of 
SC2.143
---------------------------------------------------------------------------
    \141\ Presentation entitled, ``KMatch Push Feature Campaign,'' 
undated, prepared by Marsha Peters of the Tax Innovation Center, Bates 
XX 001511.
    \142\ See, e.g., email dated 3/6/01, from US-GoSystem 
Administration to Andrew Atkin of KPMG, ``RE: Florida S corporation 
search,'' Bates KPMG 0050826; Subcommittee interview of Councill Leak 
(10/22/03).
    \143\ Id.
---------------------------------------------------------------------------
    The evidence indicates that KPMG also uses its assurance 
professionals--persons who provide auditing and related 
services to individuals and corporations--to identify existing 
KPMG audit clients who might be interested in new tax products. 
Among other documents evidencing the role of KPMG assurance 
professionals is the development and marketing of tax products 
that require the combined participation of both KPMG tax and 
assurance professionals. In 2000, for example, KPMG issued what 
it called its ``first joint solution'' requiring KPMG tax and 
assurance professionals to work together to sell and implement 
the product.144 The tax product is described as a 
``[c]ollection of assurance and tax services designed to assist 
companies in . . . realizing value from their intellectual 
property . . . [d]elivered by joint team of KPMG assurance and 
tax professionals.'' 145 Internal KPMG documentation 
states that the purpose of the new product is ``[t]o increase 
KPMG's market penetration of key clients and targets by 
enhancing the linkage between Assurance and Tax 
professionals.'' 146 Another KPMG document states: 
``Teaming with Assurance expands tax team's knowledge of client 
and industry[.] Demonstrates unified team approach that 
separates KPMG from competitors.'' 147 Another KPMG 
document shows that KPMG used both its internal tax and 
assurance client lists to target clients for a sales pitch on 
the new product:
---------------------------------------------------------------------------
    \144\ Presentation dated 7/17/00, ``Targeting Parameters: 
Intellectual Property--Assurance and Tax,'' with attachment dated 
September 2000, entitled ``Intellectual Property Services,'' at page 1 
of the presentation, Bates XX 001567-93.
    \145\ Presentation dated 10/30/00, ``Intellectual Property Services 
(IPS),'' by Dut LeBlanc of Shreveport and Joe Zier of Silicon Valley, 
Bates XX 001580-93.
    \146\ Presentation dated 7/17/00, ``Targeting Parameters: 
Intellectual Property--Assurance and Tax,'' with attachment dated 
September 2000, entitled ``Intellectual Property Services,'' at page 1 
of the attachment, Bates XX 001567-93.
    \147\ Presentation dated 10/30/00, ``Intellectual Property Services 
(IPS),'' by Dut LeBlanc of Shreveport and Joe Zier of Silicon Valley, 
Bates XX 001580-93.

        ``The second tab of this file contains the draft target 
        list [of companies]. This list was compiled from two 
        sources an assurance and tax list. . . . [W]e selected 
        the companies which are assurance or tax clients, which 
        resulted in the 45 companies on the next sheet. . . . 
        What should you do? Review the suspects with your 
        assurance or tax deployment counterpart. . . . 
        Prioritize your area targets, and plan how to approach 
        them.'' 148
---------------------------------------------------------------------------
    \148\ Presentation dated 7/17/00, ``Targeting Parameters: 
Intellectual Property--Assurance and Tax,'' with attachment dated 
September 2000, entitled ``Intellectual Property Services,'' at page 1 
of the attachment, Bates XX 001567-93.

    Additional tax products which relied in part on KPMG audit 
partners followed. In 2002, for example, KPMG launched a ``New 
Enterprises Tax Suite'' product 149 which it 
described internally as ``a cross-functional element of the Tax 
Practice that efficiently mines opportunities in the start-up 
and middle-market, high-growth, high-tech space.'' A 
presentation on this new product states that KPMG tax 
professionals are ``[t]eaming with Assurance . . . [and] 
fostering cross-selling among assurance and tax 
professionals.'' 150
---------------------------------------------------------------------------
    \149\ See WNT presentation dated 9/19/02, entitled ``Innovative Tax 
Solutions,'' which, at 18-26, includes a presentation by Tom Hopkins of 
Silicon Valley, ``New Enterprises Tax Suite,'' Tax Solution Alert 00-
31, Bates XX 001636-1706. The Hopkins presentation states that the new 
product is intended to be used to ``[l]everage existing client base 
(pull-through),'' ``[d]evelop and use client selection filters to 
refine our bets and reach higher market success,'' and ``[e]nhance 
relationships with client decisionmakers.'' As part of a ``Deployment 
Action Plan,'' the presentation states that KPMG ``[p]artners with 
revenue goals are given subscriptions to Venture Wire for daily lead 
generation'' and that ``[t]argeting is supplemented by daily lead 
generation from Fort Wayne'' where KPMG's telemarketing center is 
located.
    \150\ Presentation dated 3/6/00, ``Post-Transaction Integration 
Service (PTIS)--Tax,'' by Stan Wiseberg and Michele Zinn of Washington, 
D.C., Bates XX 001597-1611 (``Global collaborative service brought to 
market by tax and assurance . . . May be appropriate to initially 
unbundle the serves (`tax only,' or `assurance only') to capture an 
engagement'').
---------------------------------------------------------------------------
    Other tax products explicitly called on KPMG tax 
professionals to ask their audit counterparts for help in 
identifying potential clients. For example, a ``Middle Market 
Initiative'' launched in 2001, identified seven tax products to 
be marketed to mid-sized corporations, including SC2. It 
explicitly called upon KPMG tax professionals to contact KPMG 
audit partners to identify appropriate mid-sized corporations, 
and directed these tax professionals to pitch one or more of 
the seven KPMG tax products to KPMG audit clients. ``In order 
to maximize marketplace opportunities . . . national and area 
champions will coordinate with and involve assurance partners 
and managers in their respective areas.'' 151
---------------------------------------------------------------------------
    \151\ Email dated 8/14/01, from Jeff Stein and Walter Duer to 
``KPMG LLP Partners, Managers and Staff,'' ``Stratecon Middle Market 
Initiative,'' Bates KPMG 0050369.
---------------------------------------------------------------------------
    In addition to electronic searches, National Deployment 
Champions regularly exhorted KPMG field personnel to review 
their client lists personally to identify those that might be 
interested in a new product. In the case of SC2, deployment 
team members asked KPMG tax professionals to review their 
client lists, not once, but twice:

        ``Attached above is a listing of all potential SC2 
        engagements that did not fly over the past year. In an 
        effort to ensure we have not overlooked any potential 
        engagement during the revenue push for the last half of 
        [fiscal year] 2001, please review the list which is 
        sorted by estimated potential fees. I'd like to revisit 
        each of these potential engagements, and gather 
        comments from each of you regarding the following. . . 
        . Would further communication/dialogue with any listed 
        potential engagement be welcome? What were the reasons 
        for the potential client's declining the strategy?'' 
        152
---------------------------------------------------------------------------
    \152\ Email dated 2/9/01, from Ty Jordan to multiple KPMG tax 
professionals, ``SC2 revisit of stale leads,'' Bates KPMG 0050814.

    In addition to reviewing its own client base, KPMG worked 
with outside parties, such as banks, law firms, and other 
accounting firms, to identify outside client prospects. One 
example is the arrangement KPMG entered into with First Union 
National Bank, now part of Wachovia Bank, in which Wachovia 
referred clients to KPMG in connection with FLIP. In this case, 
Wachovia told wealthy clients about the existence of the tax 
product and allowed KPMG to set up appointments at the bank or 
elsewhere to make client presentations on FLIP.153 
KPMG apparently did not pay Wachovia a direct referral fee for 
these clients, but if a client eventually agreed to purchase 
FLIP, a portion of the fees paid by the client to Quellos, a 
investment advisory firm handling the FLIP transactions, was 
forwarded by Quellos to Wachovia. KPMG also made arrangements 
for Wachovia client referrals related to BLIPS and SC2, again 
using First Union National Bank, but it is unclear whether the 
bank actually made any referrals for these tax 
products.154 In the case of SC2, KPMG also worked 
with a variety of other outside parties, such as mid-sized 
accounting firms and automobile dealers, to locate and refer 
potential clients.155 A large law firm headquartered 
in St. Louis expressed willingness not only to issue a 
confirming tax opinion for the SC2 transaction, but also to 
introduce KPMG ``to some of their midwestern clients.'' 
156
---------------------------------------------------------------------------
    \153\ Subcommittee interview of Wachovia Bank representatives (3/
25/03).
    \154\ See, e.g., email dated 8/30/99, from Tom Newman to multiple 
First Union professionals, ``next strategy,'' Bates SEN 014622 (BLIPS 
``[f]ees to First Union will be 50 basis points if the investor is not 
a KPMG client, 25 bps if they are a KPMG client.''); email dated 11/30/
01, from Councill Leak to Larry Manth, ``FW: First Union Customer 
Services,'' Bates KPMG 0050842-44 (``I provide my comments on how we 
are bringing SC2 into certain First Union customers.''). Because KPMG 
is also Wachovia's auditor, questions have arisen as to whether their 
client referral arrangements violate SEC's auditor independence rules. 
See Section VI(B)(5) of this Report for more information on the auditor 
independence issue.
    \155\ See, e.g., email dated 1/30/01, from David Jones to Larry 
Manth, Richard Rosenthal, and Wendy Klein, ``SC2--Follow-up to 1/29 
Revisit,'' Bates KPMG 0050389 (working to form accounting firm 
alliances).
    \156\ Memorandum dated 2/16/01, from Andrew Atkin to SC2 Marketing 
Group, ``Agenda from Feb 16th call and goals for next two weeks,'' 
Bates KPMG 0051135.
---------------------------------------------------------------------------
    In addition to reviewing its own client base and seeking 
client referrals, KPMG used a variety of other means to 
identify prospective clients. In the case of SC2, for example, 
as part of its marketing efforts, KPMG obtained lists of S 
corporations in the states of Texas, North and South Carolina, 
New York, and Florida.157 It obtained these lists 
from either state government, commercial firms, or its own 
databases. The Florida list, for example, was compiled using 
KPMG's internal RIA-GoSystem containing confidential client 
data extracted from certain tax returns prepared by 
KPMG.158 Some of the lists had large blocks of S 
corporations associated with automobile or truck dealers, real 
estate firms, home builders, or architects.159 In 
some instances, KPMG tax professionals instructed KPMG 
telemarketers to contact the corporations to gauge interest in 
SC2.160 In other cases, KPMG tax professionals 
contacted the corporations personally.
---------------------------------------------------------------------------
    \157\ See, e.g., email dated 8/14/00, from Postmaster-US to unknown 
recipients, ``Action Required: Channel Conflict for SC2,'' Bates KPMG 
0049125 (S corporation list purchased from Dun & Bradstreet); 
memorandum dated 2/16/01, from Andrew Atkin to SC2 Marketing Group, 
``Agenda from Feb 16th call and goals for next two weeks,'' Bates KPMG 
0051135 (Texas S corporation list); email dated 3/7/01, from Councill 
Leak to multiple KPMG tax professionals, ``South Florida SC2 Year End 
Push,'' Bates KPMG 0050834 (Florida S corporation list); email dated 3/
26/01, from Leonard Ronnie III, to Gary Crew, ``RE: S-Corp Carolinas,'' 
Bates KPMG 0050818 (North and South Carolina S corporation list); email 
dated 4/22/01, from Thomas Crawford to John Schrier, ``RE: SC2 target 
list,'' Bates KPMG 0050029 (New York S corporation list).
    \158\ Email dated 3/6/01, from US-GoSystem Administration to Andrew 
Atkin of KPMG, ``RE: Florida S corporation search,'' Bates KPMG 
0050826. Subcommittee interview of Councill Leak (10/22/03).
    \159\ Email dated 11/17/00, from Jonathan Pullano to US-Southwest 
Tax Services Partners and others, ``FW: SW SC2 Channel Conflict,'' 
Bates KPMG 0048309.
    \160\ See, e.g., email dated 6/27/00, from Wendy Klein to Mark 
Springer and Larry Manth, ``SC2: Practice Development Coordinators 
Involvement,'' Bates KPMG 0049116; email dated 11/15/00, from Douglas 
Duncan to Michael Terracina and Gary Choat, ``FW: SW SC2 Progress,'' 
Bates KPMG 0048315-17.
---------------------------------------------------------------------------
    The lists compiled by KPMG produced literally thousands of 
potential SC2 clients, and through telemarketing and other 
calls, KPMG personnel made uncounted contacts across the 
country searching for buyers of SC2. In April 2001, the DPP 
apparently sent word to SC2 marketing teams to stop using 
telemarketing calls to find SC2 buyers,161 but 
almost as soon as the no-call policy was announced, some KPMG 
tax professionals were attempting to circumvent the ban asking, 
for example, if telemarketers could question S corporations 
about their eligibility and suitability to buy SC2, without 
scheduling future telephone contacts.162 In December 
2001, after being sent a list of over 3,100 S corporations 
targeted for telephone calls, a senior KPMG tax professional 
sent an email to the head of WNT complaining that the list 
appeared to indicate ``the firm is intent on marketing the SC2 
strategy to virtually every S corp with a pulse.'' 
163
---------------------------------------------------------------------------
    \161\ See email dated 4/22/01, from John Schrier to Thomas 
Crawford, ``RE: SC2 target list,'' Bates KPMG 0050029.
    \162\ Email dated 4/23/01, from John Schrier to Thomas Crawford, 
``RE: SC2 target list,'' Bates KPMG 0050029.
    \163\ Email dated 12/20/01, from William Kelliher to David 
Brockway, WNT head, Bates KPMG 0013311. A responsive email from Mr. 
Brockway on the same document states, ``It looks like they have already 
tried over 2/3rds of possible candidates already, if I am reading the 
spread sheet correctly.''
---------------------------------------------------------------------------
    When KPMG representatives were first asked about KPMG's use 
of telemarketers, they initially told the Subcommittee staff 
that telemarketing calls were against firm 
policy.164 When asked about the Indiana cold call 
center which KPMG has been operating for years, the KPMG 
representatives said that the center's telemarketers sought to 
introduce new clients to KPMG in a general way and did little 
more than arrange an appointment so that KPMG could explain to 
a potential client in person all of the services KPMG offers. 
When confronted with evidence of telemarketing calls for SC2, 
the KPMG representatives acknowledged that a few calls on tax 
products might have been made by telemarketers at the cold call 
center, but implied such calls were few in number and rarely 
led to sales. In a separate interview, when shown documents 
indicating that, in the case of SC2, KPMG telemarketers made 
calls to thousands of S corporations across the country, the 
KPMG tax professional being interviewed admitted these calls 
had taken place.165
---------------------------------------------------------------------------
    \164\ Subcommittee briefing by Jeffrey Eischeid and Timothy Speiss 
(9/12/03).
    \165\ Subcommittee interview of Councill Leak (10/22/03).
---------------------------------------------------------------------------
    Sales Advice. To encourage sales, KPMG would, at times, 
provide written advice to its tax professionals on how to 
answer questions about a tax product, respond to objections, or 
convince a client to buy a product.
    For example, in the case of SC2, KPMG sponsored a meeting 
for KPMG ``SC2 Team Members'' across the country and emailed 
documents providing information about the tax product as well 
as ``Appropriate Answers for Frequently Asked Shareholder 
Questions'' and ``Suggested Solutions'' to ``Sticking Points 
and Problems.'' 166 The ``Sticking Points'' document 
provided the following advice to KPMG tax professionals trying 
to sell SC2 to prospective clients:
---------------------------------------------------------------------------
    \166\ ``SC2--Meeting Agenda'' and attachments, dated 6/19/00, Bates 
KPMG 0013375-96.

        ``1) `Too Good to be true.' Some people believe that if 
        it sounds too good to be true, it's a sham. Some 
---------------------------------------------------------------------------
        suggestions for this response are the following:

          ``a) This transaction has been through KPMG's WNT 
        practice and reviewed by at least 5 specialty groups. . 
        . . Many of the specialists are ex-IRS employees.

          ``b) Many sophisticated clients have implemented the 
        strategy in conjunction with their outside counsel.

          ``c) At least one outside law firm will give a co-
        opinion on the transactions. . . .

          ``e) Absolutely last resort--At least 3 insurance 
        companies have stated that they will insure the tax 
        benefits of the transaction for a small premium. This 
        should never be mentioned in an initial meeting and 
        Larry Manth should be consulted for all insurance 
        conversations to ensure consistency and independence on 
        the transaction.

        ``2) `I Need to Think About it.' . . . We obviously do 
        not want to seem too desperate but at the same time we 
        need to keep this moving along. Some suggestions:

          ``a) `Get Even' Approach. Perhaps a good time to 
        revisit the strategy is at or near estimated tax 
        payment time when the shareholder is making or has made 
        a large estimated tax payment and is extremely 
        irritated for having done so. . . .

          ``b) Beenie Baby Approach. . . . We call the client 
        and say that the firm has decided to cap the strategy . 
        . . and the cap is quickly filling up. `Should I put 
        you on the list as a potential?' This is obviously a 
        more aggressive approach, but will tell you if the 
        client is serious about the deal.

          ``c) `Break-up' Approach. This is a risky approach 
        and should only be used in a limited number of cases. 
        This approach entails us calling the client and 
        conveying to them that they should no longer consider 
        SC2 for a reason solely related to KPMG, such as the 
        cap has been reached with respect to our city or region 
        or . . . the demand has been so great that the firm is 
        shutting it down. This approach is used as a 
        psychological tool to elicit an immediate response from 
        the client. . . .

        ``5) John F. Brown Syndrome. This is named after an 
        infamous attorney who could not get comfortable with 
        anything about the strategy. We have had a number of 
        clients with stubborn outside counsel with respect to 
        the strategy itself, the engagement letter, or other 
        aspects of the transaction. Here are some approaches:

          ``a. If we . . . know he will not approve of the 
        transaction we should tell this to the client and 
        either walk or convince the client not to use the 
        attorney or law firm for this deal. . . .

          ``c. If the fee is substantial . . . the last resort 
        is to summarize a transaction with all the possible 
        bells and whistles to make the deal as risk-free as 
        possible. For example: The client does SC2 with the 
        following elements: 1) option to reacquire stock from 
        [tax exempt organization], 2) insurance covering the 
        tax benefits plus penalties . . ., and 3) outside 
        opinion from an independent law firm. If the attorney 
        is still uncomfortable, we need to convey this to the 
        client and they can decide.''

    This document is hardly the work product of a disinterested 
tax adviser. In fact, it goes so far as to recommend that KPMG 
tax professionals employ such hard-sell tactics as making 
misleading statements to their clients--claims that SC2 will be 
sold to only a limited number of people or that it is no longer 
being sold at all in order to ``elicit an immediate response 
from the client.'' The document also depicts attorneys raising 
technical concerns about SC2 as ``stubborn'' naysayers who need 
to be circumvented, rather than satisfied. In short, rather 
than present KPMG as a disinterested tax adviser, this type of 
sales advice is evidence of a company intent on convincing an 
uninterested or hesitant client to buy a product that the 
client would apparently be otherwise unlikely to purchase or 
use.
    Using Tax Opinions and Insurance as Marketing Tools. 
Several documents obtained during the investigation demonstrate 
that KPMG deliberately traded on its reputation as a respected 
accounting firm and tax expert in selling questionable tax 
products to corporations and individuals. As described in the 
prior section on designing new tax products, the former WNT 
head acknowledged that KPMG's ``reputation will be used to 
market the [BLIPS] transaction. This is a given in these types 
of deals.'' In the SC2 ``Sticking Points'' document, KPMG 
instructed its tax professionals to respond to client concerns 
about the product by pointing out that SC2 had been reviewed 
and approved by five KPMG tax specialty groups and by 
specialists who are former employees of the IRS.167
---------------------------------------------------------------------------
    \167\ ``SC2--Meeting Agenda'' and attachments, dated June 19, 2000, 
at Bates KPMG 0013394.
---------------------------------------------------------------------------
    KPMG also used opinion letters as a marketing tool. Tax 
opinion letters are intended to provide written advice 
explaining whether a particular tax product is permissible 
under the law and, if challenged by the IRS, the likelihood 
that the tax product would survive court scrutiny. A tax 
opinion letter provided by a person with a financial stake in 
the tax product being analyzed has traditionally been accorded 
much less deference than an opinion letter supplied by a 
disinterested expert. As shown in the SC2 ``Sticking Points'' 
document just cited, if a client raised concerns about 
purchasing the product, KPMG instructed its tax professionals 
to respond that, ``At least one outside law firm will give a 
co-opinion on the transactions.'' 168 In another SC2 
document, KPMG advises its tax professionals to tell clients 
worried about IRS penalties: ``The opinion letters that we 
issue should get you out of any penalties. However, the Service 
could try to argue that KPMG is the promoter of the strategy 
and therefore the opinions are biased and try and assert 
penalties. We believe there is very low risk of this result. If 
you desire additional assurance, there is at least one outside 
law firm in NYC that will issue a co-opinion. The cost ranges 
between $25k-$40k.'' 169
---------------------------------------------------------------------------
    \168\ Id. Another document identified Bryan Cave, a law firm with 
over 600 professionals and offices in St. Louis, New York, and 
elsewhere, as willing ``to issue a confirming tax opinion for the SC2 
transaction.'' Memorandum dated 2/16/01, from Andrew Atkin to SC2 
Marketing Group, ``Agenda from Feb 16th call and goals for the next two 
weeks,'' Bates KPMG 0051135. See also email dated 7/19/00, from Robert 
Coplan of Ernst & Young to ``[email protected],'' Bates 2003EY011939 
(``As you know, we go to great lengths to line up a law firm to issue 
an opinion pursuant to a separate engagement letter from the client 
that is meant to make the law firm independent from us.'')
    \169\ ``SC2--Appropriate Answers for Frequently Asked Shareholder 
Questions,'' included in an SC2 information packet dated 7/19/00, Bates 
KPMG 0013393.
---------------------------------------------------------------------------
    KPMG was apparently so convinced that an outside legal 
opinion increased the marketability of its tax products, that 
in the case of FLIP, it agreed to pay Sidley Austin Brown & 
Wood a fee in any sale where a prospective buyer was told that 
the law firm would provide a favorable tax opinion letter, 
regardless of whether the opinion was actually provided. A KPMG 
tax professional explained in an email: ``Our deal with Brown 
and Wood is that if their name is used in selling the strategy 
they will get a fee. We have decided as a firm that B&W opinion 
should be given in all deals.'' 170 This guaranteed 
fee arrangement also provided an incentive for Sidley Austin 
Brown & Wood to refer clients to KPMG.
---------------------------------------------------------------------------
    \170\ ``Declaration of Richard E. Bosch,'' IRS Revenue Agent, In re 
John Doe Summons to Sidley Austin Brown & Wood (N.D. Ill. 10/16/03) at 
para. 18, citing an email dated 10/1/97, from Gregg Ritchie to Randall 
Hamilton. (Capitalizations in original omitted.)
---------------------------------------------------------------------------
    On occasion, KPMG also used insurance as a marketing tool 
to convince reluctant buyers to purchase a KPMG tax product. In 
the case of SC2, the ``Sticking Points'' document advised KPMG 
tax professionals to tell clients about the existence of an 
insurance policy that, for a ``small premium,'' could guarantee 
SC2's promised ``tax benefits'':

        ``At least 3 insurance companies have stated that they 
        will insure the tax benefits of the transaction for a 
        small premium. This should never be mentioned in an 
        initial meeting and Larry Manth should be consulted for 
        all insurance conversations to ensure consistency and 
        independence on the transaction.'' 171
---------------------------------------------------------------------------
    \171\ ``SC2--Meeting Agenda'' and attachments, dated June 19, 2000, 
Bates KPMG 0013375-96.

    According to KPMG tax professionals interviewed by 
Subcommittee staff, the insurance companies offering this 
insurance included AIG and Hartford.172 KPMG 
apparently possessed sample insurance policies that promised to 
reimburse the policy holder for a range of items, including 
penalties or fines assessed by the IRS for using SC2, 
essentially insuring the policy holder against being penalized 
for tax evasion.173 Once these policies were 
available, KPMG tax professionals were asked to re-visit 
potential clients who had declined the tax product and try 
again:
---------------------------------------------------------------------------
    \172\ See, e.g., Subcommittee interview of Lawrence Manth (11/6/
03).
    \173\ Id.

        ``Attached above is a listing of all potential SC2 
        engagements that did not fly over the past year. . . . 
        We now have a number of Insurance companies which would 
        like to underwrite the tax risk inherent in the 
        transaction. We may want to revisit those potential 
        clients that declined because of audit risk.'' 
        174
---------------------------------------------------------------------------
    \174\ Email dated 2/9/01, from Ty Jordan to multiple KPMG tax 
professionals, ``SC2 revisit of stale leads,'' Bates KPMG 0050814.

Evidence obtained by the Subcommittee indicates that at least 
half a dozen SC2 purchasers also purchased SC2 insurance.
    Tracking Sales and Revenue. KPMG repeatedly told the 
Subcommittee staff that it did not have the technical 
capability to track the sales or revenues associated with 
particular tax products.175 However, evidence 
gathered by the Subcommittee indicates that KPMG could and did 
obtain specific revenue tracking information.
---------------------------------------------------------------------------
    \175\ Subcommittee briefing by Jeffrey Eischeid (9/12/03); 
Subcommittee interview of Jeffrey Stein (10/31/03).
---------------------------------------------------------------------------
    The Subcommittee learned, for example, that once a tax 
product was sold to a client and the client signed an 
engagement letter, KPMG assigned the transaction an 
``engagement number,'' and recorded in an electronic database 
all revenues resulting from that engagement. This engagement 
data could then be searched and manipulated to provide revenue 
information and totals for individual tax products.
    Specific evidence that revenue information was collected 
for tax products was obtained by the Subcommittee during the 
investigation from parties other than KPMG. For example, an SC2 
``update'' prepared in mid-2001, includes detailed revenue 
information, including total nationwide revenues produced by 
the tax product since it was launched, total nationwide 
revenues produced during the 2001 fiscal year, and FY01 
revenues broken down by each of six regions in the United 
States: 176
---------------------------------------------------------------------------
    \176\ Internal KPMG presentation, dated 6/18/01, by Andrew Atkin 
and Bob Huber, entitled ``S-Corporation Charitable Contribution 
Strategy (SC2) Update,'' Bates XX 001553.

        ``Revenue since solution was launched:
          $20,700,000

        ``Revenue this fiscal year only:
          $10,700,000

        ``Revenue by Region this Fiscal Year

          * West    $7,250,000
          * Southeast    $1,300,000
          * Southwest    $850,000
          * Mid-Atlantic    $550,000
          * Midwest    $425,000
          * Northeast    $300,000

KPMG never produced this document to the 
Subcommittee.177 However, one email related to SC2 
that KPMG did produce states that monthly OMS ``tracking 
reports'' were used to measure sales results for specific tax 
products, and these reports were regularly shared with National 
Deployment Champions, Tax Service Line leaders, and Area 
Managing Partners.178
---------------------------------------------------------------------------
    \177\ Another document provided to the Subcommittee by parties 
other than KPMG carefully traces the increase in the Tax Services 
Practice's ``gross revenue.'' It shows a ``45.5% Cumulative Growth'' in 
gross revenue over a 4-year period, with $829 million in FY98, $1.001 
million in FY99, $1.184 million in FY00, and $1.239 million in FY01. 
See chart entitled, ``Tax Practice Growth Gross Revenue,'' included in 
a presentation dated 7/19/01, entitled, ``Innovative Tax Solutions,'' 
by Marsha Peters of Washington National Tax, Bates XX 001340.
    \178\ Email dated 8/6/00 from Jeffrey Stein to15 National 
Deployment Champions, Bates KPMG 050016.
---------------------------------------------------------------------------
    Moreover, KPMG's Tax Innovation Center reported in 2001, 
that it had developed new software that ``captured solution 
development costs and revenue'' and that it had begun 
``[p]repar[ing] quarterly Solution Profitability reports.'' 
179 This information suggests that KPMG was refining 
its revenue tracking capabilities to be able to track not only 
gross revenues produced by a tax product, but also net 
revenues, and that it had begun collecting and monitoring this 
information on a regular basis. KPMG's statement, ``the firm 
does not maintain any systematic, reliable method of recording 
revenues by tax product on a national basis,'' 180 
was contradicted by the evidence.
---------------------------------------------------------------------------
    \179\ Internal KPMG presentation, dated 5/30/01, by the Tax 
Innovation Center, entitled ``Tax Innovation Center Solution and Idea 
Development--Year-End Results,'' Bates XX 001490-1502.
    \180\ Letter from KPMG to Subcommittee, dated 4/22/03, attached 
one-page chart entitled, ``Good Faith Estimate of Top Revenue-
Generating Strategies,'' n.1.
---------------------------------------------------------------------------
    No Industry Slow-Down. Some members of the U.S. tax 
profession have asserted that professional firms are beginning 
to turn away from marketing illegal tax shelters, so there is 
no need for investigations, reforms, or stronger laws in this 
area. KPMG has claimed that it is no longer marketing 
aggressive tax products designed to be sold to multiple 
clients. The Subcommittee investigation, however, found that, 
while a few professional firms have reduced or stopped selling 
generic tax products in the last 2 years, KPMG and other 
professional firms appear to be committed to continuing and 
deepening their efforts to develop and market generic, 
potentially abusive, tax products to multiple clients.
    Evidence of KPMG's commitment to ongoing tax product sales 
appears throughout this Report. For example, KPMG provided the 
Subcommittee with a 2003 list of more than 500 ``active tax 
products'' it intends to offer to multiple clients for a fee. 
Just last year, in 2002, KPMG established a ``Sales Opportunity 
Center'' which the firm itself has characterized as ``a 
powerful demonstration of the Firm's commitment to giving'' 
KPMG professionals ready access to marketing tools to sell 
products and services to multiple clients. Also in 2002, the 
Tax Innovation Center helped develop new software to enable 
KPMG to track tax product development costs and net revenues, 
and issue quarterly tax product profitability reports. In 2003, 
KPMG's telemarketing center in Indiana continued to be staffed 
and ready for tax product marketing assistance.
    Evidence of marketing campaigns shows KPMG sought to expand 
its tax product sales by targeting new market segments. In 
August 2001, for example, KPMG launched a ``Middle Market 
Initiative'' to increase its tax product sales to mid-sized 
corporations:

        ``Consistent with several other firm initiatives . . . 
        we are launching a major initiative in Tax to focus 
        certain of our resources on the Middle Market. A major 
        step in this initiative is driving certain Stratecon 
        high-end solutions to these companies . . . through a 
        structured, proactive program. . . . National and area 
        champions of this initiative will meet with leadership 
        . . . to discuss solutions, agree on appropriate 
        targets, and develop an area strategy. . . . In order 
        to maximize marketplace opportunities . . . national 
        and area champions will coordinate with and involve 
        assurance partners and managers in their respective 
        areas. . . . [C]hampions will also coordinate with the 
        tax practice's proposed strategic alliance with mid-
        tier accounting firms. The goal for Stratecon is to 
        close and implement engagements totaling $15 M in 
        revenues over the next 15 month period (FY ending 9/
        02).'' 181
---------------------------------------------------------------------------
    \181\ Email dated 8/14/01, from Jeff Stein and Walter Duer to 
``KPMG LLP Partners, Managers and Staff,'' ``Stratecon Middle Market 
Initiative,'' Bates KPMG 0050369.

The Middle Market Initiative identified seven KPMG tax products 
to be marketed to mid-sized corporations, including SC2. It 
explicitly called upon KPMG tax professionals to contact KPMG 
audit partners to identify appropriate mid-sized corporations, 
and then to pitch one or more of the seven KPMG tax products to 
KPMG audit clients. It is the Subcommittee staff's 
understanding that this marketing campaign is ongoing and 
successfully increasing KPMG tax product sales to mid-sized 
corporations across the United States.182
---------------------------------------------------------------------------
    \182\ Subcommittee interview of Jeffrey Stein (10/31/03).
---------------------------------------------------------------------------
    In December 2001, KPMG held a ``FY02 Tax Strategy 
Meeting,'' to discuss ``taking market leadership'' in 2002. One 
email described the meeting as follows:

        ``Thank you for attending the FY02 Tax Strategy 
        Meeting. It's now time to take action. As you enter the 
        marketplace armed with the knowledge of `Taking Market 
        Leadership,' please remember to share your thoughts and 
        experiences with us so we can better leverage the three 
        key market pillars--Market Share, Client Centricity, 
        and Market-Driven Solutions. . . .

        ``[W]e want to hear more about:

          * LTeaming with Assurance; . . .
          * LHow clients are responding to our services and 
        solutions;
          * LIdeas for new services and solutions; and
          * LBest practices.'' 183
---------------------------------------------------------------------------
    \183\ Email dated 12/12/01, from Dale Affonso to ``Tax Personnel--
LA & PSW,'' Bates XX 001733.

