E&Y enlisted a number of professional firms to help carry out CDS transactions, including two investment firms TPCMG and Bolton Capital Planning. TPCMG acted as the general partner in each trading partnership involved in a CDS transaction and directed the activities of each partnership through Bolton Capital Planning. UBS was retained for the bank loans and swap agreements. Locke, Liddell & Sapp provided clients with a legal opinion indicating that, if challenged by the IRS, CDS “should” be upheld in court.
According to E&Y, in a typical CDS $20 million loss transaction, E&Y would receive $250,000, Bolton Capital Planning would receive $250,000, and Locke, Liddell & Sapp would receive $50,000....
The Subcommittee investigation found that the internal process used by E&Y to review and approve CDS was marked by dissention and dissatisfaction within the firm. E&Y indicated that SISG tax partners had conducted their own analysis of the technical merits of the CDS transaction in 1999, after consulting with other E&Y tax professionals and an outside law firm, and determined that CDS met the requirements of federal tax law and could be sold by the firm.329 E&Y also acknowledged, however, that the firm never issued an opinion letter supporting the CDS tax product, either as one that “should” survive a legal challenge or as one that would “more likely than not” survive such a challenge. E&Y told the Subcommittee that it never issued a CDS opinion letter because, as a promoter of the product, E&Y was unable to provide a letter upon which its clients could reasonably rely to protect them from possible IRS penalties if CDS was challenged. E&Y said that it had, instead, arranged for an outside law firm, Lock, Liddell & Sapp, to provide clients with a CDS opinion letter.
This explanation fails to acknowledge or disclose, however, the divergence of opinion within the firm regarding CDS’ technical merits. Internal documents show that some E&Y tax professionals outside of SISG raised serious concerns not only about the tax product’s technical validity, but also about the firm’s failure to disclose the risks associated with the product when marketing CDS to clients. On September 8, 1999, for example, one E&Y tax professional sent this email complaining how the firm had presented CDS to one of her clients:
It has come to my attention that our firm is not at the “should” level opinion with respect to this transaction. I clearly was under the impression from your references with my client that our firm, in particular, David Garlock, was behind this transaction. You indicated that we were not issuing an opinion because we would be considered a promoter – not because we would not issue a “should” opinion….
I left the meeting, as did Meloni Hallock, with the impression that our firm, including David Garlock was at a “should” level of opinion on this transaction.It has come to my attention that the above statement is not entirely true. In fact, I think if you speak with David directly, as I have done, he isn’t even at “more likely than not” let alone “should.”
The SISG representative who had made the client presentation, responded:
David Garlock did review [Locke, Liddell & Sapp’s] opinion on our firm’s behalf. David may disagree with [the law firm’s] level of comfort, but his opinion was never needed in this situation. I represented to your client, our firm will not issue an opinion because the client could not rely on the opinion. This came from a discussion between Robert Coplan and Ron Friedman. Our firm will be considered a promoter in their view, and therefore, our clients cannot rely upon an EY opinion. …
The E&Y tax professional replied
[D]on’t you think if you were the client it would be an important fact for you to know if E&Y could not get to a “should” level on this transaction? Don’t you think that my client went away with the impression that not only the law firm was at a “should” level, but so must be E&Y since we said nothing to the contrary? Care to take any bets?
These emails demonstrate that at least two E&Y tax professionals lacked confidence in the CDS product; one was uncertain whether the product reached even a “more likely than not” standard. While SISG claimed that the firm did not issue an opinion supporting CDS because of its position as a promoter of the product, that argument appears to be inconsistent with E&Y’s actions with respect to other tax products, such as SOAP and PICANTE, in which E&Y acted as both promoter and a writer of favorable opinion letters.
Locke Liddell and Sapp LLP did, however, issue legal opinions for CDS. According to one potential investor, however, the law firm’s opinion letter was deficient in many respects.
The client’s legal advisor sent the following email to E&Y criticizing the opinion’s weak legal analysis:
I have reviewed the materials you provided to me and from all indications, the transaction appears to be a classic “sham” tax shelter that would be successfully challenged on audit by IRS. The transaction apparently has little, or any, economic significance outside the tremendous tax breaks promised to the investors and is apparently highly tax motivated, as opposed to being a bona fide transaction that people would invest in regardless of the tax breaks. The concept of a packaged tax shelter sold to investors who need specific tax breaks is under attack by the IRS and courts. My understanding is that IRS has a huge project underway to ferret out these types of tax shelters and will aggressively litigate them (expect penalties to be asserted, in addition to taxes and interest owed).
The opinion provided to me did not discuss the relevant facts, as I understand them. There was little discussion of the hedging within the transaction that will protect the investors against risk of loss or the high level of tax motivation behind the concept. The analysis of the downside to the transaction was weak and often irrelevant. Apparently, there is a dubious loan interest deduction for funds that will be parked in Treasuries. I understand that a very small portion of the investment will involve trading.
The largest problem with the structure and the opinion, however, is that the partnership is not engaged in a trade or business as a “trader;” but will have the status of an investor. Trader status is critical to claim the deductions discussed in the opinion. The opinion states that the general partner will delegate the actual trading to a Fund Manager. The opinion then wrongly states that the Fund Manager’s activities will be attributed to the partnership, thus making the partnership a trader. The opinion relies on Adda v CM (10 TC 273), 1458, a 50 year old case that has nothing to do with trader vs. investor status.
The opinion fails to address the relevant case law, which includes Mayer v CM, 94 USTC Para 50, 509 (1994), a case when [SIC] expressly states that the trading activities of others are not attributed to the taxpayer (citing the U.S. Supreme Court case of Higgins, 312 US 214) in support of its conclusion. Mayer unequivocally states that the taxpayer must personally made [SIC] the trading decisions and cannot delegate this task to others.
Based on what I have provided, my recommendation would be not to invest in this transaction until the issues raised in the email are satisfactorily addressed.
This September 1999 email provides additional evidence that E&Y knew CDS had technical problems and could qualify as an abusive tax shelter. Despite this knowledge, E&Y made the decision to continue selling CDS in 1999 and 2000....
In May 2002, the IRS listed the CDS transaction. [See Notice 2002-35 here.] In March 2002 and June 2003, the IRS commenced two different investigations of E&Y’s tax shelter activities occurring between January 1, 1995 and June 30, 2003. These investigations looked not only at CDS, but a variety of other tax products, including COBRA, SOAP, and PICANTE. On July 2, 2003, E&Y settled with the IRS. Along with a $15 million settlement payment, E&Y was required to institute systemic reforms of its tax strategies practice.