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[Senate Report 109-54]
[From the U.S. Government Publishing Office]

109th Congress                                                 S. Rept.
                                 SENATE                        
 1st Session                                                     109-54
_______________________________________________________________________

                                     

                        THE ROLE OF PROFESSIONAL

                              FIRMS IN THE

                       U.S. TAX SHELTER INDUSTRY

                               __________

                              R E P O R T

                            prepared by the

                PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

                                 of the

                              COMMITTEE ON

               HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS

                          UNITED STATES SENATE

                             APRIL 13, 2005
                   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          THOMAS R. CARPER, Delaware
TOM COBURN, Oklahoma                 MARK DAYTON, Minnesota
LINCOLN D. CHAFEE, Rhode Island      FRANK LAUTENBERG, New Jersey
ROBERT F. BENNETT, Utah              MARK PRYOR, Arkansas
PETE V. DOMENICI, New Mexico
JOHN W. WARNER, Virginia

           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
TOM COBURN, Oklahoma                 DANIEL K. AKAKA, Hawaii
LINCOLN D. CHAFEE, Rhode Island      THOMAS R. CARPER, Delaware
ROBERT F. BENNETT, Utah              MARK DAYTON, Minnesota
PETE V. DOMENICI, New Mexico         FRANK LAUTENBERG, New Jersey
JOHN W. WARNER, Virginia             MARK PRYOR, Arkansas

       Raymond V. Shepherd, III, Staff Director and Chief Counsel
                      Leland B. Erickson, Counsel
        Elise J. Bean, Minority Staff Director and Chief Counsel
    Robert L. Roach, Counsel and Chief Investigator to the Minority
                        Laura E. Stuber, Counsel
                     Mary D. Robertson, Chief Clerk

                            C O N T E N T S

                                 ------                                
                                                                   Page

I. INTRODUCTION..................................................     1

II. OVERVIEW OF U.S. TAX SHELTER INDUSTRY........................     3

III. FINDINGS AND RECOMMENDATIONS................................     5

    A. Findings..................................................     5

    B. Recommendations...........................................     7

IV. EXECUTIVE SUMMARY............................................     9

V. ROLE OF ACCOUNTANTS...........................................    11

    A. KPMG......................................................    11

       (1) Developing New Tax Products...........................    13

       (2) Mass Marketing Tax Products...........................    33

       (3) Implementing Tax Products.............................    48

       (4) Avoiding Detection....................................    56

       (5) Disregarding Professional Ethics......................    66

       (6) KPMG's Current Status.................................    73

    B. ERNST & YOUNG.............................................    77

       (1) Development of Mass-Marketed Generic Tax Products.....    77

       (2) Ernst & Young's Curent Status.........................    85

    C. PRICEWATERSHOUSECOOPERS...................................    87

       (1) Mass-Marketed Generic Tax Products....................    87

       (2) PricewaterhouseCoopers' Current Status................    93

VI. ROLE OF LAWYERS..............................................    96

    A. SIDLEY AUSTIN BROWN & WOOD................................    96

    B. SUTHERLAND ASBILL & BRENNAN...............................   100

VII. ROLE OF FINANCIAL INSTITUTIONS..............................   104

    A. DEUTSCHE BANK.............................................   105

    B. HVB BANK..................................................   109

    C. UBS BANK..................................................   113

    D. FIRST UNION NATIONAL BANK.................................   114

VIII. ROLE OF INVESTMENT ADVISORS................................   121

    A. PRESIDIO ADVISORY SERVICES................................   122

    B. QUELLOS GROUP.............................................   125

IX. ROLE OF CHARTITABLE ORGANIZATIONS............................   126

    A. LOS ANGELES DEPARTMENT OF FIRE AND POLICE PENSIONS........   127

    B. AUSTIN FIRE FIGHTERS RELIEF AND RETIREMENT FUND...........   131

 
    THE ROLE OF PROFESSIONAL FIRMS IN THE U.S. TAX SHELTER INDUSTRY

                              ----------                              

I. INTRODUCTION

    In October 2002, the U.S. Senate Permanent Subcommittee on 
Investigations of the Committee on Governmental Affairs, began 
an investigation into the development, marketing, and 
implementation of abusive tax shelters by accountants, lawyers, 
financial advisors, and bankers. The Subcommittee's Minority 
Staff initiated this investigation, at the direction of Senator 
Carl Levin, with the concurrence and support of Subcommittee 
Chairman Norm Coleman. The information in this Report is based 
upon the ensuing bipartisan investigation by the Subcommittee's 
Democratic and Republican staffs.
    In its broadest sense, the term ``tax shelter'' is a device 
used to reduce or eliminate the tax liability of the tax 
shelter user. This may encompass legitimate or illegitimate 
endeavors. While there is no one standard to determine the line 
between legitimate ``tax planning'' and ``abusive tax 
shelters,'' the latter can be characterized as transactions in 
which a significant purpose is the avoidance or evasion of 
Federal, state or local tax in a manner not intended by the 
law.
    The abusive tax shelters investigated by the Subcommittee 
were complex transactions used by corporations or individuals 
to obtain substantial tax benefits in a manner never intended 
by the Federal tax code. While some of these transactions may 
have complied with the literal language of specific tax 
provisions, they produced results that were unwarranted, 
unintended, or inconsistent with the overall structure or 
underlying policy of the Internal Revenue Code. These 
transactions had no economic substance or business purpose 
other than to reduce taxes. Abusive tax shelters can be custom-
designed for a single user or prepared as a generic tax product 
sold to multiple clients. The Subcommittee investigation 
focused on generic abusive tax shelters sold to multiple 
clients as opposed to a custom-tailored tax strategy sold to a 
single client.
    Under present law, generic tax shelters sold to multiple 
clients are not illegal per se. They are potentially illegal 
depending on how the purchasers use them and report their tax 
liability on their tax returns. Certain statutory provisions, 
judicial doctrines, and IRS administrative guidance define and 
identify abusive tax shelters that may violate Federal tax law. 
Over the last 5 years, the IRS and the Treasury Department have 
begun to publish legal guidance on transactions they consider 
to be abusive. This guidance warns 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.
    After a one-year investigation, the Permanent Subcommittee 
on Investigations held 2 days of hearings on November 18, 2003, 
and November 20, 2003, entitled U.S. Tax Shelter Industry: The 
Role of Accountants, Lawyers, and Financial Professionals.
    At the November 18 hearing, the Subcommittee heard 
testimony from three tax experts: Debra Peterson, Tax Counsel, 
California Franchise Tax Board; Mark Watson, Former Partner, 
KPMG LLP; and Calvin Johnson, Professor, The University of 
Texas at Austin School of Law. The Subcommittee also heard 
testimony from numerous tax professionals from various 
accounting firms. Tax professionals from KPMG LLP included: 
Philip Wiesner, Partner in Charge, Washington National Tax 
Client Services; Jeffrey Eischeid, Partner, Personal Financial 
Planning; Lawrence DeLap, retired National Partner in Charge, 
Department of Professional Practice-Tax; Lawrence Manth, former 
West Area Partner in Charge, Stratecon; and Richard Smith Jr., 
Vice Chair, Tax Services. Accounting firm 
PricewaterhouseCoopers was represented by Richard Berry, Jr., 
Senior Tax Partner. Accounting firm Ernst & Young LLP was 
represented by Mark Weinberger, Vice Chair, Tax Services.
    At the November 20 hearing, the Subcommittee heard 
testimony from three lawyers: Raymond Ruble, former Partner, 
Sidley Austin Brown & Wood LLP; Thomas Smith, Jr., Partner, 
Sidley Austin Brown & Wood LLP; and N. Jerold Cohen, Partner, 
Sutherland Asbill & Brennan LLP. The Subcommittee also heard 
testimony from William Boyle, former Vice President, Structured 
Finance Group, Deutsche Bank AG; Domenick DeGiorgio, former 
Vice President, Structured Finance, HVB America, Inc.; John 
Larson, Managing Director, Presidio Advisory Services; and 
Jeffrey Greenstein, Chief Executive Officer, Quellos Group LLC, 
formerly known as Quadra Advisors LLC. Lastly, the Subcommittee 
heard testimony from three regulatory and oversight agencies: 
Mark Everson, Commissioner, Internal Revenue Service; William 
McDonough, Chairman, Public Company Accounting Oversight Board; 
and Richard Spillenkothen, Director, Division of Banking 
Supervision and Regulation, The Federal Reserve.
    This Report is based upon the information gathered by the 
Subcommittee during those two hearings and the course of its 
investigation to date, including a report prepared by Senator 
Levin and released in connection with the November hearings, 
\1\ review of over 250 boxes of documents and electronic disks, 
numerous interviews, three depositions, testimony presented by 
the 20 witnesses at two hearings, and supplemental post-hearing 
information.
---------------------------------------------------------------------------
    \1\ See ``U.S. Tax Shelter Industry: The Role of Accountants, 
Lawyers, and Financial Professionals, Four KPMG Case Studies: FLIP, 
OPIS, BLIPS, and SC2,'' Minority Staff Report of the U.S. Senate 
Permanent Subcommittee on Investigations (11/18/03) (hereinafter 
``Levin Report''), S. Prt. 108-34, reprinted in ``U.S. Tax Shelter 
Industry: The Role of Accountants, Lawyers, and Financial 
Professionals,'' Subcommittee hearings (11/18/03 and 11/20/03) 
(hereinafter ``Subcommittee hearings''), S. Hrg. 108-473, at 145-274. 
This Subcommittee Report confirms the factual findings of the earlier 
Levin Report and draws heavily from its text.
---------------------------------------------------------------------------

II. OVERVIEW OF U.S. TAX SHELTER INDUSTRY

    Under current law, no single standard defines an abusive 
tax shelter. Abusive tax shelters are governed by statutory 
provisions, judicial doctrines, and administrative guidance 
used to identify transactions in which a significant purpose is 
the avoidance or evasion of income tax in a manner not intended 
by the law.
    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 \2\ or who knowingly aid or abet the filing of tax 
return information that understates a taxpayer's tax 
liability.\3\ Additional tax code provisions now require 
taxpayers and promoters to disclose to the IRS information 
about certain potentially illegal tax shelters.\4\
---------------------------------------------------------------------------
    \2\ 26 U.S.C. Sec. 6700.
    \3\ 26 U.S.C. Sec. 6701.
    \4\ 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); and 6112 (promoters must 
maintain lists of clients who purchase potentially illegal tax shelters 
and, upon request, disclose such client lists to the IRS).
---------------------------------------------------------------------------
    In 2003, 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.\5\ 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.\6\ 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 categories of disclosure 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.\7\ 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.'' \8\ 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.'' \9\ As of March 
2004, the IRS had published 31 listed transactions.\10\
---------------------------------------------------------------------------
    \5\ See, e.g., Treas. Reg. Sec. 301.6112-1 and Sec. 1.6011-4, which 
took effect on 2/28/03.
    \6\ 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.
    \7\ 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; 
``Challenges Remain in Combating Abusive Tax Shelters,'' testimony by 
Michael Brostek, Director, Tax Issues, General Accounting Office (GAO) 
before the U.S. Senate Committee on Finance, No. GAO-04-104T (10/21/03) 
(hereinafter ``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.
    \8\ 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.
    \9\ Id. at para. 16.
    \10\ In September 2004, the number of listed transactions was 
modified by the IRS and reduced to 30. See IRS Notice 2004-67 (9/23/
04).
---------------------------------------------------------------------------
    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, \11\ 
business purpose, \12\ substance-over-form, \13\ step 
transaction, \14\ and sham transaction \15\ 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.\16\
---------------------------------------------------------------------------
    \11\ 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.'').
    \12\ 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.'').
    \13\ 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.'').
    \14\ 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).
    \15\ 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.'').
    \16\ 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 long been 
advocated by the Senate Finance Committee and approved by the 
Senate on multiple occasions, but not adopted by the House of 
Representatives. During the 108th Congress, as a result of the 
Subcommittee investigation, Senators Levin and Coleman 
introduced S. 2210, the Tax Shelter and Tax Haven Reform Act, 
to strengthen penalties on tax shelter promoters, prevent 
abusive tax shelters, deter uncooperative tax havens, and 
codify the economic and business purpose doctrines. This bill 
was referred to the Senate Finance Committee which subsequently 
reported a more comprehensive tax bill, S. 1637. This bill 
included some of the tax shelter provisions in S. 2210. In May, 
the Senate considered and adopted S. 1637. During the Senate 
debate, a Levin-Coleman amendment was accepted to further 
strengthen Federal penalties on promoters, aiders and abettors 
of abusive tax shelters. In October 2004, after a House-Senate 
conference, Congress enacted into law H.R. 4520, the American 
Jobs Creation Act. This tax legislation included a number of 
tax shelter reforms supported by the Subcommittee's 
investigation and the Senate Finance Committee, including 
stronger penalties on promoters of abusive tax shelters.\17\ 
Other tax shelter reforms, such as the codification of the 
economic substance and business purpose doctrines and stronger 
penalties on aiders and abettors of tax shelters, were not 
included in the final bill.
---------------------------------------------------------------------------
    \17\ See Amendment No. 3120 to S. 1637. The Levin-Coleman bill, S. 
2210, had advocated a penalty equal to 150% of the gross income 
derived, or to be derived, by a promoter, aider, or abettor of an 
abusive tax shelter. S. 1637, in contrast, had proposed a 50% penalty 
solely on promoters. The Levin-Coleman amendment compromised by 
increasing S. 1637's penalty to 100% of the gross income derived, or to 
be derived, by a promoter, aider or abettor of an abusive tax shelter. 
Unfortunately, the final bill approved by Congress, H.R. 4520, adopted 
only the lower 50% penalty and confined it to promoters, leaving the 
penalty for aiders and abettors still in need of reform.
---------------------------------------------------------------------------
    In December 2004, the Public Company Accounting Oversight 
Board (PCAOB) proposed rules to strengthen auditor independence 
and restrict the tax services that accounting firms may provide 
to their audit clients.\18\ Among other provisions, the 
proposed rule would require any accounting firm that audits a 
publicly traded company to maintain strict independence from 
that company throughout the auditing engagement. The proposed 
rule would also bar such accounting firms from: (1) entering 
into a contingent fee arrangement with an audit client for tax 
services; (2) providing tax services to certain executives of 
an audit client; and (3) planning, marketing, or opining on 
aggressive tax positions with respect to an audit client, as 
further defined by the rule. The proposed rule would also 
require accounting firms, before providing any tax service to 
an audit client, to disclose detailed information about the tax 
service to the company's audit committee and obtain the 
committee's approval. This proposed rule, like the legislation 
enacted by Congress, represents a renewed effort to rein in 
abusive practices within the U.S. tax shelter industry.
---------------------------------------------------------------------------
    \18\ See PCAOB Release 2004-15 (12/14/04).
---------------------------------------------------------------------------

III. FINDINGS AND RECOMMENDATIONS

    The Subcommittee's investigation to date has determined 
that in 2003, the U.S. tax shelter industry no longer focused 
solely on providing individualized tax advice but had expanded 
its focus to include generic ``tax products'' aggressively 
marketed to multiple clients. The investigation also found that 
numerous respected members of the American business community 
were heavily involved in the development, marketing, and 
implementation of generic tax products whose principal 
objective was to reduce or eliminate a client's U.S. tax 
liability. These tax shelters required close collaboration 
between accounting firms, law firms, investment advisory firms, 
and banks.