    Additional evidence of KPMG's continued involvement in the 
marketing of generic tax products comes from the chart prepared 
by KPMG, at the Subcommittee's request, listing its top ten 
revenue producing tax products in 2000, 2001, and 
2002.184 The list of ten tax products for 2002 
includes, among others, the ``Tax-Efficient Minority Preferred 
Equity Sale Transaction'' (TEMPEST) and the ``Optional Tax-
Deductible Hybrid Equity while Limiting Local Obligation'' 
(OTHELLO).185 Another KPMG chart, listing Strat 
econ's tax products as of January 1, 2002, describes TEMPEST as 
a product that ``creates capital loss,'' 186 while 
OTHELLO ``[c]reates a basis step-up in built-in gain asset and 
potential for double benefit of built-in losses.'' 
187 The minimum fee KPMG intends to charge clients 
for each of these products, TEMPEST and OTHELLO, is $1 
million.188 KPMG has also indicated that each of the 
tax products listed on the Stratecon chart remained an ``active 
tax product'' as of February 10, 2003.189
---------------------------------------------------------------------------
    \184\ KPMG chart entitled, ``Good Faith Estimate of Top Revenue-
Generating Strategies,'' attached to letter dated 4/22/03, from KPMG's 
legal counsel to the Subcommittee, Bates KPMG 0001801.
    \185\ Id.
    \186\ KPMG chart entitled ``StrateconWest/FSG Solutions and 
Solution WIP--As of January 1, 2002,'' Bates XX 001009-25.
    \187\ Id. at 2.
    \188\ Id. at 2 and 4.
    \189\ See undated document provided by KPMG to the Subcommittee on 
2/10/03, ``describing all active tax products included in Tax Products 
Alerts, Tax Solutions Alerts and Tax Service Ideas,'' Bates KPMG 
0000089-90.
---------------------------------------------------------------------------
    A final example of evidence of KPMG's ongoing commitment to 
selling generic tax products is a draft business plan for 
fiscal year 2002, prepared for the Personal Financial Planning 
(PFP) tax practice's Innovative Strategies (IS) 
group.190 This business plan indicates that, while 
the IS group's marketing efforts had decreased after IRS 
issuance of new tax shelter notices, it had done all the 
preparatory work needed to resume vigorous marketing of new, 
potentially abusive tax shelters in 2002. The IS business plan 
first recounts the group's past work on FLIP, OPIS, and BLIPS, 
noting that the millions of dollars in revenue produced from 
sales of these tax products had enabled IS to exceed its annual 
revenue goals in each year from 1998 until 2000. The business 
plan then states:
---------------------------------------------------------------------------
    \190\ Document dated 5/18/01, ``PFP Practice Reorganization 
Innovative Strategies Business Plan--DRAFT,'' Bates KPMG 0050620-23, at 
1. This document was authored by Jeffrey Eischeid, according to Mr. 
Eischeid. Subcommittee interview of Jeffrey Eischeid (11/3/03).

        ``The fiscal [2001] IS revenue goal was $38 million and 
        the practice has delivered $16 million through period 
        10. The shortfall from plan is primarily attributable 
        to the August 2000 issuance [by the IRS] of Notice 
        2000-44. This Notice specifically described both the 
        retired BLIPS strategy and the then current 
        [replacement, the Short Option Strategy or] SOS 
        strategy. Accordingly, we made the business decisions 
        to stop the implementation of `sold' SOS transactions 
        and to stay out of the `loss generator' business for an 
---------------------------------------------------------------------------
        appropriate period of time.''

    The business plan then identified six tax products which 
had been approved for sale or were awaiting approval, and which 
were ``expected to generate $27 million of revenue in fiscal 
'02.'' 191 Two of these strategies, called 
``Leveraged Private Split Dollar'' and ``Monetization Tax 
Advisory Services,'' were not explained, but were projected to 
generate $5 million in 2002 fees each.192 Another 
tax product, under development and projected to generate $12 
million in 2002 fees, is described as:
---------------------------------------------------------------------------
    \191\ Id. at 3.
    \192\ Id. But see minutes dated 11/30/00, Monetization Solutions 
Task Force Teleconference, Bates KPMG 0050624-29, at 50627 (advocating 
KPMG design and implementation of ``sophisticated entity structures 
that have elements of both financial product technology and tax 
technology,'' including ``monetization solutions that have been 
traditionally offered by the investment banks'' such as ``prepaid 
forwards, puts and calls, short sales, synthetic OID conveyances, and 
other derivative structures.'')

        ``a gain mitigation solution, POPS. Judging from the 
        Firm's historic success in generating revenue from this 
        type of solution, a significant market opportunity 
        obviously exists. We have completed the solution's 
        technical review and have almost finalized the 
        rationale for not registering POPS as a tax shelter.'' 
        193
---------------------------------------------------------------------------
    \193\ Document dated 5/18/01, ``PFP Practice Reorganization 
Innovative Strategies Business Plan--DRAFT,'' Bates KPMG 0050620-23, at 
2.

Still another tax product, under development and projected to 
generate $5 million in 2002 fees, is described as a 
``conversion transaction . . . that halves the taxpayer's 
effective tax rate by effectively converting ordinary income to 
long term capital gain. . . . The most significant open issue 
is tax shelter registration and the impact registration will 
have on the solution.'' The business plan estimates that, if 
the projected sales occur, ``the planned revenue per [IS] 
partner would be $3 million and the planned contribution per 
partner would equal or exceed $1.5 million.''
    The business plan provides this analysis:


        ``[T]here has been a significant increase in the 
        regulation of `tax shelters.' Not only is this 
        regulatory activity dampening market appetite, it is 
        changing the structural nature of the underlying 
        strategies. Specifically, taxpayers are having to put 
        more money at risk for a longer period of time in order 
        to improve the business purpose economic substance 
        arguments. All things considered, it is more difficult 
        today to close tax advantaged transactions. 
        Nevertheless, we believe that the Innovative Strategies 
        practice is a sustainable business opportunity with 
        significant growth opportunity.'' 194
---------------------------------------------------------------------------
    \194\ Id. at 2.

This and other evidence obtained by the Subcommittee during the 
past year indicate an ongoing, internal effort within KPMG to 
continue the development and sale of generic tax products to 
multiple clients.

  (3) Implementing Tax Products

    (a) KPMG's Implementation Role

          LFinding: KPMG is actively involved in implementing 
        the tax shelters which it sells to its clients, 
        including by enlisting participation from banks, 
        investment advisory firms, and tax exempt 
        organizations; preparing transactional documents; 
        arranging purported loans; issuing and arranging 
        opinion letters; providing administrative services; and 
        preparing tax returns.

    In many cases, KPMG's involvement with a tax product sold 
to a client does not end with the sale itself. Many KPMG tax 
products, including the four examined by the Subcommittee, 
require the purchaser to carry out complex financial and 
investment activities in order to realize promised tax 
benefits. KPMG typically provided such clients with significant 
implementation assistance to ensure they realized the promised 
tax benefits on their tax returns. KPMG was also interested in 
successful implementation of its tax products, because the 
track record that built up over time for a particular product 
affected how KPMG could, in good faith, characterize that 
product to new clients. Implementation problems have also, at 
times, caused KPMG to adjust how a tax product is structured 
and even spurred development of a new product.
    Executing FLIP, OPIS, and BLIPS. FLIP, OPIS, and BLIPS 
required the purchaser to establish a shell corporation, join a 
partnership, obtain a multi-million dollar loan, and engage in 
a series of complex financial and investment transactions that 
had to be carried out in a certain order and in a certain way 
to realize tax benefits. The evidence collected by the 
Subcommittee shows that KPMG was heavily involved in making 
sure the client transactions were completed properly.
    As a first step, KPMG enlisted the participation of 
professional organizations to help design its products and 
carry them out. In the case of FLIP, which was the first of the 
four tax products to be developed, KPMG sought the assistance 
of investment experts at a small firm called Quellos to design 
the complex series of financial transactions called for by the 
product.195 Quellos, using contacts it had 
established in other business dealings, helped KPMG convince a 
major bank, UBS AG, to provide financing and participate in the 
FLIP transactions. Quellos worked with UBS to fine-tune the 
financial transactions, helped KPMG make client presentations 
about FLIP and, for those who purchased the product, helped 
complete the paperwork and transactions, using Quellos 
securities brokers. KPMG also enlisted help from Wachovia Bank, 
convincing the bank to refer bank clients who might be 
interested in the FLIP tax product.196 In some 
cases, the bank permitted KPMG and Quellos to make FLIP 
presentations to its clients in the bank's 
offices.197 KPMG also enlisted Sidley Austin Brown & 
Wood to issue a favorable legal opinion letter on the FLIP tax 
product.198
---------------------------------------------------------------------------
    \195\ Quellos was then known and doing business as Quadra Capital 
Management LLP or QA Investments, LLC.
    \196\ KPMG actually did business with First Union National Bank, 
which subsequently merged with Wachovia Bank.
    \197\ Subcommittee interview of First Union National Bank 
representatives (3/25/03).
    \198\ KPMG actually worked with Brown & Wood, a large New York law 
firm which subsequently merged with Sidley & Austin.
---------------------------------------------------------------------------
    In the case of OPIS and BLIPS, KPMG, again, enlisted the 
help of Sidley Austin Brown & Wood, but used a different 
investment advisory firm. Instead of Quellos, KPMG obtained 
investment advice from Presidio Advisory Services. Presidio was 
formed in 1997, by two former KPMG tax professionals, one of 
whom was a key participant in the development and marketing of 
FLIP.199 These two tax professionals left the 
accounting firm, because they wanted to focus on the investment 
side of the generic tax products being developed by 
KPMG.200 Unlike Quellos, which had substantial 
investment projects aside from FLIP, virtually all of 
Presidio's work over the following 5 years derived from KPMG 
tax products. Presidio's principals worked closely with KPMG 
tax professionals to design OPIS and BLIPS. Presidio's 
principals also helped KPMG obtain lending and securities 
services from three major banks, Deutsche Bank, HVB, and 
NatWest, to complete OPIS and BLIPS transactions.
---------------------------------------------------------------------------
    \199\ The two former KPMG tax professionals are John Larson and 
Robert Pfaff. They also formed numerous other companies, many of them 
shells, to participate in business dealings including, in some cases, 
OPIS and BLIPS transactions. These related companies include Presidio 
Advisors, Presidio Growth, Presidio Resources, Presidio Volatility 
Management, Presidio Financial Group, Hayes Street Management, Holland 
Park, Prevad, Inc., and Norwood Holdings (collectively referred to as 
``Presidio'').
    \200\ Subcommittee interview of John Larson (10/21/03); email dated 
7/29/97, from Larry DeLap to multiple KPMG tax professionals, ``Revised 
Memorandum,'' Bates KPMG JAC 331160, forwarding memorandum dated 7/29/
97, from Bob Pfaff to John Lanning, Jeff Stein and others, ``My 
Thoughts Concerning KPMG's Tax Advantaged Transaction Practice, 
Presidio's Relationship with KPMG, Transition Issues.''
---------------------------------------------------------------------------
    In addition to enlisting the participation of legal, 
investment, and financial professionals, KPMG provided 
significant administrative support for the FLIP, OPIS, and 
BLIPS transactions, using KPMG personnel to help draft and 
prepare transactional documents, and assist the investment 
advisory firms and the banks with paperwork. For example, when 
a number of loans were due to be closed in certain BLIPS 
transactions, two KPMG staffers were stationed at HVB to assist 
the bank with closing and booking issues.201 Other 
KPMG employees were assigned to Presidio to assist in 
expediting BLIPS transactions and paperwork. KPMG also worked 
with Quellos, Presidio, and the relevant banks to ensure that 
the banks established large enough credit lines, with hundreds 
of millions of dollars, to allow a substantial number of 
individuals to carry out FLIP, OPIS, and BLIPS transactions.
---------------------------------------------------------------------------
    \201\ Credit Request dated 9/26/99, Bates HVB 001166; Subcommittee 
interview of HVB representatives (10/29/03).
---------------------------------------------------------------------------
    When asked about KPMG's communications with the banks, the 
OPIS and BLIPS National Deployment Champion initially denied 
ever contacting bank personnel directly, claiming instead to 
have relied on Quellos and Presidio personnel to work directly 
with the bank personnel.202 When confronted with 
documentary evidence of direct contacts, however, the 
Deployment Champion reluctantly admitted communicating on rare 
occasions with bank personnel. Evidence obtained by the 
Subcommittee, however, shows that KPMG communications with bank 
personnel were not rare. KPMG negotiated intensively with the 
banks over the factual representations that would be attributed 
to the banks in the KPMG opinion letters. On occasion, KPMG 
stationed its personnel at the banks to facilitate transactions 
and paperwork. The BLIPS National Deployment Champion met with 
NatWest personnel regarding the BLIPS transactions. In one 
instance in 2000, documents indicate that, when clients had 
exhausted the available credit at Deutsche Bank to conduct OPIS 
transactions, the Deployment Champion planned to meet with 
senior Deutsche Bank officials about increasing the credit 
lines so that more OPIS products could be sold.203
---------------------------------------------------------------------------
    \202\ Subcommittee interview of Jeffrey Eischeid (10/8/03).
    \203\ See, e.g., memorandum dated 8/5/98, from Doug Ammerman to 
``PFP Partners,'' ``OPIS and Other Innovative Strategies,'' Bates KPMG 
0026141-43 at 2; email dated 5/13/99, sent by Barbara Mcconnachie but 
attributed to Doug Ammerman, to John Lanning and other KPMG tax 
professionals, ``FW: BLIPS,'' Bates KPMG 0011903 (``Jeff Eischeid will 
be attending a meeting . . . to address the issue of expanding capacity 
at Deutsche Bank given our expectation regarding the substantial volume 
expected from this product.'') It is unclear whether this meeting 
actually took place.
---------------------------------------------------------------------------
    Executing SC2. In the case of SC2, the tax product could 
not be executed at all without a charitable organization 
willing to participate in the required transactions. KPMG took 
on the task of locating and convincing appropriate charities to 
participate in SC2 transactions. The difficulty of this task 
was evident in several KPMG documents. For example, one SC2 
document warned KPMG personnel not to look for a specific 
charity to participate in a specific SC2 transaction until 
after an engagement letter was signed with a client because: 
``It is difficult to find qualifying tax exempts. . . . [O]f 
those that qualify only a few end up being interested and only 
a few of those will accept donations. . . . We need to be able 
to go to the tax-exempt with what we are going to give them to 
get them interested.'' 204 In another email, the SC2 
National Deployment Champion wrote:
---------------------------------------------------------------------------
    \204\ Attachment entitled, ``Tax Exempt Organizations,'' included 
in an SC2 information packet dated 7/19/00, ``SC2--Meeting Agenda,'' 
Bates KPMG 0013387.

        ``Currently we have five or six tax exempts that have 
        reviewed the transaction, are comfortable they are not 
        subject to UBIT [unrelated business income tax] and are 
        eager to receive gifts of S Corp stock. These 
        organizations are well established, solid 
        organizations, but generally aren't organizations our 
        clients and targets have made gifts to in the past. 
        This point hit painfully home when, just before signing 
        our engagement letter for an SC2 transaction with a $3 
        million fee, an Atlanta target got cold feet.'' 
        205
---------------------------------------------------------------------------
    \205\ Email dated 2/22/01, from Councill Leak to multiple KPMG tax 
professionals, ``SC2 Solution--New Development,'' Bates KPMG 0050822.

    KPMG refused to identify to the Subcommittee any of the 
charities it contacted about SC2 or any of the handful of 
charities that actually participated in SC2 stock donations, 
claiming this was ``tax return information'' that it could not 
disclose. The Subcommittee was nevertheless able to identify 
and interview two charitable organizations which, between them, 
participated in more than half of the 58 SC2 transactions KPMG 
arranged.206
---------------------------------------------------------------------------
    \206\ Subcommittee interviews with Los Angeles Department of Fire & 
Police Pension System (10/22/03) and the Austin Fire Relief and 
Retirement Fund (10/14/03).
---------------------------------------------------------------------------
    Both charities interviewed by Subcommittee staff indicated 
that they first learned of SC2 when contacted by KPMG 
personnel. Both used the same phrase, that KPMG had contacted 
them ``out of the blue.'' 207 Both charities 
indicated that KPMG personnel explained SC2 to them, convinced 
them to participate, introduced the potential SC2 donors to the 
charity, and supplied draft transactional documents. Both 
charities indicated that, with KPMG acting as a liaison, they 
then accepted S corporation stock donations from out-of-state 
residents whom they never met and with whom they had never had 
any prior contact.
---------------------------------------------------------------------------
    \207\ Id.
---------------------------------------------------------------------------
    KPMG also distributed to its personnel a document entitled, 
``SC2 Implementation Process,'' listing a host of 
implementation tasks they should complete in each transaction. 
These tasks included technical, administrative, and logistical 
chores. For example, KPMG personnel were told they should 
evaluate the S corporation's ownership structure and 
incorporation documentation; work with an outside valuation 
firm to determine the corporation's enterprise value and the 
value of the corporate stock and warrants; and physically 
deliver the appropriate stock certificates to the charity 
accepting the client's stock donation.208
---------------------------------------------------------------------------
    \208\ ``SC2 Implementation Process,'' included in an SC2 
information packet dated 7/19/00, Bates KPMG 0013385-86.
---------------------------------------------------------------------------
    Both charities said that KPMG often acted as a go-between 
for the charity and the corporate donor, shuttling documents 
back and forth and answering inquiries on both sides. KPMG 
apparently also drafted and supplied draft transactional 
documents to the S corporations and corporate 
owners.209 One of the pension funds informed the 
Subcommittee staff that, when one corporate donor needed to re-
take possession of the corporate stock due to an unrelated 
business opportunity that required use of the stock, KPMG 
assisted in the mechanics of selling the stock back to the 
donor.210
---------------------------------------------------------------------------
    \209\ Subcommittee interview of Lawrence Manth (11/6/03).
    \210\ Subcommittee interview of William Stefka, Austin Fire Relief 
and Retirement Fund (10/14/03).
---------------------------------------------------------------------------
    The documentation shows that KPMG tax professionals also 
expended significant effort developing a ``back-end deal'' for 
SC2 donors, meaning a tax transaction that could be used by the 
S corporation owner to further reduce or eliminate their tax 
liability when they retake control of the S corporation and 
distribute some or all of the income that built up within the 
company while the charity was a shareholder. The SC2 National 
Deployment Champion wrote to more than 20 of his colleagues 
working on SC2 the following:

        ``Our estimate is that by 12/31/02, there will be 
        approximately $1 billion of income generated by S-corps 
        that have implemented this strategy, and our goal is to 
        maintain the confidentiality of the strategy for as 
        long as possible to protect these clients (and new 
        clients). . . .

        ``We have had our first redemption from the LAPD. 
        Particular thanks to [a KPMG tax professional] and his 
        outstanding relationship with the LAPD fund 
        administrators, the redemption went smooth. [Three KPMG 
        tax professionals] all worked together on structuring 
        the back-end deal allowing for the shareholder to 
        recognize a significant benefit, as well as getting 
        KPMG a fee of approx. $1 million, double the original 
        SC2 fee!!

        ``[Another KPMG tax professional] is in the process of 
        working on a back-end solution to be approved by WNT 
        that will provide S-corp shareholders additional basis 
        in their stock which will allow for the cash build-up 
        inside of the S-corporation to be distributed tax-free 
        to the shareholders. This should provide us with an 
        additional revenue stream and a captive audience. Our 
        estimate is that if 50% of the SC2 clients implement 
        the back-end solution, potential fees will approximate 
        $25 million.'' 211
---------------------------------------------------------------------------
    \211\ Email dated 12/27/01, from Larry Manth to Andrew Atkin and 
other KPMG tax professionals, ``SC2,'' Bates KPMG 0048773. See also 
email dated 8/18/01, from Larry Manth to multiple KPMG tax 
professionals, ``RE: New Solutions--WNT,'' Bates KPMG 0026894.

This email communication shows that the key KPMG tax 
professionals involved with SC2 viewed the strategy as a way to 
defer and reduce taxes on substantial corporate income that was 
always intended to be returned to the control of the stock 
donor. It also shows that KPMG's implementation efforts on SC2 
continued long past the sale of the tax product to a client.
    Preparing KPMG Opinion Letters. In addition to helping 
clients complete the transactions called for in FLIP, OPIS, 
BLIPS, and SC2, when it came time for clients to submit tax 
returns at the end of the year or in subsequent years, KPMG was 
available to help its clients prepare their returns. In 
addition, whether a client's tax return was prepared by KPMG or 
someone else, KPMG supplied the client with a tax opinion 
letter explaining the tax benefits that the product provided 
and could be reflected in the client's tax return. In three of 
the cases examined by the Subcommittee, KPMG also arranged for 
its clients to obtain a second favorable opinion letter from an 
outside law firm. In the fourth case, SC2, KPMG knew of law 
firms willing to issue a second opinion letter, but it is 
unclear whether any were actually issued.
    A tax opinion letter, sometimes called a legal opinion 
letter when issued by a law firm, is intended to provide 
written advice to a client on whether a particular tax product 
is permissible under the law and, if challenged by the IRS, how 
likely it would be that the challenged product would survive 
court scrutiny. The Subcommittee investigation uncovered 
disturbing evidence related to how opinion letters were being 
developed and used in connection with KPMG's tax products.
    The first issue involves the accuracy and reliability of 
the factual representations that were included in the opinion 
letters supporting KPMG's tax products. In the four case 
histories, KPMG tax professionals expended extensive effort 
drafting a prototype tax opinion letter to serve as a template 
for the opinion letters actually sent by KPMG to its clients. 
One key step in the drafting process was the drafting of 
factual representations attributed to parties participating in 
the relevant transactions. Such factual representations play a 
critical role in the opinion letter by laying a factual 
foundation for its analysis and conclusions. Treasury 
regulations state:

        ``The advice [in an opinion letter] must not be based 
        on unreasonable factual or legal assumptions (including 
        assumptions as to future events) and must not 
        unreasonably rely on the representations, statements, 
        findings, or agreements of the taxpayer or any other 
        person. For example, the advice must not be based upon 
        a representation or assumption which the taxpayer 
        knows, or has reason to know, is unlikely to be true, 
        such as an inaccurate representation or assumption as 
        to the taxpayer's purposes for entering into a 
        transaction or for structuring a transaction in a 
        particular manner.'' 212
---------------------------------------------------------------------------
    \212\ Treas. Reg. Sec. 1.6664-4(c)(1)(ii).

    KPMG stated in its opinion letters that its analysis relied 
on the factual representations provided by the client and other 
key parties. In the BLIPS prototype tax opinion, for example, 
KPMG stated that its ``opinion and supporting analysis are 
based upon the following description of the facts and 
representations associated with the investment transactions 
undertaken by Investor.'' 213 The Subcommittee was 
told that Sidley Austin Brown & Wood relied on the same factual 
representations to compose the legal opinion letters that it 
drafted.
---------------------------------------------------------------------------
    \213\ Prototype BLIPS tax opinion letter prepared by KPMG, (12/31/
99), Bates KPMG 0000405-417, at 1.
---------------------------------------------------------------------------
    Virtually all of the FLIP, OPIS, and BLIPS opinion letters 
contained boilerplate repetitions of the factual 
representations attributed to the participating parties. For 
example, virtually all the KPMG FLIP clients made the same 
factual representations, worded in the same way. The same was 
true for KPMG's OPIS clients and for KPMG's BLIPS clients. Each 
of the banks that participated in BLIPS made factual 
representations that varied slightly from bank to bank, but did 
not vary at all for a particular bank. In other words, Deutsche 
Bank and HVB attested to slightly different versions of the 
factual representations attributed to the bank participating in 
the BLIPS transactions, but every BLIPS opinion letter that, 
for example, referred to Deutsche Bank, contained the exact 
same boilerplate language to which Deutsche Bank had agreed to 
attest.
    The evidence is clear that KPMG took the lead in drafting 
the factual representations attributed to other parties, 
including the client or ``investor'' who purchased the tax 
product, the investment advisory firm that participated in the 
transactions, and the bank that provided the financing. In the 
case of the factual representations attributed to the 
investment advisory firm or bank, the evidence indicates that 
KPMG presented its draft language to the relevant party and 
then engaged in detailed negotiations over the final 
wording.214 In the case of the factual 
representations attributed to a client, however, the evidence 
indicates KPMG did not consult with its client beforehand, even 
for representations purporting to describe, in a factual way, 
the client's intentions, motivations, or understanding of the 
tax product. KPMG alone, apparently without any client input, 
wrote the client's representations and then demanded that each 
client attest to them by returning a signed letter to the 
accounting firm.
---------------------------------------------------------------------------
    \214\ See, e.g., email dated 3/27/00, from Jeffrey Eischeid to 
Richard Smith, ``Bank representation,'' and email dated 3/28/00, from 
Jeffrey Eischeid to Mark Watson, ``Bank representation,'' Bates KPMG 
0025753 (depicting negotiations between KPMG and Deutsche Bank over 
factual representations to be included in opinion letter).
---------------------------------------------------------------------------
    The evidence indicates that KPMG not only failed to consult 
with its clients before attributing factual representations to 
them, it also refused to allow its clients to deviate from the 
KPMG-drafted representations, even when clients disagreed with 
the statements being attributed to them. For example, according 
to a court complaint filed by one KPMG client, Joseph Jacoboni, 
he initially refused to attest to the factual representations 
sent to him by KPMG about a FLIP transaction, because he had no 
first hand knowledge of the ``facts'' and did not understand 
the FLIP transaction.215 According to Mr. Jacoboni, 
KPMG would not alter the client representations in any way and 
would not supply him with any opinion letter until he attested 
to the specific factual representations attributed to him by 
KPMG. After a standoff lasting nearly 2 months, with the 
deadline for his tax return fast approaching, Mr. Jacoboni 
finally signed the representation letter attesting to the 
statements KPMG had drafted.216
---------------------------------------------------------------------------
    \215\ Jacoboni v. KPMG, Case No. 6:02-CV-510 (M.D. Fla. 4/29/02) 
Complaint at para.para. 16-17 (``[I]t seemed ridiculous to ask Mr. 
Jacoboni to sign the Representation Letter, which neither he [Mr. 
Jacoboni's legal counsel] nor Mr. Jacoboni understood. Moreover, Mr. 
Jacoboni had no personal knowledge of the factual representations in 
the letter and could not verify the facts as KPMG requested.'' Emphasis 
in original.); Subcommittee interview of Mr. Jacoboni's legal counsel 
(4/4/03).
    \216\ Id. at para.para. 18-19. Mr. Jacaboni also alleges that, 
despite finally signing the letter, he never received the promised tax 
opinion letter from KPMG.
---------------------------------------------------------------------------
    Equally disturbing is that some of the key factual 
representations KPMG attributed to its clients appear to 
contain false or misleading statements. For example, in the 
BLIPS prototype letter, KPMG wrote: ``Investor has represented 
to KPMG . . . [that the] Investor independently reviewed the 
economics underlying the [BLIPS] Investment Fund before 
entering into the program and believed there was a reasonable 
opportunity to earn a reasonable pre-tax profit from the 
transactions.'' 217 The existence of a client profit 
motive and the existence of a reasonable opportunity to earn a 
reasonable pre-tax profit are central factors in determining 
whether a tax product like BLIPS has a business purpose and 
economic substance apart from its tax benefits. It is the 
Subcommittee's understanding that this client representation 
was repeated substantially verbatim in every BLIPS tax opinion 
letter KPMG issued.
---------------------------------------------------------------------------
    \217\ Prototype BLIPS tax opinion letter prepared by KPMG, (12/31/
99), Bates KPMG 0000405-417, at 9.
---------------------------------------------------------------------------
    The first stumbling block is the notion that every client 
who purchased BLIPS ``independently'' reviewed its 
``economics'' beforehand, and ``believed'' there was a 
reasonable opportunity to make a reasonable profit. BLIPS was 
an enormously complicated transaction, with layers of 
structured finance, a complex loan, and intricate foreign 
currency trades. A technical analysis of its ``economics'' was 
likely beyond the capability of most of the BLIPS purchasers. 
In addition, KPMG knew there was only a remote possibility--not 
a reasonable possibility--of a client's earning a profit in 
BLIPS.218 Nevertheless, since the existence of a 
reasonable opportunity to earn a reasonable profit was critical 
to BLIPS' having economic substance, KPMG included that 
questionable client representation in its BLIPS tax opinion 
letter.219
---------------------------------------------------------------------------
    \218\ See email dated 5/4/99, from Mark Watson, WNT, to Larry 
DeLap, DPP, Bates KPMG 0011916 (Quoting Presidio investment experts who 
set up the BLIPS transactions, KPMG tax expert states: ``the 
probability of actually making a profit from this transaction is remote 
(possible, but remote).'').
    \219\ KPMG required the investment advisory firm, Presidio, to make 
this same factual representation, even though Presidio had informed 
KPMG personnel that ``the probability of actually making a profit from 
this transaction is remote (possible, but remote).'' The evidence 
indicates that both KPMG and Presidio knew there was only a remote 
possibility--not a reasonable possibility--of a client's earning a 
profit in the BLIPS transaction, yet both continued to issue and stand 
behind an opinion letter attesting to what both knew was an inaccurate 
factual representation.
---------------------------------------------------------------------------
    BLIPS was constructed so that the potential for client 
profit from the BLIPS transactions increased significantly if 
the client participated in all three phases of the BLIPS loan, 
which required a full 7 years to finish. The head of DPP-Tax 
observed that KPMG had drafted a factual representation for 
inclusion in the prototype BLIPS tax opinion letter stating 
that, ``The original intent of the parties was to participate 
in all three investment stages of the Investment Program.'' He 
cautioned against including this factual representation in the 
opinion letter: ``It seems to me that this [is] a critical 
element of the entire analysis and should not be blithely 
assumed as a `fact.' . . . I would caution that if there were, 
say, 50 separate investors and all 50 bailed out at the 
completion of Stage I, such a representation would not seem 
credible.'' 220
---------------------------------------------------------------------------
    \220\ Email dated 4/14/99, from Larry DeLap to multiple KPMG tax 
professionals, ``RE: BLIPS,'' Bates KPMG 0017578-79.
---------------------------------------------------------------------------
    The proposed representation was not included in the final 
version of the BLIPS prototype opinion letter, and the actual 
BLIPS track record supported the cautionary words of the DPP 
head. In 2000, the KPMG tax partner in charge of WNT wrote:

        ``Lastly, an issue that I am somewhat reluctant to 
        raise but I believe is very important going forward 
        concerns the representations that we are relying on in 
        order to render our tax opinion in BLIPS I. In each of 
        the 66 or more deals that were done at last year, our 
        clients represented that they `independently' reviewed 
        the economics of the transaction and had a reasonable 
        opportunity to earn a pretax profit. . . . As I 
        understand the facts, all 66 closed out by year-end and 
        triggered the tax loss. Thus, while I continue to 
        believe that we can issue the tax opinions on the BLIPS 
        I deals, the issue going forward is can we continue to 
        rely on the representations in any subsequent deals if 
        we go down that road? . . . My recommendation is that 
        we deliver the tax opinions in BLIPS I and close the 
        book on BLIPS and spend our best efforts on alternative 
        transactions.'' 221
---------------------------------------------------------------------------
    \221\ Email dated 2/24/00, from Philip Wiesner to multiple KPMG tax 
professionals, ``RE: BLIPS/OPIS,'' Bates KPMG 0011789.

