Free Lunch (34 page)

Finally he came up with a solution, more convoluted and subtle than his answers to simple questions. It
involved letting the three Londoners and the San Francisco tax boutique that brokered the deal, Babcock & Brown, become
investors in Long-Term Capital, even though the firm had been closed to outside investors. Neither the Londoners nor Babcock
& Brown wanted to put up any money. And neither was willing to assume any risk that the hedge fund might fail. So Scholes
arranged to lend them millions of dollars. The interest rate was lower than Long-Term Capital could have gotten on its money by
placing it elsewhere. Then he used his expertise as one of the creators of the Black-Scholes method for valuing stock options to
write several contracts whose options clauses guaranteed that these investors could not lose money.

After 14 months, the Londoners cashed out and walked away with a 22 percent profit after paying Long-Term
Capital $900,000 in fees. Those fees were the key because they gave the whole deal economic substance apart from the value of
the tax deductions.

Scholes practically boasted about how he had figured all this out. In her
back-row seat, his wife, Jan, herself a Babcock & Brown principal, began to fidget. She, and others on the benches, could
sense that the long-winded answers were blowing down a house of straw. Scholes swaggered on, oblivious.

Hurley asked about the money Scholes had spent getting expert advice on the deal. Scholes confirmed that
to make sure the tax shelter was sound, Long-Term Capital had paid more than $500,000 to the Shearman & Sterling law firm
in New York for an opinion letter that found his deal had economic substance. Long-Term Capital paid $400,000 more to King
& Spalding in Washington for an opinion letter on another part of the deal.

Scholes said
that Larry Noe, the tax director of Long-Term Capital, received a bonus of between $50,000 and $100,000 for his efforts. Taken
together, the opinion letters and Noe's bonus had eaten up all, or nearly all, of the $900,000 in fees that gave economic substance
to the tax shelter.

Then came the coup de grâce. Hurley slipped in a question about whether
Dr. Scholes had sought, and received, a bonus of several million dollars imbuing the tax shelter with economic substance so it
would survive an IRS audit. Scholes confirmed that he had, but emphasized that it had been paid in extra partnership shares, not
cash.

Counting his bonus, the tax shelter cost far more than its economic value of $900,000 in
fees, eliminating any economic substance.

“I'm being trapped here,'' Scholes blurted out, the
famously smart man realizing he had walked right into the trap set by someone of lesser station but not blinded by greed. Scholes
had finally grasped what his wife and everyone else in the courtroom had seen coming for a half hour. Because of that bonus, the
deal had no chance of turning a profit, as the judge, Janet Bond Arterton, would later confirm in her decision rejecting all of the
“disingenuous choices” Long-Term Capital made in its scheme to cheat the government.

The
hubris of this Nobel laureate illustrates how those blinded by money can rationalize the absurd. The bigger the potential gain, the
greater the temptation to cheat.

The rise of hedge funds has come at a time when there have
been big increases in stock trading just before news that leads to stock price changes. Could it be that some hedge-fund
employees are paying for inside information, which is a crime? Given that with sophisticated computer programs, big money can
be made on tiny movements in stock prices, could it be that some hedge-fund operatives are not taking advantage of price gaps,
but creating them? And are the Wall Street cops, the too-few investigators for the Securities and Exchange Commission, as
sophisticated as the hedge funds? How would they know about what the hedge funds, all wrapped in secrecy and offshore
accounting, are really doing?

Here are two things we do know from the documents made
public in the Long-Term Capital cases. First, the fund's 16 partners were themselves leveraged, putting up $250 million and
borrowing $500 million more, which created the appearance that the entire $750 million was their own money. That means when the
hedge fund had borrowed $100 for each dollar investors had put up, for the accounts of the partners that leverage was 300 to 1.
Second, UBS, the big Swiss bank, has a rule limiting loans to hedge funds to a ratio of 30 to 1. Despite this, an internal memo
revealed that UBS made loans to Long-Term Capital at leverage the bank estimated to be 250 to 1.

Leverage can be a good thing. It can help families buy a house or a car or start a business. But leverage is
also addictive. It can easily become the crack cocaine of hedge funds. Centuries of economic history show that those who try to
leverage the world bring themselves to ruin—and often drag others down with them.

And what
is the social or economic value in allowing hedge funds to operate in secrecy, borrowing other people's money? Hedge funds are
making a few people spectacularly rich, but they add nothing of value. Each trade that puts a dollar into the pockets of Simons and
his investors is a dollar someone else lost. Trading is a zero-sum game.