  A. FINDINGS

    Based upon its investigation, the Subcommittee makes the 
following findings:

      (1) The sale of potentially abusive and illegal tax 
shelters is a lucrative business in the United States, and some 
professional firms such as accounting firms, banks, law firms, 
and investment advisory firms have been major participants in 
the development, mass marketing, and implementation of generic 
tax products sold to multiple clients.

      (2) During the period 1998 to 2003, KPMG devoted 
substantial resources and maintained an extensive 
infrastructure to produce a continuing supply of generic tax 
products to sell to clients, using a process which pressured 
its tax professionals to generate new ideas, move them quickly 
through the development process, and approve, at times, illegal 
or potentially abusive tax shelters.

      (3) KPMG used aggressive marketing tactics to sell its 
generic tax products by turning tax professionals into tax 
product salespersons, pressuring its tax professionals to meet 
revenue targets, using telemarketing to find clients, 
developing an internal tax sales force, using confidential 
client tax data to find clients, targeting its own audit 
clients for sales pitches, and using tax opinion letters and 
insurance policies as marketing tools.

      (4) KPMG was actively involved in implementing the tax 
shelters which it sold 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.

      (5) KPMG took steps to conceal its tax shelter 
activities from tax authorities, including by claiming it was a 
tax advisor and not a tax shelter promoter, failing to register 
potentially abusive tax shelters, restricting file 
documentation, imposing marketing restrictions, and using 
improper tax return reporting to minimize detection by the IRS 
or others.

      (6) Since Subcommittee hearings in 2003, KPMG has 
committed to cultural, structural, and institutional changes to 
dismantle its abusive tax shelter practice, including by 
dismantling its tax shelter development, marketing and sale 
resources, dismantling certain tax practice groups, making 
leadership changes, and strengthening tax services oversight 
and regulatory compliance.

      (7) During the period 1998 to 2002, Ernst & Young sold 
generic tax products to multiple clients despite evidence that 
some, such as CDS and COBRA, were potentially abusive or 
illegal tax shelters.

      (8) Ernst & Young has committed to cultural, structural, 
and institutional changes to dismantle its tax shelter 
practice, including by eliminating the tax practice group that 
promoted its tax shelter sales, making tax leadership changes, 
and strengthening its tax services oversight and regulatory 
compliance.

      (9) During the period 1997 to 1999, 
PricewaterhouseCoopers sold generic tax products to multiple 
clients, despite evidence that some, such as FLIP, CDS, and 
BOSS, were potentially abusive or illegal tax shelters.

      (10) PricewaterhouseCoopers has committed to cultural, 
structural, and institutional changes intended to dismantle its 
abusive tax shelter practice, including by establishing a 
centralized quality and risk management process, and 
strengthening its tax services oversight and regulatory 
compliance.

      (11) Sidley Austin Brown & Wood, through its predecessor 
firm Brown & Wood, provided legal services that facilitated the 
development and sale of potentially abusive or illegal tax 
shelters, including by providing design assistance, 
collaboration on allegedly independent tax opinion letters, and 
hundreds of boilerplate tax opinion letters to clients referred 
by KPMG and others, in return for substantial fees.

      (12) Sutherland Asbill & Brennan provided legal 
representation to over 100 former KPMG clients in tax shelter 
matters before the IRS, despite a longstanding business 
relationship with KPMG and without performing any conflict of 
interest analysis prior to undertaking these representations.

      (13) Deutsche Bank, HVB Bank, and UBS Bank provided 
billions of dollars in lending critical to transactions which 
the banks knew were tax motivated, involved little or no credit 
risk, and facilitated potentially abusive or illegal tax 
shelters known as FLIP, OPIS, and BLIPS.

      (14) First Union National Bank promoted to its clients 
generic tax products which had been designed by others, 
including potentially abusive or illegal tax shelters known as 
FLIP, BLIPS, and BOSS, by introducing and explaining these 
products to its clients, providing sample opinion letters, and 
introducing its clients to the promoters of the tax products, 
in return for substantial fees.

      (15) Some investment advisors, including Presidio 
Advisory Services and the Quellos Group, helped develop, 
design, market, and execute potentially abusive or illegal tax 
shelters such as FLIP, OPIS, and BLIPS.

      (16) Some charitable organizations, including the Los 
Angeles Department of Fire and Police Pensions and Austin Fire 
Fighters Relief and Retirement Fund, participated as counter 
parties in a highly questionable tax shelter known as SC2, 
which had been developed and promoted by KPMG, in return for 
substantial payments in the future.

  B. RECOMMENDATIONS

    Based upon its investigation and the above factual 
findings, the Subcommittee makes the following recommendations:

      (1) The Internal Revenue Service and the Department of 
Justice should continue enforcement efforts aimed at stopping 
accounting firms and law firms from aiding and abetting tax 
evasion, promoting potentially abusive or illegal tax shelters, 
and violating Federal tax shelter regulations, and should 
impose substantial penalties on wrongdoers to punish and deter 
such misconduct.

      (2) Congress should enact legislation to increase the 
civil penalties on aiders and abettors of tax evasion and 
promoters of potentially abusive or illegal tax shelters, to 
ensure that they disgorge not only all illicit proceeds from 
such activities, but also pay a substantial monetary fine to 
punish and deter such misconduct.

      (3) Congress should appropriate additional funds to 
enable the IRS to hire more enforcement personnel and increase 
enforcement activities to stop the promotion of potentially 
abusive and illegal tax shelters by lawyers, accountants, and 
other financial professionals.

      (4) Congress should enact legislation to clarify and 
strengthen the economic substance doctrine and to strengthen 
civil penalties on transactions with no economic substance or 
business purpose apart from their alleged tax benefits.

      (5) Congress should enact legislation authorizing the 
IRS to disclose relevant tax shelter information to other 
Federal agencies, such as the Public Company Accounting 
Oversight Board, Federal bank regulators, and the Securities 
and Exchange Commission (SEC), to strengthen their efforts to 
stop the entities they oversee from aiding or abetting tax 
evasion or promoting potentially abusive or illegal tax 
shelters.

      (6) The Public Company Accounting Oversight Board should 
strengthen and finalize proposed rules restricting certain 
accounting firms from providing aggressive tax services to 
their audit clients, charging companies a contingent fee for 
providing tax services, and using aggressive marketing efforts 
to promote generic tax products to potential clients.

      (7) Federal bank regulators, in consultation with the 
IRS, should review tax shelter activities at major banks, and 
clarify and strengthen rules preventing banks from aiding or 
abetting tax evasion by third parties or promoting potentially 
abusive or illegal tax shelters.

      (8) The SEC, in consultation with the IRS, should review 
tax shelter activities at investment advisory and securities 
firms it oversees, and clarify and strengthen rules preventing 
such firms from aiding or abetting tax evasion by third parties 
or promoting potentially abusive or illegal tax shelters.

      (9) The IRS should further strengthen Federal tax 
practitioner rules issued under Circular 230 regarding the 
issuance of tax opinion letters to ensure that such 
practitioners, including law firms and accounting firms, have 
written procedures for issuing tax opinions, resolving internal 
disputes over legal issues addressed in such opinions, and 
preventing practitioners or their firms from aiding or abetting 
tax evasion by clients or promoting potentially abusive or 
illegal tax shelters.

      (10) The IRS should review tax shelter activities at 
charitable organizations, and clarify and strengthen rules 
preventing such organizations from aiding or abetting tax 
evasion by third parties or promoting potentially abusive or 
illegal tax shelters.

IV. EXECUTIVE SUMMARY

    This report details the Subcommittee's investigation of the 
U.S. tax shelter industry. First, this report examines the 
development of mass-marketed generic tax products sold to 
multiple clients using prominent accounting firms, banks, 
lawyers, and investment firms. Second, as a result of the 
Subcommittee's investigation, this report describes the 
commitments made by the accounting firms examined during this 
investigation to end their involvement with abusive tax 
shelters.
    The investigation found that by 2003, the U.S. tax shelter 
industry was 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 had moved from providing one-on-one tax advice 
in response to tax inquiries to also initiating, designing, and 
mass marketing tax shelter products.
    Also, the investigation found that numerous respected 
members of the American business community had been heavily 
involved in the development, marketing, and implementation of 
generic tax products whose objective was not to achieve a 
specific business or economic purpose, but to reduce or 
eliminate a client's U.S. tax liability. By 2003, dubious tax 
shelter sales were no longer the province of shady, fly-by-
night companies with limited resources. They had become 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.
    This report focuses on generic tax products developed and 
promoted by KPMG, PricewaterhouseCoopers, and Ernst & Young, 
auditors and tax experts comprising three of the top four 
accounting firms in the United States. During the 1990's, in 
response in part to the stock market boom and the proliferation 
of stock options, these firms and others designed and developed 
tax products used to generate large paper losses that could be 
used to offset or shelter gains from taxation. Tax products 
examined by the Subcommittee include: KPMG's Bond Linked Issue 
Premium Structure (BLIPS), Foreign Leveraged Investment Program 
(FLIP), and Offshore Portfolio Investment Strategy (OPIS); 
PricewaterhouseCooper's Bond and Option Sales Strategy (BOSS); 
and Ernst & Young's Contingent Deferred Swap (CDS) tax product. 
Each of these products generated hundreds of millions of 
dollars in phony paper losses for taxpayers, using a series of 
complex, orchestrated transactions, structured finance, and 
investments with little or no profit potential. All of these 
tax products have been ``listed'' by the IRS as potentially 
abusive tax shelters.\19\
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    \19\ 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). PricewaterhouseCooper's BOSS transaction is covered 
by IRS Notice 1999-59 (1999-52 IRB 761) (12/27/99). Ernst & Young's CDS 
transaction is covered by IRS Notice 2002-35 (2002-21 IRB 992) (5/28/
02).
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    Additionally, the Subcommittee examined a fourth tax 
product, S-Corporation Charitable Contribution Strategy (SC2), 
developed by KPMG. SC2 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 was 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. Recently, the IRS listed SC2 as a 
potentially abusive tax shelter.\20\
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    \20\ See IRS Notice 2004-30 (4/1/04).
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    As a result of the Subcommittee's hearings and 
investigation, each accounting firm has committed to cultural, 
structural, and institutional reforms and changes to end the 
promotion, development, implementation, and offering of mass-
marketed abusive tax shelters. KPMG informed the Subcommittee 
that the firm has dismantled its development, marketing, and 
sales infrastructure used for offering mass-marketed tax 
shelters. In addition, KPMG indicated that it has dismantled 
various tax practice groups, made leadership changes, and 
strengthened oversight and compliance. KPMG indicated that 
these changes reflect a firm-wide commitment to attain the 
highest degree of trust from the firm's clients, regulators, 
and the public at large. Similarly, Ernst & Young told the 
Subcommittee that the firm has instituted new oversight and 
leadership changes, IRS compliance and monitoring systems, and 
firm-wide policies to ensure the highest standards of 
professionalism. Lastly, PricewaterhouseCoopers told the 
Subcommittee that the firm has instituted new leadership 
positions, and a centralized product development process to 
monitor all tax services to ensure that mass-marketed abusive 
tax shelters would not be marketed by the firm in the future.
    The investigation also examined a number of professional 
firms that assisted in the development, marketing, and 
implementation of tax shelters promoted by the three accounting 
firms. Leading banks, including Deutsche Bank, HVB, and UBS, 
provided multi-billion dollar credit lines essential to the 
orchestrated transactions. Wachovia Bank, acting through First 
Union National Bank, made client referrals to KPMG and 
PricewaterhouseCoopers, playing a key role in facilitating the 
marketing of potentially abusive or illegal tax shelters. 
Leading law firms, such as Brown & Wood, which later merged 
with another firm to become Sidley Austin Brown & Wood, 
provided favorable tax opinions on these tax shelters, advising 
that they were permissible under the law. The evidence also 
suggests collaboration between Sidley Austin Brown & Wood and 
KPMG on the OPIS and BLIPS tax shelters, including the issuance 
of allegedly independent opinion letters on BLIPS containing 
numerous virtually identical paragraphs. Two investment 
advisory firms, Presidio Advisory Services and Quellos Group, 
formerly doing business as Quadra Capital Management LLP and QA 
Investments LLC, assisted in the design, development, 
marketing, and implementation of tax shelters promoted by KPMG. 
Additionally, Quellos served as the investment advisor for 
PricewaterhouseCooper's version of FLIP.
    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.