    This email and other documentation indicate that KPMG was 
well aware that the BLIPS transactions were of limited duration 
and uniformly produced substantial tax losses that 
``investors'' used to offset and shelter other income from 
taxation.222 This growing factual record, showing 
that BLIPS investors invariably lost money, made it 
increasingly difficult for KPMG to rely on an alleged client 
representation about BLIPS' having a reasonable profit 
potential. KPMG nevertheless continued to sell the product and 
to issue tax opinion letters relying on a critical client 
representation that KPMG had drafted without client input and 
attributed to its clients, but which KPMG knew or had reason to 
know, was unsupported by the facts.
---------------------------------------------------------------------------
    \222\ Email dated 5/4/99, from Mark Watson, WNT, to Larry DeLap, 
DPP, Bates KPMG 0011916. See also document dated 5/18/01, ``PFP 
Practice Reorganization Innovative Strategies Business Plan--DRAFT,'' 
authored by Jeffrey Eischeid, Bates KPMG 0050620-23, at 1-2 (referring 
to BLIPS and its predecessors, FLIP and OPIS, as a ``capital loss 
strategy,'' ``loss generator'' or ``gain mitigation solution'').
---------------------------------------------------------------------------
    Discontinuing Sales. Still another KPMG implementation 
issue involves decisions by KPMG to stop selling particular tax 
products. In all four of the case studies examined by the 
Subcommittee, KPMG stopped marketing the tax product within 1 
or 2 years of its first sale.223 The decision was 
made in each case by the head of DPP-Tax, after consultation 
with the product's Deployment Champion and other senior tax 
professionals.
---------------------------------------------------------------------------
    \223\ See, e.g., email dated 12/29/01, from Larry DeLap to multiple 
KPMG tax professionals, ``FW: SC2,'' Bates KPMG 0050562 (discontinuing 
SC2); email dated 10/1/99, from Larry DeLap to multiple KPMG tax 
professionals, ``BLIPS,'' Bates KPMG 0011716 (discontinuing BLIPS); 
email dated 12/7/98, from Larry DeLap to multiple KPMG tax 
professionals, ``OPIS,'' Bates KPMG 0025730 (discontinuing OPIS).
---------------------------------------------------------------------------
    When asked to explain why sales were discontinued, the DPP 
head offered several reasons for pulling a tax product off the 
market.224 The DPP head stated that he sometimes 
ended the marketing of a tax product out of concern that a 
judge would invalidate the tax product ``as a step 
transaction,'' using evidence that a number of persons who 
purchased the product engaged in a series of similar 
transactions.225 Limiting the number of tax products 
sold limited the evidence that each resulted in a similar set 
of transactions orchestrated by KPMG. Limiting the number of 
tax products sold also limited information about them to a 
small circle and made it more difficult for the IRS to detect 
the activity.226
---------------------------------------------------------------------------
    \224\ Subcommittee interview of Lawrence DeLap (10/30/03).
    \225\ Id.
    \226\ See Section VI(B)(4) of this Report on ``Avoiding 
Detection.''
---------------------------------------------------------------------------
    Evidence in the four case studies shows that internal KPMG 
directives to stop sales of a particular tax product were, at 
times, ignored or circumvented by KPMG tax professionals 
marketing the products. For example, the DPP head announced an 
end to BLIPS sales in the fall of 1999, but allowed KPMG tax 
professionals to complete numerous BLIPS sales in 1999 and 
2000, to persons who had been approached before the marketing 
ban was announced.227 These purchasers were referred 
to internally at KPMG as ``grandfathered BLIPS'' 
clients.228 A handful of additional sales took place 
in 2000, over the objection of the DPP head, after his 
objection was overruled by head of the Tax Services 
Practice.229 Also in 2000, some KPMG tax 
professionals attempted to restart BLIPS sales by developing a 
modified BLIPS product that would be sold to only extremely 
wealthy individuals.230 This effort was ultimately 
unsuccessful in restarting BLIPS sales.
---------------------------------------------------------------------------
    \227\ See, e.g., email dated 10/13/99, from Carl Hasting to Dale 
Baumann, ``RE: Year 2000 Blips Transactions,'' Bates KPMG 0006485 (``I 
thought we were told to quit marketing 200[0] BLIPS transactions.''); 
email dated 10/13/99, from Dale Baumann to Carl Hasting and others, 
``RE: Year 2000 Blips Transactions,'' Bates KPMG 0006485 (``No 
marketing to clients who were not on the BLIPS 2000 list. The BLIPS 
2000 list were for those individuals who we approached before Larry 
told us to stop marketing the strategy. . . .'').
    \228\ See, e.g., two emails dated 10/1/99, from Larry DeLap to 
multiple KPMG tax professionals, ``BLIPS,'' Bates KPMG 0011714.
    \229\ Subcommittee interview of Lawrence DeLap (10/30/03).
    \230\ See, e.g., email dated 6/20/00, from William Boyle of 
Deutsche Bank to other Deutsche Bank personnel, ``Updated Presidio/KPMG 
trades,'' Bates DB BLIPS 03280 (``Presidio and KPMG are developing an 
expanded version of BLIP's which it will execute on a limited basis for 
its wealthy clientele. They anticipate executing approximately 10-15 
deals of significant size (i.e. in the $100-300m. Range).'').
---------------------------------------------------------------------------
    In the case of SC2, KPMG tax professionals simply did not 
comply with announced limits on the total number of SC2 
products that could be sold or limits on the use of 
telemarketing calls to market the product.231 In the 
case of FLIP and OPIS, additional sales, again, took place 
after the DPP head had announced an end to the marketing of the 
products.232 The DPP head told Subcommittee staff 
that when he discontinued BLIPS sales in 1999, he was pressed 
by the BLIPS National Deployment Champion and others for an 
alternative product.233 The DPP head indicated that, 
because of this pressure, he relented and allowed KPMG tax 
professionals to resume sales of OPIS, which he had halted a 
year earlier.
---------------------------------------------------------------------------
    \231\ See Section VI(B)(2) of this Report on ``Mass Marketing Tax 
Products.'' See also, e.g., email dated 4/23/01, from John Schrier to 
Thomas Crawford, ``RE: SC2 target list,'' Bates KPMG 0050029; email 
dated 12/20/01, from William Kelliher to David Brockway, ``FW: SC2,'' 
Bates KPMG 0013311; and email response dated 12/29/01, from Larry DeLap 
to William Kelliher, David Brockway, and others, ``FW: SC2,'' Bates 
KPMG 0013311.
    \232\ See, e.g., email dated 9/30/99, from Jeffrey Eischeid to 
Wolfgang Stolz and others, ``OPIS,'' Bates QL S004593.
    \233\ Subcommittee interview of Lawrence DeLap (10/30/03).
---------------------------------------------------------------------------

    (b) Role of Third Parties in Implementing KPMG Tax Products

    FLIP, OPIS, BLIPS, and SC2 could not have been executed 
without the active and willing participation of the banks, 
investment advisors, lawyers, and charitable organizations that 
made these products work. The roll call of respected 
professional firms with direct and extensive involvement in the 
four KPMG case studies includes Deutsche Bank, HVB, NatWest, 
UBS, Wachovia Bank, and Sidley Austin, Brown & Wood. Smaller 
professional firms such as Quellos, and charitable 
organizations such as the Los Angeles Department of Fire & 
Police Pensions and the Austin Fire Fighters Relief and 
Retirement Fund, while less well known nationally, are 
nevertheless respected institutions who played critical roles 
in the execution of at least one of the four tax products.

          LFinding: Some major banks and investment advisory 
        firms have provided critical lending or investment 
        services or participated as essential counter parties 
        in potentially abusive or illegal tax shelters sold by 
        KPMG, in return for substantial fees or profits.

    The Role of the Banks. Five major banks participated in 
BLIPS, FLIP, and OPIS. Deutsche Bank participated in more than 
50 BLIPS transactions in 1999 and 2000, providing credit lines 
that totaled as much as $2.8 billion.234 Deutsche 
Bank also participated in about 60 OPIS transactions in 1998 
and 1999. HVB participated in more than 30 BLIPS transactions 
in 1999 and 2000, providing BLIPS credit lines that apparently 
totaled nearly $2.5 billion.235 NatWest apparently 
also participated in a significant number of BLIPS transactions 
in 1999 and 2000, providing credit lines totaling more than $1 
billion.236 UBS AG participated in 100-150 FLIP and 
OPIS transactions in 1997 and 1998, providing credit lines 
which, in the aggregate, were in the range of several billion 
Swiss francs.237
---------------------------------------------------------------------------
    \234\ See, e.g., email dated 6/20/00, from William Boyle of 
Deutsche Bank to other Deutsche Bank personnel, ``Updated Presidio/KPMG 
trades,'' Bates DB BLIPS 03280; chart entitled, ``Presidio Advisory 
Services. Deal List 1999,'' Bates HVB000875 (BLIPS transactions for 
1999); chart entitled, ``Presidio Advisory Services. Deal List 2000,'' 
Bates HVCD00018-19 (BLIPS transactions for 2000).
    \235\ See, e.g., memorandum dated 8/19/03 (this date is likely in 
error), from Ted Wolf and Sylvie DeMetrio to Christopher Thorpe and 
others, ``Presidio,'' Bates HVCD 00001; chart entitled, ``Presidio 
Advisory Services. Deal List 1999,'' Bates HVB000875 (BLIPS 
transactions for 1999); chart entitled, ``Presidio Advisory Services. 
Deal List 2000,'' Bates HVCD00018-19 (BLIPS transactions for 2000). See 
also credit request dated 1/6/00, Bates HVB 003320-30 (seeking approval 
of $1.5 billion credit line for 2000, and noting that, in 1999, the 
bank ``booked USD 950 million (out of USD 1.03 billion approved) . . . 
all cash collateralized.'')
    \236\ See, e.g., email dated 6/20/00, from William Boyle of 
Deutsche Bank to other Deutsche Bank personnel, ``Updated Presidio/KPMG 
trades,'' Bates DB BLIPS 03280.
    \237\ See, e.g., UBS memorandum dated 12/21/99, from Teri Kemmerer 
Sallwasser to Gail Fagan, ``Boss Strategy Meetings . . .,'' Bates SEN-
018253-57; Subcommittee interview of UBS representatives (4/4/03).
---------------------------------------------------------------------------
    Two investment advisory firms also participated in the 
development, marketing and implementation of BLIPS, FLIP, and 
OPIS. Quellos participated in the development, marketing, and 
execution of FLIP. It participated in over 80 FLIP transactions 
with KPMG, as well as similar number of these transactions with 
PricewaterhouseCoopers and Wachovia Bank. It also executed some 
OPIS transactions for KPMG. Presidio participated in the 
development, marketing, and implementation of OPIS and BLIPS 
transactions, including the 186 BLIPS transactions related to 
186 KPMG clients.238 The Presidio principals even 
conducted a BLIPS transaction on their own 
behalf.239
---------------------------------------------------------------------------
    \238\ See, e.g., email dated 3/14/98, from Jeff Stein to Robert 
Wells, John Lanning, Larry DeLap, Gregg Ritchie, and others, ``Simon 
Says,'' Bates 638010, filed by the IRS on June 16, 2003, as an 
attachment to Respondent's Requests for Admission, Schneider Interests 
v. Commissioner, U.S. Tax Court, Docket No. 200-02, (describing the 
role of Presidio principal, Robert Pfaff, in the development of OPIS); 
Subcommittee interviews of John Larson (10/3/03 and 10/21/03).
    \239\ Subcommittee interviews of John Larson (10/3/03 and 10/21/
03). Presidio discussed completing a BLIPS transaction on its own 
behalf with the assistance of HVB, but ultimately completed the 
transaction elsewhere. See, e.g., ``Corporate Banking Division--Credit 
Request'' dated 9/14/99, Bates HVB 000147-64; ``Corporate Banking 
Division--Credit Request'' dated 4/28/00, Bates HVB 004148-51; 
memorandum dated 9/14/99, from Robert Pfaff of Presidio to Dom 
DiGiorgio of HVB, ``BLIPS loan test case,'' Bates HVB 000202; chart 
dated 9/14/99 entitled, ``Presidio Ownership Structure,'' Bates HVB 
000215; undated document entitled, ``Structural Differences in the 
Transaction for Presidio Principals,'' Bates HVCD 00007; undated 
diagrams depicting BLIPS loans to Presidio principals, Bates HVB 
004272-75.
---------------------------------------------------------------------------
    The banks and investment advisory firms interviewed by the 
Subcommittee staff acknowledged obtaining lucrative fees for 
their participation in FLIP, OPIS, or BLIPS. Deutsche Bank 
internal documents state that the bank earned more than $33 
million from OPIS and expected to earn more than $30 million 
for BLIPS.240 HVB earned over $5.45 million for the 
BLIPS transactions it completed in less than 3 months in 1999, 
and won approval of increased BLIPS transactions throughout 
2000, ``based on successful execution of previous transactions, 
low credit risk and excellent profitability.'' 241
---------------------------------------------------------------------------
    \240\ See undated document entitled, ``New Product Committee 
Overview Memo: BLIPS Transaction,'' Bates DB BLIPS 01959; email dated 
4/28/99, from Francesco Piovanetti to Nancy Donohue, ``presidio--w. 
revisions, I will call u in 1 min.,'' Bates DB BLIPS 6911.
    \241\ See HVB credit request dated 1/6/00, Bates HVB 003320-30 (HVB 
``earned USD 4.45 million'' from BLIPS loan fees and ``approximately 
USD 1 million'' from related foreign exchange activities for BLIPS 
transactions completed from October to December 1999); HVB document 
dated 8/6/00, from Thorpe, marked ``DRAFT,'' Bates HVB 001805.
---------------------------------------------------------------------------
    The Subcommittee interviewed four of the five banks, most 
of which cooperated with the inquiry and were generally open 
and candid about their interactions with KPMG, their 
understanding of FLIP, OPIS, and BLIPS, and their respective 
roles in these tax products. Evidence obtained by the 
Subcommittee shows that the banks knew they were participating 
in transactions whose primary purpose was to provide tax 
benefits to persons who had purchased tax products from KPMG. 
Some of the documentation also make it plain that the bank was 
aware that the tax product was potentially abusive and carried 
a risk to the reputation of any bank choosing to participate in 
it.
    For example, a number of Deutsche Bank documents make it 
clear that the bank knew BLIPS was a tax related transaction 
and posed a reputational risk to the bank if the bank chose to 
participate in it. One Deutsche Bank official working to obtain 
bank approval to participate in BLIPS wrote:

        ``In this transaction, reputation risk is tax related 
        and we have been asked by the Tax Department not to 
        create an audit trail in respect of the Bank's tax 
        affaires. The Tax department assumes prime 
        responsibility for controlling tax related risks 
        (including reputation risk) and will brief senior 
        management accordingly. We are therefore not asking R&R 
        [Reputation & Risk] Committee to approve reputation 
        risk on BLIPS. This will be dealt with directly by the 
        Tax Department and [Deutsche Bank Chief Executive 
        Officer] John Ross.'' 242
---------------------------------------------------------------------------
    \242\ Email dated 7/30/99, from Ivor Dunbar of Deustche Bank, DMG 
UK, to multiple Deutsche Bank professionals, ``Re: Risk & Resources 
Committee Paper--BLIPS,'' unreadable Bates number. See also email dated 
7/29/99 from Mick Wood to Francesco Piovanetti and other Deutsche bank 
personnel, ``Re: Risk & Resources Committee Paper--BLIPS,'' Bates DB 
BLIPS 6556 (paper prepared for the Risk & Resources Committee ``skirts 
around the basic issue rather than addressing it head on (the tax 
reputational risk).'').

    Another Deutsche Bank memorandum, prepared for the ``New 
Product Committee'' to use in reviewing BLIPS, included the 
---------------------------------------------------------------------------
following statements explaining the transaction:

        ``BLIPS will be marketed to High Net Worth Individual 
        Clients of KPMG. . . . Loan conditions will be such as 
        to enable DB to, in effect, force (p)repayment after 60 
        days at its option. . . . For tax and accounting 
        purposes, repaying the [loan] premium amount will 
        `count' '' like a loss for tax and accounting purposes. 
        . . . At all times, the loan will maintain collateral 
        of at least 101% to the loan + premium amount. . . . It 
        is imperative that the transaction be wound up after 
        45-60 days and the loan repaid due to the fact that the 
        HNW individual will not receive his/her capital loss 
        (or tax benefit) until the transaction is wound up and 
        the loan repaid. . . . At no time will DB Private Bank 
        provide any tax advice to any individuals involved in 
        the transactions. This will be further buttressed by 
        signed disclaimers designed to protect and `hold 
        harmless' DB. . . . DB has received a legal opinion 
        from Shearman & Sterling which validates our envisaged 
        role in the transaction and sees little or no risk to 
        DB in the trade. Furthermore opinions have been issued 
        from KPMG Central Tax department and Brown & Wood 
        attesting to the soundness of the transactions from a 
        tax perspective.'' 243
---------------------------------------------------------------------------
    \243\ Undated document entitled, ``New Product Committee Overview 
Memo: BLIPS Transaction,'' Bates DB BLIPS 01959-63.

Still another Deutsche Bank document states: ``For tax and 
accounting purposes, the [loan] premium amount will be treated 
as a loss for tax purposes.'' 244
---------------------------------------------------------------------------
    \244\ Email dated 7/1/99 from Francesco Piovanetti to Ivor Dunbar, 
`` `Hugo' BLIPS Paper,'' with attachment entitled, ``Bond Linked 
Indexed Premium Strategy `BLIPS,' '' Bates DB BLIPS 6585-87 at 6587.
---------------------------------------------------------------------------
    Bank documentation indicates that a number of internal bank 
departments, including the tax, accounting, and legal 
departments, were asked to and did approve the bank's 
participation in BLIPS. BLIPS was also brought to the attention 
of the bank's Chief Executive Officer John Ross who made the 
final decision on the bank's participation.245 
Minutes describing the meeting in which Mr. Ross approved the 
bank's participation in BLIPS state:
---------------------------------------------------------------------------
    \245\ See email dated 10/13/99, from Peter Sturzinger to Ken Tarr 
and other Deutsche Bank personnel, ``Re: BLIPS,'' attaching minutes 
dated 8/4/99, from a ``Deutsche Bank Private Banking, Management 
Committee Meeting'' that discussed BLIPS, Bates DB BLIPS 6520-6521.

        ``[A] meeting with John Ross was held on August 3, 1999 
        in order to discuss the BLIPS product. [A bank 
        representative] represented [Private Banking] 
        Management's views on reputational risk and client 
        suitability. John Ross approved the product, however 
        insisted that any customer found to be in litigation be 
        excluded from the product, the product be limited to 25 
        customers and that a low profile be kept on these 
        transactions. . . . John Ross also requested to be kept 
        informed of future transactions of a similar nature.'' 
        246
---------------------------------------------------------------------------
    \246\ Id. at 6520.

Given the extensive and high level attention provided by the 
Bank regarding its participation in BLIPS, it seems clear that 
the bank had evaluated BLIPS carefully and knew what it was 
getting into.
    Other evidence shows that Deutsche Bank was aware that the 
BLIPS loans were not run-of-the-mill commercial loans, but had 
unusual features. Deutsche Bank refused, for example, to sign a 
letter representing that the BLIPS loan structure, which 
included an unusual multi-million dollar ``loan premium'' 
credited to a borrower's account at the start of the 
loan,247 was consistent with ``industry standards.'' 
The BLIPS National Deployment Champion had asked the bank to 
make this representation to provide ``comfort that the loan was 
being made in line with conventional lending practices.'' 
248 When the bank declined to make the requested 
representation, the BLIPS National Deployment Champion tried a 
second time, only to report to his colleagues: ``The bank has 
pushed back again and said they simply will not represent that 
the large premium loan is consistent with industry standards.'' 
249 He tried a third time and reported: ``I've 
pushed really hard for our original language. To say they are 
resisting is an understatement.'' 250 The final tax 
opinion letter issued by KPMG contained compromise language 
which said little more than the loan complied with the bank's 
own procedures: ``The loan . . . was approved by the competent 
authorities within [the Bank] as consistent, in the light of 
all the circumstances such authorities consider relevant, with 
[the Bank's] credit and documentation standards.'' 
251
---------------------------------------------------------------------------
    \247\ See Appendix A.
    \248\ Email dated 3/20/00, from Jeffrey Eischeid to Mark Watson, 
``Bank representation,'' Bates KPMG 0025754.
    \249\ Email dated 3/27/00, from Jeffrey Eischeid to Richard Smith, 
``Bank representation,'' Bates KPMG 0025753.
    \250\ Email dated 3/28/00, from Jeffrey Eischeid to Mark Watson, 
``Bank representation,'' Bates KPMG 0025753.
    \251\ KPMG prototype tax opinion letter on BLIPS, dated 12/31/99, 
at 11.
---------------------------------------------------------------------------
    A year after Deutsche Bank began executing BLIPS 
transactions, a key bank official handling these transactions 
wrote an email which acknowledged the ``tax benefits'' 
associated with BLIPS and noted, again, the reputational risk 
these transactions posed to the bank:

        ``During 1999, we executed $2.8b. of loan premium deals 
        as part of the BLIP's approval process. At that time, 
        NatWest and [HVB] had executed approximately $0.5 b. of 
        loan premium deals. I understand that we based our 
        limitations on concerns regarding reputational risk 
        which were heightened, in part, on the proportion of 
        deals we have executed relative to the other banks. 
        Since that time, [HVB], and to a certain extent 
        NatWest, have participated in approximately an 
        additional $1.0-1.5 b. of grandfathered BLIP's deals. . 
        . . [HVB] does not have the same sensitivity to and 
        market exposure as DB does with respect to the 
        reputational risk from making the high-coupon loan to 
        the client. . . . As you are aware, the tax benefits 
        from the transaction potentially arise from a 
        contribution to the partnership subject to the high-
        coupon note and not from the execution of FX positions 
        in the partnership, activities which we perform in the 
        ordinary course of our business.'' 252
---------------------------------------------------------------------------
    \252\ Email dated 6/20/00, from William Boyle to multiple Deutsche 
Bank professionals, ``Updated Presidio/KPMG trades,'' Bates DB BLIPS 
03280.

    This document shows that Deutsche Bank was fully aware of 
and had a sophisticated understanding of the tax aspects of 
BLIPS. To address the issue of reputational risk, the email 
went on to propose that, because HVB had a limited capacity to 
issue more BLIPS loans, and Deutsche Bank did not want to 
expose itself to increased reputational risk by making 
additional direct loans to BLIPS clients, ``we would like to 
lend an amount of money to [HVB] equal to the amount of money 
[HVB] lends to the client. . . . We would like tax department 
approval to participate in the aforementioned more complex 
trades by executing the underlying transactions and making 
loans to [HVB].'' In other words, Deutsche Bank wanted to be 
the bank behind HVB, financing more BLIPS loans in exchange for 
fees and other profits.
    Other Deutsche Bank documents suggest that the bank may 
have been helping KPMG find clients or otherwise marketing the 
BLIPS tax products. A November 1999 presentation by the bank's 
``Structured Finance Group,'' for example, listed BLIPS as one 
of several tax products the group was offering to U.S. and 
European clients seeking ``gain mitigation.'' 253 
The presentation listed as the bank's ``strengths'' its ability 
to lend funds in connection with BLIPS and its ``relationships 
with [the] `promoters' '' 254 later named as 
Presidio and KPMG.255 An internal bank email a few 
months earlier asked: ``What is the status of the BLIPS. Are 
you still actively marketing this product[?]'' 256
---------------------------------------------------------------------------
    \253\ Email dated 4/3/02, from Viktoria Antoniades to Brian McGuire 
and other Deutsche Bank personnel, ``US GROUP 1 Pres,'' DB BLIPS 6329-
52, attaching a presentation dated 11/15/99, entitled ``Structured 
Transactions Group North America,'' at 6336, 6346.
    \254\ Id. at 6337.
    \255\ Id. at 6346.
    \256\ Email dated 7/19/99, involving multiple Deutsche Bank 
employees, ``Update NY Issues,'' Bates DB BLIPS 6775.
---------------------------------------------------------------------------
    The same document suggests that Deutsche Bank may have been 
a tax shelter promoter in its own right. For example, the 
document indicates that, in 1999, the Structured Transactions 
Group was offering over a dozen sophisticated tax products to 
U.S. and European clients seeking to ``execute tax driven 
deals'' or ``gain mitigation'' strategies.257 The 
document indicates that Deutsche Bank was aggressively 
marketing these tax products to large U.S. corporations and 
individuals, and planning to close billions of dollars worth of 
transactions.258 At least two of the tax products 
listed by Deutsche Bank, BLIPS and the Customized Adjustable 
Rate Debt Facility (CARDS), were later determined by the IRS to 
be potentially abusive tax shelters. During the late 1990's and 
early 2000, Deutsche Bank was also involved, either directly or 
through Bankers Trust (which Deutsche Bank acquired in June 
1999), in a number of tax-driven transactions with Enron 
Corporation, including Project Steele, Project Cochise, Project 
Tomas, and Project Valhalla.259
---------------------------------------------------------------------------
    \257\ Email dated 4/3/02, from Viktoria Antoniades to Brian McGuire 
and other Deutsche Bank personnel, ``US GROUP 1 Pres,'' DB BLIPS 6329-
52, attaching a presentation dated 11/15/99, entitled ``Structured 
Transactions Group North America,'' at 6336. See also undated document 
entitled, ``Update on the Private Exchange Fund,'' Bates DB BLIPS 6433 
(describing the packaging of another tax product offered by the 
Structured Transactions Group).
    \258\ Id. at 6345-46.
    \259\ See ``Report of Investigation of Enron Corporation and 
Related Entities Regarding Federal Tax and Compensation Issues, and 
Policy Recommendations,'' Joint Committee on Taxation Staff (Report No. 
JCS-3-03, February 2003).
---------------------------------------------------------------------------
    Despite the bank's involvement in and sophisticated 
knowledge of generic tax products, when asked about BLIPS 
during a Subcommittee interview, the Deutsche Bank 
representative insisted that BLIPS was an investment strategy 
which, like all investment products, had tax implications. The 
bank representative also indicated that, despite handling BLIPS 
transactions for the bank, he did not understand the details of 
the BLIPS transactions, and downplayed any reputational risk 
that BLIPS might have posed to the bank.260
---------------------------------------------------------------------------
    \260\ Subcommittee interview of Deutsche Bank, (11/10/03).
---------------------------------------------------------------------------
    In contrast to Deutsche Bank's stance, in which its 
representative's oral information repeatedly contradicted its 
internal documentation, HVB representatives provided oral 
information that was fully consistent with the bank's internal 
documentation. HVB's representative acknowledged, for example, 
that HVB knew BLIPS had been designed and was intended to 
provide tax benefits to KPMG clients. The bank indicated that, 
at the time it became involved, it felt it had no obligation to 
refrain from participating in BLIPS, since KPMG had provided 
the bank with an opinion stating that BLIPS complied with 
federal tax law. For example, in one document seeking approval 
to provide a significant line of credit to finance BLIPS loans, 
HVB wrote this about the tax risks associated with BLIPS: 
``Disallowance of tax attributes. A review by the IRS could 
potentially result in a ruling that would disallow the [BLIPS] 
structure. . . . We are confident that none of the foregoing 
would affect the bank or its position in any meaningful way for 
the following reasons. . . . KPMG has issued an opinion that 
the structure will most likely be upheld, even if challenged by 
the IRS.'' 261 A handwritten document prepared by 
HVB personnel is even more direct. It characterizes the 7% fee 
charged to KPMG clients for BLIPS as ``paid by investor for tax 
sheltering.'' 262 This document also states that the 
bank ``amortizes premium over the life of loan for tax 
purposes.''
---------------------------------------------------------------------------
    \261\ Credit request dated 9/26/99, Bates HVB 001166.
    \262\ Undated one-page, handwritten document outlining BLIPS 
structure entitled, ``Presidio,'' which Alex Nouvakhov of HVB 
acknowledged during his Subcommittee interview had been written by him, 
Bates HVB 000204.
---------------------------------------------------------------------------
    When it became clear that the IRS would list BLIPS as an 
abusive tax shelter, an internal HVB memorandum again 
acknowledged that BLIPS was a tax transaction and ordered a 
halt to financing the product, while disavowing any liability 
for the bank's role in carrying out the BLIPS transactions:

        ``[I]t is clear that the tax benefits for individuals 
        who have participated in the [BLIPS] transaction will 
        not be grandfathered because Treasury believe that 
        their actions were contrary to current law. . . . It is 
        not likely that KPMG/Presidio will go forward with 
        additional transactions. . . . As we have stated 
        previously, we anticipate no adverse consequences for 
        the HVB since we have not promoted the transaction. We 
        have simply been a lender and nothing in the notice 
        implies a threat to our position.

        ``In view of the tone of the notice we will not book 
        any new transactions and will cancel our existing 
        unused [credit] lines prior to the end of this month.'' 
        263
---------------------------------------------------------------------------
    \263\ Memorandum dated 8/16/00, from Dom DeGiorgio and Richard 
Pankuch to Christopher Thorpe and others, ``Presidio BLIPS 
Transactions,'' Bates HVB 003346.

    HVB's representative explained to the Subcommittee staff 
that the apparent bank risk in lending substantial sums to a 
shell corporation had been mitigated by the terms of the BLIPS 
loan which gave the bank virtually total control over the BLIPS 
loan proceeds and enabled the bank to ensure the loan and loan 
premium would be repaid.264 The bank explained, for 
example, that from the start of the loan, the borrower was 
required to maintain collateral equal to 101% of the loan 
proceeds and loan premium and could place these funds only in a 
narrow range of bank-approved investments.265 That 
meant the bank treated not only all of the loan proceeds and 
loan premium as collateral, but also additional funds supplied 
by the KPMG client to meet the 101% collateral requirement. HVB 
wrote: ``We are protected in our documentation through a 
minimum overcollateralization ratio of 1.0125 to 1 at all 
times. Violation of this ratio triggers immediate acceleration 
under the loan agreements without notice.'' 266 HVB 
also wrote: ``The Permitted Investments . . . are either 
extremely conservative in nature . . . or have no collateral 
value for margin purposes.'' 267 KPMG put it this 
way: ``Lender holds all cash as collateral in addition to being 
custodian and clearing agent for Partnership. . . . All 
Partnership trades can only be executed through Lender or an 
affiliate. . . . Lender must authorize trades before 
execution.'' 268
---------------------------------------------------------------------------
    \264\ Subcommittee interview of HVB representative (10/29/03).
    \265\ See, e.g., email dated 10/29/99, from Richard Pankuch to 
Erwin Volt, ``KWG I capital treatment for our Presidio Transaction,'' 
Bates HVB 000352 (``Our structure calls for all collateral to be placed 
in a collateral account pledged to the bank.''); email dated 9/24/99, 
from Richard Pankuch to Christopher Thorpe and other HVB professionals, 
``Re: Presidio,'' Bates HVB 000682 (``all collateral is in our own 
hands and subject to the Permitted Investment requirement''). Compare 
undated Deutsche Bank document, likely prepared in 1999, ``New Product 
Committee Overview Memo: BLIPS Transaction,'' Bates DB BLIPS 01959-63, 
at 1961 (``At all times, the loan will maintain collateral of at least 
101% to the loan + loan premium amount. If the amount goes below this 
limit, the loan will be unwound and the principal + premium repaid.''); 
email dated 7/1/99, from Francesco Piovanetti to Ivor Dunbar, `` `Hugo' 
BLIPS Paper,'' with attachment entitled, ``Bond Linked Indexed Premium 
Strategy `BLIPS','' Bates HVB DB BLIPS 6885-87 (``The loan proceeds 
(par and premium) will be held in custody at DB in cash or money market 
deposits. . . . Loan conditions will be such as to enable DB to, in 
effect, force prepayment after sixty days at its option.'').
    \266\ BLIPS credit request dated 9/14/99, Bates HVB 000155. See 
also Memorandum dated 7/29/99, from William Boyle to Mick Wood and 
other Deutsche Bank personnel, ``GCI Risk and Resources Committee--
BLIPS Transaction,'' Bates DB BLIPS 06566, at 3 (The BLIPS loan ``will 
be overcollateralized and should the value of the collateral drop below 
a 1.0125:1.0 ratio, DB may liquidate the collateral immediately and 
apply the proceeds to repay amounts due under the Note and swap 
agreements.'')
    \267\ BLIPS credit request dated 9/14/99, Bates HVB 000155.
    \268\ Document dated 3/4/99, ``BLIPS--transaction description and 
checklist,'' Bates KPMG 0003933-35.
---------------------------------------------------------------------------
    Deutsche Bank and HVB were not the only banks involved in 
executing KPMG tax products. Another was Wachovia Bank, acting 
through First Union National Bank, which not only referred bank 
clients to KPMG to purchase FLIP, but also directly sold FLIP 
to many of its clients, and considered becoming involved with 
BLIPS and SC2 as well.269 A 1999 Wachovia internal 
email demonstrates that the bank was fully aware that it was 
being asked to facilitate transactions designed to reduce or 
eliminate tax liability for KPMG clients:
---------------------------------------------------------------------------
    \269\ See Section VI(2) of this Report for discussion of Wachovia's 
client referral activities.

        ``[A] KPMG investment/tax strategy . . . was voted and 
        approved by the due diligence subcommittee last week. 
        This means that the Risk Oversight Committee will have 
        this particular strategy on its agenda at its Wednesday 
        meeting. . . . The strategy will service to offset 
        either ordinary income or capital gains ($20 million 
---------------------------------------------------------------------------
        minimum).

        ``There are several critical points that should be 
        noted with respect to this strategy if we get it 
        approved. Many of these points related to Sandy Spitz' 
        concern (and KPMG's concern) that First Union has a 
        very high profile across our franchise for being 
        associated with `tax' strategies: namely, FLIP and 
        BOSS. Sandy does not want this kind of high profile to 
        be associated with this new strategy.

        ``In order to address some of Sandy's concerns and 
        lower our profile . . .

          ``* The strategy has an KPMG acronym which will not 
        be shared with the general First Union community. We 
        will probably assign a generic name. . . .

          ``* No one-pager will be distributed to our referral 
        sources describing the strategy. . . .

          ``* Fees to First Union will be 50 basis points if 
        the investor is not a KPMG client, 25 bps if they are a 
        KPMG client. . . .

        ``I have written up a technical summary of the tax 
        opinion since Sandy will only allow us to read a draft 
        copy of the opinion in his office without making a 
        copy.'' 270
---------------------------------------------------------------------------
    \270\ Email dated 8/30/99, from Tom Newman to multiple First Union 
professionals, ``next strategy,'' Bates SEN-014622.

Clearly, First Union was well aware that it was handling 
products intended to help clients reduce or eliminate their 
taxes and was worried about its own high profile from being 
``associated with `tax' strategies'' like FLIP.
    In addition to its participation in KPMG-developed tax 
products, First Union helped develop and market the BOSS tax 
product sold by PricewaterhouseCoopers (``PWC''), which was 
later determined by the IRS to be a potentially abusive tax 
shelter. First Union had in its files the following document 
advocating the bank's involvement with BOSS:

        ``The proposed transaction takes advantage of an 
        anomaly in current tax law which we expect will be 
        closed down by legislation as soon as Congress finds 
        out about it. We make this investment available only to 
        select clients in order to limit the number of people 
        who know about it. We hope that will delay the time 
        Congress finds out about it, but at some point, it is 
        likely that they will find out and enact legislation to 
        shut it down. First Union acts as sales agent for PwC 
        with respect to this transaction, since the bankers are 
        in a very good position to know when a client has 
        entered into a significant transaction which might have 
        generated significant taxable income. 
        PricewaterhouseCoopers would provide a Tax Opinion 
        Letter which would say that if the entity were examined 
        by the IRS, the transaction would `more likely than 
        not' be successfully upheld.'' 271
---------------------------------------------------------------------------
    \271\ Memorandum dated 12/21/99, from Teri Kemmerer Sallwasser to 
Gail Fagan, ``Boss Strategy Meetings . . .'' Bates SEN-018253-57.