At the same time,
borrowing 10 times, 100 times, even 250 times as much money as investors actually put at risk means that everyone is at risk,
including the vast majority on the losing sides of these zero-sum games. This is economic pollution. Risk does not darken the sky
or make the water smell, but spewing it unnecessarily into the system degrades the financial system for everyone else. And if
something unexpected goes wrong, it can bring ruin to the many.

A lawyer working with
Quellos, a financial boutique that works closely with hedge funds, sat down to coffee with me and explained that the firm had
identified 26 different risks that come with owning a stock. For a fee any of those risks, up to 25 of them, could be hedged away, the
last needing to remain or the problem that destroyed the Scholes tax shelter would arise, the lack of economic substance.
Hedging—buying a financial instrument to protect against risk—comes at a cost. Hedging away 5 or even 25 risks could wipe out
any potential gain. But there is a deeper risk here, not unlike that in new drugs or chemicals that find their way into the
environment. By hedging away so much risk, what new risks are created?

Seeking answers to
that question has produced some intriguing academic research. But the real answer will come like the collapse of Long-Term
Capital, which followed the unexpected repudiation of debt by the Russian government in 1998. The real answer will come only
after something unexpected happens and we all bear the burden of allowing secret, offshore, unregulated investment pools to
operate with oceans of borrowed money from lenders that mix retail banking with investment banking. So far, with the collapse of
Long-Term Capital and a few other funds that placed risky bets that did not work out, the failures have been small enough for the
market, sometimes with help from the government, to ride out. That gives comfort, but not much.

The world is complex; even geniuses like Myron Scholes can make colossal errors in judgment, and all the
new financial devices aimed at limiting risk may themselves meld into some disaster we cannot imagine. If the day comes when the
disaster is so big that the market, the Federal Reserve, the Treasury, and all the king's men cannot put the financial Humpty
Dumpty back together again, we could have the kind of worldwide financial collapse that Long-Term Capital nearly caused. That is
the risk we are running under current government policies that favor the wealthy few, who take huge risks with the bank deposits
of the many.

Another way to get rich is by rigging pay. The rank and file cannot do that, but
senior executives can—and thousands of them did in ways that cheated investors. Our government knew about this, but did
nothing until one brave bureaucrat took a stand.

R
EMY WELLING IS A SMALL, NERVOUS WOMAN IN HER FIFTIES
WITH
light brown hair and a nose as slender as her athletic figure, which is
supported by a backbone of extraordinary strength. Her lonely acts of heroism ought to earn her a statue on Wall Street as a
champion of investors and another statute in Washington as a guardian of the public treasury. Instead, Welling was threatened
with prison, forced to resign her career with the government after 22 years, and then barred by our government from working in her
chosen field.

What Welling discovered was a corporate plot taken straight from
The Sting
, the 1973 movie starring Paul Newman and Robert Redford as two very creative
con men. In the movie, they come up with a scheme to place horse-racing bets that are guaranteed to win. How? They place their
bets after the races are run. And how do they do that? They trick the bookies into thinking the races have yet to start.

Many corporate executives also figured out a way to do something like that, only one that is far more lucrative
and doesn't carry the risk of getting a belly full of lead if caught. Welling figured out what they were up to.

Her story shows how thoroughly our government looks out for the interests of the rich and powerful and how
willing it is to savage those who reveal inconvenient facts. It shows how government secrecy shields corporate misconduct, letting
executives steal from investors with little risk. And it underscores how a pervasive executive pay practice that enriched the few by
cheating the many was not stopped when Welling brought it to the government's attention.

Welling's story begins in December 2002. It was a typical weekday in Silicon Valley, where the crush of
morning traffic congeals into an awful traffic jam. Welling had to go to the office in San Jose that day, although she usually worked
from her home, an airy little condominium.

By nature, Welling is a ferret. At the IRS, she
specialized in assembling subtle clues into a map leading to well-hidden pots of untaxed riches. She honed these skills by putting
together jigsaw puzzles, some with 1,500 pieces.

Welling had just finished a case in which she
had uncovered $14 million of additional taxes owed by an entrepreneur. Later Welling learned that she had wasted her time. Her
bosses let the man slip away without paying. To her, it was pretty much par for the course. It was a little like fly fishing. She would
catch the tax cheats and, too often in her view, her bosses would release them. This taxpayer got away because he did the smart
thing. He hired a fixer.