V. ROLE OF ACCOUNTANTS

    The Subcommittee's investigation of the U.S. tax shelter 
industry found that leading U.S. accounting firms were focused 
on developing generic ``tax products'' aggressively marketed to 
multiple clients from the late 1990's to as late as 2003, 
despite increasing IRS enforcement efforts to halt the tax 
shelters they were promoting. Accounting firms were devoting 
substantial resources to develop, market, and implement tax 
shelters, costing the Treasury billions of dollars in lost tax 
revenues.\21\ To illustrate the problems, the Subcommittee 
developed case histories focused on tax shelters promoted by 
KPMG, PricewaterhouseCoopers, and Ernst & Young. The 
investigation also uncovered evidence that these firms took 
steps to conceal their tax shelter activities from tax 
authorities and the public, including by failing to register 
potentially abusive tax shelters with the IRS.
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    \21\ According to the General Accounting Office, 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. See GA0-04-104T, at 3 (2003). GAO estimates potential tax 
losses of about $33 billion from transactions listed by the IRS as 
potentially abusive, and another $52 billion from non-listed abusive 
transactions, for a combined total of $85 billion. Id. at 10.
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  A. KPMG

    The Subcommittee conducted its most detailed examination of 
four potentially abusive or illegal tax shelters that were 
developed, marketed, and implemented by KPMG. KPMG 
International is one of the largest public accounting firms in 
the world, with over 700 offices in 152 countries.\22\ In 2002, 
it employed over 100,000 people and had worldwide revenues of 
$10.7 billion. KPMG International, organized as a Swiss ``non-
operating association,'' functions as a federation of 
partnerships around the globe, and maintains its headquarters 
in Amsterdam.
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    \22\ 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).
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    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'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 has generated more than $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.\23\ The 
Tax Services Practice is headquartered in New York, has 122 
U.S. offices, and maintains additional offices around the 
world. The head of the Tax Service during the period of the 
investigation was Vice Chairman for Tax, Richard Smith, Jr.
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    \23\ Internal KPMG presentation dated 7/19/01, by Rick Rosenthal 
and Marsha Peters, entitled ``Innovative Tax Solutions.'' 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.
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    The Tax Services Practice has over two dozen subdivisions, 
offices, ``practices,'' or ``groups'' which over the years have 
changed missions and personnel. Many played key roles in 
developing, marketing, or implementing KPMG's generic tax 
products, including the four KPMG products featured in this 
Report. One key group is the Washington National Tax (WNT) 
Practice which provides technical tax expertise to the entire 
KPMG firm. During the course of the Subcommittee's 
investigation, a WNT subgroup, the Tax Innovation Center, led 
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 focused on selling 
``tax-advantaged'' products to high net worth individuals and 
large corporations.\24\ Through a subdivision known as the 
Capital Transaction Services (CaTS) Practice, later renamed the 
Innovative Strategies Practice, PFP led KPMG's efforts on FLIP, 
OPIS, and BLIPS.\25\ KPMG's Stratecon Practice, which focused 
on ``business based'' tax planning and tax products, led the 
firm's efforts on SC2. Innovative Strategies and Stratecon were 
later disbanded, and their tax professionals assigned to other 
groups.\26\ The Tax Innovation Center was apparently closed in 
2003.
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    \24\ Minutes dated 11/30/00, Monetization Solutions Task Force 
Teleconference, Bates KPMG 0050624-29, at 50625.
    \25\ Document dated 5/18/01, ``PFP Practice Reorganization 
Innovative Strategies Business Plan--DRAFT,'' Bates KPMG 0050620-23, at 
50621.
    \26\ KPMG told the Subcommittee that both groups were disbanded 
over time in 2002; it is unclear exactly when each ceased to function.
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    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, 
and, in part, due to new tax leadership that was enthusiastic 
about increasing tax product sales. 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.

  (1) Developing New Tax Products

      Finding: During the period 1998 to 2003, KPMG devoted 
substantial resources and maintained an extensive 
infrastructure to produce a continuing supply of generic tax 
products to sell to clients, using a process which pressured 
its tax professionals to generate new ideas, move them quickly 
through the development process, and approve, at times, illegal 
or potentially abusive tax shelters.

    During the investigation, KPMG preferred to describe itself 
as a tax advisor that responded to client inquiries seeking tax 
planning services to structure legitimate business transactions 
in a tax efficient way. The Subcommittee investigation 
determined, however, that KPMG had also developed and supported 
an extensive internal infrastructure of offices, programs, and 
procedures designed to churn out a continuing supply of new 
generic tax products, unsolicited by a specific client, for 
mass marketing to multiple clients.
    Drive to Produce New Tax Products. In 1997, KPMG 
established the Tax Innovation Center whose sole mission was to 
push the development of new KPMG tax products. Located within 
the Washington National Tax (WNT) Practice, the Center was 
staffed with about a dozen full-time employees and assisted by 
others who worked 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.'' \27\
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    \27\ ``Tax Innovation Center Overview,'' Solution Development 
Process Manual (4/7/01), prepared by the KPMG Tax Innovation Center 
(hereinafter ``TIC Manual''), at i.
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    Essentially, the Tax Innovation Center encouraged KPMG tax 
professionals to propose new tax product ideas and then 
provided administrative support to develop the proposals into 
approved tax products and move them into the marketing stage. 
As part of this effort, the Center maintained a ``Tax Services 
Idea Bank'' which it used to drive and track new tax product 
ideas. The Center asked 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.\28\
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    \28\ ``TIC Solution Development Process,'' TIC Manual at 6.
---------------------------------------------------------------------------
    In recent years, the Center 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.'' \29\ On May 30, 2001, the Center reported on the Tax 
Services' progress in meeting this goal as part of a larger 
Powerpoint 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 showed 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.
---------------------------------------------------------------------------
    \29\ KPMG presentation dated 5/30/01, ``Tax Innovation Center 
Solution and Idea Development--Year-End Results,'' Bates XX 001755-56, 
at 1754.
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    Development and Approval Process. Once ideas were deposited 
into the Tax Services Idea Bank, KPMG 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 was described in its Tax Services Manual and Tax 
Innovation Center Manual.\30\ Essentially, the process 
consisted of three stages, each of which could overlap with 
another. In the first stage, the new tax idea underwent an 
initial screening ``for technical and revenue potential.'' \31\ 
This initial analysis was supposed to be provided by a ``Tax 
Lab'' which was a formal meeting, arranged by the Tax 
Innovation Center, of six or more KPMG tax experts specializing 
in the tax issues or industry affected by the proposed 
product.\32\ Promising proposals were 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 and later succeeded by Andrew 
Atkin.
---------------------------------------------------------------------------
    \30\ KPMG Tax Services Manual, Sec. 24.1 to 24.7.
    \31\ TIC Manual at 5.
    \32\ 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 survived the initial screening, in the second 
stage it underwent a thorough review by the Washington National 
Tax Practice (``WNT review''), which was responsible for 
determining whether the product met the technical requirements 
of existing tax law.\33\ WNT personnel often spent significant 
time identifying and searching for ways to resolve problems 
with how the proposed product was structured or was intended to 
be implemented. The WNT review also included analysis of the 
product by the WNT Tax Controversy Services group ``to address 
tax shelter regulations issues.'' \34\ WNT was required to 
``sign-off'' on the technical merits of the proposal before it 
was approved for sale to clients.
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    \33\ 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).
    \34\ KPMG Tax Services Manual, Sec. 24.4.1, at 24-2.
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    In the third and final stage, the product underwent review 
and approval by the Department of Practice and Professionalism 
(``DPP review''). The DPP review had to determine that the 
product not only complied with the law, but also met KPMG's 
standards for ``risk management and professional practice.'' 
\35\ This latter review included 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 were to be structured, 
whether auditor independence issues needed to be addressed, and 
the potential impact of a proposed tax product on the firm's 
reputation.\36\
---------------------------------------------------------------------------
    \35\ Id., Sec. 24.5.2, at 24-3.
    \36\ Subcommittee interview of Lawrence DeLap (10/30/03). The 
Subcommittee staff was told that, since 1997, DPP-Tax had very limited 
resources to conduct its new product reviews. Until 2002, for example, 
DPP-Tax had a total of less than 10 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, had well 
over 100 employees.
---------------------------------------------------------------------------
    The KPMG development and approval process was 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 stated 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.'' \37\ KPMG defines ``more likely than not'' as a 
``greater than 50 percent probability of success if [a tax 
product is] challenged by the IRS.'' \38\ 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.
---------------------------------------------------------------------------
    \37\ KPMG Tax Services Manual, Sec. 24.5.2, at 24-3.
    \38\ 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.\39\ In addition, to ``launch'' the new product 
within KPMG, the Tax Innovation Center was supposed to prepare 
a ``Tax Solution Alert'' which served ``as the official 
notification'' that the tax product was available for sale to 
clients.\40\ This Alert was 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. 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.
---------------------------------------------------------------------------
    \39\ Id., Sec. 24.4.2, at 24-2. See also TIC Manual at 10.
    \40\ 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.\41\ 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.'' \42\ 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.
---------------------------------------------------------------------------
    \41\ KPMG Tax Services Manual, Sec. 41.17.1, at 41-8.
    \42\ 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 tax products examined by the 
Subcommittee.
    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 
worked. 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.\43\ After this notice was issued, KPMG 
discontinued sales of the product.
---------------------------------------------------------------------------
    \43\ IRS Notice 2000-44 (2000-36 IRB 255) (9/5/00).
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    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, and Presidio Advisory 
Services, an investment advisory firm run by two former KPMG 
tax professionals. Key documents written at the beginning and 
during a key two-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,'' \44\ 
the head of the entire Tax Services Practice wrote:
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    \44\ 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.\45\
---------------------------------------------------------------------------
    \45\ 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 postscript: ``P.S. I don't like this pressure any 
more than you do.'' \46\
---------------------------------------------------------------------------
    \46\ 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.\47\ 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.'' \48\ 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.
---------------------------------------------------------------------------
    \47\ ``Meeting Summary'' for meeting held on 2/19/99, Bates MTW 
0009.
    \48\ 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.\49\
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    \49\ 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.'' \50\ 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.\51\
---------------------------------------------------------------------------
    \50\ Email dated 5/5/99, from Larry DeLap to Mark Watson, Bates 
KPMG 0011916.
    \51\ 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.'' \52\
---------------------------------------------------------------------------
    \52\ 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 6 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???'' \53\
---------------------------------------------------------------------------
    \53\ 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.'' \54\
---------------------------------------------------------------------------
    \54\ 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? \55\
---------------------------------------------------------------------------
    \55\ 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.\56\
---------------------------------------------------------------------------
    \56\ 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.'' \57\
---------------------------------------------------------------------------
    \57\ Email dated 5/10/99, from Jeffrey Stein to Philip Wiesner 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.\58\
---------------------------------------------------------------------------
    \58\ 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.'' \59\
---------------------------------------------------------------------------
    \59\ 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.'' \60\
---------------------------------------------------------------------------
    \60\ 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.\61\
---------------------------------------------------------------------------
    \61\ 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.\62\ 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.\63\
---------------------------------------------------------------------------
    \62\ Id.
    \63\ 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.'' \64\ His superiors indicated that they were.
---------------------------------------------------------------------------
    \64\ 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.

      LNonetheless, 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.\65\
---------------------------------------------------------------------------
    \65\ Email dated 8/4/99, from Mark Watson to David Brockway, Mark 
Springer and Douglas 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.\66\
---------------------------------------------------------------------------
    \66\ Id.

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.'' \67\ One of the WNT technical 
reviewers who had objected to the original BLIPS again 
expressed his concerns:
---------------------------------------------------------------------------
    \67\ 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 urging the analysis of the 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.

      LIn short, in my view, I do not believe that KPMG can 
reasonably issue a more-likely-than-not opinion on these 
issues.\68\
---------------------------------------------------------------------------
    \68\ 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.\69\ A BLIPS Powerpoint 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.'' \70\ In response to 
an email on BLIPS stating that the firm would provide a more 
likely than not opinion, indicating a greater than 50 percent 
chance of success on the merits, one KPMG tax professional who 
refused to sell BLIPS to his clients wrote ``[j]ust so we are 
clear, I personally view it no greater than 15%.'' \71\
---------------------------------------------------------------------------
    \69\ Subcommittee interview of Lawrence DeLap (10/30/03).
    \70\ Powerpoint presentation dated June 1999, by Carol Warley, 
Personal Financial Planning group, ``BLIPS AND TRACT,'' Bates KPMG 
00496339-45, at 496340. Repeated capitalizations in original text not 
included.
    \71\ Email dated 5/5/99, from William Goldberg to Paul Kearns, 
``RE: BLIPs,'' Bates KPMG 0028162.
---------------------------------------------------------------------------
    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.'' \72\ The IRS' 
disallowance of BLIPS has not yet been tested in court. Rather 
than defend BLIPS in court, however, KPMG and many BLIPS 
purchasers appear to be engaged in settlement negotiations with 
the IRS to reduce penalty assessments.
---------------------------------------------------------------------------
    \72\ 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, \73\ 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.
---------------------------------------------------------------------------
    \73\ See document dated 5/18/01, ``PFP Practice Reorganization 
Innovative Strategies Business Plan--DRAFT,'' Bates KPMG 0050620-23, at 
50621.
---------------------------------------------------------------------------
    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.\74\ 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.''
---------------------------------------------------------------------------
    \74\ 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.\75\ 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.
---------------------------------------------------------------------------
    \75\ 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 
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[ed] 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.\76\ The IRS has since audited 
and penalized numerous taxpayers for using these illegal tax 
shelters.\77\
---------------------------------------------------------------------------
    \76\ IRS Notice 2001-45 (2001-33 IRB 129) (8/13/01).
    \77\ 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.
    Documents preceding 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, 1 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. . 
. .'' \78\
---------------------------------------------------------------------------
    \78\ 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.\79\
---------------------------------------------------------------------------
    \79\ 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.\80\
---------------------------------------------------------------------------
    \80\ 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.\81\ 
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.\82\ KPMG tax professionals identified other technical 
problems as well involving assignment of income, reliance on 
tax indifferent parties, and valuation issues.\83\
---------------------------------------------------------------------------
    \81\ See, e.g., email dated 3/13/00, from Richard Bailene to 
Phillip Galbreath, ``S-CAEPS,'' Bates KPMG 0015744.
    \82\ 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.
    \83\ 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.\84\
---------------------------------------------------------------------------
    \84\ Email dated 12/20/01, from William Kelliher to David Brockway, 
``FW: SC2,'' Bates, KPMG 0012723.