This document provides additional, unmistakable evidence that 
First Union knew it was participating in transactions whose 
primary purpose was to reduce or eliminate clients' taxes.
    Still another bank that handled KPMG tax products is UBS 
AG, now one of the largest banks in the world. UBS was 
convinced by Quellos and KPMG to participate in numerous FLIP 
and OPIS transactions in 1997 and 1998, referred to 
collectively by UBS as ``redemption transactions.''
    UBS documentation clearly and repeatedly describes these 
transactions as tax-related. For example, one UBS document 
explaining the transactions is entitled: ``U.S. Capital Loss 
Scheme--UBS `redemption trades.' '' It states:

        ``The essence of the UBS redemption trade is the 
        creation of a capital loss for U.S. tax purposes which 
        may be used by a U.S. tax resident to off-set any 
        capital gains tax liability to which it would otherwise 
        be subject. The tax structure was originally devised by 
        KPMG. . . . In October 1996, UBS was approached jointly 
        by Quadra . . . and KPMG with a view to it seeking UBS' 
        participation in a scheme that implemented the tax loss 
        structure developed by KPMG. The role sought of UBS was 
        one purely of execution counterparty. . . . It was 
        clear from the outset--and has been continually 
        emphasised since--that UBS made no endorsement of the 
        scheme and that its connection with the structure 
        should not imply any implicit confirmation by UBS that 
        the desired tax consequences will be recognized by the 
        U.S. tax authorities. . . . UBS undertook a thorough 
        investigation into the propriety of its proposed 
        involvement in these transactions. The following steps 
        were undertaken: [redacted by UBS as `privileged 
        material'].'' 272
---------------------------------------------------------------------------
    \272\ UBS internal document dated 3/1/99, ``Equities Large/Heavily 
Structured Transaction Approval,'' with attachment entitled, ``U.S. 
Capital Loss Scheme--UBS `redemption trades,' '' Bates UBS 000009-15.

At another point, the UBS document explains the ``Economic 
Rationale'' for redemption transactions to be: ``Tax benefit 
for client,'' 273 while still another UBS document 
states: ``The motivation for this structure is tax optimisation 
for U.S. tax residents who are enjoying capital gains that are 
subject to U.S. tax. The structure creates a capital loss from 
a U.S. tax point of view (but not from an economic point of 
view) which may be offset against existing capital gains.'' 
274
---------------------------------------------------------------------------
    \273\ Id. at UBS 000010.
    \274\ UBS internal document dated 11/13/97, ``Description of the 
UBS `Redemption' Structure,'' Bates UBS 000031.
---------------------------------------------------------------------------
    In February 1998, an unidentified UBS ``insider'' sent a 
letter to UBS management in London ``to let you know that [UBS 
unit] Global Equity [D]erivatives is currently offering an 
illegal capital gains tax evasion scheme to US tax payers,'' 
meaning the redemption transactions. The letter continued:

        ``This scheme is costing the US Internal Revenue 
        [S]ervice several hundred million dollars a year. I am 
        concerned that once IRS comes to know about this scheme 
        they will levy huge financial/criminal penalties on UBS 
        for offering tax evasion schemes. . . . In 1997 several 
        billion dollars of this scheme was sold to high 
        networth US tax payers, I am told that in 1998 the plan 
        is continu[ing] to market this scheme and to offer 
        several new US tax avoidance schemes involving swaps.

        ``My sole objective is to let you know about this 
        scheme, so that you can take some concrete steps to 
        minimise the financial and reputational damage to UBS. 
        . . .

        ``P.S. I am sorry I cannot disclose my identity at this 
        time because I don't know whether this action of mine 
        will be rewarded or punished.'' 275
---------------------------------------------------------------------------
    \275\ Letter dated 2/12/98, addressed to SBC Warburg Dillon Read in 
London, Bates UBS 000038.

In response to the letter, UBS halted all redemption trades for 
several months.276 UBS apparently examined the 
nature of the transactions as well as whether they should be 
registered in the United States as tax shelters. UBS later 
resumed selling the products, stopping only after KPMG 
discontinued the sales.277
---------------------------------------------------------------------------
    \276\ See email dated 3/27/98, from Chris Donegan of UBS to Norm 
Bontje of Quadra and others, ``Re: Redemption Trade,'' UBS 000039 
(``Wolfgang and I are presently unable to execute any redemption 
transactions on UBS stock. The main reason for this seems to be a 
concern within UBS that this trade should be registered as a tax 
shelter with the IRS.'').
    \277\ Subcommittee interview with UBS representative (10/28/03).
---------------------------------------------------------------------------
    The UBS documents show that the bank was well aware that 
FLIP and OPIS were designed and sold to KPMG clients as ways to 
reduce or eliminate their U.S. tax liability. The bank 
apparently justified its participation in the transactions by 
reasoning that its participation did not signify its 
endorsement of the transactions and did not constitute aiding 
or abetting tax evasion. The bank then proceeded to provide the 
financing that made these tax products possible.
    The Role of the Investment Advisors. Bank personnel were 
not the only financial professionals assisting KPMG with BLIPS, 
FLIP, and OPIS. Investment experts also played key roles in 
designing, marketing, and implementing the three tax products, 
working closely with KPMG tax professionals throughout the 
process. For example, the investment experts involved with 
BLIPS, FLIP, and OPIS helped KPMG with designing the specific 
financial transactions, making client presentations, obtaining 
financing from the banks, preparing the transactional 
documents, establishing the required shell corporations and 
partnerships, and facilitating the completion of individual 
client transactions. In the case of FLIP, investment experts at 
Quellos, then known as Quadra, provided these services. In the 
case of OPIS, both Quellos and Presidio provided these 
services. In the case of BLIPS, these services were generally 
provided by Presidio.
    A memorandum sent by a Quellos investment expert to a 
banker at UBS explained the investment company's role in FLIP 
and the nature of the tax product itself as follows:

        ``KPMG approached us as to whether we could affect the 
        security trades necessary to achieve the desired tax 
        results. I indicated that I felt we could and they are 
        currently not looking elsewhere for assistance in 
        executing the transaction.

        ``The tax opportunity created is extremely complex, and 
        is really based more on the structuring of the entities 
        involved in the securities transactions rather than the 
        securities transactions themselves. KPMG has assured me 
        that prior to spending much time, beyond just 
        conceptually seeing if we can do it, they would provide 
        Quadra and any counterparty (UBS) with the necessary 
        legal opinions and representatives letters as to why 
        they are recommending this transaction to their 
        clients. Assuming their tax analysis is complete, our 
        challenge is to design a series of securities/
        derivatives trades that meet the required objectives.

        ``In summary, this tax motivated transaction is 
        designed for U.S. companies requiring a tax loss. The 
        way this loss is generated is through the U.S. company 
        exercising a series of options to acquire majority 
        ownership in a Foreign investment (Fund). The tax 
        benefits are created for U.S. Co. based on the types of 
        securities transactions done in the foreign investment 
        Fund and shifting the cost basis to the parent U.S. 
        Company. . . .

        ``If a U.S. company/individual has a $100 million 
        dollar capital gain they owe taxes, depending on their 
        tax position, ranging from $28 million to $35 million. 
        As a result, they are more than willing to pay $2 to $4 
        million to generate a tax loss to offset the capital 
        gain and corresponding taxes. . . .

        ``I have told KPMG that we should be able to execute 
        the transaction once they have a commitment from a 
        potential client. KPMG has already had a number of 
        preliminary meetings with potential clients and one of 
        their challenges was to identify a party that can 
        manage the Fund level and facilitate the transactions 
        with Foreign Co. Given your ability to act as Foreign 
        Co., and facilitate the securities trades, I have told 
        them to stop looking. Once they have a firm client, 
        then we can map out the various details to execute the 
        transaction.'' 278
---------------------------------------------------------------------------
    \278\ Memorandum dated 8/12/96, from Jeff Greenstein of Quellos to 
Wolfgang Stolz of UBS, Bates UBS 000002.

This document leaves no doubt that Quellos was fully aware that 
FLIP was a ``tax motivated transaction'' designed for companies 
or individuals ``requiring a tax loss.''
    Quellos was successful in convincing UBS to participate in 
not only FLIP, but also OPIS transactions throughout 1997 and 
1998, as described earlier. Quellos may also have been a tax 
shelter promoter in its own right. For example, in addition to 
its dealings with KPMG on FLIP and OPIS, Quellos teamed up with 
First Union National Bank and PWC to execute about 80 FLIP 
transactions for them. In addition, Quellos held discussions 
with KPMG regarding at least two tax products that Quellos 
itself had developed, but it is unclear whether sales of these 
products actually took place.279 A UBS document 
states that Quellos' ``specialty is providing tax efficient 
investment schemes for high net worth U.S. individuals and 
their investment vehicles.'' 280
---------------------------------------------------------------------------
    \279\ See, e.g., email dated 12/10/99, from Douglas Ammerman to 
multiple KPMG tax professionals, ``Innovative Strategy Development,'' 
Bates KPMG 0036736 (discusses KPMG working with Quellos on two products 
that Quellos had developed, called FORTS, a ``loss generating 
strategy,'' and WEST, a ``conversion strategy.'').
    \280\ Undated UBS internal document, ``Memorandum on USB' 
involvement in U.S. Capital Loss Generation Scheme (the `CLG 
Scheme'),'' Bates UBS 000006.
---------------------------------------------------------------------------
    Presidio played a similar role in the design, marketing, 
and implementation of OPIS and BLIPS. Two of Presidio's 
principals are former KPMG tax professionals who knew the KPMG 
tax professionals working on OPIS and BLIPS. These Presidio 
principals were repeatedly identified by KPMG as members of 
``the working group'' developing OPIS and were described as 
having contributed to the design and implementation of 
OPIS.281 Moreover, Presidio initially brought the 
idea for BLIPS to KPMG, and was thoroughly involved in the 
development, marketing, and implementation of the product. On 
May 1, 1999, prior to the final approval of BLIPS, Presidio 
representatives made a detailed presentation to KPMG tax 
professionals on how the company was planning to implement the 
BLIPS transactions.282 During the presentation, 
among other points, Presidio representatives disclosed that 
there was only a ``remote'' possibility that any investor would 
actually profit from the contemplated foreign currency 
transactions, and that the banks providing the financing 
planned to retain, under the terms of the contemplated BLIPS 
``loans,'' an effective ``veto'' over how the ``loan proceeds'' 
could be invested. These statements, among others, caused 
KPMG's key technical reviewer in the Washington National Tax 
group to reconsider his approval of the BLIPS product, in part 
because he felt he had ``not been given complete information 
about how the transaction would be structured.'' 283
---------------------------------------------------------------------------
    \281\ See , e.g., memorandum dated 3/13/98, from Robert Simon to 
Jeff Stein and Sandy Smith, all of KPMG, ``OPIS,'' Bates KPMG 0010262 
(``The attached went to the entire working group (Pfaff, Ritchie, R.J. 
Ruble of Brown & Wood, Bickham, and Larson).''); email dated 3/14/98 
from Jeff Stein to multiple KPMG tax professionals, ``Simon Says,'' 
Bates 638010, filed by the IRS on June 16, 2003, as an attachment to 
Respondent's Requests for Admission, Schneider Interests v. 
Commissioner, U.S. Tax Court, Docket No. 200-02 (``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 
[sic] and R.J. Ruble of the law firm of Brown & Wood let me know and I 
will fax it over to you as well.''). Robert Pfaff and John Larson are 
the former KPMG tax professionals who left the firm to open Presidio.
    \282\ See, e.g., email dated 5/10/99, from Mark Watson to John 
Lanning and others, ``FW: BLIPS,'' Bates MTW 0039; email dated 5/5/99, 
from Mark Watson to Larry DeLap, Bates KPMG 0011915-16. See also, e.g., 
memorandum dated 4/20/99, from Amir Makov of Presidio to John Rolfes of 
Deutsche Bank, ``BLIPS friction costs,'' Bates DB BLIPS 01977 (showing 
Presidio's role in planning the BLIPS transactions; includes statement: 
``On day 60, Investor exits partnership and unwinds all trades in 
partnership.'')
    \283\ See Section VI(B)(1) of this Report discussing the BLIPS 
development and approval process; email dated 5/10/99, from Mark Watson 
to John Lanning and others, ``FW: BLIPS,'' Bates MTW 0039.
---------------------------------------------------------------------------
    When BLIPS was eventually approved over the objections of 
the WNT technical reviewer, Presidio played a key role in 
making client presentations to sell the product and in 
executing the actual BLIPS transactions. One of the most 
important roles Presidio played in BLIPS was, in each BLIPS 
transaction, to direct two of the companies it controlled, 
Presidio Growth and Presidio Resources, to enter into a 
``Strategic Investment Fund'' partnership with the relevant 
BLIPS client. This partnership was central to the entire BLIPS 
transaction, since it was this partnership that assumed and 
repaid the purported ``loan'' that gave rise to the BLIPS 
client's ``tax loss.'' In each BLIPS transaction, a Presidio 
company acted as the managing partner for the partnership and 
contributed a small portion of the funds used in the BLIPS 
transactions. Presidio also performed administrative tasks 
that, while more mundane, were critical to the success of the 
the tax product. For example, when BLIPS was just starting to 
get underway, Presidio took several steps to facilitate the 
transactions, including stationing personnel at one of the law 
firms preparing the transactional documents.284
---------------------------------------------------------------------------
    \284\ Email dated 5/13/99, from Barbara Mcconnachie to multiple 
KPMG tax professionals, ``FW: BLIPS,'' Bates MTW 0045 (``Presidio has 2 
individuals permanently housed at Sherman & Sterling to assist in the 
necessary documentation.''). Sherman & Sterling prepared many of the 
key transactional documents for BLIPS transactions involving Deutsche 
Bank.
---------------------------------------------------------------------------
    When a problem arose indicating that currency conversions 
in two BLIPS transactions had been timed in such a way that 
they would create negative tax consequences for the BLIPS 
clients, Presidio apparently took the lead in correcting the 
``errors.'' An email sent by Presidio to HVB states:

        ``I know that Steven has talked to you regarding the 
        error for Roanoke Ventures. I have also noted an error 
        for Mobil Ventures. None of the Euro's should have been 
        converted to [U.S. dollars] in 1999. Due to the tax 
        consequences that result from these sales, it is 
        critical that these transactions be reversed and made 
        to look as though they did not occur at all.'' 
        285
---------------------------------------------------------------------------
    \285\ Email dated 12/28/99, from Kerry Bratton of Presidio to 
Alexandre Nouvakhov and Amy McCarthy of HVB, ``FX Confirmations,'' 
Bates HVB 002035.

Other documents suggest that, as Presidio requested, the 
referenced 1999 currency trades were somehow ``reversed'' and 
then executed the next month in early 2000.286 HVB 
told Subcommittee staffers that they had been unaware of this 
matter and would have to research the transactions to determine 
whether, in fact, trades or paperwork had been 
altered.287
---------------------------------------------------------------------------
    \286\ See, e.g., memorandum dated 12/23/99, from Kerry Bratton of 
Presidio to Amy McCarthy of HVB, ``Transfer Instructions,'' Bates HVB 
001699; memorandum dated 1/19/00, from Steven Buss at Presidio to Alex 
Nouvakhov at HVB, ``FX Instructions--Mobile Ventures LLC,'' Bates HVB 
001603; email dated 1/19/00, from Alex Nouvakhov at HVB to Matt Dunn at 
HVB, ``Presidio,'' Bates HVB 001601 (``We need to sell Euros for 
another Presidio account and credit their [U.S. dollar] DDA account. It 
is the same deal as the one for Roanoke you did earlier today.''); 
email dated 1/19/00, from Alex Nouvakhov at HVB to Steven Buss at 
Presidio, ``Re: mobile,'' Bates HVB 001602; memorandum dated 1/19/00, 
from Steven Buss at Presidio to Timothy Schifter at KPMG, ``Sale 
Confirmation,'' Bates HVB 001600.
    \287\ Subcommittee interview of HVB bank representatives (10/29/
03).
---------------------------------------------------------------------------
    Presidio has worked with KPMG on a number of tax products 
in addition to the four examined in this Report. A Presidio 
representative told the Subcommittee staff that 95% of the 
company's revenue came from its work with KPMG.288
---------------------------------------------------------------------------
    \288\ Subcommittee interview of John Larson (6/20/03).

          LFinding: Some law firms have provided legal services 
        that facilitated KPMG's development and sale of 
        potentially abusive or illegal tax shelters, including 
        by providing design assistance or collaborating on 
        allegedly ``independent'' opinion letters representing 
        to clients that a tax product would withstand an IRS 
---------------------------------------------------------------------------
        challenge, in return for substantial fees.

    The Role of the Law Firms. The evidence obtained by the 
Subcommittee during the course of the investigation determined 
that one law firm, Sidley Austin Brown & Wood, played a 
significant and ongoing role in the development, marketing, and 
implementation of the four KPMG tax products featured in this 
Report.
    Sidley Austin Brown & Wood is currently being audited by 
the IRS to evaluate the firm's ``role . . . in the organization 
and sale of tax shelters'' and compliance with federal tax 
shelter requirements.289 In court pleadings, the IRS 
has alleged the following:
---------------------------------------------------------------------------
    \289\ ``Declaration of Richard E. Bosch,'' IRS Revenue Agent, In re 
John Doe Summons to Sidley Austin Brown & Wood (N.D. Ill. 10/16/03) at 
para. 5.

        ``[I]t appears that [Sidley Austin Brown & Wood] was 
        involved in the organization and sale of transactions 
        which were or later became `listed transactions,' or 
        that may be other `potentially abusive tax shelters.' 
        The organization and sale of these transactions appears 
        to have been coordinated by [primarily] . . . Raymond 
        J. Ruble. . . . During the investigation, I learned 
        that [Sidley Austin Brown & Wood] issued approximately 
        600 opinions with respect to certain listed 
        transactions promoted (or co-promoted) by, among 
        others, KPMG, Arthur Andersen, BDO Seidman, Diversified 
        Group, Inc., and Ernst & Young. . . . The IRS has 
        identified transactions for which [Sidley Austin Brown 
        & Wood] provided opinions, . . . FLIPS, OPIS, COBRA, 
        BLIPS and CARDS, as `listed transactions.' 
        ''290
---------------------------------------------------------------------------
    \290\ Id. para.para. 9, 10, 12.

The IRS also alleges that, in response to a December 2001 
disclosure initiative in which taxpayers obtained penalty 
waivers in exchange for identifying their tax shelter 
promoters, 80 disclosure statements named Sidley Austin Brown & 
Wood as ``promoting, soliciting, or recommending their 
participation in certain tax shelters.'' 291 The IRS 
also alleges that the law firm provided approximately 600 
opinions for at least 13 tax products, including FLIP, OPIS, 
and BLIPS.292
---------------------------------------------------------------------------
    \291\ Id. at para. 14.
    \292\ Id. at para. 27(a).
---------------------------------------------------------------------------
    Information obtained by the Subcommittee indicates that 
Sidley Austin Brown & Wood, through the efforts of Mr. Ruble, 
did more than simply draft opinion letters supporting KPMG tax 
products; the law firm formed an alliance with KPMG to develop 
and market these tax products. IRS court pleadings, for 
example, quote a December 1997 email in which Mr. Ruble states: 
``This morning my managing partner, Tom Smith, approved Brown & 
Wood LLP working with the newly conformed tax products group at 
KPMG on a joint basis in which we would jointly develop and 
market tax products and jointly share in the fees.'' 
293 An internal KPMG memorandum around the same time 
states: ``[W]e need to consummate a formal strategic allicance 
with Brown & Wood.'' 294
---------------------------------------------------------------------------
    \293\ Id. at para. 15, citing an email dated 12/15/97, from R.J. 
Ruble. This email also references a meeting to be set up between KPMG 
and two partners at Sidley Austin Brown & Wood, Paul Pringle and Eric 
Haueter. See also email dated 12/24/97, from R.J. Ruble to Randall 
Brickham at KPMG, ``Confidential Matters,'' Bates KPMG 0047356 
(``Thanks again . . . for spending time with Paul and Eric. Their 
meeting you all helps me immensely with the politics here.'').
    \294\ Memorandum dated 12/19/97, from Randall Bickham to Gregg 
Ritchie, ``Business Model--Brown & Wood Strategic Alliance,'' Bates 
KPMG 0047228.
---------------------------------------------------------------------------
    Three months later, an internal KPMG memorandum discussing 
an upcoming meeting between KPMG and Brown & Wood states that 
KPMG tax professionals intended to discuss ``how to 
institutionalize the KPMG/B&W relationship.'' 295 
Among other items, KPMG planned to discuss ``the key profit-
drivers for our joint practice,'' citing in particular KPMG's 
``Customer list'' and ``Financial commitment'' and Brown & 
Wood's ``Institutional relationships within the investment 
banking community.'' The memorandum states that KPMG also 
planned to discuss ``[w]hat should be the profit-split between 
KPMG, B&W and the tax products group/implementor for jointly-
developed products,'' and suggesting that in ``a 7% deal'' 
KPMG, B&W and the ``Implementor'' should split the net profits 
evenly, after awarding a ``finder's allocation'' to the party 
who found the tax product purchaser. Still other documents 
indicate that Sidley Austin Brown & Wood, through Mr. Ruble, 
became a member of a working group that jointly developed 
OPIS.296 Evidence obtained by the Subcommittee also 
indicates that Sidley Austin Brown & Wood, through Mr. Ruble, 
was an active participant in the development of BLIPS, 
expending significant time working with KPMG tax professionals 
to author their respective opinion letters.
---------------------------------------------------------------------------
    \295\ Memorandum dated 3/2/98, from Randall Bickham to Gregg 
Ritchie, ``B&W Meeting,'' Bates KPMG 0047225-27.
    \296\ See , e.g., memorandum dated 3/13/98, from Robert Simon to 
Jeff Stein and Sandy Smith, all of KPMG, ``OPIS,'' Bates KPMG 0010262 
(``The attached went to the entire working group (Pfaff, Ritchie, R.J. 
Ruble of Brown & Wood, Bickham, and Larson).''); email dated 3/14/98 
from Jeff Stein to multiple KPMG tax professionals, ``Simon Says,'' 
Bates 638010, filed by the IRS on June 16, 2003, as an attachment to 
Respondent's Requests for Admission, Schneider Interests v. 
Commissioner, U.S. Tax Court, Docket No. 200-02 (``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 
[sic] and R.J. Ruble of the law firm of Brown & Wood let me know and I 
will fax it over to you as well.'').
---------------------------------------------------------------------------
    In the case histories examined by the Subcommittee, once 
the design of a KPMG tax product was complete and KPMG began 
selling the product to clients, Sidley Austin Brown & Wood's 
primary implementation role became one of issuing legal opinion 
letters to the persons who had purchased the products. Sidley 
Austin Brown & Wood, through Mr. Ruble, wrote literally 
hundreds of legal opinions supporting FLIP, OPIS, and 
BLIPS.297 In the case of SC2, KPMG had apparently 
made arrangements for clients to obtain a second opinion from 
either Sidley Austin Brown & Wood 298 or Bryan Cave, 
another major law firm,299 but it is unclear how 
many SC2 buyers, if any, took advantage of these arrangements 
and bought a second opinion.
---------------------------------------------------------------------------
    \297\ See ``Declaration of Richard E. Bosch,'' IRS Revenue Agent, 
In re John Doe Summons to Sidley Austin Brown & Wood (N.D. Ill. 10/16/
03) at para. 18, citing an email by KPMG tax professional Gregg 
Ritchie.
    \298\ Subcommittee interview of Lawrence Manth (11/6/03).
    \299\ See memorandum dated 2/16/01, from Andrew Atkin to SC2 
Marketing Group, ``Agenda from Feb 16th call and goals for next two 
weeks,'' Bates KPMG 0051135.
---------------------------------------------------------------------------
    Traditionally, second opinion letters are supplied by a 
disinterested tax expert with no financial stake in the 
transaction being evaluated, and this expert sends an 
individualized letter to a single client. Certain IRS 
penalties, in fact, can be waived if a taxpayer relies ``in 
good faith'' on expert tax advice.300 The mass 
marketing of tax products to multiple clients, however, has 
been followed by the mass production of opinion letters that, 
for each letter sent to a client, earns its author a handsome 
fee. Since there are few costs associated with producing new 
opinion letters, once a prototype opinion letter has been 
completed for the generic tax product, the mass production of 
largely boilerplate opinion letters has become a lucrative 
business for firms like Sidley Austin Brown & Wood. The 
attractive profits available from these letters have also 
created new incentives for law firms to team up with tax 
product promoters to become the preferred source for a second 
opinion letter. This profit motive undermines an arms-length 
relationship between the two opinion writers.
---------------------------------------------------------------------------
    \300\ See 26 U.S.C. Sec. 6662(d)(2)(C)(i); Treas.Reg. 
Sec. Sec. 1.6662-4(g)(4)(ii) and 1.6664-4(c)(1).
---------------------------------------------------------------------------
    Actions taken by Sidley Austin Brown & Wood and KPMG to 
collaborate on their respective opinion letters raises 
additional questions about the law firm's independent status. 
The evidence indicates that the law firm collaborated 
extensively with KPMG in the drafting of the BLIPS, FLIP, and 
OPIS opinion letters. This collaboration included joint 
identification, research, and analysis of key legal and tax 
issues; discussions about the best way to organize and present 
the reasoning used in their respective letters; and joint 
efforts to identify necessary factual representations by the 
participating parties in the transactions being analyzed. In 
the case of FLIP, Mr. Ruble faxed a copy of his draft opinion 
letter to KPMG before issuing it.301 In the case of 
BLIPS, Sidley Austin Brown & Wood and KPMG actually exchanged 
copies of their respective draft opinion letters and conducted 
a detailed ``side-by-side'' review ``to make sure we each cover 
everything the other has.'' 302 The result was two, 
allegedly independent opinion letters containing numerous, 
virtually identical paragraphs.
---------------------------------------------------------------------------
    \301\ Facsimile cover sheet dated 2/26/97, from R.J. Ruble to David 
Lippman and John Larson at KPMG, Bates XX 001440.
    \302\ Email dated 9/24/99, from R.J. Ruble of Brown & Wood, to 
Jeffrey Eischeid and Rick Bickham of KPMG, Bates KPMG 0033497; followed 
by other emails exchanged between Brown & Wood and KPMG personnel, from 
9/25/99 to 10/29/99, Bates KPMG 0033496-97.
---------------------------------------------------------------------------
    KPMG used the availability of a second opinion letter from 
Sidley Austin Brown & Wood as a marketing tool to increase 
sales of its tax products, telling clients that having this 
second letter would help protect them from accuracy-related 
penalties if the IRS were to later invalidate a tax 
product.303 Many clients were apparently swayed by 
this advice and sought an opinion letter from the law firm. 
Evidence obtained by the Subcommittee indicates that the 
opinion letters provided by the law firm were, like KPMG's 
opinion letters, virtually identical in content and reflected 
little, if any, individualized client interaction or legal 
advice. In some cases, KPMG arranged to obtain a client's 
opinion letter directly from the law firm and delivered it to 
the client, apparently without the client's ever speaking to 
any Sidley Austin Brown & Wood lawyer. One individual told the 
Subcommittee staff that after KPMG sold him FLIP, KPMG arranged 
for him to obtain a favorable opinion letter from Sidley Austin 
Brown & Wood without his ever contacting the law firm or 
directly speaking with a lawyer.304 An individual 
testifying at a recent Senate Finance Committee hearing 
testified that he had received a Sidley Austin Brown & Wood 
opinion letter for COBRA, a tax product he had purchased from 
Ernst & Young, by picking up the letter from the accounting 
firm's office. He testified that he never communicated with 
anyone at the law firm.305 This type of evidence 
suggests that the law firm's focus was not on providing 
individualized legal advice to clients, but on churning out 
boilerplate opinion letters for a fee.
---------------------------------------------------------------------------
    \303\ See, e.g., KPMG document dated 6/19/00, entitled ``SC2--
Meeting Agenda,'' Bates KPMG 0013375-96, at 13393; see also Section 
VI(B)(2) of this Report on using tax opinion letters as a marketing 
tool.
    \304\ Jacoboni v. KPMG, Case No. 02-CV-510 (D.M.D. Fla. 4/29/02), 
at para. 19 (``Mr. Jacoboni later received a copy of a `concurring 
opinion' dated August 31, 1998, from the law firm Brown & Wood, LLP, 
which was requested by Dale Baumann of KPMG. The Brown & Wood 
concurring opinion was mailed from New York to Mr. Jacoboni in 
Florida.''); Subcommittee interview of legal counsel to Joseph Jacoboni 
(4/4/03).
    \305\ See testimony of Henry Camferdam regarding his purchase of 
COBRA, Senate Finance Committee hearing, ``Tax Shelters: Who's Buying, 
Who's Selling, and What's the Government Doing About It?'' (10/21/03) 
(Camferdam: ``I never talked to anyone at Brown & Wood. In fact, all of 
their documents were sent to us via [Ernst & Young]--not directly to 
us.'').
---------------------------------------------------------------------------
    By routinely directing clients to Sidley Austin Brown & 
Wood to obtain a second opinion letter, KPMG produced a steady 
stream of income for the law firm. In the case of BLIPS, FLIP, 
and OPIS, Sidley Austin Brown & Wood was apparently paid at 
least $50,000 per opinion. One document indicates that Sidley 
Austin Brown & Wood was paid this fee in every case where its 
name was mentioned during a sales pitch for BLIPS, whether or 
not the client actually purchased the law firm's opinion 
letter. Other evidence indicates that in some BLIPS 
transactions expected to produce a very large ``tax loss'' for 
the client, Sidley Austin Brown & Wood was paid more than 
$50,000 for its opinion letter.
    Sidley Austin Brown & Wood provided opinion letters not 
only to KPMG, but also to other firms selling similar tax 
products. For example, the law firm also issued favorable 
opinion letters for COBRA, a tax product similar to OPIS, but 
sold by Ernst & Young. An email seems to suggest that when a 
client sought a tax opinion letter for a product from Ernst & 
Young and was turned down, Sidley Austin Brown & Wood may have 
advised the client to try KPMG instead. The internal Ernst & 
Young email states:

        ``[Redacted name] told me that during the January 
        meeting, Richard Shapiro gave him the name of R.J. 
        Rubell [sic] at Brown and Wood and said that they could 
        contact him directly regarding the tax opinion and 
        other issues. He did that. Rubell said that Brown and 
        Wood stands by the deal and is willing to issue the 
        same opinion letter as before. They and others do not 
        see the risk that E&Y sees. Apparently, B&W is also 
        working with Diversified and KPMG and Rubell steered 
        them in that direction.'' 306
---------------------------------------------------------------------------
    \306\ Email dated 2/11/00, from Alexander Eckman to David G. 
Johnson and others, subject line redacted, Bates 2003EY011640.

It is unclear exactly what problem is being addressed, but this 
email raises concerns about opinion letter shopping and about 
the propriety of the law firm's steering clients away from 
Ernst & Young, apparently because that firm refused to issue a 
requested letter, and toward KPMG.
    In short, in exchange for substantial fees, Sidley Austin 
Brown & Wood provided legal services that facilitated KPMG's 
development and sale of potentially abusive or illegal tax 
shelters such as FLIP, OPIS, and BLIPS, including by providing 
design assistance and collaborating on allegedly 
``independent'' opinion letters representing to clients that 
the KPMG tax products would withstand an IRS challenge.

          LFinding: Some charitable organizations have 
        participated as essential counter parties in a highly 
        questionable tax shelter developed and sold by KPMG, in 
        return for donations or the promise of future 
        donations.