No one in America calls himself a fixer. Instead their business cards
display titles like partner or vice president. The big accounting firms, and the specialty tax boutiques, are stocked with former IRS
managers and executives who know how to go to bat for clients inside their former agency. They know from experience who is a
team player and who, like Welling, is decidedly not. And they know who will be retiring and looking for a job soon. Like generals
and colonels who approve inflated bills from military contractors and then retire into lucrative new careers, the tax world also has
its public-private revolving door.

Fixing a case is easy under government rules, because
secrecy is the overarching principle. Congress gives the IRS broad discretion to overrule what its auditors recommend. It can settle
for pennies on the dollar. All a supervisor has to do is show that the case is so complicated or costly that litigation would tie up too
much in resources to make it worth the fight. So long as the audit did not find blatant fraud, like a smoking gun memo about
cheating the government, reasons to justify settlement are not that hard to develop. And if a taxpayer can show that an auditor
made an error, however minor, the chances of getting the matter settled rise even further.

The
only risk of doing a well-documented favor as a professional courtesy is that someone in the quality review squad might ask
inconvenient questions. However, no one on that squad has ever been fired for
not
asking such a question.

The case that ended Welling's career began when her boss, Ron
Yokoo, called her into his office. He gave her a thin file on the Micrel Corporation, a small semiconductor maker.

When Welling opened the file she was surprised to find not the usual paperwork, but a two-page document. It
was titled “Department of the Treasury–Internal Revenue Service Closing Agreement on Final Determination Covering Specific
Issues.” The agreement required the IRS to cooperate with the company in not telling shareholders what was going
on.

Welling refused to sign off on it. “An auditor cannot sign off on an agreement closing an
audit before the audit. That's just not legal, not proper,” Welling would say later.

Since Welling
was known as a stickler in the extreme, it seems bizarre that Yokoo gave her this particular case. A team player might well have just
signed the record and been done with it. Perhaps Yokoo never looked inside the file before he handed it over. Because of secrecy
rules he won't say.

Outraged, and now determined to pursue the audit, Welling ordered copies
of Micrel's tax returns. She tried to turn the jigsaw puzzle of all the numbers on all the forms into a coherent picture of what had
happened. Before long she started focusing on the stock options Micrel had given to its executives and employees. Something did
not add up. Welling started adding up the tax liabilities. The numbers were in the tens of millions of dollars.

Soon Welling discovered that earlier that year the IRS was approached by a former high-level IRS official
named James Casimir, who had since joined the accounting firm PricewaterhouseCoopers. Without disclosing initially whom he
represented, Casimir said he wanted the IRS's help in avoiding a big tax bill for his client. He said that his client had not been
following the rules on stock options, the form of compensation most sought after in Silicon Valley.

An option is the right to buy a share of stock in the future at a price that is set today. For little companies
anticipating a big future, options are a way to get rich fast if everything pans out, even briefly. The rules say that the option price,
called the strike price, must be equal to or higher than the share price on the day the employee is given the option. This created a
problem in the volatile market for high tech stocks. Shares at many Silicon Valley companies rose and fell as wildly as the wooden
roller coaster in nearby Santa Cruz. Say all newly hired managers were granted 10,000 options. Joe gets hired on Monday when
shares sell for $10 and Jane gets hired a week later when the price is only $5. Jane's options are worth a lot more than Joe's. If they
both sell their options when the stock price reaches $15 then Joe gets $50,000 and Jane gets $100,000.

On the advice of the Deloitte & Touche accounting firm, Micrel gave employees options at the lowest
price its shares traded at during a 30-day time period. The rules do not allow this practice, but Deloitte said it had found a way
around the rule and would bless the sales in return for a substantial extra fee. No one outside the company knew, however,
because Micrel did not tell its shareholders.

Under rules in effect at the time a company could
often wait months before having to disclose the dates and prices of options granted to top executives. That government rule
created an opportunity to just pick a date, the one with the lowest stock price, to make the options as valuable as possible. There
was no way for investors to figure this out, either, from the reports sent out by the company.

Unable to get Yokoo or anyone else in the auditing division to act, Welling started looking outside for help.
She went to the Securities and Exchange Commission, the FBI, the IRS's own criminal investigation unit, and the inspector general,
as well as the Senate Finance Committee staff. Some of them told her to get lost. No one helped. Ultimately she came to me and to
Warren Rojas, then with the magazine
Tax Notes
.

When the news broke, the IRS acted swiftly. Welling was threatened with prosecution, a very real threat given
the way the law is written. She did not blink. Next the IRS dangled a disability pension in front of her. Welling would not budge. So
they fired her. And when she applied to become a kind of income tax preparer called an enrolled agent, Welling was rejected on
moral grounds.