    At the Subcommittee hearings in November 2003, Lawrence E. 
Manth, KPMG's designated National Product Champion for SC2 and 
the tax professional primarily responsible for its creation and 
development, read a statement defending the tax product and 
claiming that SC2 was ``consistent with the law.'' \85\ Certain 
statements made by Mr. Manth under oath, however, regarding two 
critical elements of SC2 are directly contradicted by KPMG 
documents, information from SC2 participants, and the actual 
implementation history of some SC2 transactions.
---------------------------------------------------------------------------
    \85\ See Manth testimony at the Subcommittee Hearings (11/18/03), 
at 34-35.
---------------------------------------------------------------------------
    The first element involves distributions of income by an S 
Corporation during the period in which most of its stock is 
being held by a tax exempt organization. This issue is 
important, because it provides evidence relevant to determining 
the true nature of the SC2 transaction. If distributions of 
income were limited or suspended while a tax exempt entity held 
most of the S Corporation stock (and was therefore entitled to 
most of the distributions), questions necessarily arise as to 
whether the stock ``donation'' was a genuine transfer of 
ownership to the tax exempt entity or a mere ploy to defer 
taxation on retained corporate income until the original owner 
of the stock redeems the shares a few years later.
    As part of his testimony before the Subcommittee, Mr. Manth 
made the following statement regarding the limitation or 
suspension of distributions by S Corporations implementing an 
SC2 transaction:

      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.\86\
---------------------------------------------------------------------------
    \86\ Id., at 35.

Yet, in March 2000, when a KPMG colleague characterized the SC2 
transaction as ``nothing more that a[n] old give stock to 
---------------------------------------------------------------------------
charity and then redeem it play,'' Mr. Manth responded:

      Yes, very similar, but during the time the tax exempt 
owns the stock it will be allocated 90% of the income, be paid 
no distributions, and be redeemed for a small value.\87\
---------------------------------------------------------------------------
    \87\ Email dated 3/13/00, between Mr. Manth, Richard Baline, and 
other KPMG tax personnel, ``RE: S-CAEPS,'' Bates KPMG 0015738-0015747, 
reprinted in the Subcommittee Hearings as Hearing Exhibit 49, at 574-
83.

    In an e-mail written on April 11, 2000, Larry DeLap, head 
of KPMG's Department of Professional Practice for Tax, provided 
---------------------------------------------------------------------------
the following description of the SC2 transaction:

      The strategy involves the transfer of a substantial 
portion of S Corporation stock to a section 401(a) governmental 
pension plan, with the intention that such stock be redeemed 
from the pension plan after about 2 years. The intent is that 
most of the earnings of the S Corporation would be allocated to 
the pension plan during the period it owns the S Corporation 
stock, but relatively little of the earnings would be 
distributed during that period.\88\
---------------------------------------------------------------------------
    \88\ Email dated 4/11/00, from Larry DeLap to KPMG's Tax 
Professional Practice partners, ``S-Corporation Charitable Contribution 
Strategy (SC2),'' Bates KPMG 0015631, reprinted in the Subcommittee 
Hearings as Hearing Exhibit 50 at 584.

    On February 22, 2001, James Councill Leak, a tax 
professional at KPMG who worked on the sale of the SC2 tax 
product, sent an email to a large number of KPMG employees and 
---------------------------------------------------------------------------
included this description of the SC2 product.

      SC2 is designed to allow an S Corp shareholder to obtain 
a charitable deduction for a gift of non-voting stock to a 
qualified tax exempt entity. After the gift, the tax exempt 
will be allocated a significant portion of the S Corp taxable 
income. The S Corp will curtail cash distributions that would 
otherwise have been made to fund quarterly tax obligations. The 
cash will build up inside the S Corp and can be used for any 
corporate purpose. After 2 or 3 years, the tax exempt has the 
right to ``put'' the stock back to the S Corp for redemption. 
After redeeming the shares, the S Corp can resume making cash 
distributions. The end result is a deferral of income tax and 
the ultimate conversion from ordinary to capital gain tax rates 
on S Corp income.

Mr. Manth sent the following response to Mr. Leak's memo:

      Great e-mail, Councill!! Andrew [Atkin], you may 
consider sending this to other regions.\89\
---------------------------------------------------------------------------
    \89\ Series of emails dated 3/05/2001, between Mr. Manth, Mr. Leak, 
and others, ``RE: SC2 Solution--New Development,'' Bates KPMG 0048251-
54, reprinted in the Subcommittee Hearings as Hearing Exhibit 96 x.

    In the spring of 2000, KPMG produced a packet of 
information describing the SC2 product, its implementation, and 
how to address questions raised by potential customers. Mr. 
Leak advised the Subcommittee that this was the packet of 
information used to train KPMG tax professionals who were going 
to sell the SC2 product, and that Mr. Manth and other KPMG 
employees conducted the training session. Mr. Manth informed 
the Subcommittee that he had a role in the development of the 
information packet. The packet includes a Powerpoint 
presentation on how the SC2 transaction works, and one of the 
pages in this presentation states: ``For valid business 
purposes, the S-corporation will decrease its cash 
distributions during the tax-exempt shareholder's stock 
ownership.'' \90\
---------------------------------------------------------------------------
    \90\ ``SC2--Meeting Agenda June 19th, 2000,'' Bates KPMG 0013375-
96, at KPMG 0013383, reprinted in the Subcommittee Hearings as Hearing 
Exhibit 21.
---------------------------------------------------------------------------
    Also included in the packet is a section entitled: ``SC2 
IMPLEMENTATION PROCESS,'' which states the following:

      c. Corporate issues--we need to review copies of 
Articles of Incorporation, By Laws and any shareholder 
agreements. Make sure that there are no provisions in any 
corporate documents:

        i. requiring the Corporation to make dividends (e.g. 
to pay taxes);

        ii. allowing the corporation or other shareholders to 
redeem stock; or

        iii. giving shareholders indemnification for any 
actions;

        If any of these provisions exist, we will probably 
need to delete or alter them before the contribution.\91\
---------------------------------------------------------------------------
    \91\ Id., at KPMG 0013385.

An addendum to the KPMG ``White Paper'' description and 
---------------------------------------------------------------------------
analysis of the SC2 product contains similar passages:

      (1) Distribution requirements. Are there any provisions 
in the by-laws, articles of incorporation, shareholders' 
agreements or elsewhere that mandates that the company make a 
distribution to pay the shareholders' taxes? If so, these 
provisions should be deleted prior to implementation. . . .

      (3) The issuance of notes may also be beneficial where 
the shareholders are dependent on distributions for their 
primary source of income. During the transaction period, 
distributions normally are not made. Therefore, if the 
shareholders will need cash from the corporation during the 
transaction period, a note should be distributed prior to the 
transaction.\92\
---------------------------------------------------------------------------
    \92\ ``SC2 Outline'' and ``SC2 White Paper,'' Bates 0013397-447, at 
KPMG 0013430 and 38, reprinted in the Subcommittee Hearings as Hearing 
Exhibit 96 b. The addendum also states:
        ``WNT [Washington National Tax, the KPMG group that reviewed 
the technical aspects of SC2] thinks payment of dividends would reduce 
the taxpayers' level of risk by making it more difficult for the IRS to 
successfully argue that the taxpayer has retained beneficial ownership 
of the stock contributed to the exempt pension fund. WNT thinks it 
would also bolster the taxpayers' `economic substance' argument. 
Although the payment of dividends to the exempt pension fund would be 
an additional cost to the taxpayer, that cost would provide a 
corresponding benefit in the event of an examination challenge.''
    Id., at KPMG 0013444. This advice was not, however, followed in 
most of the SC2 transactions reviewed by the Subcommittee.

    KPMG prepared packets containing boilerplate legal 
documents that could be provided to S Corporations planning to 
implement the SC2 transaction. One such packet included sample 
Board and Shareholder resolutions supporting the amendment of 
the shareholders agreement to provide that the S Corporation 
was not obligated to make distributions to shareholders for the 
payment of income tax due with respect to their S Corporation 
shares.\93\
---------------------------------------------------------------------------
    \93\ See sample documents, Bates KPMG 0015569-89, at KPMG 0015572-
74, reprinted in the Subcommittee Hearings as Hearing Exhibit 96 l.
---------------------------------------------------------------------------
    Finally, as explained later in this Report, most of the SC2 
transactions reviewed by the Subcommittee did not, in fact, 
include any distributions of income to the tax exempt entity 
holding the S Corporation stock.\94\ For example, the Los 
Angeles Department of Fire and Police Pensions, which engaged 
in 28 SC2 transactions, told the Subcommittee that only nine, 
or less than one-third of the S Corporations in which it held 
stock, actually paid any distributions of income while it held 
the stock. Two-thirds of the S Corporations made no 
distributions to the pension fund at all.
---------------------------------------------------------------------------
    \94\ For more information, see Section IX(A) of this Report.
---------------------------------------------------------------------------
    In short, KPMG documents and communications, some of which 
were authored by or included Mr. Manth, as well as the actual 
SC2 transactions examined by the Subcommittee, contradict Mr. 
Manth's testimony that a resolution limiting or suspending 
distributions was not an element of SC2. Given his active 
involvement in the development, sale, and implementation of the 
SC2 product, Mr. Manth should have known that his testimony on 
this matter was not accurate.
    A second issue of concern involves Mr. Manth's testimony at 
the Subcommittee hearings in November 2003, regarding the role 
of warrants in the SC2 transactions. In every SC2 transaction 
examined by the Subcommittee, the transfer of S Corporation 
shares to a tax exempt entity was preceded by the creation and 
distribution to the existing S Corporation shareholders of 
thousands of warrants, enabling these shareholders to purchase 
additional S Corporation shares. If exercised, these warrants 
would give the holders additional shares representing 85% to 
90% of the S Corporation's entire stock, and significantly 
dilute the percentage and value of the shares held by the tax 
exempt, as well as the percentage of distributions to which the 
tax exempt entity would have been entitled. If these warrants 
were used as a means to ensure that the tax exempt entity would 
re-sell the S Corporation shares to the original owner, as 
planned in the SC2 transaction, this tactic would provide 
evidence that the original owner had no real intent to donate 
the S Corporation shares to the tax exempt entity, but only to 
temporarily shift the shares to a tax exempt entity, thereby 
deferring and mitigating the tax liability of the original, and 
subsequent, owner of the shares.
    Regarding the intended use of warrants in the SC2 
transactions, Mr. Manth testified at the Subcommittee hearings 
as follows:

      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 share 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.\95\
---------------------------------------------------------------------------
    \95\ Manth testimony at the Subcommittee Hearings (11/18/03), at 
34-35.

    Again, internal KPMG documents and communications 
contradict this statement. For example, the SC2 information 
packet produced by KPMG in the spring of 2000, which was used 
to train KPMG tax professionals planning to sell the SC2 
product, contained a section entitled: ``SC\2\--Appropriate 
Answers for Frequently Asked Shareholder Questions.'' Question 
---------------------------------------------------------------------------
1 reads as follows:

      Q1: What happens if the tax-exempt (``TE'') does not 
want to redeem the stock to the S-corp?

      A1: First, the longer the TE owns the stock, the more 
benefit the company will receive (assuming the company 
continues to make money). Secondly, the TE would have no reason 
not to sell the stock back, since the company is really its 
only source of liquidity (nobody will want the stock). Third, 
the only reason for the TE to accept the stock is to get cash. 
Also, the TE knows the deal prior to accepting the stock. It 
signs a redemption agreement that discloses the warrants as 
well as the fact that no distributions are required to be made.

      However, if we assume the TE gets a new board, and the 
board wants to hold the company ``hostage,'' the shareholders 
can exercise their warrants that can dilute the TE to less than 
10%.\96\
---------------------------------------------------------------------------
    \96\``SC2--Meeting Agenda June 19th, 2000,'' Bates KPMG 0013375-96, 
at KPMG 0013389, reprinted in the Subcommittee Hearings as Hearing 
Exhibit 21.

    A similar message is contained in an addendum to the KPMG 
White Paper on SC2. One part of this addendum addresses a 
number of implementation issues. A section entitled 
---------------------------------------------------------------------------
``Frequently Asked Questions'' contains the following:

      (ii) What if the tax-exempt won't redeem?