    The Role of the Charitable Organizations. SC2 transactions 
could not have taken place at all without the willing 
participation of a charitable organization. To participate in 
SC2 transactions, a charity had to undertake a number of non-
routine and potentially expensive, time-consuming tasks. For 
example, the charity had to agree to accept an S corporation 
stock donation, which for many charities is, in itself, 
unusual; make sure it is exempt from the unrelated business 
income tax (hereinafter ``UBIT'') and would not be taxed for 
any corporate income earned during the time when the charity 
was a shareholder; sign a redemption agreement; determine how 
to treat the stock donation on its financial statements; and 
then hold the stock for several years before receiving any cash 
donation for its efforts. Moreover, relatively few charities 
are exempt from the UBIT, and those that are--like pension 
funds--do not normally receive large contributions from private 
donors.
    KPMG approved SC2 for sale to clients in March 2000, and 
discontinued all sales 18 months later, around September 2001, 
after selling the tax product to about 58 S corporations. The 
SC2 sales produced fees exceeding $26 million for KPMG, making 
SC2 one of KPMG's top ten revenue producers in 2000 and 2001. 
Although KPMG refused to identify the charities that 
participated in the SC2 transactions, the Subcommittee was able 
to identify and interview two which, between them, participated 
in more than half of the SC2 transactions KPMG arranged.
    The two charities interviewed by the Subcommittee staff 
indicated that they would not have participated in the SC2 
transactions absent being approached, convinced, and assisted 
by KPMG. The Los Angeles Department of Fire & Police Pensions 
System is a $10 billion pension fund that serves the police and 
fire departments in the city of Los Angeles in California. The 
Austin Fire Fighters Relief and Retirement Fund is a much 
smaller pension fund serving the fire departments in Austin, 
Texas.
    Based upon information provided to the Subcommittee, it 
appears that, out of the about 58 SC2 tax products sold by KPMG 
in 2000 and 2001, the Los Angeles pension fund participated in 
29 of the SC2 transactions, while the Austin pension fund 
participated in five. The Los Angeles pension fund indicated 
that, as a result of the SC2 transactions, it is currently 
holding stock valued at about $7.3 million from 16 S 
corporations, and has sold back donated stock to 13 
corporations in exchange for cash payments totaling about $5.5 
million. Both pension funds told the Subcommittee that the SC2 
stock donors and their corporations had generally been from 
out-of-state. The Los Angeles pension fund indicated that it 
had received stock from S corporations in Arizona, Georgia, 
Hawaii, Missouri, and North Carolina. The Austin pension fund 
indicated that it had received stock from S corporations in 
California, Mississippi, New Jersey, and New York. Both pension 
funds indicated that they had not met any of the SC2 donors 
until KPMG introduced them to the charities.
    Both charities indicated to the Subcommittee staff that, in 
determining whether to participate in the SC2 transactions, 
they relied on KPMG's representation that the transactions 
complied with federal tax law. The Los Angeles pension fund 
also obtained from an outside law firm a legal opinion letter 
on the narrow issue of whether the charity had the legal 
authority to accept a donation of S corporation stock. In 
analyzing this issue, the law firm notes first in the legal 
opinion letter that all of the facts recited about the 
transaction had been provided to the law firm by a KPMG tax 
professional.307 The letter concludes that the 
pension fund may accept an S corporation stock donation from an 
unrelated third party: ``Although this is a very unusual 
transaction, and there is almost no statutory, regulatory or 
other authority addressing the issue, we believe the Plan is 
permitted to accept a contribution.'' The letter also states, 
however, that the law firm had not been asked to provide any 
legal advice about the substance of the SC2 transaction itself, 
that it had not been given any documentation to review, and 
that it was not offering any opinion on ``the impact of the 
transaction on the `donor' from a tax or other standpoint.'' 
308
---------------------------------------------------------------------------
    \307\ Letter dated 12/30/99, from Seyfarth, Shaw, Fairweather & 
Geraldson to the Los Angeles pension fund, at 3.
    \308\ Id. The letter states: ``You have asked us to advise you 
concerning the ability of the L.A. Fire & Police Pension System (the 
`Plan') to accept a contribution from an unrelated third party in the 
form of nonvoting stock of a closely held California S corporation. . . 
. It should be noted that, from a procedural and due-diligence 
standpoint, (1) we have not been asked to conduct, and we have not 
conducted, any investigation into the company and/or the individual 
involved, (2) we have not yet reviewed any of the underlying 
documentation in connection with the donation or the possible future 
redemption of the stock, and offer no opinion on such agreements or 
their impact on any of the views expressed in this letter, (3) we have 
not examined, or opined in any way about, the impact of the transaction 
on the `donor' from a tax or other standpoint, and (4) we have not 
checked the investment against any investment policy guidelines that 
may have been adopted by the Board.''
---------------------------------------------------------------------------
    Apparently, neither charity obtained a legal or tax opinion 
letter or other written legal advice, from KPMG or any other 
firm, on whether the SC2 tax product and related transactions 
complied with federal tax law or whether the charity's 
participation in SC2 transactions could be viewed as aiding or 
abetting tax evasion. The two pension funds told the 
Subcommittee that they simply relied on KPMG's reputation as a 
reputable firm in assuming the donation strategy was within the 
law.
    Both pension funds told the Subcommittee that, in every SC2 
transaction, it was their expectation that they would not 
retain ownership of the donated stock, but would sell it back 
to the stock donor after the expiration of the period of time 
indicated in the redemption agreement. They also indicated that 
they did not expect to obtain significant amounts of money from 
the S corporation during the period in which the charity was a 
stockholder but expected, instead, to obtain a large cash 
payment at the time the charity sold the stock back to the 
donor. Moreover, the charities told the Subcommittee staff that 
their expectations have, in fact, been met, and the SC2 
transactions have been carried out as planned by KPMG, the 
donors, and the charities. These facts and expectations raise 
serious questions about whether the SC2 transactions ever truly 
passed ownership of the stock to the charity or acted merely as 
an assignment of income for a specified period time to the 
charitable organization.
    In the case of BLIPS, FLIP, OPIS, and SC2, major banks, 
investment advisory firms, law firms, and charitable 
organizations provided critical services or acted as essential 
counterparties in the transactions called for by the tax 
products. Each obtained lucrative fees, often totaling in the 
millions of dollars, for their participation. Despite the 
complexity, frequency, and size of the transactions and their 
clear connection to tax avoidance schemes, none of the 
participating organizations presented to the Subcommittee a 
reasoned, contemporaneous analysis of the tax shelter, 
reputational risk, ethical, or professional issues justifying 
the organization's role in facilitating these highly 
questionable and abusive tax transactions.

  (4) Avoiding Detection

          Finding: KPMG has taken steps to conceal its tax 
        shelter activities from tax authorities and the public, 
        including by refusing to register potentially abusive 
        tax shelters with the IRS, restricting file 
        documentation, and using improper tax return reporting 
        techniques.

    Evidence obtained by the Subcommittee in the four KPMG case 
studies shows that KPMG has taken a number of steps to conceal 
its tax shelter activities from IRS, law enforcement, and the 
public. In the first instance, it has simply denied being a tax 
shelter promoter and claimed that tax shelter information 
requests do not apply to its products. Second, evidence in the 
FLIP, OPIS, BLIPS, and SC2 case histories indicate that KPMG 
took a number of precautions in the way it designed, marketed, 
and implemented these tax products to avoid or minimize 
detection of its activities.
    No Tax Shelter Disclosure. KPMG's public position is that 
it does not develop, sell or promote tax shelters, as explained 
earlier in this Report. As a consequence, KPMG has not 
voluntarily registered, and thereby disclosed to the IRS, a 
single one of its tax products. A memorandum quoted at length 
earlier in this Report 309 establishes that, in 
1998, a KPMG tax professional advised the firm not to register 
the OPIS tax product with the IRS, even if OPIS qualified as a 
tax shelter under the law, citing competitive pressures and a 
perceived lack of enforcement or effective penalties for 
noncompliance with the registration requirement. Another 
document discussing registration of OPIS had this to say: 
``Must register the product. B&W concerns--risk is too high. 
Confirm w/Presidio that they will register.'' 310 
The head of DPP-Tax told the Subcommittee staff that he had 
recommended registering not only OPIS, but also BLIPS, but was 
overruled in each instance by the top official in charge of the 
Tax Services Practice.311
---------------------------------------------------------------------------
    \309\ See Section VI(B) of this Report.
    \310\ Handwritten notes dated 3/4/98, author not indicated, 
regarding ``Brown & Wood'' and ``OPIS,'' Bates KPMG 0047317. Emphasis 
in original. ``B&W'' refers to Brown & Wood, the law firm that worked 
with KPMG on OPIS. Presidio is an investment firm that worked with KPMG 
on OPIS.
    \311\ Subcommittee interview of Lawrence DeLap (10/30/03).
---------------------------------------------------------------------------
    Other documents show that consideration of tax shelter 
registration issues was a required step in the tax product 
approval process, but rather than resulting in IRS 
registrations, KPMG appears to have devoted resources to 
devising rationales for not registering a product with the IRS. 
KPMG's Tax Services Manual states that every new tax product 
must be analyzed by the WNT Tax Controversy Services group ``to 
address tax shelter regulations issues.'' 312 For 
example, one internal document analyzing tax shelter 
registration issues discusses the ``policy argument'' that 
KPMG's tax ``advice . . . does not meet the paradigm of 6111(c) 
registration'' and identifies other flaws with the legal 
definition of ``tax shelter'' that may excuse registration. The 
email also suggests possibly creating a separate entity to act 
as the registrant for KPMG tax products:
---------------------------------------------------------------------------
    \312\ KPMG Tax Services Manual, Sec. 24.4.1, at 24-2.

        ``If we decide we will be registering in the future, 
        thought should be given to establishing a separate 
        entity that meets the definition of an organizer for 
        all of our products with registration potential. This 
        entity, rather than KPMG, would then be available 
        through agreement to act as the registering organizer. 
        . . . If such an entity is established, KPMG can avoid 
        submitting its name as the organizer of a tax shelter 
        on Form(s) 8264 to be filed in the future.'' 
        313
---------------------------------------------------------------------------
    \313\ Email dated 5/11/98, from Jeffrey Zysik to multiple KPMG tax 
professionals, ``Registration,'' Bates KPMG 0034805-06. See also email 
dated 5/12/98, from Jeffrey Zysik to multiple KPMG tax professionals, 
``Registration requirements.,'' Bates KPMG 0034807-11 (reasonable cause 
exception, tax shelter definitions, number of registrations required); 
email dated 5/20/98, from Jeffrey Zysik to multiple KPMG tax 
professionals, ``Misc. Tax Reg. issues,'' Bates KPMG 0034832-33 
(``reasonable cause exception for not registering''; application of 
regulatory ``tax shelter ratio'' to identify tax shelters; 
``establishing a separate entity to act as the entity registering ALL 
tax products. . . . Otherwise we must submit our name as the tax 
shelter organizer.'').

    Another KPMG document, a fiscal year 2002 draft business 
plan for the Personal Financial Planning Practice, describes 
two tax products under development, but not yet approved, due 
in part to pending tax shelter registration 
issues.314 The first, referred to as POPS, is 
described as ``a gain mitigation solution.'' The business plan 
states: ``We have completed the solution's technical review and 
have almost finalized the rationale for not registering POPS as 
a tax shelter.'' The second product is described as a 
``conversion transaction . . . that halves the taxpayer's 
effective tax rate by effectively converting ordinary income to 
long term capital gain.'' The business plan notes: ``The most 
significant open issue is tax shelter registration and the 
impact registration will have on the solution.''
---------------------------------------------------------------------------
    \314\ Document dated 5/18/01, ``PFP Practice Reorganization 
Innovative Strategies Business Plan--DRAFT,'' Bates KPMG 0050620-23, at 
2.
---------------------------------------------------------------------------
    The IRS has issued ``listed transactions'' that explicitly 
identify FLIP, OPIS, and BLIPS as potentially abusive tax 
shelters. Due to these tax products and others, the IRS is 
investigating KPMG to determine whether it is a tax shelter 
promoter and is complying with the tax shelter requirements in 
Federal law.315 KPMG continues flatly to deny that 
it is a tax shelter promoter and has continued to resist 
registering any of its tax products with the IRS.
---------------------------------------------------------------------------
    \315\ See United States v. KPMG, Case No. 1:02MS00295 (D.D.C. 9/6/
02).
---------------------------------------------------------------------------
    A second consequence of KPMG's public denial that it is a 
tax shelter promoter has been its refusal fully to comply with 
the document requests made by the IRS for lists of clients who 
purchased tax shelters from the firm. In a recent hearing 
before the Senate Finance Committee, the U.S. Department of 
Justice stated that, although the client-list maintenance 
requirement enacted by Congress ``clearly precludes any claim 
of identity privilege for tax shelter customers regardless of 
whether the promoters happen to be accountants or lawyers, the 
issue continues to be the subject of vigorous litigation.'' 
316 The Department pointed out that one circuit 
court of appeals and four district courts had already ruled 
that accounting firms, law firms, and a bank must divulge 
client information requested by the IRS under the tax shelter 
laws, but certain accounting firms were continuing to contest 
IRS document requests. At the same hearing, the former IRS 
chief counsel characterized the refusal to disclose client 
names by invoking either attorney-client privilege or Section 
7525 of the tax code as ``frivolous,'' while also noting that 
one effect of the ensuing litigation battles ``was to delay 
[promoter] audits to the point of losing one or more tax years 
to the statute of limitations.'' 317
---------------------------------------------------------------------------
    \316\ Testimony of Eileen J. O'Connor, Assistant Attorney General 
for the Tax Division, U.S. Department of Justice, before the Senate 
Committee on Finance, ``Tax Shelters: Who's Buying, Who's Selling and 
What's the Government Doing About It?'' (10/21/03), at 3.
    \317\ Testimony of B. John Williams, Jr. former IRS chief counsel, 
before the Senate Committee on Finance, ``Tax Shelters: Who's Buying, 
Who's Selling and What's the Government Doing About It?'' (10/21/03), 
at 4-5.
---------------------------------------------------------------------------
    IRS Commissioner, Mark Everson, testified at the same 
hearing that the IRS had filed suit against KPMG in July 2002, 
``to compel the public accounting firm to disclose information 
to the IRS about all tax shelters it has marketed since 1998.'' 
318 He stated, ``Although KPMG has produced many 
documents to the IRS, it has also withheld a substantial 
number.''
---------------------------------------------------------------------------
    \318\ Testimony of Mark W. Everson, IRS Commissioner, before the 
Senate Committee on Finance, ``Tax Shelters: Who's Buying, Who's 
Selling and What's the Government Doing About It?'' (10/21/03), at 11.
---------------------------------------------------------------------------
    Some of the documents obtained by the Subcommittee during 
its investigation illustrate the debate within KPMG over 
responding to the IRS requests for client names and other 
information. In April 2002, one KPMG tax professional wrote:

        ``I have two clients who are about to file [tax 
        returns] for 2001. We have discussed with each of them 
        what is happening between KPMG and IRS and both do not 
        plan to disclose at this time. Since Larry's message 
        indicated the information requested was to respond to 
        an IRS summons, I am concerned we are about to turn 
        over a new list of names for transactions I believe IRS 
        has no prior knowledge of. I need to know immediately 
        if that is what is happening. It will obviously have a 
        material effect on their evaluation of whether they 
        wish to disclose and what positions they wish to take 
        on their 2001 returns. Since April 15th is Monday, I 
        need a response. . . . [I]f we are responding to what 
        appears to be an IRS fishing expedition, it is going to 
        reflect very badly on KPMG. Several clients have 
        seriously questioned whether we are doing everything we 
        can to protect their interests.'' 319
---------------------------------------------------------------------------
    \319\ Email dated 4/9/02, from Deke Carbo to Jeffrey Eischeid, 
``Larry's Message,'' Bates KPMG 0024467. See also email dated 4/19/02, 
from Ken JOnes to multiple KPMG tax professionals, ``TCS Weekly 
Update,'' Bates KPMG 0050430-31 (``We have just hand-carried the lists 
of investors over to the IRS, for the following deals: . . . SC2. . . . 
Note that not all cilents names were turned over for each of these 
Solutions . . . so if you need to find out if a company or individual 
was on the list . . . call or email me.'').

    Tax Return Reporting. KPMG also took a number of 
questionable steps to minimize the amount of information 
reported in tax returns about the transactions involved in its 
tax products in order to limit IRS detection.
    Perhaps the most disturbing of these actions was first 
taken in tax returns reporting transactions related to OPIS. To 
minimize information on the relevant tax returns and avoid 
alerting the IRS to the OPIS tax product, some KPMG tax 
professionals advised their OPIS clients to participate in the 
transactions through ``grantor trusts.'' These KPMG tax 
professionals also advised their clients to file tax returns in 
which all of the losses from the OPIS transactions were 
``netted'' with the capital gains realized by the taxpayer at 
the grantor trust level, instead of reporting each individual 
gain or loss, so that only a single, small net capital gain or 
loss would appear on the client's personal income tax return. 
This netting approach, advocated in an internally-distributed 
KPMG memorandum,320 elicited intense debate within 
the firm. KPMG's top WNT technical tax expert on the issue of 
grantor trusts wrote the following in two emails over the span 
of 4 months:
---------------------------------------------------------------------------
    \320\ ``Grantor Trust Reporting Requirements for Capital 
Transactions,'' KPMG WNT internal memorandum (2/98).

        ``I don't think netting at the grantor trust level is a 
        proper reporting position. Further, we have never 
        prepared grantor trust returns in this manner. What 
        will our explanation be when the Service and/or courts 
        ask why we suddenly changed the way we prepared grantor 
        trust returns/statements only for certain clients? When 
        you put the OPIS transaction together with this 
        `stealth' reporting approach, the whole thing stinks.'' 
        321
---------------------------------------------------------------------------
    \321\ Email dated 9/2/98, from Mark Watson to John Gardner, Jeffrey 
Eischeid, and others; ``RE:FW: Grantor trust memo,'' Bates KPMG 
0035807. See also email dated 9/3/98, from Mark Watson to Jeffrey 
Eischeid and John Gardner, ``RE:FW: Grantor trust memo,'' Bates KPMG 
0023331-32 (explaining objections to netting at the grantor trust 
level).

        ``You should all know that I do not agree with the 
        conclusion reached in the attached memo that capital 
        gains can be netted at the trust level. I believe we 
        are filing misleading, and perhaps false, returns by 
        taking this reporting position.'' 322
---------------------------------------------------------------------------
    \322\ Email dated 1/21/99, from Mark Watson to multiple KPMG tax 
professionals, ``RE: Grantor trust reporting,'' Bates KPMG 0010066.

---------------------------------------------------------------------------
    One of the tax professionals selling OPIS wrote:

        ``This `debate' . . . [over grantor trust netting] 
        affects me in a significant way in that a number of my 
        deals were sold giving the client the option of 
        netting. . . . Therefore, if they ask me to net, I feel 
        obligated to do so. These sales were before Watson went 
        on record with his position and after the memo had been 
        outstanding for some time.

        ``What is our position as a group? Watson told me he 
        believes it is a hazardous professional practice issue. 
        Given that none of us wants to face such an issue, I 
        need some guidance.'' 323
---------------------------------------------------------------------------
    \323\ Email dated 1/21/99, from Carl Hasting to Jeffrey Eischeid, 
``FW: Grantor trust reporting,'' Bates KPMG 0010066.

The OPIS National Deployment Champion responded: ``[W]e 
concluded that each partner must review the WNT memo and decide 
for themselves what position to take on their returns--after 
discussing the various pros and cons with their clients.'' 
324
---------------------------------------------------------------------------
    \324\ Email dated 1/22/99, from Jeffrey Eischeid to Carl Hasting, 
``FW: Grantor trust reporting,'' Bates KPMG 0010066. Other OPIS tax 
return reporting issues are discussed in other KPMG documentation 
including, for example, memorandum dated 12/21/98, from Bob Simon/
Margaret Lukes to Robin Paule, ``Certain U.S. International Tax 
Reporting Requirements re: OPIS,'' Bates KPMG 0050630-40.
---------------------------------------------------------------------------
    The technical reviewer who opposed grantor trust netting 
told the Subcommittee staff that it was his understanding that, 
as the top WNT technical expert, his technical judgment on the 
matter should have stopped KPMG tax professionals from using or 
advocating the use of this technique and thought he had done 
so, before leaving for a KPMG post outside the United States. 
He told the Subcommittee staff he learned later, however, that 
the OPIS National Deployment Champion had convened a conference 
call without informing him and told the participating KPMG tax 
professionals that they could use the netting technique if they 
wished. He indicated that he also learned that some KPMG tax 
professionals were apparently advising BLIPS clients to use 
grantor trust netting to avoid alerting the IRS to their BLIPS 
transactions.325
---------------------------------------------------------------------------
    \325\ Subcommittee interview of Mark Watson (11/4/03).
---------------------------------------------------------------------------
    In September 2000, the IRS issued Notice 2000-44, 
invalidating the BLIPS tax product. This Notice included a 
strong warning against grantor trust netting:

        ``[T]he Service and the Treasury have learned that 
        certain persons who have promoted participation in 
        transactions described in this notice have encouraged 
        individual taxpayers to participate in such 
        transactions in a manner designed to avoid the 
        reporting of large capital gains from unrelated 
        transactions on their individual income tax returns 
        (Form 1040). Certain promoters have recommended that 
        taxpayers participate in these transactions through 
        grantor trusts and . . . advised that the capital gains 
        and losses from these transactions may be netted, so 
        that only a small net capital gain or loss is reported 
        on the taxpayer's individual income tax return. In 
        addition to other penalties, any person who willfully 
        conceals the amount of capital gains and losses in this 
        manner, or who willfully counsels or advises such 
        concealment, may be guilty of a criminal offense. . . 
        .'' 326
---------------------------------------------------------------------------
    \326\ IRS Notice 2000-44 (2000-36 IRB 255) (9/5/00) at 256.

The technical reviewer who had opposed using grantor trust 
netting told the Subcommittee that, soon after this Notice was 
published, he had received a telephone call from his WNT 
replacement informing him of the development and seeking his 
advice. He indicated that it was his understanding that a 
number of client calls were later made by KPMG tax 
professionals.327
---------------------------------------------------------------------------
    \327\ Subcommittee interview of Mark Watson (11/4/03). See also 
Memorandum of Telephone Call, dated 5/24/00, from Kevin Pace regarding 
a telephone conversation with Carl Hastings, Bates KPMG 0036353 
(``[T]here is quite a bit of activity in the trust area . . . because 
they have figured out that trusts are a common element in some of these 
shelter deals. So our best intelligence is that you are increasing your 
odds of being audited, not decreasing your odds by filing that Grantor 
Trust return. So we have discontinued doing that.'')
---------------------------------------------------------------------------
    Other tax return reporting concerns also arose in 
connection with BLIPS. In an email with the subject line, ``Tax 
reporting for BLIPS,'' a KPMG tax professional sent the 
following message to the BLIPS National Deployment Champion: 
``I don't know if I missed this on a conference call or if 
there's a memo floating around somewhere, but could we get 
specific guidance on the reporting of the BLIPS transaction. . 
. . I have `IRS matching' concerns.'' The email later 
continues:

        ``One concern I have is the IRS trying to match the 
        Deutsche dividend income which contains the Borrower 
        LLC's FEIN [Federal Employer Identification Number][.] 
        (I understand they're not too efficient on matching K-
        1's but the dividends come through on a 1099 which they 
        do attempt to match). I wouldn't like to draw any 
        scrutiny from the Service whatsoever. If we don't file 
        anything for Borrower LLC we could get a notice which 
        would force us to explain where the dividends 
        ultimately were reported. Not fatal but it is scrutiny 
        nonetheless.'' 328
---------------------------------------------------------------------------
    \328\ Email dated 2/15/00, from Robert Jordan to Jeffrey Eischeid, 
``Tax reporting for BLIPS,'' Bates KPMG 0006537.

    About a month later, another KPMG tax professional wrote to 
---------------------------------------------------------------------------
the BLIPS National Deployment Champion:

        ``We spoke to Steven Buss about the possibility of re-
        issuing the Presidio K-1s in the EIN of the member of 
        the single member [limited liability corporations used 
        in BLIPS].  He  said  that  you  guys  hashed  it  out  
        on  Friday 3/24  and  in  a  nutshell,  Presidio  is  
        not  going  to  re-issue  K-1s.

        ``David was wondering what the rationale was since the 
        instructions and PPC say that single member LLCs are 
        disregarded entities so 1099s, K-1s should use the EIN 
        of the single member.'' 329
---------------------------------------------------------------------------
    \329\ Email dated 3/28/00, from Jean Monahan to Jeffrey Eischeid 
and other KPMG tax professionals, ``presidio K-1s,'' Bates KPMG 
0024451. See also email dated 3/22/00, unidentified sender and 
recipients, ``Nondisclosure,'' Bates KPMG 0025704.

---------------------------------------------------------------------------
She received the following response:

        ``It was discussed on the national conference call 
        today. Tracey Stone has been working with Mark Ely on 
        the issue. Ely has indicated that while the IRS may 
        have the capability to match ID numbers for 
        partnerships, they probably lack the resources to do 
        so. While technically the K-1's should have the social 
        security number of the owner on them, it is my 
        understanding that Mark has suggested that we not file 
        a partnership for the single member LLC and that 
        Presidio not file amended K-1s. . . . Tracey indicated 
        that Mark did not like the idea of having us prepare 
        partnership returns this year because then the IRS 
        would be looking for them in future years.'' 
        330
---------------------------------------------------------------------------
    \330\ Email dated 3/27/00, unidentified sender and recipients, 
``presidio K-1s,'' Bates KPMG 0024451.

Additional emails sent among various KPMG tax professionals 
discuss whether BLIPS participants should extend or amend their 
tax returns, or file certain other tax forms, again with 
repeated references to minimizing IRS scrutiny of client return 
information.331
---------------------------------------------------------------------------
    \331\ See, e.g., emails dated 4/1/00-4/3/00 among Mark Ely, David 
Rivkin and other KPMG tax professionals, ``RE: Blips and tax filing 
issues,'' Bates KPMG 0006481-82; emails dated 3/23/00, between Mark 
Watson, Jeffrey Eischeid, David Rivkin and other KPMG tax 
professionals, ``RE: Blips and tax filing issues,'' Bates KPMG 0006480. 
See also email dated 7/27/99, from Deke Carbo to Randall Bickham, 
Jeffrey Eischeid, and Shannon Liston, ``Grouping BLIPS Investors,'' 
KPMG Bates 0023350 (suggests ``grouping'' multiple, unrelated BLIPS 
investors in a single Deutsche Bank account, possibly styled as a joint 
venture account, which might not qualify as a partnership required to 
file a K-1 tax return); email response dated 7/27/99, unidentified 
sender and recipients, ``Grouping BLIPS Investors,'' KPMG Bates 0023350 
(promises followup on suggestion which may ``[solve] our grouping 
problem'').
---------------------------------------------------------------------------
    In the case of FLIP, KPMG tax professionals devised a 
different approach to avoiding IRS detection.332 
Again, the focus was on tax return reporting. The idea was to 
arrange for the offshore corporation involved in FLIP 
transactions to designate a fiscal year that ended in some 
month other than December in order to extend the year in which 
the corporation would have to report FLIP gains or losses on 
its tax return. For example, if the offshore corporation were 
to use a fiscal year ending in June, FLIP transactions which 
took place in August 1997, would not have to be reported on the 
corporation's tax return until after June 1998. Meanwhile, the 
individual taxpayer involved with the same FLIP transactions 
would have reported the gains or losses in his or her tax 
return for 1997. The point of arranging matters so that the 
FLIP transactions would be reported by the corporation and 
individual in tax returns for different years was simply to 
make it more difficult for the IRS to detect a link between the 
two participants in the FLIP transactions.
---------------------------------------------------------------------------
    \332\ See email dated 3/11/98 from Gregg Ritchie to multiple KPMG 
tax professionals, ``Potential FLIP Reporting Strategy,'' Bates KPMG 
0034372-75. See also internal KPMG memorandum dated 3/31/98, by Robin 
Paule, Los Angeles/Warner Center, ``Form 5471 Filing Issues,'' Bates 
KPMG 0011952-53; and internal KPMG memorandum dated 3/6/98, by Bob 
Simon and Margaret Lukes, ``Potential FLIP Reporting Strategy,'' Bates 
KPMG 0050644-45.
---------------------------------------------------------------------------
    In the case of SC2, KPMG advised its tax professionals to 
tell potential buyers worried about being audited:

        ``[T]his transaction is very stealth. We are not 
        generating losses or other highly visible items on the 
        S-corp return. All income of the S-corp is allocated to 
        the shareholders, it just so happens that one 
        shareholder [the charity] will not pay tax.'' 
        333
---------------------------------------------------------------------------
    \333\ ``SC2--Meeting Agenda'' and attachments, dated 6/19/00, Bates 
KPMG 0013375-96, at 13394.

    No Roadmaps. A Subcommittee hearing held in December 2002, 
on an abusive tax shelter sold by J.P. Morgan Chase & Co. to 
Enron presented evidence that the bank and the company 
explicitly designed that tax shelter to avoid providing a 
``roadmap'' to tax authorities.334 KPMG appears to 
have taken similar precautions in FLIP, OPIS, BLIPS, and SC2.
---------------------------------------------------------------------------
    \334\ ``Fishtail, Bacchus, Sundance, and Slapshot: Four Enron 
Transactions Funded and Facilitated by U.S. Financial Institutions,'' 
Report prepared by the U.S. Senate Permanent Subcommittee on 
Investigations of the Committee on Governmental Affairs, S. Prt. 107-82 
(1/2/03), at 32.
---------------------------------------------------------------------------
    In the case of SC2, in an exchange of emails among senior 
KPMG tax professionals discussing whether to send clients a 
letter explicitly identifying SC2 as a high-risk strategy and 
outlining certain specific risks, the SC2 National Deployment 
Champion wrote:

        ``[D]o we need to disclose the risk in the engagement 
        letter? . . . Could we have an addendum that discloses 
        the risks? If so, could the Service have access to 
        that? Obviously the last thing we want to do is provide 
        the Service with a road map.'' 335
---------------------------------------------------------------------------
    \335\ Email dated 3/25/00, from Larry Manth to Larry DeLap, Phillip 
Galbreath, Mark Springer, and Richard Smith, ``RE: S-corp Product,'' 
Bates KPMG 0016986-87.

---------------------------------------------------------------------------
The DPP head responded:

        ``. . . If the risk has been disclosed and the IRS is 
        successful in a challenge, the client can't maintain he 
        was bushwhacked because he wasn't informed of the risk. 
        . . . We could have a statement in the engagement 
        letter that the client acknowledges receipt of a 
        memorandum concerning risks associated with the 
        strategy, then cover the double taxation risk and 
        penalty risks (and other relevant risks) in that 
        separate memorandum. Depending on how one interprets 
        section 7525(b), such a memorandum arguably qualifies 
        for the federal confidential communications privilege 
        under section 7525(a).'' 336
---------------------------------------------------------------------------
    \336\ Email dated 3/27/00, from Larry DeLap to Larry Manth, Phillip 
Galbreath, Mark Springer and Richard Smith, ``RE: S-Corp Product,'' 
Bates KPMG 0016986.

    This was not the only KPMG document that discussed using 
attorney-client or other legal privileges to limit disclosure 
of KPMG documents and activities related to its tax products. 
For example, a 1998 document containing handwritten notes from 
a KPMG tax professional about a number of issues related to 
OPIS states, under the heading ``Brown & Wood'': ``Privilege[:] 
B&W can play a big role at providing protection in this area.'' 
337
---------------------------------------------------------------------------
    \337\ Handwritten notes dated 3/4/98, author not indicated, 
regarding ``Brown & Wood'' and ``OPIS,'' Bates KPMG 0047317.
---------------------------------------------------------------------------
    Other parties who participated in the KPMG tax products 
also discussed using attorney-client privilege to conceal their 
activities. One was Deutsche Bank, which participated in both 
OPIS and BLIPS. In an internal email, one Deutsche Bank 
employee wrote to another regarding BLIPS: ``I would have 
thought you could still ensure that . . . the papers are 
prepared, and all discussion held, in a way which makes them 
legally privileged. (. . . you may remember that was one of my 
original suggestions).'' 338 Earlier, when 
considering whether to participate in BLIPS initially, the bank 
decided to limit its discussion of BLIPS on paper and not to 
obtain the approval of the bank committee that normally 
evaluates the risk that a transaction poses to the reputation 
of the bank, in order not to leave ``an audit trail'':
---------------------------------------------------------------------------
    \338\ Email dated 7/29/99, from Mick Wood to Francesco Piovanetti 
and other Deutsche Bank professionals, ``Re: Risk & Resources Committee 
Paper--BLIPS,'' Bates DB BLIPS 6556.

        ``1. STRUCTURE: A diagramatic representation of the 
        deal may help the Committee's understanding--we can 
---------------------------------------------------------------------------
        prepare this.

        ``2. PRIVILEDGE [sic]: This is not easy to achieve and 
        therefore a more detailed description of the tax issues 
        is not advisable.

        ``3. REPUTATION RISK: In this transaction, reputation 
        risk is tax related and we have been asked by the Tax 
        Department not to create an audit trail in respect of 
        the Bank's tax affaires. The Tax department assumes 
        prime responsibility for controlling tax related risks 
        (including reputation risk) and will brief senior 
        management accordingly. We are therefore not asking R&R 
        Committee to approve reputation risk on BLIPS. This 
        will be dealt with directly by the Tax Department and 
        John Ross.'' 339
---------------------------------------------------------------------------
    \339\ Email dated 7/30/99, from Ivor Dunbar to multiple Deutsche 
Bank professionals, ``Re: Risk & Resources Committee Paper--BLIPS,'' 
unreadable Bates DB BLIPS number.

    Another bank that took precautions against placing tax 
product information on paper was Wachovia Bank's First Union 
National Bank. A First Union employee sent the following 
instructions to a number of his colleagues apparently in 
connection with the bank's approving sales of a new KPMG tax 
---------------------------------------------------------------------------
product:

        ``In order to . . . lower our profile on this 
        particular strategy, the following points should be 
        noted: The strategy has an KPMG acronym which will not 
        be shared with the general First Union community. . . . 
        Our traditional sources of client referrals inside 
        First Union should not be informed of which Big 5 
        accounting firm we will choose to bring in on a 
        strategy meeting with a client. . . . No one-pager will 
        be distributed to our referral sources describing the 
        strategy.'' 340
---------------------------------------------------------------------------
    \340\ Email dated 8/30/99, from Tom Newman to multiple First Union 
professionals, ``next strategy,'' Bates SEN-014622.