The IRS commissioner, Mark W. Everson, citied the secrecy law in saying he
could not discuss her case. He did say, however, that the agency “has long-established standards and safeguards designed to
ensure that there is no undue influence over decisions by our enforcement personnel.” There is no way to check that because of
the secrecy law.

The last time Congress took a serious, rather than overtly political, look at the
nation's tax police was back in 1952. It found rampant corruption, with bribes routine in some offices of what was then the Bureau
of Internal Revenue. Hundreds of IRS agents, lawyers, specialists, and others have told me that a serious look today would show
hardly anyone taking cash bribes as in days of old, but that favorable treatment is rampant for sophisticated taxpayers who hire
former IRS executives and high-level managers.

What Welling had stumbled into was
something far bigger than one small company listening to advice it wanted to hear about how to ignore the crystal-clear rules on
stock options. Indeed, documents from Casimir showed that he represented other firms that had engaged in the same practice. So
did papers in a lawsuit Micrel filed against Deloitte & Touche over its advice, as costly as it was bad, on backdating
options.

In the months after Welling's story broke, a small number of companies reported that
they had mispriced their stock options and were making adjustments to their financial statements. In a very few cases, executives
left the companies.

The traffic in options was so huge that several professors of finance had
been studying them. David Yermack of New York University wrote papers on curious patterns he detected. So did Erik Lie of the
University of Iowa. It was Lie, together with Randall Heron of the University of Indiana, who finally put together solid evidence of the
wrongdoing that the IRS, the SEC, and the FBI were told about, but had no interest in pursuing. Lie cited as his inspiration both my
report in
The New York Times
and the more detailed article in
Tax Notes
.

Lie and Heron fed into a computer almost
39,000 stock-option grants made to executives at more than 7,700 companies between 1996 and 2005. Then they compared this to
the ups and downs in the stock price of each company. The executives had an uncanny ability to have options granted to them on
the days when the stock price was at its low point during each period. The timing was too perfect to be possible were the rules
being followed.

The professors concluded that 14 percent of all stock options granted to top
executives during those 10 years were backdated or otherwise manipulated. And for special stock-option grants, the kind a board
might make to keep an executive from leaving, a quarter were on dates chosen after the fact.

Much later the serious disclosures came out, like the fabricated Apple board meeting that was worth an extra
$70 million to Steve Jobs. The company blamed it on mistakes by a low-level employee.

Lie
noted that backdating options was not only illegal, it cheated both investors and the government. Companies reported larger
profits than they actually earned, which tends to push up their stock price, which tends to make options worth more. The
companies also paid fewer taxes. And the whole scheme required filing false reports with the Securities and Exchange
Commission. Manipulating stock option dates was “pervasive,” Lie concluded.

Lax
government rules, like the long delays in reporting when executives were given options, enabled these thefts. Equally lax
enforcement is allowing the few who stole from the many to keep most of their ill-gotten gains. Only a relative handful of executives
are being prosecuted.

Six of the most prominent tax lawyers in Washington wrote to the IRS in
2006 asking that they just allow all the companies that backdated their options to settle up with no penalties and put the matter
behind them. The lead name on the letter was Pamela Olson of the Skadden, Arps law firm. In the early part of the decade, Olson
had been the Bush administration's chief tax policy official at the Treasury Department.

In
thinking about the executives who got away with their crimes, keeping their riches, and about Olson's letter asking that it all be
treated as just a little mistake of no consequence, keep in mind the name Leandro Andrade. Andrade is a petty criminal, a thief. His
last crime was stealing nine videotapes of children's shows from a California KMart. They were worth $150 retail. Andrade claimed
he was going to give the tapes away. For this theft he was sentenced to 50 years in prison with no possibility of parole. The United
States Supreme Court upheld that punishment in 2003. The high court ruled that it did not violate the Eighth Amendment
prohibition against punishment that is cruel and unusual.

Stock-option thievery has decreased
dramatically since Welling came across it and scholars like Lie documented how widespread it was. The reason is the
Sarbanes-Oxley Act. It was passed in the wake of the Wall Street scandals at the turn of the millennium with the stated purpose of
making executives responsible for what they do. One provision requires both chief executives and chief financial officers to certify
the company's books. Ken Lay of Enron and even more so Bernie Ebbers of WorldCom both claimed that they just did not
understand the financial reports of the companies they ran.