      (1) The tax-exempt has no reason to hold onto the stock 
after the redemption period. First, it has no vote to authorize 
a distribution. Secondly, the market for it to sell the stock 
is severely limited because most holders of this stock would 
incur more tax liability than the stock is worth. In addition, 
the stock has limited appreciation potential. Therefore, the 
tax-exempt has nothing to gain by holding the stock beyond the 
redemption period.

      (2) Still, if tax-exempt won't redeem, exercising the 
warrants will immediately dilute the tax-exempt's interest.'' 
\97\
---------------------------------------------------------------------------
    \97\ ``SC2 Outline'' and SC2 White Paper, Bates KPMG 0013446-47, 
reprinted in the Subcommittee Hearings as Hearing Exhibit 96 b.

    These documents show that the warrants were characterized 
internally at KPMG and to potential clients as a tool which 
could be used, if necessary, to dilute a tax exempt entity's 
interest in, and corresponding claim on, distributions from the 
S Corporation. The documents also show that KPMG viewed the 
possibility of the warrants being exercised to dilute the tax 
exempt's holdings as a way, not only to ensure that the tax 
exempt entity would resell its shares to the S Corporation 
shareholders, but also prevent the tax exempt from threatening 
to retain the stock in order to extract large payments or a 
greater buyout price from the S-corporation shareholders. These 
documents present a very different picture from the one 
provided by Mr. Manth at the Subcommittee hearings. Given his 
active involvement in the development, sale, and implementation 
of the SC2 product, Mr. Manth should have known that his 
testimony on this matter was not accurate.
    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 were approved for sale and made their 
way to market.

  (2) Mass Marketing Tax Products

      Finding: KPMG used aggressive marketing tactics to sell 
its generic tax products by turning tax professionals into tax 
product salespersons, pressuring its tax professionals to meet 
revenue targets, using telemarketing to find clients, 
developing an internal tax sales force, using confidential 
client tax data to find clients, targeting its own audit 
clients for sales pitches, and using tax opinion letters and 
insurance policies as marketing tools.

    One of the more striking aspects of the Subcommittee 
investigation was its discovery of the substantial efforts KPMG 
had expended to market its tax products, including extensive 
efforts to target clients and, at times, use high-pressure 
sales tactics. Evidence 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 was launched within the firm, the ``Tax Solution 
Alert'' was 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 designated one or more persons to lead the 
marketing effort for a new tax product. These persons were 
referred to as the product's ``National Deployment Champions,'' 
``National Product Champions,'' or ``Deployment Leaders.'' With 
regard to the tax products 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 were given significant 
institutional support to market their assigned tax product. For 
example, KPMG maintained a national marketing office that 
included marketing professionals and resources ``dedicated to 
tax.'' \98\ Champions could 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.\99\ These individuals 
became members of the product's official ``deployment team.''
---------------------------------------------------------------------------
    \98\ KPMG Tax Services Manual, Sec. 2.21.1, at 2-14.
    \99\ Id.
---------------------------------------------------------------------------
    Champions could also draw on a Tax Services group skilled 
in marketing research to identify prospective clients and 
develop target client lists. This group was known as the Tax 
Services Marketing and Research Support group. Champions could 
also make use of a KPMG ``cold call center'' in Indiana. This 
center was 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 
could and, at times did, make cold calls to sell specific tax 
shelters such as SC2.\100\
---------------------------------------------------------------------------
    \100\ 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 002560.
---------------------------------------------------------------------------
    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.\101\
---------------------------------------------------------------------------
    \101\ Email dated 8/6/00 from Jeffrey Stein to 15 National 
Deployment Champions, Bates KPMG 050016. The Opportunity Management 
System (OMS) 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.

    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.\102\
---------------------------------------------------------------------------
    \102\ Email dated 3/14/02, from Rick Rosenthal and other KPMG 
professionals, to ``US Management Group,'' Bates XX 001730-32 (emphasis 
in original).

    Corporate Culture: Sell Sell Sell. After a new tax product 
was ``launched'' within KPMG, one of the primary tasks of a 
National Deployment Champion was to educate KPMG tax 
professionals about the new product and motivate them to sell 
it.
    Documentation obtained by the Subcommittee shows that 
National Deployment Champions and senior KPMG tax officials 
expended significant effort to convince KPMG personnel to 
devote time and resources to selling new products. Senior tax 
professionals used 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 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!! \103\
---------------------------------------------------------------------------
    \103\ 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. See email dated 4/21/00, from Michael Terracina, KPMG 
office in Houston, to Gary Choate, KPMG office in Dallas, Bates KPMG 
0048191.

    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.\104\ 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.\105\ For 
example, a member of the SC2 deployment team, who also worked 
for Stratecon, sent an email to a 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:
---------------------------------------------------------------------------
    \104\ 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.
    \105\ See e.g., email dated 12/2/00, from Lawrence Manth to 
multiple tax professionals, Bates XX 000021.

      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.\106\
---------------------------------------------------------------------------
    \106\ Email dated 2/22/01, from Councill Leak to multiple tax 
professionals, Bates KPMG 0050822-23.

    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.\107\ The email states in part:
---------------------------------------------------------------------------
    \107\ 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.\108\ 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.\109\ 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.\110\
---------------------------------------------------------------------------
    \108\ Presentation entitled, ``KMatch Push Feature Campaign,'' 
undated, prepared by Marsha Peters of the Tax Innovation Center, Bates 
XX 001511.
    \109\ 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).
    \110\ Id.
---------------------------------------------------------------------------
    The evidence indicates that KPMG also used 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 are those requiring the combined participation of 
both KPMG tax and assurance professionals to market specified 
tax products.
    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.\111\ 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.'' \112\ Internal KPMG documentation states that 
the purpose of the new product was ``[t]o increase KPMG's 
market penetration of key clients and targets by enhancing the 
linkage between Assurance and Tax professionals.'' \113\ 
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.'' 
\114\ 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:
---------------------------------------------------------------------------
    \111\ 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 001567-94.
    \112\ Presentation dated 10/30/00, ``Intellectual Property Services 
(IPS),'' by Dut LeBlanc of Shreveport and Joe Zier of Silicon Valley, 
Bates XX 001580-94.
    \113\ 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 001567-94.
    \114\ Presentation dated 10/30/00, ``Intellectual Property Services 
(IPS),'' by Dut LeBlanc of Shreveport and Joe Zier of Silicon Valley, 
Bates XX 001580-94.

      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.\115\
---------------------------------------------------------------------------
    \115\ 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 001567-94.

    Additional tax products which relied in part on KPMG audit 
partners followed. In 2002, for example, KPMG launched a ``New 
Enterprises Tax Suite'' product \116\ 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.'' \117\
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    \116\ 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 001503-05. 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.
    \117\ 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.'' \118\
---------------------------------------------------------------------------
    \118\ 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 
KPMG client lists personally to identify clients 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? \119\
---------------------------------------------------------------------------
    \119\ 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 an 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.\120\ 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.\121\ 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.\122\ 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.'' \123\
---------------------------------------------------------------------------
    \120\ Subcommittee interview of Wachovia Bank representatives (3/
25/03).
    \121\ See, e.g., Memorandum dated 9/3/99, from Karen Chovan, 
Financial Advisory Services to CMG Risk Review Oversight Committee, 
``Meeting Minutes of September 1 . . .,'' Bates SEN-008629-31 (``Senior 
PFC Advisor and CMG Risk Review Subcommittee (`subcommittee or SC') 
member Tom Newman presented an overview of an enhanced investment 
strategy for OC vote to be able to present it to selected First Union 
clients. KPMG brought the BLIPS strategy (referred hereafter as the 
`Alpha' strategy) to First Union. . . .''); 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 V(A)(5) of this Report for more information on the auditor 
independence issue.
    \122\ 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).
    \123\ 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.\124\ It obtained these lists from either 
state governments, 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.\125\ Some of the lists 
had large blocks of S Corporations associated with automobile 
or truck dealers, real estate firms, home builders, or 
architects.\126\ In some instances, KPMG tax professionals 
instructed KPMG telemarketers to contact the corporations to 
gauge interest in SC2.\127\ In other cases, KPMG tax 
professionals contacted the corporations personally.
---------------------------------------------------------------------------
    \124\ 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).
    \125\ 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).
    \126\ Email dated 11/17/00, from Jonathan Pullano to US-Southwest 
Tax Services Partners and others, ``FW: SW SC2 Channel Conflict,'' 
Bates KPMG 0048309.
    \127\ 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, \128\ 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.\129\ 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.'' \130\
---------------------------------------------------------------------------
    \128\ See email dated 4/22/01, from John Schrier to Thomas 
Crawford, ``RE: SC2 target list,'' Bates KPMG 0050029.
    \129\ See email dated 4/23/01, from John Schrier to Thomas 
Crawford, ``RE: SC2 target list,'' Bates KPMG 0050029.
    \130\ 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.\131\ 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.\132\
---------------------------------------------------------------------------
    \131\ Subcommittee briefing by Jeffrey Eischeid and Timothy Speiss 
(9/12/03).
    \132\ Subcommittee interview of Councill Leak (10/22/03). See also 
KPMG/Peat Marwick memorandum dated 11/24/98, from Jeffrey Stein to KPMG 
Tax Partners, ``Tax Sales Organization and Telemarketing,'' at 5 (``The 
Tax practice has also made a significant investment in building our 
marketing capabilities and has expanded our telemarketing resources to 
support our national services and initiatives. . . . The telemarketers 
already have an impressive track record; they have played a critical 
role in our SALT practice and most recently helped drive the COLI and 
Export Tax Minimization product `blitzes.' '')
---------------------------------------------------------------------------
    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.'' \133\ The ``Sticking Points'' document provided 
the following advice to KPMG tax professionals trying to sell 
SC2 to prospective clients:
---------------------------------------------------------------------------
    \133\ ``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. . . .

    This document was hardly the work product of a 
disinterested tax adviser. In fact, it went 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.'' 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.
    Tax Shelter Sales Force. In addition to exhorting its tax 
professionals to spend more time selling KPMG tax products, 
beginning in 1997, KPMG established a dedicated sales position, 
known as a Business Development Manager (BDM), to market its 
tax shelters, as well as other KPMG products and services. The 
Subcommittee interviewed former BDMs and obtained documentation 
related to BDM involvement in KPMG's tax shelter activities.
    A key KPMG document describing the newly established 
``National BDM Tax Sales Initiative'' states that one of its 
goals was to ``[h]elp create an aggressive sales culture'' at 
KPMG.\134\ A document establishing the terms and conditions for 
BDM compensation states that the primary duty of a BDM selling 
tax products was to maximize revenue to KPMG through aggressive 
sales:
---------------------------------------------------------------------------
    \134\ `` `The Blueprint' National BDM Tax Sales Initiative: 
Objectives, Roles & Responsibilities'' (undated) at 14.

      The duty of each Tax Business Development Manager is to 
produce the Maximum revenue for the Firm. The Tax Business 
Development Manager's contribution to maximum revenue will be 
primarily via the sale of Tax Services to new and existing 
Clients.\135\
---------------------------------------------------------------------------
    \135\ KPMG document, ``Tax Business Development Stub Fiscal Year 
2001 and Full Fiscal Year 2002 (15 Months Beginning July 1, 2001 and 
Ending September 30, 2003) Compensation Plan Terms & Conditions,'' 
(date uncertain) (hereinafter ``Tax BDM 2001-2002 Compensation Plan'') 
at 2.