    Other documents obtained by the Subcommittee include 
instructions by senior KPMG tax professionals to their staff 
not to keep certain revealing documentation in their files or 
to clean out their files, again to avoid or limit detection of 
firm activity. For example, in the case of BLIPS, a KPMG tax 
professional sent an email to multiple colleagues stating: 
``You may want to remind everyone on Monday NOT to put a copy 
of Angie's email on the 988 elections in their BLIPS file. It 
is a road map for the taxing authorities to all the other 
listed transactions. I continue to find faxes from Quadra in 
the files . . . in the two 1996 deals here which are under CA 
audit which reference multiple transactions--not good if we 
would have to turn them over to California.'' 341 In 
the case of OPIS, a KPMG tax professional wrote: ``I have quite 
a few documents/papers/notes related to the OPIS transaction. . 
. . Purging unnecessary information now pursuant to an 
established standard is probably ok. If the Service asks for 
information down the road (and we have it) we'll have to give 
it to them I suspect. Input from (gulp) DPP may be 
appropriate.'' 342
---------------------------------------------------------------------------
    \341\ Email dated 1/3/00, from Dale Baumann to ``Jeff,'' ``988 
election memo,'' Bates KPMG 0026345.
    \342\ Email dated 9/16/98, from Bob to unknown recipients, 
``Documentation,'' Bates KPMG 0025729. Documents related to other KPMG 
tax products, such as TEMPEST and OTHELLO, contain similar information. 
See, e.g., message from Bob McCahill and Ken Jones, attached to an 
email dated 3/1/02, from Walter Duer to multiple KPMG tax 
professionals, ``RE: TCS Review of TEMPEST and OTHELLO,'' Bates KPMG 
0032378-80 (``There is current IRS audit activity with respect to two 
early TEMPEST engagements. One situation is under fairly intense 
scrutiny by IRS Financial Institutions and Products specialists. . . . 
Although KPMG has yet to receive a subpoena or any other request for 
documents, client lists, etc. we believe it is likely that such a 
request(s) is inevitable. Since TEMPEST is a National Stratecon 
solution for which Bob McCahill and Bill Reilly were the Co-Champions . 
. . it is most efficient to have all file reviews and ``clean-ups'' 
(electronic or hard copy) performed in one location, namely the FS NYC 
office. This effort will be performed by selected NE Stratecon 
professionals . . . with ultimate review and final decision making by 
Ken Jones. . . . [W]e want the same approach to be followed for OTHELLO 
as outlined above for TEMPEST. Senior tax leadership, Jeff Stein and 
Rick Rosenthal concur with this approach.'')
---------------------------------------------------------------------------
    Marketing Restrictions. KPMG also took precautions against 
detection of its activities during the marketing of the four 
products studied by the Subcommittee. FLIP and OPIS were 
explained only after potential clients signed a confidentiality 
agreement promising not to disclose the information to anyone 
else.343 In the case of BLIPS, KMPG tax 
professionals were instructed to obtain ``[s]igned 
nondisclosure agreements . . . before any meetings can be 
scheduled.'' 344 KPMG also limited the paperwork 
used to explain the products to clients. Client presentations 
were done on chalkboards or erasable whiteboards, and written 
materials were retrieved from clients before leaving a 
meeting.345 KPMG determined as well that 
``[p]roviding a copy of a draft opinion letter will no longer 
be done to assist clients in their due diligence.'' 
346 In SC2, the DPP head instructed KPMG tax 
professionals not to provide any ``sample documents'' directly 
to a client.347
---------------------------------------------------------------------------
    \343\ See, e.g., memorandum dated 8/5/98, from Doug Ammerman to PFP 
Partners, ``OPIS and Other Innovative Strategies,'' Bates KPMG 0026141-
43, at 2-3 (``subject to their signing a confidentiality agreement''); 
Jacoboni v. KPMG, Case No. 6:02-CV-510 (District Court for the Middle 
District of Florida) Complaint (filed 4/29/02), at para. 9 (``KPMG 
executives told [Mr. Jacoboni] he could not involve any other 
professionals because the investment `strategy' [FLIP] was 
`confidential.' '' Emphasis in original.); Subcommittee interview of 
legal counsel of Mr. Jacoboni (4/4/03).
    \344\ Email dated 5/5/99, from Jeffrey Eischeid to multiple KPMG 
tax professionals, ``Marketing BLIPS,'' Bates KPMG 0006106.
    \345\ Subcommittee interview of Wachovia Bank representatives (3/
25/03); Subcommittee interview of legal counsel of Theodore C. Swartz 
(9/16/03).
    \346\ Email dated 5/5/99, from Jeffrey Eischeid to multiple KPMG 
tax professionals, ``Marketing BLIPS,'' Bates KPMG 0006106.
    \347\ Email dated 4/11/00, from Larry DeLap to Tax Professional 
Practice Partners, ``S-Corporation Charitable Contribution Strategy 
(SC2),'' Bates KPMG 0052582.
---------------------------------------------------------------------------
    KPMG also attempted to place marketing restrictions on the 
number of products sold so that word of them would be 
restricted to a small circle. In the case of BLIPS, the DPP 
initially authorized only 50 to be sold.348 In the 
case of SC2, a senior tax professional warned against mass 
marketing the product to prevent the IRS from getting ``wind of 
it'':
---------------------------------------------------------------------------
    \348\ Email dated 5/5/99, from Jeffrey Eischeid to multiple KPMG 
tax professionals, ``Marketing BLIPS,'' Bates KPMG 0006106.

        ``I was copied on the message below, which appears to 
        indicate that the firm is intent on marketing the SC2 
        strategy to virtually every S corp with a pulse (if S 
        corps had pulses). Going way back to Feb. 2000, when 
        SC2 first reared its head, my recollection is that SC2 
        was intended to be limited to a relatively small number 
        of large S corps. That plan made sense because, in my 
        opinion, there was (and is) a strong risk of a 
        successful IRS attack on SC2 if the IRS gets wind of 
        it. . . . [T]he intimate group of S corps potentially 
        targeted for SC2 marketing has now expanded to 3,184 
        corporations. Call me paranoid, but I think that such a 
        widespread marketing campaign is likely to bring KPMG 
        and SC2 unwelcome attention from the IRS. . . . I 
        realize the fees are attractive, but does the firm's 
        tax leadership really think that his is an appropriate 
        strategy to mass market?'' 349
---------------------------------------------------------------------------
    \349\ Email dated 12/20/01, from William Kelliher to WNT head David 
Brockway, ``FW: SC2,'' Bates KPMG 0013311.

The DPP head responded: ``We had a verbal agreement following a 
conference call with Rick Rosenthal earlier this year that SC2 
would not be mass marketed. In any case, the time has come to 
formally cease all marketing of SC2. Please so notify your 
deployment team and the marketing directors.'' 350
---------------------------------------------------------------------------
    \350\ Email dated 12/29/01, from Larry DeLap to Larry Manth, David 
Brockway, William Kelliher and others, ``FW: SC2,'' Bates KPMG 0013311.
---------------------------------------------------------------------------

  (5) Disregarding Professional Ethics

    In addition to all the other problems identified in the 
Subcommittee investigation, troubling evidence emerged 
regarding how KPMG handled certain professional ethics issues, 
including issues related to fees, auditor independence, and 
conflicts of interest in legal representation.
    Contingent, Excessive, and Joint Fees. The fees charged by 
KPMG in connection with its tax products raise several 
concerns. It is clear that the lucrative nature of the fees 
drove the marketing efforts and helped convince other parties 
to participate.351 KPMG made more than $124 million 
from just the four tax products featured in this Report. Sidley 
Austin Brown & Wood made millions from issuing concurring legal 
opinions on the validity of the four tax products. Deutsche 
Bank made more than $30 million in fees and other profits from 
BLIPS.
---------------------------------------------------------------------------
    \351\ See, e.g., email dated 3/14/98, from Jeff Stein to multiple 
KPMG tax professionals, ``Simon Says,'' Bates 638010, filed by the IRS 
on June 16, 2003, as an attachment to Respondent's Requests for 
Admission, Schneider Interests v. Commissioner, U.S. Tax Court, Docket 
No. 200-02 (addressing a dispute over which of two tax groups, Personal 
Financial Planning and International, should get credit for revenues 
generated by OPIS).
---------------------------------------------------------------------------
    Traditionally, accounting firms charged flat fees or hourly 
fees for tax services. In the 1990's, however, accounting firms 
began charging ``value added'' fees based on ``the value of the 
services provided, as opposed to the time required to perform 
the services.'' 352 In addition, some firms began 
charging ``contingent fees'' that were paid only if a client 
obtained specified results from the services offered, such as 
achieving specified tax savings.353 Many states 
prohibit accounting firms from charging contingent fees due to 
the improper incentives they create, and a number of SEC, IRS, 
state, and AICPA rules allow their use in only limited 
circumstances.354
---------------------------------------------------------------------------
    \352\ KPMG Tax Services Manual, Sec. 31.11.1 at 31-6.
    \353\ See AICPA Code of Professional Conduct, Rule 302 (``[A] 
contingent fee is a fee established for the performance of any service 
pursuant to an arrangement in which no fee will be charged unless a 
specified finding or result is attained, or in which the amount of the 
fee is otherwise dependent upon the finding or result of such 
service.'')
    \354\ See, e.g., AICPA Rule 302; 17 C.F.R. Sec. 210.2-01(c)(5) (SEC 
contingent fee prohibition: ``An accountant is not independent if, any 
point during the audit and professional engagement period, the 
accountant provides any service or product to an audit client for a 
contingent fee.''); KPMG Tax Services Manual, Sec. 32.4 on contingent 
fees in general and Sec. 31.10.3 at 31-5 (DPP head determines whether 
specific KPMG fees comply with various rules on contingent fees.)
---------------------------------------------------------------------------
    Within KPMG, the head of DPP-Tax took the position that 
fees based on projected client tax savings were contingent fees 
prohibited by AICPA Rule 302.355 Other KPMG tax 
professionals disagreed, complained about the DPP 
interpretation, and pushed hard for fees based on projected tax 
savings. For example, one memorandum objecting to the DPP 
interpretation of Rule 302 warned that it ``threatens the value 
to KPMG of a number of product development efforts,'' ``hampers 
our ability to price the solution on a value added basis,'' and 
will cost the firm millions of dollars.356 The 
memorandum also objected strongly to applying the contingent 
fee prohibition to, not only the firm's audit clients, but also 
to any individual who ``exerts significant influence over'' an 
audit client, such as a company director or officer, as 
required by the DPP. The memorandum stated this expansive 
reading of the prohibition was problematic, because ``many, if 
not most, of our CaTS targets are officers/directors/
shareholders of our assurance clients.'' 357 The 
memorandum states: ``At the present time, we do not know if 
DPP's interpretation of Rule 302 has been adopted with the full 
awareness of the firm's leadership. . . . However, it is our 
impression that no one other than DPP has fully considered the 
issue and its impact on the tax practice.''
---------------------------------------------------------------------------
    \355\ Subcommittee interview of Lawrence DeLap (10/30/03); 
memorandum dated 7/14/98, from Gregg Ritchie to multiple KPMG tax 
professionals, ``Rule 302 and Contingency Fees--CONFIDENTIAL,'' Bates 
KPMG 0026557-58.
    \356\ Memorandum dated 7/14/98, from Gregg Ritchie to multiple KPMG 
tax professionals, ``Rule 302 and Contingency Fees--CONFIDENTIAL,'' 
Bates KPMG 0026555-59.
    \357\ ``CaTS'' stands for KPMG's Capital Transaction Services Group 
which was then in existence and charged with selling tax products to 
high net worth individuals.
---------------------------------------------------------------------------
    In the four case studies examined by the Subcommittee, the 
fees charged by KPMG for BLIPS, OPIS, and FLIP were clearly 
based upon the client's projected tax savings.358 In 
the case of BLIPS, for example, the BLIPS National Deployment 
Champion wrote the following description of the tax product and 
recommended that fees be set at 7% of the generated ``tax 
loss'' that clients would achieve on paper from the BLIPS 
transactions and could use to offset and shelter other income 
from taxation:
---------------------------------------------------------------------------
    \358\ If a client objected to the requested fee, KPMG would, on 
occasion, negotiate a lower, final amount.

        ``BLIPS . . . [A] key objective is for the tax loss 
        associated with the investment structure to offset/
        shelter the taxpayer's other, unrelated, economic 
        profits. . . . The all-in cost of the program, assuming 
        a complete loss of investment principal, is 7% of the 
        targeted tax loss (pre-tax). The tax benefit of the 
        investment program, which ranges from 20% to 45% of the 
        targeted tax loss, will depend on the taxpayer's 
---------------------------------------------------------------------------
        effective tax rates.

        ``FEE: BLIPS is priced on a fixed fee basis which 
        should approximate 1.25% of the tax loss. Note that 
        this fee is included in the 7% described above.'' 
        359
---------------------------------------------------------------------------
    \359\ Document dated 7/21/99, entitled ``Action Required,'' 
authored by Jeffrey Eischeid, Bates KPMG 0040502. See also, e.g., 
memorandum dated 8/5/98, from Doug Ammerman to ``PFP Partners,'' ``OPIS 
and Other Innovative Strategies,'' Bates KPMG 0026141-43 at 2 (``In the 
past KPMG's fee related to OPIS has been paid by Presidio. According to 
DPP-Assurance, this fee structure may constitute a contingent fee and, 
as a result, may be a prohibited arrangement. . . . KPMG's fee must be 
a fixed amount and be paid directly by the client/target.'' Emphasis in 
original.)

    Another document, an email sent from Presidio to KPMG, 
provides additional detail on the 7% fee charged to BLIPS 
clients, ascribing ``basis points'' or portions of the 7% fee 
to be paid to various participants for various expenses. All of 
these basis points, in turn, depended upon the size of the 
client's expected tax loss to determine their amount. The email 
---------------------------------------------------------------------------
states:

        ``The breakout for a typical deal is as follows:
            Bank Fees    125
            Mgmt Fees    275
            Gu[aran]teed Pymt.    8
            Net Int. Exp.    6
            Trading Loss    70
            KPMG    125
            Net return to Class A 91'' 360
---------------------------------------------------------------------------
    \360\ Email dated 5/24/00, from Kerry Bratton of Presidio to Angie 
Napier of KPMG, ``RE: BLIPS--7 percent,'' Bates KPMG 0002557.

Virtually all BLIPS clients were charged this 7% fee.
    In the case of SC2, which was constructed to shelter 
certain S corporation income otherwise attributable and taxable 
to the corporate owner, KPMG described SC2 fees as ``fixed'' at 
the beginning of the engagement at an amount that ``generally . 
. . approximated 10 percent of the expected average taxable 
income of the S Corporation for the 2 years following 
implementation.'' 361 SC2 fees were set at a minimum 
of $500,000, and went as high as $2 million per 
client.362
---------------------------------------------------------------------------
    \361\ Tax Solution Alert for S-Corporation Charitable Contribution 
Strategy, FY00-28, revised as of 12/7/01, at 2. See also email dated 
12/27/01, from Larry Manth to Andrew Atkin and other KPMG tax 
professionals, ``SC2,'' Bates KPMG 0048773 (describing SC2 fees as 
dependent upon client tax savings).
    \362\ Id.
---------------------------------------------------------------------------
    The documents suggest that, at least in some cases, KPMG 
deliberately manipulated the way it handled certain tax 
products to circumvent state prohibitions on contingent fees. 
For example, a document related to OPIS identifies the states 
that prohibit contingent fees. Then, rather than prohibit OPIS 
transactions in those states or require an alternative fee 
structure, the memorandum directs KPMG tax professionals to 
make sure the OPIS engagement letter is signed, the engagement 
is managed, and the bulk of services is performed ``in a 
jurisdiction that does not prohibit contingency fees.'' 
363
---------------------------------------------------------------------------
    \363\ Memorandum dated 7/1/98, from Gregg Ritchie and Jeffrey Zysik 
to ``CaTS Team Members,'' ``OPIS Engagements--Prohibited States,'' 
Bates KPMG 0011954.
---------------------------------------------------------------------------
    Another set of fee issues related to the fees paid to the 
key law firm that issued concurring legal opinions supporting 
the four KPMG tax products, Sidley Austin Brown & Wood. This 
law firm was paid $50,000 for each legal opinion it provided in 
connection with BLIPS, FLIP, and OPIS. Documents and interview 
evidence obtained by the Subcommittee indicate that the law 
firm was paid even more in transactions intended to provide 
clients with large tax losses, and that the amount paid to the 
law firm may have been linked directly to the size of the 
client's expected tax loss. For example, one email describing 
the fee amounts to be paid to Sidley Austin Brown & Wood in 
BLIPS and OPIS deals appears to assign to the law firm ``basis 
points'' or percentages of the client's expected tax loss:

        ``Brown & Wood fees:
            Quadra OPIS98--30 bpts
            Quadra OPIS99--30 bpts
            Presidio OPIS98--25 bpts
            Presidio OPIS99--25 bpts
            BLIPS--30 bpts'' 364
---------------------------------------------------------------------------
    \364\ Email dated 5/15/00, from Angie Napier to Jeffrey Eischied 
and others, ``B&W fees and generic FLIP rep letter,'' Bates KPMG 
0036342.

    American Bar Association (ABA) Model Rule 1.5 states that 
``[a] lawyer shall not make an agreement for, charge, or 
collect an unreasonable fee,'' and cites as the factors to 
consider when setting a fee amount ``the time and labor 
required, the novelty and difficulty of the questions involved, 
and the skill requisite to perform the legal service 
properly.'' Sidley Austin Brown & Wood charged substantially 
the same fee for each legal opinion it issued to a FLIPS, OPIS, 
or BLIPS client, even when opinions drafted after the initial 
prototype opinion contained no new facts or legal analysis, 
were virtually identical to the prototype except for client 
names, and in many cases required no client consultation. As 
mentioned earlier, in BLIPS, Sidley Austin Brown & Wood was 
also paid a fee in any sale where a prospective buyer was told 
that the law firm would provide a favorable tax opinion letter 
if asked, regardless of whether the opinion was later requested 
or provided.365 These fees, with few costs after the 
prototype opinion was drafted, raise questions about the firm's 
compliance with ABA Model Rule 1.5.
---------------------------------------------------------------------------
    \365\ See ``Declaration of Richard E. Bosch,'' IRS Revenue Agent, 
In re John Doe Summons to Sidley Austin Brown & Wood (N.D. Ill. 10/16/
03) at para. 18, citing an email dated 10/1/97, from Gregg Ritchie to 
Randall Hamilton, ``Flip Tax Opinion.''
---------------------------------------------------------------------------
    Still another issue involves joint fees. In the case of 
BLIPS, clients were charged a single fee equal to 7% of the tax 
losses to be generated by the BLIPS transactions. The client 
typically paid this fee to Presidio, an investment advisory 
firm, which then apportioned the fee amount among various firms 
according to certain factors. The fee recipients typically 
included KPMG, Presidio, participating banks, and Sidley Austin 
Brown & Wood, and one of the factors determining the fee 
apportionment was who had brought the client to the table. This 
fee splitting arrangement may violate restrictions on 
contingency and client referral fees, as well as an American 
Bar Association prohibition against law firms sharing legal 
fees with non-lawyers.366
---------------------------------------------------------------------------
    \366\ See ABA Model Rule 5.4, ``A lawyer or law firm shall not 
share legal fees with a non-lawyer.'' Reasons provided for this rule 
include ``protect[ing] the lawyer's professional independence of 
judgment.''
---------------------------------------------------------------------------
    Auditor Independence. Another professional ethics issue 
involves auditor independence. Deutsche Bank, HVB, and Wachovia 
Bank are all audit clients of KPMG, and at various times all 
three have played roles in marketing or implementing KPMG tax 
products. Deutsche Bank and HVB provided literally billions of 
dollars in financing to make OPIS and BLIPS transactions 
possible. Wachovia, through First Union National Bank, referred 
clients to KPMG and was paid or promised a fee for each client 
who actually purchased a tax product. For example, one internal 
First Union email on fees stated: ``Fees to First Union will be 
50 basis points if the investor is not a KPMG client, and 25 
bps if they are a KPMG client.'' 367
---------------------------------------------------------------------------
    \367\ Email dated 8/30/99, from Tom Newman to multiple First Union 
employees, ``next strategy,'' Bates SEN-014622.
---------------------------------------------------------------------------
    KPMG Tax Services Manual states: ``Due to independence 
considerations, the firm does not enter into alliances with SEC 
audit clients.'' 368 KPMG defines an ``alliance'' as 
``a business relationship between KPMG and an outside firm in 
which the parties intend to work together for more than a 
single transaction.'' 369 KPMG policy is that ``[a]n 
oral business relationship that has the effect of creating an 
alliance should be treated as an alliance.'' 370 
Another provision in KPMG's Tax Services Manual states: ``The 
SEC considers independence to be impaired when the firm has a 
direct or material indirect business relationship with an SEC 
audit client.'' 371
---------------------------------------------------------------------------
    \368\ KPMG Tax Services Manual, Sec. 52.1.3 at 52-1.
    \369\ Id., Sec. 52.1.1 at 52-1.
    \370\ Minutes dated 9/28/98, of KPMG ``Assurance/Tax Professional 
Practice Meeting'' in New York, ``Summary of Conclusions and Action 
Steps,'' Bates XX 001369-74, at 1373.
    \371\ KPMG Tax Services Manual, Sec. 52.5.2 at 52-6 (Emphasis in 
original.). The SEC ``Business Relationships'' regulation states: ``An 
accountant is not independent if, at any point during the audit and 
professional engagement period, the accounting firm or any covered 
person in the firm has any direct or material indirect business 
relationship with an audit client, or with persons associated with the 
audit client in a decision-making capacity, such as an audit client's 
officers, directors, or substantial stockholders.'' 17 C.F.R. 
Sec. 210.2-01(c)(3).
---------------------------------------------------------------------------
    Despite the SEC prohibition and the prohibitions and 
warnings in its own Tax Services Manual, KPMG worked with audit 
clients, Deutsche Bank, HVB, and Wachovia, on multiple BLIPS, 
FLIP, and OPIS transactions. In fact, at Deutsche Bank, the 
KPMG partner in charge of Deutsche Bank audits in the United 
States expressly approved the bank's accounting of the loans 
for the BLIPS transactions.372 KPMG tax 
professionals were aware that doing business with an audit 
client raised auditor independence concerns.373 KPMG 
apparently attempted to resolve the auditor independence issue 
by giving clients a choice of banks to use in the OPIS and 
BLIPS transactions, including at least one bank that was not a 
KPMG audit client.374 It is unclear, however, 
whether individuals actually could choose what bank to use. It 
is also unclear how providing clients with a choice of banks 
alleviated KPMG's conflict of interest, since it still had a 
direct or material, indirect business relationship with banks 
whose financial statements were certified by KPMG auditors.
---------------------------------------------------------------------------
    \372\ Undated document prepared by Deutsche Bank in 1999, ``New 
Product Committee Overview Memo: BLIPS Transaction,'' Bates DB BLIPS 
6906-10, at 6909-10.
    \373\ See, e.g., memorandum dated 8/5/98, from Doug Ammerman to 
``PFP Partners,'' ``OPIS and Other Innovative Strategies,'' Bates KPMG 
0026141-43 (``Currently, the only institution participating in the 
transaction is a KPMG audit client. . . . As a result, DPP-Assurance 
feels there may be an independence problem associated with our 
participation in OPIS . . .''); email dated 2/11/99, from Larry DeLap 
to multiple KPMG tax professionals, ``RE: BLIPS,'' Bates KPMG 0037992 
(``The opinion letter refers to transactions with Deutsche Bank. If the 
transactions will always involve Deutsche Bank, we could have an 
independence issue.''); email dated 4/20/99, from Larry DeLap to 
multiple KPMG tax professionals, ``BLIPS,'' Bates KPMG 0011737-38 
(Deutsche Bank, a KPMG audit client, is conducting BLIPS transactions); 
email dated 11/30/01, from Councill Leak to Larry Manth, ``FW: First 
Union Customer Services,'' Bates KPMG 0050842 (lengthy discussion of 
auditor independence concerns and First Union).
    \374\ See, e.g., email dated 4/20/99, from Larry DeLap to multiple 
KPMG tax professionals, ``BLIPS,'' Bates KPMG 0011737-38 (discussing 
using Deutsche Bank, a KPMG audit client, in BLIPS transactions).
---------------------------------------------------------------------------
    In 2003, the SEC opened an informal inquiry into whether 
the client referral arrangements between KPMG and Wachovia 
violated the SEC's auditor independence rules. In its second 
quarter filing with the SEC in August 2003, Wachovia provides 
the following description of the ongoing SEC inquiry:

        ``On June 19, 2003, the Securities and Exchange 
        Commission informally requested Wachovia to produce 
        certain documents concerning any agreements or 
        understandings by which Wachovia referred clients to 
        KPMG LLP during the period January 1, 1997 to the 
        present. Wachovia is cooperating with the SEC in its 
        inquiry. Wachovia believes the SEC's inquiry relates to 
        certain tax services offered to Wachovia customers by 
        KPMG LLP during the period from 1997 to early 2002, and 
        whether these activities might have caused KPMG LLP not 
        to be `independent' from Wachovia, as defined by 
        applicable accounting and SEC regulations requiring 
        auditors of an SEC-reporting company to be independent 
        of the company. Wachovia and/or KPMG LLP received fees 
        in connection with a small number of personal financial 
        consulting transactions related to these services. 
        During all periods covered by the SEC's inquiry, 
        including the present, KPMG LLP has confirmed to 
        Wachovia that KPMG LLP was and is `independent' from 
        Wachovia under applicable accounting and SEC 
        regulations.''

In its third quarter filing with the SEC, Wachovia stated that, 
on October 21, 2003, the SEC issued a ``formal order of 
investigation'' into this matter, and the bank is continuing to 
cooperate with the inquiry.
    A second set of auditor independence issues involves KPMG's 
decision to market tax products to its own audit clients. 
Evidence appears throughout this Report of KPMG's efforts to 
sell tax products to its audit clients or the officers, 
directors, or shareholders of its audit clients. This evidence 
includes instances in which KPMG mined its audit client data to 
develop a list of potential clients for a particular tax 
product; 375 tax products that were designed and 
explicitly called for ``fostering cross-selling among assurance 
and tax professionals''; 376 and marketing 
initiatives that explicitly called upon KPMG tax professionals 
to contact their audit partner counterparts and work with them 
to identify appropriate clients and pitch KPMG tax products to 
those audit clients.377 A KPMG memorandum cited 
earlier in this Report observed that ``many, if not most, of 
our CaTS targets are officers/directors/shareholders of our 
assurance clients.'' 378
---------------------------------------------------------------------------
    \375\ See, e.g., Presentation dated 7/17/00, ``Targeting 
Parameters: Intellectual Property--Assurance and Tax,'' with attachment 
dated September 2000, entitled ``Intellectual Property Services,'' at 
page 1 of the attachment, Bates XX 001567-93.
    \376\ Presentation dated 3/6/00, ``Post-Transaction Integration 
Service (PTIS)--Tax,'' by Stan Wiseberg and Michele Zinn of Washington, 
D.C., Bates XX 001597-1611.
    \377\ Email dated 8/14/01, from Jeff Stein and Walter Duer to 
``KPMG LLP Partners, Managers and Staff,'' ``Stratecon Middle Market 
Initiative,'' Bates KPMG 0050369.
    \378\ Memorandum dated 7/14/98, from Gregg Ritchie to multiple KPMG 
tax professionals, ``Rule 302 and Contingency Fees--CONFIDENTIAL,'' 
Bates KPMG 0026555-59. CaTS stands for the Capital Transaction Services 
Group which was then in existence and charged with selling tax products 
to high net worth individuals.
---------------------------------------------------------------------------
    By using its audit partners to identify potential clients 
and targeting its audit clients for tax product sales pitches, 
KPMG not only took advantage of its auditor-client 
relationship, but also created a conflict of interest in those 
cases where it successfully sold a tax product to an audit 
client. This conflict of interest arises when the KPMG auditor 
reviewing the client's financial statements is required, as 
part of that review, to examine the client's tax return and its 
use of the tax product to reduce its tax liability and increase 
its income. In such situations, KPMG is, in effect, auditing 
its own work.
    The inherent conflict of interest is apparent in the 
minutes of a 1998 meeting held in New York between KPMG top tax 
and assurance professionals to address topics of concern to 
both divisions of KPMG.379 A written summary of this 
meeting includes as its first topic: ``Accounting 
Considerations of New Tax Products.'' The section makes a 
single point: ``Some tax products have pre-tax accounting 
implications. DPP-Assurance's role should be to review the 
accounting treatment, not to determine it.'' 380 
This characterization of the issue implies not only a tension 
between KPMG's top auditing and tax professionals, but also an 
effort to diminish the authority of the top assurance 
professionals and make it clear that they may not ``determine'' 
the accounting treatment for new tax products.
---------------------------------------------------------------------------
    \379\ Minutes dated 9/28/98, of KPMG ``Assurance/Tax Professional 
Practice Meeting'' in New York, ``Summary of Conclusions and Action 
Steps,'' Bates XX 001369-74. (Capitalization in original omitted.)
    \380\ Id. at Bates XX 001369. (Emphasis in original.)
---------------------------------------------------------------------------
    The next topic in the meeting summary is: ``Financial 
Statement Treatment of Aggressive Tax Positions.'' 
381 Again, the section discloses an ongoing tension 
between KPMG's top auditing and tax professionals on how to 
account for aggressive tax products in an audit client's 
financial statements. The section notes that discussions had 
taken place and further discussions were planned ``to determine 
whether modifications may be made'' to KPMG's policies on how 
``aggressive tax positions'' should be treated in an audit 
client's financial statements. An accompanying issue list 
implies that the focus of the discussions will be on weakening 
rather than strengthening the existing policies. For example, 
among the policies to be re-examined were KPMG's policies that, 
``[n]o financial statement tax benefit should be provided 
unless it is probable the position will be allowed,'' 
382 and that the ``probable of allowance'' test had 
to be based solely on technical merits and could not consider 
the ``probability'' that a client might win a negotiated 
settlement with the IRS. The list also asked, in effect, 
whether the standard for including a financial statement tax 
benefit in a financial statement could be lowered to include, 
not only tax products that ``should'' survive an IRS challenge, 
which KPMG interprets as having a 70% or higher probability, 
but also tax products that are ``more-likely-than-not'' to 
withstand an IRS challenge, meaning a better than 50% 
probability.
---------------------------------------------------------------------------
    \381\ Minutes dated 9/28/98, of KPMG ``Assurance/Tax Professional 
Practice Meeting'' in New York, ``Summary of Conclusions and Action 
Steps,'' Bates XX 001369-74.
    \382\ Id. at Bates XX 001370. (Emphasis in original.)
---------------------------------------------------------------------------
    Conflicts of Interest in Legal Representation. A third set 
of professional ethics issues involves legal representation of 
clients who, after purchasing a tax product from KPMG, have 
come under the scrutiny of the IRS for buying an illegal tax 
shelter and understating their tax liability on their tax 
returns. The mass marketing of tax products has led to mass 
enforcement efforts by the IRS after a tax product has been 
found to be abusive and the IRS obtains the lists of clients 
who purchased the product. In response, certain law firms have 
begun representing multiple clients undergoing IRS audit for 
purchasing similar tax shelters.
    One key issue involves KPMG's role in referring its tax 
shelter clients to specific law firms. In 2002, KPMG assembled 
a list of ``friendly'' attorneys and began steering its clients 
to them for legal representation. For example, an internal KPMG 
email providing guidance on ``FLIPS/OPIS/BLIPS Attorney 
Referrals'' states: ``This is a list that our group put 
together. All of the attorneys are part of the coalition and 
friendly to the firm. Feel free to forward to a client if they 
would like a referral.'' 383 The ``coalition'' 
referred to in the email is a group of attorneys who had begun 
working together to address IRS enforcement actions taken 
against taxpayers who had used the FLIP, OPIS, or BLIPS tax 
products.
---------------------------------------------------------------------------
    \383\ Email dated 4/9/02, from Erin Collins to multiple KPMG tax 
professionals, ``FLIPS/OPIS/BLIPS Attorney Referrals,'' Bates KPMG 
0050113. See also email dated 11/4/02, from Ken Jones to multiple KPMG 
tax professionals, ``RE: Script,'' Bates KPMG 0050130 (``Attached is a 
list of law firms that are handling FLIP/OPIS cases. Note that there 
are easily another 15 or so law firms . . . but these are firms that we 
have dealt with in the past. Note that we are not making a 
recommendation, although if someone wants to talk about the various 
strengths/weaknesses of one firm vs. another . . . we can do that.'').
---------------------------------------------------------------------------
    One concern with the KPMG referral list is that at least 
some of the clients being steered to ``friendly'' law firms 
might want to sue KPMG itself for selling them an illegal tax 
shelter. In one instance examined by the Subcommittee, for 
example, a KPMG client under audit by the IRS for using BLIPS 
was referred by KPMG to a law firm, Sutherland, Asbill & 
Brennan, with which KPMG had a longstanding relationship but 
with which the client had no prior contact. In this particular 
instance, the law firm did not even have offices in the 
client's state. The client was also one of more than two dozen 
clients that KPMG had steered to this law firm. While KPMG did 
not obtain a fee for making those client referrals, the firm 
likely gained favorable attention from the law firm for sending 
it multiple clients with similar cases. These facts suggest 
that Sutherland Asbill would owe a duty of loyalty to KPMG, not 
only as a longstanding and important client, but also as a 
welcome source of client referrals.
    The engagement letter signed by the KPMG client, in which 
he agreed to pay Sutherland Asbill to represent him before the 
IRS in connection with BLIPS, contained this disclosure:

        ``In the event you desire to pursue claims against the 
        parties who advised you to enter into the transaction, 
        we would not be able to represent you in any such 
        claims because of the broad malpractice defense 
        practice of our litigation team (representing all of 
        the Big Five accounting firms, for example).'' 
        384
---------------------------------------------------------------------------
    \384\ Engagement letter between Sutherland Asbill & Brennan LLP and 
the client, dated 7/23/02, at 1, Bates SA 001964.