A 1998 memorandum to KPMG tax partners urging greater use of 
BDMs declared that ``a solid sales team dedicated to Tax is 
critical to our marketplace success.'' \136\
---------------------------------------------------------------------------
    \136\ KPMG/Peat Marwick memorandum dated 11/24/98, from Jeffrey 
Stein to KPMG Tax Partners, ``Tax Sales Organization and 
Telemarketing'' (hereinafter ``Stein Memorandum'') at 1.
---------------------------------------------------------------------------
    KPMG established an initial sales force of 6 to 10 BDMs in 
1997, and increased the number of BDMs over the following 5 
years to a maximum of 125 individuals. KPMG provided the 
Subcommittee with these total, annual BDM employment figures: 
FY1998: 34; FY1999: 84; FY2000: 88; FY2001: 98; FY2002: 125; 
and FY2003: 89.\137\
---------------------------------------------------------------------------
    \137\ See letter dated 1/15/04, from KPMG to the Subcommittee, at 
7. See also written responses to Subcommittee questions dated 4/25/04, 
from a former KPMG BDM, who estimated that, in FY2000, 65 to 70 of 
KPMG's BDMs sold tax products and services (``Tax BDMs''), while 15 to 
20 sold assurance products and services (``Audit BDMs'').
---------------------------------------------------------------------------
    The BDM sales force was organized by region, using six 
geographic areas: Northeast, Mid-Atlantic, Southeast, Midwest, 
Southwest, and West.\138\ The BDMs within a region reported to 
an Area Sales Director (ASD), who in turn reported to a 
National Partner in Charge of the Business Development 
Managers. Each ASD was responsible for recruiting and training 
BDMs, ensuring the BDMs met specified sales quotas, leading 
sales effort on at least five major accounts within their 
markets, coordinating with the KPMG Area Managing Partner for 
Tax, and developing national sales strategies with other 
ASDs.\139\ The BDM training program consisted of a new hire 
orientation, two sessions of sales ``Boot Camp,'' a course in 
``Selling with Confidence,'' mock sales calls, self training 
videos, and weekly national conference calls launching new 
products.\140\ The program also included ``intense training in 
several of the innovative Tax Products that KPMG was 
marketing.'' \141\
---------------------------------------------------------------------------
    \138\ KPMG presentation dated 12/9/98, ``Tax Sales Organization.'' 
See also ANational Tax BDM Roster,'' dated 2/1/01. The documents 
indicate that no ASD was appointed for the Mid-Atlantic region.
    \139\ Stein Memorandum at 2.
    \140\ KPMG presentation, ``BDM Training Program Components'' 
(undated).
    \141\ Written responses to Subcommittee questions, dated 4/25/04, 
by a former KPMG BDM.
---------------------------------------------------------------------------
    In a 1998 memorandum, the head of KPMG Tax Practice 
operations instructed KPMG's tax partners to integrate BDMs 
into their sales operations.\142\ The memorandum explained that 
each member of the BDM sales force had been designated as 
either a ``Product'' or ``Area'' BDM. Product BDMs, the 
memorandum explained, Awill be dedicated to and responsible for 
a select number of national tax products--that are perceived to 
yield the greatest return and represent our highest 
opportunities.'' \143\ With respect to Area BDMs, the 
memorandum stated that Atheir primary focus will be to team 
with the Tax Services Partners (TSPs) to promote a specific 
portfolio of tax products including select new tax initiatives 
as they are developed by the Tax Innovation Center (TIC).'' 
\144\
---------------------------------------------------------------------------
    \142\ Stein Memorandum at 1.
    \143\ Id. at 4. The list of tax products available for sale by BDMs 
included tax products under the jurisdiction of Capital Transaction 
Strategies, the KPMG tax practice that led the efforts on FLIP, OPIS, 
and BLIPS. Id. at 3. Internal KPMG emails also indicate that at least 
one BDM was engaged in selling BLIPS. See email dated 2/22/00, from 
KPMG BDM Tobin Gilman to Ian Harrison and Robert Wells, ``FW: Multi-
Year Engagements, Contingent Engagements, Etc.''
    \144\ Stein Memorandum at 2.
---------------------------------------------------------------------------
    To promote tax product sales, KPMG set individual sales 
quotas for each BDM \145\ and stated that it was Aexpected that 
each Tax Business Development Manager shall achieve 100% of 
their sales quotas.'' \146\ These individual BDM sales quotas 
were apparently based upon area and national BDM revenue 
targets that were also established by KPMG. For example, a KPMG 
presentation entitled ``The Blueprint'' set national revenue 
goals for BDMs of $50 million in FY1999, $100 million in 
FY2000, and $150 million in FY2001.\147\ A later KPMG document 
cites actual BDM tax sales revenue of about $33 million in 
FY1999 and $109 million in FY2000, with projected FY2001 sales 
revenue of $125 million.\148\
---------------------------------------------------------------------------
    \145\ See, e.g., Tax BDM 2001-2002 Compensation Plan at 2.
    \146\ Id. at 5.
    \147\ `` `The Blueprint' National BDM Tax Sales Initiative: 
Objectives, Roles & Responsibilities'' (undated) at 3.
    \148\ KPMG presentation dated 2001, ``BDM Tax Sales Organization 
Financial Trends.''
---------------------------------------------------------------------------
    BDM compensation routinely included sales commissions and, 
at times, also included bonuses or awards for meeting or 
exceeding sales revenue targets. In general, the evidence 
indicates that each BDM received a base salary and commission 
based on booked fees, billed accountancy income, and collected 
accountancy income.\149\ In FY 1999, for example, BDMs received 
a base salary of $75,000 plus a 3% commission on sales revenue. 
In FY 2000, BDMs received a base salary of $90,000 plus a 3% 
commission on sales to existing clients, a 4% commission for 
new sales to ``idle'' accounts, and a 6% commission on sales to 
new clients. In FY 2001, the evidence indicates that the 4% 
commission level was eliminated, and some experienced new hires 
received base salaries of between $200,000 and $300,000.\150\
---------------------------------------------------------------------------
    \149\ KPMG document dated 4/20/99, ``Fiscal Year 1999 Tax Business 
Development Manager Compensation Plan,'' at 4.
    \150\ Written responses to Subcommittee questions, dated 4/25/04, 
by a former KPMG BDM, at 2.
---------------------------------------------------------------------------
    According to a June 2000 compensation plan analysis, the 
levels of compensation promised meant that a BDM with a base 
salary of $90,000 and who met a $3 million sales target would 
earn an annual income of up to $243,360. If the same BDM were 
to sell $4 million worth of tax products, he or she would earn 
up to $324,000.\151\ Top-selling BDMs were also offered, at 
times, rewards for their sales, such as an opportunity to 
attend a luxurious ``Performance Club 1999'' retreat in Carmel, 
California.\152\
---------------------------------------------------------------------------
    \151\ KPMG document dated 6/30/00, ``BDM Comp. Plan Analysis,'' at 
1.
    \152\ Letter dated 9/29/99, from KPMG's Ian Harrison to a BDM.
---------------------------------------------------------------------------
    The BDMs were heavily involved in the marketing of tax 
shelter products. A lengthy Tax Sales Organization area 
analysis of 2001 sales trends, for example, demonstrates the 
level of BDM involvement with KPMG tax shelter sales. It states 
that ``BDMs are pushing heavily on SC2,'' one of the tax 
shelters featured in this Report.\153\ It describes the sales 
efforts of a top-selling BDM based in Dallas by referring to 
his sales of several tax shelter products and to his working 
relationship with Stratecon, a KPMG group involved in 
developing and marketing tax shelter products to KPMG clients: 
``Significant portion (90%) of pipeline is Stratecon, with 
CLAS, SC2, and Gain Mitigation. Works extremely close with 
Stratecon Partner--and is widely known as a strong 
prospector.'' \154\ The analysis also states that a Seattle-
based BDM sold $5.4 million worth of tax products in FY 2000, 
focusing on SALT, TAS and SC2; while a Silicon Valley-based BDM 
had pending FY 2001 fees related to SC2 totaling $2 
million.\155\
---------------------------------------------------------------------------
    \153\ KPMG presentation dated 2001, ``BDM Tax Sales Organization 
Financial Trends,'' at 4.
    \154\ Id. at 9.
    \155\ Id. at 13.
---------------------------------------------------------------------------
    This sales analysis suggests that KPMG encouraged its BDMs 
to engage in aggressive sales of its tax products. It describes 
a Dallas-based BDM as Aa strong prospector, who has already 
garnered strong praise from several Partners for his aggressive 
marketing stance.'' \156\ It commends a Stamford-based BDM 
projected to achieve $6 million in FY 2001 sales for being 
Aextremely aggressive, as he easily averages 1 to 2 new 
relationship meetings each week.'' \157\ It also singles out 
BDMs with the ability to make ``cold'' sales. An Atlanta-based 
BDM, for example, is cited for success with Aaccounts where 
KPMG has no acquaintances, the `coldest' of category 1 gain 
accounts. Several have become KPMG solution buyers.'' \158\ The 
analysis notes that a number of BDMs had been deployed 
exclusively against cold accounts.\159\
---------------------------------------------------------------------------
    \156\ Id. at 9.
    \157\ Id. at 19.
    \158\ Id. at 25.
    \159\ Id.
---------------------------------------------------------------------------
    In response to a Subcommittee inquiry about the current 
status of KPMG's sales force, KPMG informed the Subcommittee 
that it was refocusing the BDM position by eliminating sales 
commissions and training BDMs as relationship managers.\160\ In 
September 2004, KPMG held a national conference call in which 
it was announced that many BDMs would be terminated. Those 
remaining with the firm would have their job titles changed to 
``Account Relationship Managers.'' However, it appears as if 
their primary job responsibility continued to be sales, albeit 
primarily in audit and tax services.''
---------------------------------------------------------------------------
    \160\ See letter dated 1/15/04, from KPMG to the Subcommittee, at 
7.
---------------------------------------------------------------------------
    Using Tax Opinions and Insurance as Marketing Tools. 
Documents obtained during the Subcommittee's 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 an earlier 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 were former employees of the IRS.\161\
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    \161\ ``SC2--Meeting Agenda'' and attachments, dated 6/19/00, at 
Bates KPMG 0013394.
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    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.'' \162\ In another SC2 
document, KPMG advised its tax professionals to tell clients 
worried about IRS penalties:
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    \162\ ``SC2--Meeting Agenda'' and attachments, dated 6/19/00, Bates 
KPMG 0013394. 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.'')

      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.\163\
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    \163\ ``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. 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.'' \164\
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    \164\ ``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.)
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    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.'' \165\
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    \165\ ``SC2--Meeting Agenda'' and attachments, dated 6/19/00, Bates 
KPMG 0013375-96.
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    According to KPMG tax professionals interviewed by 
Subcommittee staff, the insurance companies offering this 
insurance included AIG and Hartford.\166\ In response to 
posthearing questions, KPMG produced copies of a redacted 
insurance policy from Lexington Insurance Company and a sample 
``fiscal event'' insurance policy prepared by AIG, both of 
which related to SC2.\167\ The AIG policy, for example, 
promises to reimburse the policy holder for a range of payments 
made to a Federal or state taxing authority related to SC2, 
including any payment made for an assessment of unpaid taxes, 
interest, a fine or penalty. Once these policies became 
available, KPMG tax professionals were asked to re-visit 
potential clients who had declined the tax product and try 
again.\168\ Evidence obtained by the Subcommittee indicates 
that at least half a dozen SC2 purchasers also purchased SC2 
insurance.
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    \166\ See, e.g., Subcommittee interview of Lawrence Manth (11/6/
03).
    \167\ See insurance policies reprinted in Subcommittee hearing 
record at 2911-29.
    \168\ Email dated 2/9/01, from Ty Jordan to multiple KPMG tax 
professionals, ``SC2 revisit of stale leads,'' Bates KPMG 0050814.
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    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.\169\ However, evidence gathered by the 
Subcommittee indicates that KPMG could and did obtain specific 
revenue tracking information.
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    \169\ Subcommittee briefing by Jeffrey Eischeid (9/12/03); 
Subcommittee interview of Jeffrey Stein (10/31/03).
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    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, included 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 FY2001 
revenues broken down by each of six regions in the United 
States: \170\
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    \170\ Internal KPMG presentation, dated 6/18/01, by Andrew Atkin 
and Bob Huber, entitled ``S-Corporation Charitable Contribution 
Strategy (SC2) Update,'' Bates XX 001553.

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      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.\171\
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    \171\ 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 FY1998, $1.001 
million in FY1999, $1.184 million in FY2000, and $1.239 million in 
FY2001. 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 
001503.
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    Another document obtained by the Subcommittee from a party 
other than KPMG is a 1998 memorandum sent by a senior KPMG tax 
official to all U.S. KPMG tax partners directing them to begin 
using a special database to track all KPMG tax sales 
activity.\172\ The memorandum states:
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    \172\ KPMG/Peat Marwick memorandum by Jeffrey Stein to KPMG Tax 
Partners, ``Tax Sales Organization and Telemarketing'' (11/24/98), 
reprinted in Subcommittee Hearings as Hearing Exhibit 97 kk.

      The Opportunity Management System (OMS) will serve as 
the Tax practice's central Database for all sales activity. It 
is essential that we have one system that captures the activity 
of the [Business Development Managers,] Telemarketers and our 
professionals. This will ensure that we leverage our 
relationships and coordinate our sales efforts for increased 
success. The BDMs, Telemarketers and Marketing already use OMS 
as their repository for all information. And plans are to make 
OMS available to all Tax partners on a read only basis by the 
beginning of December. . . . You must be sure to report your 
individual sales activity to your Area Marketing Leader-Tax for 
input into the system. Reports are generated from OMS are the 
tool the Tax Leadership Team will be using to measure 
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individual partner activity.

    A later email sent in August 2000, which KPMG did produce 
to the Subcommittee, indicates that by the year 2000, 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.\173\
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    \173\ Email dated 8/6/00 from Jeffrey Stein to 15 National 
Deployment Champions, Bates KPMG 050016. See also KPMG 2001 
presentation, ``Tax Sales Organization Financial Trends,'' indicating 
that KPMG carefully tracked the sales revenues generated by its 
Business Development Managers, not only to calculate their sales 
commissions, but also to develop BDM revenue targets and sales quotas.
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    Moreover, KPMG's Tax Innovation Center reported in 2001 
that it had developed new software that ``captured solution 
development costs and revenue'' and had begun ``[p]repar[ing] 
quarterly Solution Profitability reports.'' \174\ 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. These documents, as well as other information, 
contradict KPMG's statement that ``the firm does not maintain 
any systematic, reliable method of recording revenues by tax 
product on a national basis.'' \175\
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    \174\ 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.
    \175\ Letter from KPMG to Subcommittee, dated 4/22/03, attached 
one-page chart entitled, ``Good Faith Estimate of Top Revenue-
Generating Strategies,'' n.1.
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  (3) Implementing Tax Products

      Finding: KPMG was actively involved in implementing the 
tax shelters which it sold 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 did not end with the sale itself. Many KPMG tax 
products, including the four examined by the Subcommittee, 
required the purchaser to carry out complex financial and 
investment activities in order to realize promised tax 
benefits. KPMG typically provided 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 also, at times, 
caused KPMG to adjust how a tax product was structured and even 
spurred development of new products.
    Executing FLIP, OPIS, and BLIPS. FLIP, OPIS, and BLIPS each 
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 Group to 
design the complex series of financial transactions called for 
by the product.\176\ Using contacts it had established in other 
business dealings, Quellos 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, 
where the bank referred bank clients who might be interested in 
the FLIP tax product to KPMG tax professionals.\177\ In some 
cases, the bank permitted KPMG and Quellos Group to make FLIP 
presentations to its clients in the bank's offices.\178\ KPMG 
also enlisted Sidley Austin Brown & Wood to issue a favorable 
legal opinion letter on the FLIP tax product.\179\
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    \176\ Quellos Group was then known and doing business as Quadra 
Capital Management LLP or QA Investments, LLC.
    \177\ KPMG actually did business with First Union National Bank, 
which subsequently merged with Wachovia Bank.
    \178\ Subcommittee interview of First Union National Bank 
representatives (3/25/03).
    \179\ KPMG actually worked with Brown & Wood, a large New York law 
firm which subsequently merged with Sidley & Austin.
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    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 Group, 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.\180\ 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.\181\ Unlike Quellos Group, 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.
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    \180\ 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'').
    \181\ 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.\182\ Other KPMG employees were 
assigned to Presidio to assist in expediting BLIPS transactions 
and paperwork. KPMG also worked with Quellos Group, Presidio, 
and the relevant banks to ensure that the banks established 
large enough credit lines, at times in the billions of dollars, 
to allow a substantial number of individuals to carry out FLIP, 
OPIS, and BLIPS transactions.
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    \182\ Credit Request dated 9/26/99, Bates HVB 001166; Subcommittee 
interview of HVB representatives (10/29/03).
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    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.\183\ 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.\184\
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    \183\ Subcommittee interview of Jeffrey Eischeid (10/8/03).
    \184\ 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.'' \185\
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    \185\ Attachment entitled, ``Tax Exempt Organizations,'' included 
in an SC2 information packet dated 7/19/00, ``SC2--Meeting Agenda,'' 
Bates KPMG 0013387.
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    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.\186\
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    \186\ Subcommittee interviews with Los Angeles Department of Fire 
and Police Pensions (10/22/03) and the Austin Fire Relief and 
Retirement Fund (10/14/03).
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    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.'' \187\ 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.
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    \187\ Id.
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    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.\188\
---------------------------------------------------------------------------
    \188\ ``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 stock 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.\189\ 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.\190\
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    \189\ Subcommittee interview of Lawrence Manth (11/6/03).
    \190\ Subcommittee interview of William Stefka, Austin Fire Relief 
and Retirement Fund (10/14/03).
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    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 re-took control of the S Corporation and 
distributed some or all of the income that had built up within 
the company while the charity was a shareholder. The SC2 
National Deployment Champion wrote the following to more than 
20 of his colleagues working on SC2:

      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.\191\
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    \191\ 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 tax shelters 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 instance, 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. 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.\192\
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    \192\ 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.'' \193\ The Subcommittee was told that 
Sidley Austin Brown & Wood relied on the same factual 
representations to compose the legal opinion letters that it 
drafted.
---------------------------------------------------------------------------
    \193\ Prototype BLIPS tax opinion letter prepared by KPMG, (12/31/
99), Bates KPMG 0000405-417, at 1.
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    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.\194\ 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.
---------------------------------------------------------------------------
    \194\ 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).
---------------------------------------------------------------------------
    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.'' \195\ 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.
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    \195\ Prototype BLIPS tax opinion letter prepared by KPMG, (12/31/
99), Bates KPMG 0000405-417, at 9.
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    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.\196\ 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.\197\
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    \196\ 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, a KPMG tax expert states: ``the 
probability of actually making a profit from this transaction is remote 
(possible, but remote).'').
    \197\ 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.
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    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.'' \198\
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    \198\ Email dated 4/14/99, from Larry DeLap to multiple KPMG tax 
professionals, ``RE: BLIPS,'' Bates KPMG 0017578-79.
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    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.\199\
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    \199\ 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.\200\ 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.
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    \200\ 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 involved decisions by KPMG to stop selling particular tax 
products. In all four of the tax products examined by the 
Subcommittee, KPMG stopped marketing the tax product within 1 
or 2 years of its first sale.\201\ 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.
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    \201\ 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.\202\ 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.\203\ 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.\204\
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    \202\ Subcommittee interview of Lawrence DeLap (10/30/03).
    \203\ Id.
    \204\ See next section of this Report on ``Avoiding Detection.''
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    Evidence 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.\205\ These purchasers were referred to internally at 
KPMG as ``grandfathered BLIPS'' clients.\206\ 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.\207\ 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.\208\ This effort was ultimately 
unsuccessful in restarting BLIPS sales.
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    \205\ 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. . . .'').
    \206\ See, e.g., two emails dated 10/1/99, from Larry DeLap to 
multiple KPMG tax professionals, ``BLIPS,'' Bates KPMG 0011714.
    \207\ Subcommittee interview of Lawrence DeLap (10/30/03).
    \208\ 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.\209\ 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.\210\ 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.\211\ 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.
---------------------------------------------------------------------------
    \209\ See Section V(A)(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.
    \210\ See, e.g., email dated 9/30/99, from Jeffrey Eischeid to 
Wolfgang Stolz and others, ``OPIS,'' Bates QL S004593.
    \211\ Subcommittee interview of Lawrence DeLap (10/30/03).
---------------------------------------------------------------------------

  (4) Avoiding Detection

      Finding: KPMG took steps to conceal its tax shelter 
activities from tax authorities, including by claiming it was a 
tax advisor and not a tax shelter promoter, failing to register 
potentially abusive tax shelters, restricting file 
documentation, imposing marketing restrictions, and using 
improper tax return reporting to minimize detection by the IRS 
or others.

    Evidence obtained by the Subcommittee 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 with regard to FLIP, OPIS, 
BLIPS, and SC2 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 has been 
it does not develop, sell or promote tax shelters. As a 
consequence, as of the time of the Subcommittee hearings in 
2003, KPMG had not voluntarily registered, and thereby 
disclosed to the IRS, a single one of its tax products, even 
after being advised by a senior tax professionals that a 
particular tax product should be registered.
    One glaring example of this flawed approach involves a 1998 
memorandum sent by a KPMG tax professional to the second most 
senior KPMG tax official at KPMG advising the firm not to 
register the OPIS tax product with the IRS, even if OPIS 
qualified as a tax shelter under the law.\212\ The memorandum 
stated in part:
---------------------------------------------------------------------------
    \212\ 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.

      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. . . .

      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. . . .

      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. . . .

      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.

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 learned that some KPMG tax professionals 
agreed with this analysis, \213\ while other senior KPMG tax 
professionals provided the opposite advice to the firm.\214\ 
The head of KPMG's Tax Services Practice, the Vice Chairman for 
Tax, ultimately determined not to register the tax product as a 
tax shelter. 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 Vice Chairman 
for Tax.\215\
---------------------------------------------------------------------------
    \213\ 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).
    \214\ 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). See also handwritten notes 
dated 3/4/98, author not indicated, regarding ``Brown & Wood'' and 
``OPIS,'' Bates KPMG 0047317 (``Must register the product. B&W 
concerns--risk is too high. Confirm w/Presidio that they will 
register.'' Emphasis in original.) (``B&W'' refers to Brown & Wood, the 
law firm that worked with KPMG on OPIS; Presidio is the investment firm 
that worked with KPMG on OPIS.).
    \215\ 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.'' \216\ 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:
---------------------------------------------------------------------------
    \216\ KPMG Tax Services Manual, Sec. 24.4.1, at 24-2.

      LIf 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.\217\
---------------------------------------------------------------------------
    \217\ 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.\218\ 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.''
---------------------------------------------------------------------------
    \218\ 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, BLIPS, and SC2 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.\219\
---------------------------------------------------------------------------
    \219\ See United States v. KPMG, Case No. 1: 02MS00295 (D.D.C. 9/6/
02).
---------------------------------------------------------------------------
    At the November 18 hearing before this Subcommittee, KPMG 
was asked directly whether its tax professionals promoted the 
sale of its tax products to potential clients. Then head of 
KPMG's Tax Practice avoided answering the question in sparring 
that lasted more than ten minutes, before finally admitting 
that KPMG did.\220\
---------------------------------------------------------------------------
    \220\ See Subcommittee Hearings (11/18/03), at 65-67.
---------------------------------------------------------------------------
    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.'' 
\221\ 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.'' \222\
---------------------------------------------------------------------------
    \221\ 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.
    \222\ 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.'' 
\223\ He stated, ``Although KPMG has produced many documents to 
the IRS, it has also withheld a substantial number.''
---------------------------------------------------------------------------
    \223\ 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.\224\
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    \224\ Email dated 4/9/02, from Deke Carbo to Jeffrey Eischeid, 
``Larry's Message,'' Bates KPMG 0024467.

    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, \225\ 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:
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    \225\ ``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.'' \226\
---------------------------------------------------------------------------
    \226\ 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.\227\
---------------------------------------------------------------------------
    \227\ 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.\228\
---------------------------------------------------------------------------
    \228\ 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.'' 
\229\
---------------------------------------------------------------------------
    \229\ 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.\230\
---------------------------------------------------------------------------
    \230\ 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. . . .\231\
---------------------------------------------------------------------------
    \231\ 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.\232\
---------------------------------------------------------------------------
    \232\ 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.\233\
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    \233\ 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-1's 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-1's.

      David was wondering what the rationale was since the 
instructions and PPC say that single member LLCs are 
disregarded entities so 1099s, K-1's should use the EIN of the 
single member.\234\
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    \234\ 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.

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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-1's. . . . 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.\235\
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    \235\ 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.\236\
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    \236\ 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'').
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    In the case of FLIP, KPMG tax professionals devised a 
different approach to avoiding IRS detection.\237\ 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.
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    \237\ 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.
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    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.\238\
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    \238\ ``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.\239\ KPMG appears to have taken 
similar precautions in FLIP, OPIS, BLIPS, and SC2.
---------------------------------------------------------------------------
    \239\ ``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.\240\
---------------------------------------------------------------------------
    \240\ 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).\241\
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    \241\ 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 contained 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.'' 
\242\
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    \242\ Handwritten notes dated 3/4/98, author not indicated, 
regarding ``Brown & Wood'' and ``OPIS,'' Bates KPMG 0047317.
---------------------------------------------------------------------------
    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.'' \243\ 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.'' \244\
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    \243\ Email dated 1/3/00, from Dale Baumann to ``Jeff,'' ``988 
election memo,'' Bates KPMG 0026345.
    \244\ 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.\245\ With OPIS, KPMG tax professionals were instructed 
``you should NOT leave this [marketing] material with clients 
or targets under any circumstances. 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.'' \246\ In the case of BLIPS, KMPG tax 
professionals were instructed to obtain ``[s]igned 
nondisclosure agreements . . . before any meetings can be 
scheduled.'' \247\ 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.\248\ 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.'' \249\ In SC2, the DPP head instructed KPMG tax 
professionals not to provide any ``sample documents'' directly 
to a client.\250\
---------------------------------------------------------------------------
    \245\ 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 paragraph 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 
Mr. Jacoboni (4/4/03).
    \246\ Email dated 6/8/98, from Gregg W. Ritchie to multiple KPMG 
tax professionals, ``RE[2]: OPIS,'' Bates XX 001932 (emphasis in 
original).
    \247\ Email dated 5/5/99, from Jeffrey Eischeid to multiple KPMG 
tax professionals, ``Marketing BLIPS,'' Bates KPMG 0006106.
    \248\ Subcommittee interview of Wachovia Bank representatives (3/
25/03); Subcommittee interview of legal counsel of Theodore C. Swartz 
(9/16/03).
    \249\ Email dated 5/5/99, from Jeffrey Eischeid to multiple KPMG 
tax professionals, ``Marketing BLIPS,'' Bates KPMG 0006106.
    \250\ 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.\251\ In the case of 
SC2, a senior tax professional warned against mass marketing 
the product to prevent the IRS from getting ``wind of it'':
---------------------------------------------------------------------------
    \251\ 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 this is an appropriate 
strategy to mass market? \252\
---------------------------------------------------------------------------
    \252\ 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.'' \253\
---------------------------------------------------------------------------
    \253\ 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 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.\254\ 
For example, KPMG made more than $124 million from just the 
four tax products featured in this Report. Sidley Austin Brown 
& Wood obtained fees for issuing concurring legal opinions on 
these three tax products, FLIP, OPIS and BLIPS, totaling more 
than $23 million.\255\
---------------------------------------------------------------------------
    \254\ 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).
    \255\ Letter dated 1/16/04, from Sidley Austin Brown & Wood to the 
Subcommittee, at 2.
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    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.'' \256\ 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.\257\ 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.\258\
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    \256\ KPMG Tax Services Manual, Sec. 31.11.1 at 31-6.
    \257\ 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.'')
    \258\ 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.). In 
December 2004, the Public Company Accounting Oversight Board proposed 
rules which would, among other provisions, bar any accounting firm that 
audits a publicly traded company from entering into a contingent fee 
arrangement with an audit client for tax services.
---------------------------------------------------------------------------
    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.\259\ 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.\260\ 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.'' 
\261\ 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.''
---------------------------------------------------------------------------
    \259\ 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.
    \260\ Memorandum dated 7/14/98, from Gregg Ritchie to multiple KPMG 
tax professionals, ``Rule 302 and Contingency Fees--CONFIDENTIAL,'' 
Bates KPMG 0026555-59.
    \261\ ``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 tax products examined by the Subcommittee, the fees 
charged by KPMG for BLIPS, OPIS, and FLIP were clearly based 
upon the client's projected tax savings.\262\ 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:
---------------------------------------------------------------------------
    \262\ 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.\263\
---------------------------------------------------------------------------
    \263\ Document dated 7/21/99, entitled ``Action Required,'' 
authored by Jeff 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 \264\
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    \264\ 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.'' \265\ SC2 fees were set at a minimum of 
$500,000, and went as high as $2 million per client.\266\
---------------------------------------------------------------------------
    \265\ 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).
    \266\ 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.'' \267\
---------------------------------------------------------------------------
    \267\ Memorandum dated 7/1/98, from Gregg Ritchie and Jeffrey Zysik 
to ``CaTS Team Members,'' ``OPIS Engagements--Prohibited States,'' 
Bates KPMG 0011954.
---------------------------------------------------------------------------
    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.\268\
---------------------------------------------------------------------------
    \268\ 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 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 a fee for each client who actually 
purchased a tax product.
    KPMG Tax Services Manual states: ``Due to independence 
considerations, the firm does not enter into alliances with SEC 
audit clients.'' \269\ 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.'' \270\ KPMG policy is that ``[a]n oral business 
relationship that has the effect of creating an alliance should 
be treated as an alliance.'' \271\ 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.'' \272\
---------------------------------------------------------------------------
    \269\ KPMG Tax Services Manual, Sec. 52.1.3 at 52-1.
    \270\ Id., Sec. 52.1.1 at 52-1.
    \271\ 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.
    \272\ Id., 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.\273\ KPMG tax professionals were 
aware that doing business with an audit client raised auditor 
independence concerns.\274\ 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.\275\ 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.
---------------------------------------------------------------------------
    \273\ Undated document prepared by Deutsche Bank in 1999, ``New 
Product Committee Overview Memo: BLIPS Transaction,'' Bates DB BLIPS 
6906-10, at 6909-10.
    \274\ 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).
    \275\ 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).
---------------------------------------------------------------------------
    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; \276\ tax products that were designed and explicitly 
called for ``fostering cross-selling among assurance and tax 
professionals''; \277\ 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.\278\ 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.'' 
\279\
---------------------------------------------------------------------------
    \276\ 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 001567-94.
    \277\ 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.
    \278\ See e.g. 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.
    \279\ 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.\280\ 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.'' \281\ 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.
---------------------------------------------------------------------------
    \280\ 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.)
    \281\ Id. at Bates XX 001369.
---------------------------------------------------------------------------
    The next topic in the meeting summary is: ``Financial 
Statement Treatment of Aggressive Tax Positions.'' \282\ 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,'' \283\ 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.
---------------------------------------------------------------------------
    \282\ 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.
    \283\ Id. at Bates XX 001370 (emphasis in original).
---------------------------------------------------------------------------
    Conflicts of Interest in Legal Representation. Another 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.'' \284\ 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.
---------------------------------------------------------------------------
    \284\ 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. 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. In fact, although Sutherland, Asbill & Brennan 
represented 39 ``matters,'' involving 113 separate clients, in 
connection with a KPMG tax product or service, 17, or nearly 
half of these ``matters'' were directly attributable to 
referrals from KPMG.\285\ The conflict of interest issue here 
involves, 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.
---------------------------------------------------------------------------
    \285\ Letter dated 12/19/03, from Sutherland Asbill & Brennan to 
the Subcommittee. See also Section VI(B) of this Report.
---------------------------------------------------------------------------