The KPMG client told the Subcommittee that he had not 
understood at the time that this disclosure meant that 
Sutherland Asbill was already representing KPMG in other 
``malpractice defense'' matters and therefore could not 
represent him if he decided to sue KPMG for selling him an 
illegal shelter. The client signed the engagement letter on 
July 24, 2002.
    On September 8, 2002, Sutherland Asbill ``engaged KPMG'' 
itself to assist the law firm in its representation of KPMG's 
former client, including with respect to ``investigation of 
facts, review of tax issues, and other such matters as Counsel 
may direct.'' This engagement meant that KPMG, as Sutherland 
Asbill's agent, would have access to confidential information 
related to its client's legal representation, and that KPMG 
itself would be providing key information and analysis in the 
case. It also meant that the KPMG client would be paying for 
the services provided by the same accounting firm that had sold 
him the tax shelter. When a short while later, the client asked 
Sutherland Asbill about the merits of suing KPMG, he was told 
that the firm could not represent him in such a legal action, 
and he switched to new legal counsel.
    The conflict of interest issues here involve, not only 
whether KPMG should be referring its clients to a ``friendly'' 
law firm, but also whether the law firm itself should be 
accepting these clients, in light of the firm's longstanding 
and close relationship with KPMG. While both KPMG and the 
client have an immediate joint interest in defending the 
validity of the tax product that KPMG sold and the client 
purchased, their interests could quickly diverge if the suspect 
tax product is found to be in violation of federal tax law. 
This divergence in interests has been demonstrated repeatedly 
since 2002, as growing numbers of KPMG clients have filed suit 
against KPMG seeking a refund of past fees paid to the firm and 
additional damages for KPMG's selling them an illegal tax 
shelter.
    The preamble to the American Bar Association (ABA) Model 
Rules states that ``a lawyer, as a member of the legal 
profession, is a representative of clients, an officer of the 
legal system and a public citizen having special responsibility 
for the quality of justice. . . . As (an) advocate, a lawyer 
zealously asserts the client's position under the rules of the 
adversary system.'' The problem here is the conflict of 
interest that arises when a law firm attempts to represent an 
accounting firm's client at the same time it is representing 
the accounting firm itself, and the issue in controversy is a 
tax product that the accounting firm sold and the client 
purchased. In such a case, the attorney cannot zealously 
represent the interests of both clients due to conflicting 
loyalties. A related issue is whether the law firm can 
ethically use the accounting firm as the tax expert in the 
client's case, given the accounting firm's self interest in the 
case outcome.
    At the request of the Subcommittee, the Congressional 
Research Service's American Law Division analyzed the possible 
conflict of interest issues.385 The CRS analysis 
concluded that, under American Bar Association Model Rule 1.7, 
a law firm should decline to represent an accounting firm 
client in a tax shelter case if the law firm already represents 
the accounting firm itself on other matters. The CRS analysis 
identified ``two possible, and interconnected, conflicts of 
interest'' that should lead the law firm to decline the 
engagement. The first is a ``current conflict of interest'' at 
the time of engagement, which arises from ``a `substantial 
risk' that the attorney . . . would be `materially limited' by 
his responsibilities to another client'' in ``pursuing certain 
relevant and proper courses of action on behalf of the new 
client'' such as filing suit against the firm's existing 
client, the accounting firm. The second is a ``potential 
conflict of interest whereby the attorney may not represent the 
new client in litigation . . . against an existing, current 
client. That particular, potential conflict of interest could 
not be waived.''
---------------------------------------------------------------------------
    \385\ Memorandum dated 11/14/03, by Jack Maskell, Legislative 
Attorney, American Law Division, Congressional Research Service, 
``Attorneys and Potential Conflicts of Interest Between New Clients and 
Existing Clients.''
---------------------------------------------------------------------------
    The CRS analysis also recommends that the law firm fully 
inform a potential client about the two conflicts of interest 
prior to any engagement, so that the client can make a 
meaningful decision on whether he or she is willing to be 
represented by a law firm that already represents the 
accounting firm that sold the client the tax product at issue. 
According to ABA Model Rule 1.7, informed consent must be in 
writing, but ``[t]he requirement of a writing does not supplant 
the need in most cases for the lawyer to talk with the client, 
to explain the risks and advantages, if any, of representation 
burdened with a conflict of interest, as well as reasonably 
available alternatives, and to afford the client a reasonable 
opportunity to consider the risks and alternatives and to raise 
questions and concerns.'' The CRS analysis opines that a 
``blanket disclosure'' provided by a law firm in an engagement 
letter is insufficient, without additional information, to 
ensure the client fully understands and consents to the 
conflicts of interest inherent in the law firm's dual 
representation of the client and the accounting firm.


                               APPENDICES

                              ----------                              
                               APPENDIX A


       CASE STUDY OF BOND LINKED ISSUE PREMIUM STRUCTURE (BLIPS)

    KPMG approved the Bond Linked Issue Premium Structure 
(BLIPS) for sale to multiple clients in 1999. KPMG marketed 
BLIPS for about 1 year, from about October 1999 to about 
October 2000. KPMG sold BLIPS to 186 individuals, in 186 
transactions, and obtained more than $53 million in revenues, 
making BLIPS one of KPMG's top revenue producers in the years 
it was sold and the highest revenue-producer of the four case 
studies examined by the Subcommittee.
    BLIPS was developed by KPMG primarily as a replacement for 
earlier KPMG tax products, FLIP and OPIS, each of which KPMG 
has characterized as a ``loss generator'' or ``gain mitigation 
strategy.'' 386 In 2000, the IRS issued a notice 
declaring transactions like BLIPS to be potentially abusive tax 
shelters.387
---------------------------------------------------------------------------
    \386\ See, e.g., document dated 5/18/01, ``PFP Practice 
Reorganization Innovative Strategies Business Plan--DRAFT,'' authored 
by Jeffrey Eischeid, Bates KPMG 0050620-23, at 1.
    \387\ BLIPS is covered by IRS Notice 2000-44 (2000-36 IRB 255) (9/
5/00).
---------------------------------------------------------------------------
    BLIPS is so complex that a full explanation of it would 
take more space that this Report allows, but it can be 
summarized as follows. Charts depicting a typical BLIPS 
transaction are also provided.388
---------------------------------------------------------------------------
    \388\ A detailed explanation of these charts is included in the 
opening statement of Senator Carl Levin at the hearing before the 
Senate Permanent Subcommittee on Investigations, ``U.S. Tax Shelter 
Industry: The Role of Accountants, Lawyers, and Financial 
Professionals'' (11/18/03).

    1) The Gain. Individual has ordinary or capital gains 
---------------------------------------------------------------------------
income (e.g., $20 million).

    2) The Sales Pitch. Individual is approached with a ``tax 
advantaged investment strategy'' by KPMG and Presidio, an 
investment advisory firm, to generate an artificial ``loss'' 
sufficient to offset the income and shelter it from taxation. 
Individual is told that, for a fee, Presidio will arrange the 
required investments and bank financing, and KPMG and a law 
firm will provide separate opinion letters stating it is ``more 
likely than not'' the tax loss generated by the investments 
will withstand an IRS challenge.

    3) The Shell Corporation. Pursuant to the strategy, 
Individual forms a single-member limited liability corporation 
(``LLC'') and contributes cash equal to 7% ($1.4 million) of 
the tax loss ($20 million) to be generated by the strategy.

    4) The ``Loan.'' LLC obtains from a bank, for a fee, a non-
recourse ``loan'' (e.g., $50 million) with an ostensible 7-year 
term at an above-market interest rate, such as 16%. Because of 
the above-market interest rate, LLC also obtains from the bank 
a large cash amount up-front (e.g., $20 million) referred to as 
a ``loan premium.'' The ``premium'' equals the net present 
value of the portion of the ``loan'' interest payments that 
exceed the market rate and that LLC is required to pay during 
the full 7-year ``loan.'' The ``loan premium'' also equals the 
tax loss to be generated by the strategy. LLC thus receives two 
cash amounts from the bank ($50 million plus $20 million 
totaling $70 million).

    5) The ``Loan'' Restrictions. LLC agrees to severe 
restrictions on the ``loan'' to make it a very low credit risk. 
Most importantly, LLC agrees to maintain ``collateral'' in cash 
or liquid securities equal to 101% of the ``loan'' amount, 
including the ``loan premium'' (e.g., $70.8 million). LLC also 
agrees to severe limits on how the ``loan proceeds'' may be 
invested and gives the bank unilateral authority to terminate 
the ``loan'' if the ``collateral'' amount drops below 101% of 
the ``loan'' amount.

    6) The Partnership. LLC and two Presidio affiliates form a 
partnership called a Strategic Investment Fund (``Fund'') in 
which LLC has a 90% partnership interest, one Presidio 
affiliate holds a 9% interest, and the second Presidio 
affiliate has a 1% interest. The 1% Presidio affiliate is the 
managing partner.

    7) The Assets. The Fund is capitalized with the following 
assets. The LLC contributes all of its assets, consisting of 
the ``loan'' ($50 million), ``loan premium'' ($20 million), and 
the Individual's cash contribution ($1.4 million). Presidio's 
two affiliates contribute cash equal to 10% of the LLC's total 
assets ($155,000). The Fund's capital is a total of these 
contributions ($71.6 million).

    8) The Loan Transfer. LLC assigns the ``loan'' to the Fund 
which assumes LLC's obligation to repay it. This obligation 
includes repayment of the ``loan'' and ``loan premium,'' since 
the ``premium'' consists of a portion of the interest payments 
owed on the ``loan'' principal.

    9) The Swap. At the same time, the Fund enters into a swap 
transaction with the bank on the ``loan'' interest rate. In 
effect, the Fund agrees to pay a floating market rate on an 
amount equal to the ``loan'' and ``loan premium'' (about 8% on 
$70 million), while the bank agrees to pay the 16% fixed rate 
on the face amount of the ``loan'' (16% on $50 million). The 
effect of this swap is to reduce the ``loan'' interest rate to 
a market-based rate.

    10) The Foreign Currency Investment ``Program.'' The Fund 
converts most of its U.S. dollars into euros with a contract to 
convert the funds back into U.S. dollars in 30-60 days. This 
amount includes most or all of the loan and loan premium 
amount. Any funds not converted into euros remain in the Fund 
account. The euros are placed in an account at the bank. The 
Fund engages in limited transactions which involve the 
``shorting'' of certain low-risk foreign currencies and which 
are monitored by the bank to ensure that only a limited amount 
of funds are ever placed at risk and that the funds deemed as 
101% ``collateral'' for the bank ``loan'' are protected.

    11) The Unwind. After 60 to 180 days, LLC withdraws from 
the partnership. The partnership unwinds, converts all cash 
into U.S. dollars, and uses that cash to repay the ``loan'' 
plus a ``prepayment penalty'' equal to the unamortized amount 
of the ``loan premium,'' so that the ``loan'' and ``loan 
premium'' are paid in full. Any remaining partnership assets 
are apportioned and distributed to the LLC and Presidio 
partners, either in cash or securities. LLC sells any 
securities at fair market value.

    12) Tax Claim for Cost Basis. For tax purposes, the LLC's 
income or loss passes to its owner, the Individual. According 
to the opinion letters, the Individual can attempt to claim, 
for tax purposes, that he or she retained a cost basis in the 
partnership equal to the LLC's contributions of cash ($1.4 
million) and the ``loan premium'' ($20 million), even though 
the partnership later assumed the LLC's ``loan'' obligation and 
repaid the ``loan'' in full, including the ``premium amount.'' 
According to the opinion letters, the individual can attempt to 
claim a tax loss equal to the cost basis ($21.4 million), 
adjusted for any gain or loss from the currency trades, and use 
that tax loss to offset ordinary or capital gains income.

    13) IRS Action. In 2000, the IRS issued a notice declaring 
that the ``purported losses'' arising from these types of 
transactions, which use an ``artificially high basis,'' ``do 
not represent bona fide losses reflecting actual economic 
consequences'' and ``are not allowable as deductions for 
federal income tax purposes.'' IRS Notice 2000-44 listed this 
transaction as a potentially abusive tax shelter.

[GRAPHIC] [TIFF OMITTED] T0655.001

[GRAPHIC] [TIFF OMITTED] T0655.002

[GRAPHIC] [TIFF OMITTED] T0655.003

[GRAPHIC] [TIFF OMITTED] T0655.004

[GRAPHIC] [TIFF OMITTED] T0655.005

[GRAPHIC] [TIFF OMITTED] T0655.006

[GRAPHIC] [TIFF OMITTED] T0655.007

[GRAPHIC] [TIFF OMITTED] T0655.008



                               APPENDIX B

   CASE STUDY OF S-CORPORATION CHARITABLE CONTRIBUTION STRATEGY (SC2)

    KPMG approved the S-Corporation Charitable Contribution 
Strategy (SC2) for sale to multiple clients in 2000. KPMG 
marketed SC2 for about 18 months, from about March 2000 to 
about September 2001. KPMG sold SC2 to 58 S-corporations, in 58 
transactions, and obtained more than $26 million in revenues, 
making SC2 one of KPMG's top ten revenue producers in 2000 and 
2001. SC2 is not covered by a ``listed transaction'' issued by 
the IRS, but is currently under IRS review.
    SC2 can be summarized as follows. A chart depicting a 
typical SC2 transaction is also provided.389
---------------------------------------------------------------------------
    \389\ A detailed explanation of this chart is included in the 
opening statement of Senator Carl Levin at the hearing before the 
Senate Permanent Subcommittee on Investigations, ``U.S. Tax Shelter 
Industry: The Role of Accountants, Lawyers, and Financial 
Professionals'' (11/18/03).

    1) The Income. Individual owns 100% of S-corporation which 
---------------------------------------------------------------------------
earns net income (e.g., $3 million annually).

    2) The Sales Pitch. Individual is approached by KPMG with a 
``charitable donation strategy'' to shelter a significant 
portion (often 90%) of the S-corporation's income from taxation 
by ``allocating,'' with little or no distribution, the income 
to a charitable organization. Individual is told that, for a 
fee, KPMG will arrange a temporary ``donation'' of corporate 
non-voting stock to the charity and will provide an opinion 
letter stating it is ``more likely than not'' that nonpayment 
of tax on the income ``allocated'' to the charity while it 
``owns'' the stock will withstand an IRS challenge, even if the 
allocated income is not actually distributed to the charity and 
the individual regains control of the income. The individual is 
told he can also take a personal tax deduction for the 
``donation.''

    3) Setting Up The Transaction. The S-corporation issues 
non-voting shares of stock that, typically, equal 9 times the 
total number of outstanding shares (e.g., corporation with 100 
voting shares issues 900 non-voting shares). Corporation gives 
the non-voting shares to the existing individual-shareholder. 
Corporation also issues to the individual-shareholder warrants 
to purchase a substantial number of company shares (e.g., 7,000 
warrants). Corporation issues a resolution limiting or 
suspending income distributions to all shareholders for a 
specified period of time (e.g., generally the period of time in 
which the charity is intended to be a shareholder, typically 2 
or 3 years). Prior to issuing this resolution, corporation may 
distribute cash to the existing individual-shareholder.

    4) The Charity. A ``qualifying'' charity (one which is 
exempt from federal tax on unrelated business income) agrees to 
accept S-corporation stock donation. KPMG actively seeks out 
qualified charities and identifies them for the individual.

    5) The ``Donation.'' S-corporation employs an independent 
valuation firm to analyze and provide a valuation of its non-
voting shares. Due to the non-voting character of the shares 
and the existence of a large number of warrants, the non-voting 
shares have a very low fair market value (e.g., $100,000). 
Individual ``donates'' non-voting shares to the selected 
charity, making the charity the temporary owner of 90% of the 
corporation's shares. Individual claims a charitable deduction 
for this ``donation.'' At the same time, the corporation and 
charity enter into a redemption agreement allowing the charity, 
after a specified period of time (generally 2 or 3 years), to 
require the corporation to buy back the shares at fair market 
value. The individual also pledges to donate an additional 
amount to the charity to ensure it obtains the shares' original 
fair market value in the event that the shares' value 
decreases. The charity does not receive any cash payment at 
this time.

    6) The ``Allocation.'' During the period in which the 
charity owns the non-voting shares, the S-corporation 
``allocates'' its annual net income to the charity and original 
individual-shareholder in proportion to the percentage of 
overall shares each holds (e.g., 90:10 ratio). However, 
pursuant to the corporate resolution adopted before the non-
voting shares were issued and donated to the charity, little or 
no income ``allocated'' to the charity is actually distributed. 
The corporation retains or reinvests the non-distributed 
income.

    7) The Redemption. After the specified period in the 
redemption agreement, the charity sells back the non-voting 
shares to the S-corporation for fair market value (e.g., 
$100,000). The charity obtains a cash payment from the 
corporation for the shares at this time. Should the charity not 
resell the stock, the individual-shareholder can exercise the 
warrants, obtain additional corporate shares, and substantially 
dilute the value of the charity's shares. Once the non-voting 
shares are repurchased by the corporation, the corporation 
distributes to the individual-shareholder, who now owns 100% of 
the corporation's outstanding shares, all of the undistributed 
cash from previously earned income.

    8) Taxpayer's Claim. Due to its tax exempt status, the 
charity pays no tax on the corporate income ``allocated'' or 
distributed to it. According to the KPMG opinion letter, for 
tax purposes, the individual can claim a charitable deduction 
for the ``donated'' shares in the year in which the 
``donation'' took place. During the years in which the charity 
``owned'' most of the corporate shares, individual will pay 
taxes on only that portion of the corporate income that was 
``allocated'' to him or her. KPMG also advised that all income 
``allocated'' to the charity is then treated as previously 
taxed, even after the corporation buys back the non-voting 
stock and the individual regains control of the corporation. 
KPMG also advised the individual that, when the previously 
``allocated'' income was later distributed to the individual, 
the individual could treat some or all as long-term capital 
gains rather than ordinary income, taxable at the lower capital 
gains rate. The end result is that the individual owner of the 
S-corporation was told by KPMG that he or she could defer and 
reduce the rate of the taxes paid on income earned by the S-
corporation.

    9) IRS Action. This transaction is under review by the IRS.
    [GRAPHIC] [TIFF OMITTED] T0655.009
    
    [GRAPHIC] [TIFF OMITTED] T0655.010
    


                               APPENDIX C

           OTHER KPMG INVESTIGATIONS OR ENFORCEMENT ACTIONS

    In recent years, KPMG has become the subject of IRS, SEC, 
and state investigations and enforcement actions in the areas 
of tax, accounting fraud, and auditor independence. These 
enforcement actions include ongoing litigation by the IRS to 
enforce tax shelter related document requests and a tax 
promoter audit of the firm, which are described in the text of 
the Report. They also include SEC, California, and New York 
investigations examining a potentially abusive tax shelter 
involving at least ten banks that are allegedly using sham 
mutual funds established on KPMG's advice; SEC and Missouri 
enforcement actions related to alleged KPMG involvement in 
accounting fraud at Xerox and General American Mutual Holding 
Co.; an SEC censure of KPMG for violating auditor independence 
restrictions by investing in AIM mutual funds while AIM was a 
KPMG audit client; and a bankruptcy examiner report on 
misleading accounting at Polaroid while KPMG was Polaroid's 
auditor.

SHAM MUTUAL FUND INVESTIGATION

    KPMG is currently under investigation by the SEC and tax 
authorities in California and New York for advising at least 
ten banks to shift as much as $17 billion of bank assets into 
shell regulated investment companies, allegedly to shelter more 
than $750 million in income from taxation.
    A regulated investment company (RIC), popularly known as a 
mutual fund, is designed to pool funds from at least 100 
investors to purchase securities. RIC investors, also known as 
mutual fund shareholders, are normally taxed on the income they 
receive as dividends from their shares, while the RIC itself is 
tax exempt. In this instance, KPMG allegedly advised each bank 
to set up one or more RICs as a bank subsidiary, to transfer 
some portfolio of bank assets to the RIC, and then to declare 
any income as dividends payable to the bank. Citing KPMG tax 
advice, the banks allegedly claimed that they did not have to 
pay taxes on the dividend income due to state laws exempting 
from taxation money transferred between a subsidiary and its 
corporate parent. Zions Bancorp., for example, has stated to 
the press: ``These registered investment companies were 
established upon our receiving tax and accounting guidance from 
KPMG and the securities law counsel from the Washington, D.C. 
firm of Ropes & Grey.'' 390
---------------------------------------------------------------------------
    \390\ ``Zions Among Banks Accused of Scheme,'' Desert News (8/8/
03).
---------------------------------------------------------------------------
    The RICs established by the banks are allegedly sham mutual 
funds whose primary purpose was not to establish an investment 
pool, but to shelter bank income from taxation. The evidence 
allegedly suggests that the funds really had one investor--the 
parent bank--rather than 100 investors as required by the SEC. 
Press reports state, for example, that some of the RICs had 
apparently sold all 100 shares to the employees of the parent 
bank. Also according to press reports, the existence of this 
tax avoidance scheme was discovered after a bank was approached 
by KPMG, declined to participate, and asked its legal counsel 
to alert California officials to what the bank saw as an 
improper tax shelter. When asked about this matter, California 
Controller Steve Westly has been quoted as saying, ``We do not 
believe this is appropriate.'' 391 RICs established 
by the ten banks participating in this tax shelter have since 
been voluntarily de-registered, according to press reports, 
with the last removed from SEC records in 2002.
---------------------------------------------------------------------------
    \391\ ``Banks Shifted Billions Into Funds Sheltering Income From 
Taxes,'' Wall Street Journal (8/7/03).
---------------------------------------------------------------------------

KPMG ACCOUNTING FRAUD AT XEROX

    On January 29, 2003, the SEC filed suit in federal district 
court charging KPMG and four KPMG partners with accounting 
fraud for knowingly allowing Xerox to file 4 years of false 
financial statements which distorted Xerox's filings by 
billions of dollars.392 The prior year, in 2002, 
without admitting or denying guilt, Xerox paid the SEC a $10 
million civil penalty, then the highest penalty ever paid to 
the SEC for accounting fraud, and agreed to restate its 
financial results for the years 1997 through 2000. In July 
2003, six former Xerox senior executives paid the SEC civil 
penalties totaling over $22 million in connection with the 
false financial statements.
---------------------------------------------------------------------------
    \392\ SEC v. KPMG, Case No. 03-CV-0671 (D.S.D.N.Y. 1/29/03).
---------------------------------------------------------------------------
    KPMG is contesting the SEC civil suit and denies any 
liability for the accounting fraud. Two of the named KPMG 
partners remain employed by the firm. The SEC complaint 
includes the following statements:

        ``KPMG and certain KPMG partners permitted Xerox to 
        manipulate its accounting practices and fill a $3-
        billion `gap' between actual operating results and 
        results reported to the investing public from 1997 
        through 2000. The fraudulent scheme allowed Xerox to 
        claim it met performance expectations of Wall Street 
        analysts, to mislead investors and, consequently, to 
        boost the company's stock price. The KPMG defendants 
        were not the watch dogs on behalf of shareholders and 
        the public that the securities laws and the rules of 
        the auditing profession required them to be. Instead of 
        putting a stop to Xerox's fraudulent conduct, the KPMG 
        defendants themselves engaged in fraud by falsely 
        representing to the public that they had applied 
        professional auditing standards to their review of 
        Xerox's accounting, that Xerox's financial reporting 
        was consistent with Generally Accepted Accounting 
        Principles and that Xerox's reported results fairly 
        represented the financial condition of the company. . . 
        .

        ``In the course of auditing Xerox for the years 1997 
        through 2000, defendants KPMG [and the four KPMG 
        partners] knew, or were reckless in not knowing, for 
        each year in which they were responsible for the Xerox 
        audit, that Xerox was preparing and filing quarterly 
        and annual financial statements and other reports which 
        likely contained material misrepresentations and 
        omissions in violation of the antifraud provisions of 
        the federal securities laws. . . .

        ``In the summer or early fall of 1999, Xerox complained 
        to KPMG's chairman, Stephen Butler, about the 
        performance of [one of the defendant KPMG audit 
        partners], who questioned Xerox management about 
        several of the topside accounting devices that formed 
        the fraudulent scheme. Although KPMG policy was to 
        review assignments of an engagement partner after five 
        years, and [the KPMG partner] had been assigned to 
        Xerox less than two years, Butler responded to Xerox's 
        complaints by offering [the KPMG partner] a new 
        assignment in Finland. After [the KPMG partner] 
        declined the new assignment, KPMG replaced [him] as the 
        worldwide lead engagement partner with [another of the 
        defendant KPMG partners] for the 2000 audit. This was 
        the second time in six years in which KPMG removed the 
        senior engagement partner early in his tenure at 
        Xerox's request.''

    KPMG was Xerox's auditor for approximately 40 years, 
through the 2000 audit. KPMG was paid $26 million for auditing 
Xerox's financial results for fiscal years 1997 through 2000. 
It was paid $56 million for non-audit services during that 
period. When Xerox finally restated its financial results for 
1997-2000, it restated $6.1 billion in equipment revenues and 
$1.9 billion in pre-tax earnings--the largest restatement in 
U.S. history to that time.

MISSOURI DEPARTMENT OF INSURANCE V. KPMG

    On December 10, 2002, the Director of the Missouri 
Department of Insurance, acting as the liquidator for an 
insurance firm, General American Mutual Holding Company 
(``General American''), sued KPMG alleging that: (1) KPMG, 
acting in conflicting roles as consultant and auditor, 
misrepresented the financial statements of its client, General 
American, and (2) KPMG failed to disclose substantial risks 
associated with an investment product called Stable Value 
which, with KPMG's knowledge and assistance, was sold by 
General American during the 1990's.393
---------------------------------------------------------------------------
    \393\ Lakin v. KPMG, (MO Cir. 12/10/02).
---------------------------------------------------------------------------
    Stable Value was an investment product that, in essence, 
allowed General American to borrow money from investors and 
reinvest it in high-risk securities to obtain a greater return. 
In the event General American was downgraded by a ratings 
agency, however, the terms of the Stable Value product allowed 
investors to withdraw their funds. In 1999, General American, 
in fact, suffered a ratings downgrade, and hundreds of Stable 
Value holders redeemed their shares, forcing General American 
to go into receivership and subjecting its investors to huge 
losses. KPMG is alleged to have never disclosed the risks of 
the Stable Value product to General American and, according to 
the Missouri Department of Insurance, actively attempted to 
conceal this risk.
    The following excerpts are taken from a complaint filed by 
the Director of the Missouri Department of Insurance against 
KPMG in the Jackson County Circuit Court:

        ``In the 1990's, with KPMG knowledge, and assistance, 
        General American management developed and grew to 
        obscene proportions a high-risk product known as Stable 
        Value. In essence, certain General American management, 
        with KPMG's help, bet the very existence of General 
        American on its Stable Value business segment and lost. 
        . . . With KPMG's knowledge, General American 
        management forced an otherwise conservative company to 
        engage in an ever-increasing extremely volatile 
        product. When this scheme failed, it was General 
        American's innocent members who were harmed. . . .

        ``KPMG consciously chose to: (a) misrepresent General 
        American's financial position; (b) not require the 
        mandated disclosures regarding the magnitude and risks 
        associated with the Stable Value product; and (c) 
        conceal from and misrepresent to the Missouri 
        Department of Insurance and General American's members 
        and outside Board of Directors, the true nature of the 
        Stable Value product. And during this same time, when 
        KPMG was setting up General American's innocent members 
        for huge financial losses, KPMG kept scooping up as 
        much money in fees as possible. . . . KPMG abandoned 
        and breached its professional obligations owed to 
        General American, General American's members and the 
        Missouri Department of Insurance. KPMG's failures 
        include a lack of independence, conflicts of interest, 
        breaches of ethical standards, and other gross 
        departures from the most basic of auditing and other 
        professional obligations. . . .

        ``To further the cover-up of its wrongful acts, KPMG 
        engaged in a continued pattern of deceit during the 
        Missouri Department of Insurance's investigation into 
        General American's liquidity crisis. The record is 
        replete with KPMG witnesses giving false testimony, 
        evasive answers and just `playing dumb' in an apparent 
        hope to avoid State of Missouri regulatory scrutiny and 
        the filing of this Petition. What KPMG wanted to hide 
        from the regulators was its misrepresentations, gross 
        breaches of its professional obligations and numerous 
        failures regarding full and fair financial reporting 
        for General American.''

SEC CENSURES KPMG

    On January 14, 2002, the SEC censured KPMG for engaging in 
improper professional conduct in violation of the SEC's rules 
on auditor independence and in violation of Generally Accepted 
Auditing Standards. KPMG consented to the SEC's order but did 
not admit or deny the SEC's findings.
    The following is taken from the SEC's press release 
announcing the censure of KPMG: 394
---------------------------------------------------------------------------
    \394\ Press Release by the SEC, ``SEC Censures KPMG for Auditor 
Independence Violation,'' (No. 2002-4 1/14/02), available at 
www.sec.gov/news/press/2002-4.txt.

        ``The SEC found that, from May through December 2000, 
        KPMG held a substantial investment in the Short-Term 
        Investments Trust (STIT), a money market fund within 
        the AIM family of funds. According to the SEC's order, 
        KPMG opened the money market account with an initial 
        deposit of $25 million on May 5, 2000, and at one point 
        the account balance constituted approximately 15% of 
        the fund's net assets. In the order, the SEC found that 
        KPMG audited the financial statements of STIT at a time 
        when the firm's independence was impaired, and that 
        STIT included KPMG's audit report in 16 separate 
        filings it made with the SEC on November 9, 2000. The 
        SEC further found that KPMG repeatedly confirmed its 
        putative independence from the AIM funds it audited, 
        including STIT, during the period in which KPMG was 
---------------------------------------------------------------------------
        invested in STIT.

        `` `This case illustrates the dangers that flow from a 
        failure to implement adequate polices and procedures 
        designed to detect and prevent auditor independence 
        violations,' said Paul R. Berger, Associate Director of 
        Enforcement.''

    In addition to censuring the firm, the SEC ordered KPMG to 
undertake certain remedies designed to prevent and detect 
future independence violations caused by financial 
relationships with, and investments in, the firm's audit 
clients.

POLAROID AND KPMG

    Polaroid Corporation filed for bankruptcy protection in 
October 2001. In February 2003, a federal bankruptcy court 
named Perry Mandarino, a tax expert, as an independent examiner 
for Polaroid. In August 2003, the bankruptcy examiner issued a 
report stating that Polaroid and its accounting firm, KPMG, had 
engaged in improper accounting procedures and failed to warn 
investors of Polaroid's impending bankruptcy. KPMG attempted to 
keep the report sealed, but the court made the report available 
to the public. Since the issuance of the examiner's report, 
shareholders have filed a class action lawsuit against Polaroid 
and KPMG alleging violations of the Securities and Exchange Act 
for filing false financial statements.
    Both the report and the lawsuit allege that KPMG and 
Polaroid engaged in a series of fraudulent accounting 
transactions, including overstating the value of assets and 
issuing financial statements that made the company appear 
healthier than it was. The examiner determined that KPMG should 
have provided a qualified opinion on the corporation's 
financial statements and included a warning about its status as 
a ``going concern.'' The examiner found that KPMG had been 
considering such a warning, but decided against issuing it 
after a telephone call was made by Polaroid's chief executive 
to KPMG's chairman.395 KPMG has charged that the 
report is ``unfounded'' and ``incorrect.'' 396
---------------------------------------------------------------------------
    \395\ See, e.g., ``KPMG Defends Audit Work for Polaroid,'' Wall 
Street Journal (8/25/03).
    \396\ ``Polaroid Hit with Lawsuit After Report,'' Boston Globe (8/
27/03).

[GRAPHIC] [TIFF OMITTED] T1043.001

[GRAPHIC] [TIFF OMITTED] T1043.002

[GRAPHIC] [TIFF OMITTED] T1043.003

[GRAPHIC] [TIFF OMITTED] T1043.004

[GRAPHIC] [TIFF OMITTED] T1043.005

[GRAPHIC] [TIFF OMITTED] T1043.006

[GRAPHIC] [TIFF OMITTED] T1043.007

[GRAPHIC] [TIFF OMITTED] T1043.008

[GRAPHIC] [TIFF OMITTED] T1043.009

[GRAPHIC] [TIFF OMITTED] T1043.010

[GRAPHIC] [TIFF OMITTED] T1043.011

[GRAPHIC] [TIFF OMITTED] T1043.012

[GRAPHIC] [TIFF OMITTED] T1043.013

[GRAPHIC] [TIFF OMITTED] T1043.014

[GRAPHIC] [TIFF OMITTED] T1043.015

[GRAPHIC] [TIFF OMITTED] T1043.016

[GRAPHIC] [TIFF OMITTED] T1043.017

[GRAPHIC] [TIFF OMITTED] T1043.018

[GRAPHIC] [TIFF OMITTED] T1043.019

[GRAPHIC] [TIFF OMITTED] T1043.020

[GRAPHIC] [TIFF OMITTED] T1043.021

[GRAPHIC] [TIFF OMITTED] T1043.022

[GRAPHIC] [TIFF OMITTED] T1043.023

[GRAPHIC] [TIFF OMITTED] T1043.024

[GRAPHIC] [TIFF OMITTED] T1043.025

[GRAPHIC] [TIFF OMITTED] T1043.026

[GRAPHIC] [TIFF OMITTED] T1043.027

[GRAPHIC] [TIFF OMITTED] T1043.028

[GRAPHIC] [TIFF OMITTED] T1043.029

[GRAPHIC] [TIFF OMITTED] T1043.030

[GRAPHIC] [TIFF OMITTED] T1043.031

[GRAPHIC] [TIFF OMITTED] T1043.032

[GRAPHIC] [TIFF OMITTED] T1043.033

[GRAPHIC] [TIFF OMITTED] T1043.034

[GRAPHIC] [TIFF OMITTED] T1043.035

[GRAPHIC] [TIFF OMITTED] T1043.036

[GRAPHIC] [TIFF OMITTED] T1043.037

[GRAPHIC] [TIFF OMITTED] T1043.038

[GRAPHIC] [TIFF OMITTED] T1043.039

[GRAPHIC] [TIFF OMITTED] T1043.040

[GRAPHIC] [TIFF OMITTED] T1043.041

[GRAPHIC] [TIFF OMITTED] T1043.042

[GRAPHIC] [TIFF OMITTED] T1043.043

[GRAPHIC] [TIFF OMITTED] T1043.044

[GRAPHIC] [TIFF OMITTED] T1043.045

[GRAPHIC] [TIFF OMITTED] T1043.046

[GRAPHIC] [TIFF OMITTED] T1043.047

[GRAPHIC] [TIFF OMITTED] T1043.048

[GRAPHIC] [TIFF OMITTED] T1043.049

[GRAPHIC] [TIFF OMITTED] T1043.050

[GRAPHIC] [TIFF OMITTED] T1043.051

[GRAPHIC] [TIFF OMITTED] T1043.052

[GRAPHIC] [TIFF OMITTED] T1043.053

[GRAPHIC] [TIFF OMITTED] T1043.054

[GRAPHIC] [TIFF OMITTED] T1043.055

[GRAPHIC] [TIFF OMITTED] T1043.056

[GRAPHIC] [TIFF OMITTED] T1043.057

[GRAPHIC] [TIFF OMITTED] T1043.058

[GRAPHIC] [TIFF OMITTED] T1043.059

[GRAPHIC] [TIFF OMITTED] T1043.060

[GRAPHIC] [TIFF OMITTED] T1043.061

[GRAPHIC] [TIFF OMITTED] T1043.062

[GRAPHIC] [TIFF OMITTED] T1043.063

[GRAPHIC] [TIFF OMITTED] T1043.064

[GRAPHIC] [TIFF OMITTED] T1043.065

[GRAPHIC] [TIFF OMITTED] T1043.066

[GRAPHIC] [TIFF OMITTED] T1043.067

[GRAPHIC] [TIFF OMITTED] T1043.068

[GRAPHIC] [TIFF OMITTED] T1043.069

[GRAPHIC] [TIFF OMITTED] T1043.070

[GRAPHIC] [TIFF OMITTED] T1043.071

[GRAPHIC] [TIFF OMITTED] T1043.072

[GRAPHIC] [TIFF OMITTED] T1043.073

[GRAPHIC] [TIFF OMITTED] T1043.074

[GRAPHIC] [TIFF OMITTED] T1043.075

[GRAPHIC] [TIFF OMITTED] T1043.076

[GRAPHIC] [TIFF OMITTED] T1043.077

[GRAPHIC] [TIFF OMITTED] T1043.078

[GRAPHIC] [TIFF OMITTED] T1043.079

[GRAPHIC] [TIFF OMITTED] T1043.080

[GRAPHIC] [TIFF OMITTED] T1043.081

[GRAPHIC] [TIFF OMITTED] T1043.082

[GRAPHIC] [TIFF OMITTED] T1043.083

[GRAPHIC] [TIFF OMITTED] T1043.084

[GRAPHIC] [TIFF OMITTED] T1043.085

[GRAPHIC] [TIFF OMITTED] T1043.086

[GRAPHIC] [TIFF OMITTED] T1043.087

[GRAPHIC] [TIFF OMITTED] T1043.088

[GRAPHIC] [TIFF OMITTED] T1043.089

[GRAPHIC] [TIFF OMITTED] T1043.090

[GRAPHIC] [TIFF OMITTED] T1043.091

[GRAPHIC] [TIFF OMITTED] T1043.092

[GRAPHIC] [TIFF OMITTED] T1043.093

[GRAPHIC] [TIFF OMITTED] T1043.094

[GRAPHIC] [TIFF OMITTED] T1043.095

[GRAPHIC] [TIFF OMITTED] T1043.096

[GRAPHIC] [TIFF OMITTED] T1043.097

[GRAPHIC] [TIFF OMITTED] T1043.098

[GRAPHIC] [TIFF OMITTED] T1043.099

[GRAPHIC] [TIFF OMITTED] T1043.100

[GRAPHIC] [TIFF OMITTED] T1043.101

[GRAPHIC] [TIFF OMITTED] T1043.102

[GRAPHIC] [TIFF OMITTED] T1043.103

[GRAPHIC] [TIFF OMITTED] T1043.104

[GRAPHIC] [TIFF OMITTED] T1043.105

[GRAPHIC] [TIFF OMITTED] T1043.106

[GRAPHIC] [TIFF OMITTED] T1043.107

[GRAPHIC] [TIFF OMITTED] T1043.108

[GRAPHIC] [TIFF OMITTED] T1043.109

[GRAPHIC] [TIFF OMITTED] T1043.110

[GRAPHIC] [TIFF OMITTED] T1043.111

[GRAPHIC] [TIFF OMITTED] T1043.112

[GRAPHIC] [TIFF OMITTED] T1043.113

[GRAPHIC] [TIFF OMITTED] T1043.114

[GRAPHIC] [TIFF OMITTED] T1043.115

[GRAPHIC] [TIFF OMITTED] T1043.116

[GRAPHIC] [TIFF OMITTED] T1043.117

[GRAPHIC] [TIFF OMITTED] T1043.118

[GRAPHIC] [TIFF OMITTED] T1043.119

[GRAPHIC] [TIFF OMITTED] T1043.120

[GRAPHIC] [TIFF OMITTED] T1043.121

[GRAPHIC] [TIFF OMITTED] T1043.122

[GRAPHIC] [TIFF OMITTED] T1043.123

[GRAPHIC] [TIFF OMITTED] T1043.124

[GRAPHIC] [TIFF OMITTED] T1043.125

[GRAPHIC] [TIFF OMITTED] T1043.126

[GRAPHIC] [TIFF OMITTED] T1043.127

[GRAPHIC] [TIFF OMITTED] T1043.128

[GRAPHIC] [TIFF OMITTED] T1043.129

[GRAPHIC] [TIFF OMITTED] T1043.130

[GRAPHIC] [TIFF OMITTED] T1043.131

[GRAPHIC] [TIFF OMITTED] T1043.132

[GRAPHIC] [TIFF OMITTED] T1043.133

[GRAPHIC] [TIFF OMITTED] T1043.134

[GRAPHIC] [TIFF OMITTED] T1043.135

[GRAPHIC] [TIFF OMITTED] T1043.136

[GRAPHIC] [TIFF OMITTED] T1043.137

[GRAPHIC] [TIFF OMITTED] T1043.138

[GRAPHIC] [TIFF OMITTED] T1043.139

[GRAPHIC] [TIFF OMITTED] T1043.140

[GRAPHIC] [TIFF OMITTED] T1043.141

[GRAPHIC] [TIFF OMITTED] T1043.142

[GRAPHIC] [TIFF OMITTED] T1043.143

[GRAPHIC] [TIFF OMITTED] T1043.144

[GRAPHIC] [TIFF OMITTED] T1043.145

[GRAPHIC] [TIFF OMITTED] T1043.146

[GRAPHIC] [TIFF OMITTED] T1043.147

[GRAPHIC] [TIFF OMITTED] T1043.148

[GRAPHIC] [TIFF OMITTED] T1043.149

[GRAPHIC] [TIFF OMITTED] T1043.150

[GRAPHIC] [TIFF OMITTED] T1043.151

[GRAPHIC] [TIFF OMITTED] T1043.152

[GRAPHIC] [TIFF OMITTED] T1043.153

[GRAPHIC] [TIFF OMITTED] T1043.154

[GRAPHIC] [TIFF OMITTED] T1043.155

[GRAPHIC] [TIFF OMITTED] T1043.156

[GRAPHIC] [TIFF OMITTED] T1043.157

[GRAPHIC] [TIFF OMITTED] T1043.158

[GRAPHIC] [TIFF OMITTED] T1043.159

[GRAPHIC] [TIFF OMITTED] T1043.160

[GRAPHIC] [TIFF OMITTED] T1043.161

[GRAPHIC] [TIFF OMITTED] T1043.162

[GRAPHIC] [TIFF OMITTED] T1043.163

[GRAPHIC] [TIFF OMITTED] T1043.164

[GRAPHIC] [TIFF OMITTED] T1043.165

[GRAPHIC] [TIFF OMITTED] T1043.166

[GRAPHIC] [TIFF OMITTED] T1043.167

[GRAPHIC] [TIFF OMITTED] T1043.168

[GRAPHIC] [TIFF OMITTED] T1043.169

[GRAPHIC] [TIFF OMITTED] T1043.170

[GRAPHIC] [TIFF OMITTED] T1043.171

[GRAPHIC] [TIFF OMITTED] T1043.172

[GRAPHIC] [TIFF OMITTED] T1043.173

[GRAPHIC] [TIFF OMITTED] T1043.174

[GRAPHIC] [TIFF OMITTED] T1043.175

[GRAPHIC] [TIFF OMITTED] T1043.176

[GRAPHIC] [TIFF OMITTED] T1043.177

[GRAPHIC] [TIFF OMITTED] T1043.178

[GRAPHIC] [TIFF OMITTED] T1043.179

[GRAPHIC] [TIFF OMITTED] T1043.180

[GRAPHIC] [TIFF OMITTED] T1043.181

[GRAPHIC] [TIFF OMITTED] T1043.182

[GRAPHIC] [TIFF OMITTED] T1043.183

[GRAPHIC] [TIFF OMITTED] T1043.184

[GRAPHIC] [TIFF OMITTED] T1043.185

[GRAPHIC] [TIFF OMITTED] T1043.186

[GRAPHIC] [TIFF OMITTED] T1043.187

[GRAPHIC] [TIFF OMITTED] T1043.188

[GRAPHIC] [TIFF OMITTED] T1043.189

[GRAPHIC] [TIFF OMITTED] T1043.190

[GRAPHIC] [TIFF OMITTED] T1043.191

[GRAPHIC] [TIFF OMITTED] T1043.192

[GRAPHIC] [TIFF OMITTED] T1043.193

[GRAPHIC] [TIFF OMITTED] T1043.194

[GRAPHIC] [TIFF OMITTED] T1043.195

[GRAPHIC] [TIFF OMITTED] T1043.196

[GRAPHIC] [TIFF OMITTED] T1043.197

[GRAPHIC] [TIFF OMITTED] T1043.198

[GRAPHIC] [TIFF OMITTED] T1043.199

[GRAPHIC] [TIFF OMITTED] T1043.200

[GRAPHIC] [TIFF OMITTED] T1043.201

[GRAPHIC] [TIFF OMITTED] T1043.202

[GRAPHIC] [TIFF OMITTED] T1043.203

[GRAPHIC] [TIFF OMITTED] T1043.204

[GRAPHIC] [TIFF OMITTED] T1043.205

[GRAPHIC] [TIFF OMITTED] T1043.206

[GRAPHIC] [TIFF OMITTED] T1043.207

[GRAPHIC] [TIFF OMITTED] T1043.208

[GRAPHIC] [TIFF OMITTED] T1043.209

[GRAPHIC] [TIFF OMITTED] T1043.210

[GRAPHIC] [TIFF OMITTED] T1043.211

[GRAPHIC] [TIFF OMITTED] T1043.212

[GRAPHIC] [TIFF OMITTED] T1043.213

[GRAPHIC] [TIFF OMITTED] T1043.214

[GRAPHIC] [TIFF OMITTED] T1043.215

[GRAPHIC] [TIFF OMITTED] T1043.216

[GRAPHIC] [TIFF OMITTED] T1043.217

[GRAPHIC] [TIFF OMITTED] T1043.218

[GRAPHIC] [TIFF OMITTED] T1043.219

[GRAPHIC] [TIFF OMITTED] T1043.220

[GRAPHIC] [TIFF OMITTED] T1043.221

[GRAPHIC] [TIFF OMITTED] T1043.222

[GRAPHIC] [TIFF OMITTED] T1043.223

[GRAPHIC] [TIFF OMITTED] T1043.224

[GRAPHIC] [TIFF OMITTED] T1043.225

[GRAPHIC] [TIFF OMITTED] T1043.226

[GRAPHIC] [TIFF OMITTED] T1043.227

[GRAPHIC] [TIFF OMITTED] T1043.228

[GRAPHIC] [TIFF OMITTED] T1043.229

[GRAPHIC] [TIFF OMITTED] T1043.230

[GRAPHIC] [TIFF OMITTED] T1043.231

[GRAPHIC] [TIFF OMITTED] T1043.232

[GRAPHIC] [TIFF OMITTED] T1043.233

[GRAPHIC] [TIFF OMITTED] T1043.234

[GRAPHIC] [TIFF OMITTED] T1043.235

[GRAPHIC] [TIFF OMITTED] T1043.236

[GRAPHIC] [TIFF OMITTED] T1043.237

[GRAPHIC] [TIFF OMITTED] T1043.238

[GRAPHIC] [TIFF OMITTED] T1043.239

[GRAPHIC] [TIFF OMITTED] T1043.240

[GRAPHIC] [TIFF OMITTED] T1043.241

[GRAPHIC] [TIFF OMITTED] T1043.242

[GRAPHIC] [TIFF OMITTED] T1043.243

[GRAPHIC] [TIFF OMITTED] T1043.244

[GRAPHIC] [TIFF OMITTED] T1043.245

[GRAPHIC] [TIFF OMITTED] T1043.246

[GRAPHIC] [TIFF OMITTED] T1043.247

[GRAPHIC] [TIFF OMITTED] T1043.248

[GRAPHIC] [TIFF OMITTED] T1043.249

[GRAPHIC] [TIFF OMITTED] T1043.250

[GRAPHIC] [TIFF OMITTED] T1043.251

[GRAPHIC] [TIFF OMITTED] T1043.252

[GRAPHIC] [TIFF OMITTED] T1043.253

[GRAPHIC] [TIFF OMITTED] T1043.254

[GRAPHIC] [TIFF OMITTED] T1043.255

[GRAPHIC] [TIFF OMITTED] T1043.256

[GRAPHIC] [TIFF OMITTED] T1043.257

[GRAPHIC] [TIFF OMITTED] T1043.258

[GRAPHIC] [TIFF OMITTED] T1043.259

[GRAPHIC] [TIFF OMITTED] T1043.260

[GRAPHIC] [TIFF OMITTED] T1043.261

[GRAPHIC] [TIFF OMITTED] T1043.262

[GRAPHIC] [TIFF OMITTED] T1043.263

[GRAPHIC] [TIFF OMITTED] T1043.264

[GRAPHIC] [TIFF OMITTED] T1043.265

[GRAPHIC] [TIFF OMITTED] T1043.266

[GRAPHIC] [TIFF OMITTED] T1043.267

[GRAPHIC] [TIFF OMITTED] T1043.268

[GRAPHIC] [TIFF OMITTED] T1043.269

[GRAPHIC] [TIFF OMITTED] T1043.270

[GRAPHIC] [TIFF OMITTED] T1043.271

[GRAPHIC] [TIFF OMITTED] T1043.272

[GRAPHIC] [TIFF OMITTED] T1043.273

[GRAPHIC] [TIFF OMITTED] T1043.274

[GRAPHIC] [TIFF OMITTED] T1043.275

[GRAPHIC] [TIFF OMITTED] T1043.276

[GRAPHIC] [TIFF OMITTED] T1043.277

[GRAPHIC] [TIFF OMITTED] T1043.278

[GRAPHIC] [TIFF OMITTED] T1043.279

[GRAPHIC] [TIFF OMITTED] T1043.280

[GRAPHIC] [TIFF OMITTED] T1043.281

[GRAPHIC] [TIFF OMITTED] T1043.282

[GRAPHIC] [TIFF OMITTED] T1043.283

[GRAPHIC] [TIFF OMITTED] T1043.284

[GRAPHIC] [TIFF OMITTED] T1043.285

[GRAPHIC] [TIFF OMITTED] T1043.286

[GRAPHIC] [TIFF OMITTED] T1043.287

[GRAPHIC] [TIFF OMITTED] T1043.288

[GRAPHIC] [TIFF OMITTED] T1043.289

[GRAPHIC] [TIFF OMITTED] T1043.290

[GRAPHIC] [TIFF OMITTED] T1043.291

[GRAPHIC] [TIFF OMITTED] T1043.292

[GRAPHIC] [TIFF OMITTED] T1043.293

[GRAPHIC] [TIFF OMITTED] T1043.294

[GRAPHIC] [TIFF OMITTED] T1043.295

[GRAPHIC] [TIFF OMITTED] T1043.296

[GRAPHIC] [TIFF OMITTED] T1043.297

[GRAPHIC] [TIFF OMITTED] T1043.298

[GRAPHIC] [TIFF OMITTED] T1043.299

[GRAPHIC] [TIFF OMITTED] T1043.300

[GRAPHIC] [TIFF OMITTED] T1043.301

[GRAPHIC] [TIFF OMITTED] T1043.302

[GRAPHIC] [TIFF OMITTED] T1043.303

[GRAPHIC] [TIFF OMITTED] T1043.304

[GRAPHIC] [TIFF OMITTED] T1043.305

[GRAPHIC] [TIFF OMITTED] T1043.306

[GRAPHIC] [TIFF OMITTED] T1043.307

[GRAPHIC] [TIFF OMITTED] T1043.308

[GRAPHIC] [TIFF OMITTED] T1043.309

[GRAPHIC] [TIFF OMITTED] T1043.310

[GRAPHIC] [TIFF OMITTED] T1043.311

[GRAPHIC] [TIFF OMITTED] T1043.312

[GRAPHIC] [TIFF OMITTED] T1043.313

[GRAPHIC] [TIFF OMITTED] T1043.314

[GRAPHIC] [TIFF OMITTED] T1043.315

[GRAPHIC] [TIFF OMITTED] T1043.316

[GRAPHIC] [TIFF OMITTED] T1043.317

[GRAPHIC] [TIFF OMITTED] T1043.318

[GRAPHIC] [TIFF OMITTED] T1043.319

[GRAPHIC] [TIFF OMITTED] T1043.320

[GRAPHIC] [TIFF OMITTED] T1043.321

[GRAPHIC] [TIFF OMITTED] T1043.322

[GRAPHIC] [TIFF OMITTED] T1043.323

[GRAPHIC] [TIFF OMITTED] T1043.324

[GRAPHIC] [TIFF OMITTED] T1043.325

[GRAPHIC] [TIFF OMITTED] T1043.326

[GRAPHIC] [TIFF OMITTED] T1043.327

[GRAPHIC] [TIFF OMITTED] T1043.328

[GRAPHIC] [TIFF OMITTED] T1043.329

[GRAPHIC] [TIFF OMITTED] T1043.330

[GRAPHIC] [TIFF OMITTED] T1043.331

[GRAPHIC] [TIFF OMITTED] T1043.332

[GRAPHIC] [TIFF OMITTED] T1043.333

[GRAPHIC] [TIFF OMITTED] T1043.334

[GRAPHIC] [TIFF OMITTED] T1043.335

[GRAPHIC] [TIFF OMITTED] T1043.336

[GRAPHIC] [TIFF OMITTED] T1043.337

[GRAPHIC] [TIFF OMITTED] T1043.338

[GRAPHIC] [TIFF OMITTED] T1043.339

[GRAPHIC] [TIFF OMITTED] T1043.340

[GRAPHIC] [TIFF OMITTED] T1043.341

[GRAPHIC] [TIFF OMITTED] T1043.342

[GRAPHIC] [TIFF OMITTED] T1043.343

[GRAPHIC] [TIFF OMITTED] T1043.344

[GRAPHIC] [TIFF OMITTED] T1043.345

[GRAPHIC] [TIFF OMITTED] T1043.346

[GRAPHIC] [TIFF OMITTED] T1043.347

[GRAPHIC] [TIFF OMITTED] T1043.348

[GRAPHIC] [TIFF OMITTED] T1043.349

[GRAPHIC] [TIFF OMITTED] T1043.350

[GRAPHIC] [TIFF OMITTED] T1043.351

[GRAPHIC] [TIFF OMITTED] T1043.352

[GRAPHIC] [TIFF OMITTED] T1043.353

[GRAPHIC] [TIFF OMITTED] T1043.354

[GRAPHIC] [TIFF OMITTED] T1043.355

[GRAPHIC] [TIFF OMITTED] T1043.356

[GRAPHIC] [TIFF OMITTED] T1043.357

[GRAPHIC] [TIFF OMITTED] T1043.358

[GRAPHIC] [TIFF OMITTED] T1043.359

[GRAPHIC] [TIFF OMITTED] T1043.360

[GRAPHIC] [TIFF OMITTED] T1043.361

[GRAPHIC] [TIFF OMITTED] T1043.362

[GRAPHIC] [TIFF OMITTED] T1043.363

[GRAPHIC] [TIFF OMITTED] T1043.364

[GRAPHIC] [TIFF OMITTED] T1043.365

[GRAPHIC] [TIFF OMITTED] T1043.366

[GRAPHIC] [TIFF OMITTED] T1043.367

[GRAPHIC] [TIFF OMITTED] T1043.368

[GRAPHIC] [TIFF OMITTED] T1043.369

[GRAPHIC] [TIFF OMITTED] T1043.370

[GRAPHIC] [TIFF OMITTED] T1043.371

[GRAPHIC] [TIFF OMITTED] T1043.372

[GRAPHIC] [TIFF OMITTED] T1043.373

[GRAPHIC] [TIFF OMITTED] T1043.374

[GRAPHIC] [TIFF OMITTED] T1043.375

[GRAPHIC] [TIFF OMITTED] T1043.376

[GRAPHIC] [TIFF OMITTED] T1043.377

[GRAPHIC] [TIFF OMITTED] T1043.378

[GRAPHIC] [TIFF OMITTED] T1043.379

[GRAPHIC] [TIFF OMITTED] T1043.380

[GRAPHIC] [TIFF OMITTED] T1043.381

[GRAPHIC] [TIFF OMITTED] T1043.382

[GRAPHIC] [TIFF OMITTED] T1043.383

[GRAPHIC] [TIFF OMITTED] T1043.384

[GRAPHIC] [TIFF OMITTED] T1043.385

[GRAPHIC] [TIFF OMITTED] T1043.386

[GRAPHIC] [TIFF OMITTED] T1043.387

[GRAPHIC] [TIFF OMITTED] T1043.388

[GRAPHIC] [TIFF OMITTED] T1043.389

[GRAPHIC] [TIFF OMITTED] T1043.390

[GRAPHIC] [TIFF OMITTED] T1043.391

[GRAPHIC] [TIFF OMITTED] T1043.392

[GRAPHIC] [TIFF OMITTED] T1043.393

[GRAPHIC] [TIFF OMITTED] T1043.394

[GRAPHIC] [TIFF OMITTED] T1043.395

[GRAPHIC] [TIFF OMITTED] T1043.396

[GRAPHIC] [TIFF OMITTED] T1043.397

[GRAPHIC] [TIFF OMITTED] T1043.398

[GRAPHIC] [TIFF OMITTED] T1043.399

[GRAPHIC] [TIFF OMITTED] T1043.400

[GRAPHIC] [TIFF OMITTED] T1043.401

[GRAPHIC] [TIFF OMITTED] T1043.402

[GRAPHIC] [TIFF OMITTED] T1043.403

[GRAPHIC] [TIFF OMITTED] T1043.404

[GRAPHIC] [TIFF OMITTED] T1043.405

[GRAPHIC] [TIFF OMITTED] T1043.406

[GRAPHIC] [TIFF OMITTED] T1043.407

[GRAPHIC] [TIFF OMITTED] T1043.408

[GRAPHIC] [TIFF OMITTED] T1043.409

[GRAPHIC] [TIFF OMITTED] T1043.410

[GRAPHIC] [TIFF OMITTED] T1043.411

[GRAPHIC] [TIFF OMITTED] T1043.412

[GRAPHIC] [TIFF OMITTED] T1043.413

[GRAPHIC] [TIFF OMITTED] T1043.414

[GRAPHIC] [TIFF OMITTED] T1043.415

[GRAPHIC] [TIFF OMITTED] T1043.416

[GRAPHIC] [TIFF OMITTED] T1043.417

[GRAPHIC] [TIFF OMITTED] T1043.418

[GRAPHIC] [TIFF OMITTED] T1043.419

[GRAPHIC] [TIFF OMITTED] T1043.420

[GRAPHIC] [TIFF OMITTED] T1043.421

[GRAPHIC] [TIFF OMITTED] T1043.422

[GRAPHIC] [TIFF OMITTED] T1043.423

[GRAPHIC] [TIFF OMITTED] T1043.424

[GRAPHIC] [TIFF OMITTED] T1043.425

[GRAPHIC] [TIFF OMITTED] T1043.426

[GRAPHIC] [TIFF OMITTED] T1043.427

[GRAPHIC] [TIFF OMITTED] T1043.428

[GRAPHIC] [TIFF OMITTED] T1043.429

[GRAPHIC] [TIFF OMITTED] T1043.430

[GRAPHIC] [TIFF OMITTED] T1043.431

[GRAPHIC] [TIFF OMITTED] T1043.432

[GRAPHIC] [TIFF OMITTED] T1043.433

[GRAPHIC] [TIFF OMITTED] T1043.434

[GRAPHIC] [TIFF OMITTED] T1043.435

[GRAPHIC] [TIFF OMITTED] T1043.436

[GRAPHIC] [TIFF OMITTED] T1043.437

[GRAPHIC] [TIFF OMITTED] T1043.438

[GRAPHIC] [TIFF OMITTED] T1043.439

[GRAPHIC] [TIFF OMITTED] T1043.440

[GRAPHIC] [TIFF OMITTED] T1043.441

[GRAPHIC] [TIFF OMITTED] T1043.442

[GRAPHIC] [TIFF OMITTED] T1043.443

[GRAPHIC] [TIFF OMITTED] T1043.444

[GRAPHIC] [TIFF OMITTED] T1043.445

[GRAPHIC] [TIFF OMITTED] T1043.446

[GRAPHIC] [TIFF OMITTED] T1043.447

[GRAPHIC] [TIFF OMITTED] T1043.448

[GRAPHIC] [TIFF OMITTED] T1043.449

[GRAPHIC] [TIFF OMITTED] T1043.450

[GRAPHIC] [TIFF OMITTED] T1043.451

[GRAPHIC] [TIFF OMITTED] T1043.452

[GRAPHIC] [TIFF OMITTED] T1043.453

[GRAPHIC] [TIFF OMITTED] T1043.454

[GRAPHIC] [TIFF OMITTED] T1043.455

[GRAPHIC] [TIFF OMITTED] T1043.456

[GRAPHIC] [TIFF OMITTED] T1043.457

[GRAPHIC] [TIFF OMITTED] T1043.458

[GRAPHIC] [TIFF OMITTED] T1043.459

[GRAPHIC] [TIFF OMITTED] T1043.460

[GRAPHIC] [TIFF OMITTED] T1043.461

[GRAPHIC] [TIFF OMITTED] T1043.462

[GRAPHIC] [TIFF OMITTED] T1043.463

[GRAPHIC] [TIFF OMITTED] T1043.464

[GRAPHIC] [TIFF OMITTED] T1043.465

[GRAPHIC] [TIFF OMITTED] T1043.466

[GRAPHIC] [TIFF OMITTED] T1043.467

[GRAPHIC] [TIFF OMITTED] T1043.468

[GRAPHIC] [TIFF OMITTED] T1043.469

[GRAPHIC] [TIFF OMITTED] T1043.470

[GRAPHIC] [TIFF OMITTED] T1043.471

[GRAPHIC] [TIFF OMITTED] T1043.472

[GRAPHIC] [TIFF OMITTED] T1043.473

[GRAPHIC] [TIFF OMITTED] T1043.474

[GRAPHIC] [TIFF OMITTED] T1043.475

[GRAPHIC] [TIFF OMITTED] T1043.476

[GRAPHIC] [TIFF OMITTED] T1043.477

[GRAPHIC] [TIFF OMITTED] T1043.478

[GRAPHIC] [TIFF OMITTED] T1043.479

[GRAPHIC] [TIFF OMITTED] T1043.480

[GRAPHIC] [TIFF OMITTED] T1043.481

[GRAPHIC] [TIFF OMITTED] T1043.482

[GRAPHIC] [TIFF OMITTED] T1043.483

[GRAPHIC] [TIFF OMITTED] T1043.484

[GRAPHIC] [TIFF OMITTED] T1043.485

[GRAPHIC] [TIFF OMITTED] T1043.486

[GRAPHIC] [TIFF OMITTED] T1043.487

[GRAPHIC] [TIFF OMITTED] T1043.488

[GRAPHIC] [TIFF OMITTED] T1043.489

[GRAPHIC] [TIFF OMITTED] T1043.490

[GRAPHIC] [TIFF OMITTED] T1043.491

[GRAPHIC] [TIFF OMITTED] T1043.492

[GRAPHIC] [TIFF OMITTED] T1043.493

[GRAPHIC] [TIFF OMITTED] T1043.494

[GRAPHIC] [TIFF OMITTED] T1043.495

[GRAPHIC] [TIFF OMITTED] T1043.496

[GRAPHIC] [TIFF OMITTED] T1043.497

[GRAPHIC] [TIFF OMITTED] T1043.498

[GRAPHIC] [TIFF OMITTED] T1043.499

[GRAPHIC] [TIFF OMITTED] T1043.500

[GRAPHIC] [TIFF OMITTED] T1043.501

[GRAPHIC] [TIFF OMITTED] T1043.502

[GRAPHIC] [TIFF OMITTED] T1043.503

[GRAPHIC] [TIFF OMITTED] T1043.504

[GRAPHIC] [TIFF OMITTED] T1043.505

[GRAPHIC] [TIFF OMITTED] T1043.506

[GRAPHIC] [TIFF OMITTED] T1043.507

[GRAPHIC] [TIFF OMITTED] T1043.508

[GRAPHIC] [TIFF OMITTED] T1043.509

[GRAPHIC] [TIFF OMITTED] T1043.510

[GRAPHIC] [TIFF OMITTED] T1043.511

[GRAPHIC] [TIFF OMITTED] T1043.512

[GRAPHIC] [TIFF OMITTED] T1043.513

[GRAPHIC] [TIFF OMITTED] T1043.514

[GRAPHIC] [TIFF OMITTED] T1043.515

[GRAPHIC] [TIFF OMITTED] T1043.516

[GRAPHIC] [TIFF OMITTED] T1043.517

[GRAPHIC] [TIFF OMITTED] T1043.518

[GRAPHIC] [TIFF OMITTED] T1043.519

[GRAPHIC] [TIFF OMITTED] T1043.520

[GRAPHIC] [TIFF OMITTED] T1043.521

[GRAPHIC] [TIFF OMITTED] T1043.522

[GRAPHIC] [TIFF OMITTED] T1043.523

[GRAPHIC] [TIFF OMITTED] T1043.524

[GRAPHIC] [TIFF OMITTED] T1043.525

[GRAPHIC] [TIFF OMITTED] T1043.526

[GRAPHIC] [TIFF OMITTED] T1043.527

[GRAPHIC] [TIFF OMITTED] T1043.528

[GRAPHIC] [TIFF OMITTED] T1043.529

[GRAPHIC] [TIFF OMITTED] T1043.530

[GRAPHIC] [TIFF OMITTED] T1043.531

[GRAPHIC] [TIFF OMITTED] T1043.532

[GRAPHIC] [TIFF OMITTED] T1043.533

[GRAPHIC] [TIFF OMITTED] T1043.534

[GRAPHIC] [TIFF OMITTED] T1043.535

[GRAPHIC] [TIFF OMITTED] T1043.536

[GRAPHIC] [TIFF OMITTED] T1043.537

[GRAPHIC] [TIFF OMITTED] T1043.538

[GRAPHIC] [TIFF OMITTED] T1043.539

[GRAPHIC] [TIFF OMITTED] T1043.540

[GRAPHIC] [TIFF OMITTED] T1043.541

[GRAPHIC] [TIFF OMITTED] T1043.542

[GRAPHIC] [TIFF OMITTED] T1043.543

[GRAPHIC] [TIFF OMITTED] T1043.544

[GRAPHIC] [TIFF OMITTED] T1043.545

[GRAPHIC] [TIFF OMITTED] T1043.546

[GRAPHIC] [TIFF OMITTED] T1043.547

[GRAPHIC] [TIFF OMITTED] T1043.548

[GRAPHIC] [TIFF OMITTED] T1043.549

[GRAPHIC] [TIFF OMITTED] T1043.550

[GRAPHIC] [TIFF OMITTED] T1043.551

[GRAPHIC] [TIFF OMITTED] T1043.552

[GRAPHIC] [TIFF OMITTED] T1043.553

[GRAPHIC] [TIFF OMITTED] T1043.554

[GRAPHIC] [TIFF OMITTED] T1043.555

[GRAPHIC] [TIFF OMITTED] T1043.556

[GRAPHIC] [TIFF OMITTED] T1043.557

[GRAPHIC] [TIFF OMITTED] T1043.558

[GRAPHIC] [TIFF OMITTED] T1043.559

[GRAPHIC] [TIFF OMITTED] T1043.560

[GRAPHIC] [TIFF OMITTED] T1043.561

[GRAPHIC] [TIFF OMITTED] T1043.562

[GRAPHIC] [TIFF OMITTED] T1043.563

[GRAPHIC] [TIFF OMITTED] T1043.564

[GRAPHIC] [TIFF OMITTED] T1043.565

[GRAPHIC] [TIFF OMITTED] T1043.566

[GRAPHIC] [TIFF OMITTED] T1043.567

[GRAPHIC] [TIFF OMITTED] T1043.568

[GRAPHIC] [TIFF OMITTED] T1043.569

[GRAPHIC] [TIFF OMITTED] T1043.570

[GRAPHIC] [TIFF OMITTED] T1043.571

[GRAPHIC] [TIFF OMITTED] T1043.572

[GRAPHIC] [TIFF OMITTED] T1043.573

[GRAPHIC] [TIFF OMITTED] T1043.574

[GRAPHIC] [TIFF OMITTED] T1043.575

[GRAPHIC] [TIFF OMITTED] T1043.576

[GRAPHIC] [TIFF OMITTED] T1043.577

[GRAPHIC] [TIFF OMITTED] T1043.578

[GRAPHIC] [TIFF OMITTED] T1043.579

[GRAPHIC] [TIFF OMITTED] T1043.580

[GRAPHIC] [TIFF OMITTED] T1043.581

[GRAPHIC] [TIFF OMITTED] T1043.582

[GRAPHIC] [TIFF OMITTED] T1043.583

[GRAPHIC] [TIFF OMITTED] T1043.584

[GRAPHIC] [TIFF OMITTED] T1043.585

[GRAPHIC] [TIFF OMITTED] T1043.586

[GRAPHIC] [TIFF OMITTED] T1043.587

[GRAPHIC] [TIFF OMITTED] T1043.588

[GRAPHIC] [TIFF OMITTED] T1043.589

[GRAPHIC] [TIFF OMITTED] T1043.590

[GRAPHIC] [TIFF OMITTED] T1043.591

[GRAPHIC] [TIFF OMITTED] T1043.592

[GRAPHIC] [TIFF OMITTED] T1043.593

[GRAPHIC] [TIFF OMITTED] T1043.594