  (6) KPMG's Current Status

      Finding: Since Subcommittee hearings in 2003, KPMG has 
committed to cultural, structural, and institutional changes to 
dismantle its abusive tax shelter practice, including by 
dismantling its tax shelter development, marketing and sale 
resources, dismantling certain tax practice groups, making 
leadership changes, and strengthening its tax services 
oversight and regulatory compliance.

    At the Subcommittee hearing on November 18, 2003, the head 
of KPMG's Tax Practice testified that ``[i]t 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.'' \286\ KPMG also told the 
Subcommittee that the firm ``recognizes that certain tax 
strategies previously offered, and the manner in which they 
were offered, were inconsistent with the role expected of a 
professional organization to which public trust and confidence 
is indispensable.'' \287\
---------------------------------------------------------------------------
    \286\ Prepared statement of Richard Smith, Jr., Vice Chair, Tax 
Services, KPMG, Subcommittee Hearings (11/18/03).
    \287\ Letter dated 5/10/04 from KPMG to the Subcommittee, at 2.
---------------------------------------------------------------------------
    Dismantling its Tax Shelter Development, Marketing and 
Sales Infrastructure. As part of KPMG's commitment not to 
engage in tax services that ``could in any way risk the 
reputations of KPMG or [its] clients,'' the firm announced a 
number of changes in its Tax Practice. KPMG informed the 
Subcommittee that it had refocused its tax services to 
emphasize advice tailored to a client's specific facts and 
circumstances, rather than continue mass marketing generic tax 
products to multiple clients.\288\ KPMG also told the 
Subcommittee that it no longer offers, implements, or endorses 
aggressive strategies such as FLIP, OPIS, BLIPS, or SC2.\289\
---------------------------------------------------------------------------
    \288\ See id., at 2. See also KPMG testimony at the Subcommittee 
hearing: ``[W]e have shifted our approach from one focused on taking 
solutions to clients to one that works with clients to address their 
individual situations.'' Testimony of Jeffrey Eischeid at Subcommittee 
Hearings (11/18/03).
    \289\ See testimony of Jeffrey Eischeid, Subcommittee Hearings (11/
18/03) (``None of these strategies--nor anything like these 
strategies--is currently being presented to clients by KPMG. . . . 
Today, KPMG does not present any aggressive tax strategies specifically 
designed to be sold to multiple clients, like FLIP, OPIS, BLIPS, and 
SC2.'') KPMG also stated at the hearing: ``[T]he 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.'' Id.
---------------------------------------------------------------------------
    In addition, KPMG has indicated that it has dismantled much 
of the development, marketing, and sales infrastructure it had 
used to mass market its tax products to multiple clients. For 
example, KPMG has eliminated the Tax Innovation Center, which 
was responsible for coordinating the development and deployment 
of new generic tax strategies. It has closed the telemarketing 
center in Fort Wayne, Indiana, which KPMG had used to market 
tax products through cold calls and sales appointments.\290\ 
KPMG also informed the Subcommittee that it was in the process 
of ``disbanding our network of business development managers,'' 
although the current status of these employees is unclear.\291\ 
KPMG told the Subcommittee that it was also re-evaluating its 
personnel requirements for market research and account 
management.\292\ KPMG further announced that it had ``abolished 
positions such as national deployment champions and area 
deployment champions,'' which had been used to facilitate 
nationwide sales of its tax products to multiple clients.\293\
---------------------------------------------------------------------------
    \290\ Letter dated 1/15/04, from Richard Smith, Jr., to the 
Subcommittee, at 8. In apparent contradiction to its action closing its 
own telemarketing center, KPMG disclosed that it had also contracted 
with MarketSource Corporation to perform centralized business 
development telemarketing for KPMG for the purpose of scheduling face-
to-face or conference call appointments between KPMG professionals and 
prospective clients. Id. at 8-9. When asked about this telemarketing 
contract, KPMG subsequently informed the Subcommittee that the firm had 
also terminated all contracts with Marketsource for telemarketing 
services. KPMG meeting with the Subcommittee (5/12/04).
    \291\ Letter dated 5/10/04, from KPMG to the Subcommittee, at 2 and 
5; KPMG meeting with the Subcommittee (5/12/04).
    \292\ Letter dated 5/10/04, from KPMG to the Subcommittee, at 3.
    \293\ Id., at 2.
---------------------------------------------------------------------------
    Dismantling of Stratecon and Innovative Strategies Practice 
Groups. At the November 18, 2003, Subcommittee hearing, the 
head of KPMG's Tax Practice testified that two of the key 
practice groups responsible for the FLIP, OPIS, BLIPS, and SC2 
tax products, known as Stratecon and Innovative Solutions, had 
been disbanded. Under questioning by Senator Levin, the Tax 
Practice head testified that both groups had been eliminated in 
April 2002, when he first assumed his position as head of the 
Practice. When asked at the hearing about KPMG's FY2003 
organizational chart which listed Stratecon as a functioning 
office and a November 2002 document listing tax products then 
being sold by Stratecon, KPMG's Tax Practice head testified 
that the documents reflect ``the fact that the systems that we 
had had not yet been changed at the particular point in time 
when this document was produced.''
    In a letter dated January 15, 2004, to the Subcommittee, 
KPMG clarified that the Stratecon and Innovative Strategies 
practice groups had actually been disbanded over a period of 
time, although the decision to terminate these groups had been 
made in April 2002.\294\ In response to a request from the 
Subcommittee for contemporaneous documentation, KPMG provided a 
number of documents demonstrating the process undertaken to 
dismantle the Stratecon practice group. KPMG also stated, 
however, that it had ``not been able to locate any specific 
documentation relating to the closure or the decision to close 
Innovative Strategies.'' \295\
---------------------------------------------------------------------------
    \294\ Letter dated 1/15/04, from Richard Smith, Jr., to the 
Subcommittee, at 2.
    \295\ Id. at 3.
---------------------------------------------------------------------------
    The absence of any Innovative Strategies documentation is 
particularly troubling in light of a draft Innovative 
Strategies Business Plan for 2002, which suggests that this 
group was continuing to work on abusive tax shelters. The 2002 
draft business plan stated, for example, that after the IRS 
listed the BLIPS transaction as potentially abusive, KPMG had 
made the business decision to stay out of the loss generator 
business ``for an appropriate period of time.'' \296\ 
Nevertheless, Innovative Strategies reported that it had 
continued to work on developing a new tax shelter product known 
as POPS, in which ``[t]he last significant hurdle in 
aggressively taking the solution to market [SIC] will likely be 
obtaining a commitment from tax leadership to re-enter the 
individual `loss-generator' business.'' \297\ In addition, the 
draft business plan 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.'' 
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.
---------------------------------------------------------------------------
    \296\ PFP Practice Reorganization (5/18/01), ``Innovative 
Strategies Business Plan--DRAFT,'' Bates KPMG 0050620-23.
    \297\ Id. As recently as last year KPMG seemed committed to 
maintaining or expanding tax services. For example, KPMG had provided 
the Subcommittee a 2003 list of more than 500 active tax products for 
various tax practice groups, which were intended to be offered to 
multiple clients for a fee.
---------------------------------------------------------------------------
    On May 10, 2004, KPMG assured the Subcommittee that 
Stratecon and Innovative Strategies had been disbanded, because 
the firm ``realized that these practices were not consistent 
with our commitment to upholding the trust placed in us by our 
clients, or with meeting the responsibilities incumbent upon us 
from our regulators and the public at large.'' \298\ KPMG 
indicated that of the 13 partners and professionals assigned to 
Innovative Strategies, five have left the firm, two had been 
transferred to the Federal Tax practice and six had been 
transferred to the Personal Financial Planning practice. KPMG 
stated that of the approximately 115 Stratecon professionals, 
57 partners and professionals had left the firm, and the 
remaining 58 had been reassigned to other practice groups 
within the firm. KPMG told the Subcommittee that the 
individuals transferred from Stratecon and Innovative 
Strategies to other KPMG practices were ``not involved with the 
development or deployment of aggressive look-alike strategies 
like FLIP, OPIS, BLIPS or SC2.'' \299\
---------------------------------------------------------------------------
    \298\ Letter dated 5/10/04 from KPMG to the Subcommittee, at 3.
    \299\ Id.
---------------------------------------------------------------------------
    Leadership Changes, Strengthening Oversight and Regulatory 
Compliance. In addition to dismantling various practice groups 
and tax development and marketing units, KPMG has reported 
taking steps to strengthen oversight and regulatory compliance 
within the firm. In May 2002, to strengthen the independence 
and objectivity of its regulatory compliance functions, for 
example, KPMG established a new senior position of Vice Chair 
for Risk and Regulatory Matters. This senior officer is 
authorized to report directly to the chief executive officer of 
KPMG rather than to any business unit.\300\ Another change is 
the establishment of a new position of a Partner in Charge of 
Risk and Regulatory Matters for Tax. This position is supposed 
to work independently of tax operations, report directly to the 
Vice Chair for Risk and Regulatory Matters, and wield ultimate 
authority to define the parameters for acceptable tax 
services.\301\
---------------------------------------------------------------------------
    \300\ Id.; KPMG meeting with the Subcommittee (5/12/04).
    \301\ Letter dated 5/10/04 from KPMG to the Subcommittee, at 3.
---------------------------------------------------------------------------
    In addition, KPMG announced that it had strengthened the 
independence of its Department of Practice and Professionalism 
for Tax (DPP), which provides final approval of new KPMG tax 
products, helps draft KPMG tax analysis, helps determine which 
tax products should be registered with the IRS, and can take 
existing KPMG tax products off the market, among other tasks. 
KPMG told the Subcommittee that the head of DPP now reports 
directly to the Partner in Charge of Tax Risk and Regulatory 
Matters rather than to the business leaders of the Tax 
Practice.\302\ In light of the instances described in this 
Report in which the KPMG Tax Practice head overruled or 
pressured the DPP head on matters related to tax shelters, this 
institutional change appears necessary and should help ensure 
that tax issues raising questions of reputational risk or legal 
or ethical concerns receive scrutiny from senior KPMG officers 
outside of the Tax Practice.
---------------------------------------------------------------------------
    \302\ Id.
---------------------------------------------------------------------------
    In addition, KPMG told the Subcommittee that it has 
instituted a more rigorous and formal procedure to review its 
tax services, requiring three levels of approval. Approval is 
required from the Partner in Charge of Risk and Regulatory 
Matters for Tax, the Washington National Tax Practice, and the 
Department of Professional Practice for Tax. If any of these 
three withhold approval, the Partner in Charge of Risk and 
Regulatory Matters for Tax and the DPP-Tax make the ultimate 
joint determination on whether a proposed tax service is 
acceptable.\303\ In another change, KPMG said that it was 
requiring audit clients with tax services resulting in material 
financial statement benefits to obtain a ``should'' level tax 
opinion from a third party before KPMG would accept the 
financial statement benefits.\304\
---------------------------------------------------------------------------
    \303\ Letter dated 5/10/04 from KPMG to the Subcommittee, at 3-4.
    \304\ Id., at 4.
---------------------------------------------------------------------------
    KPMG also told the Subcommittee that it had instituted 
firm-wide enhanced training programs to strengthen regulatory 
compliance.\305\ KPMG reported that this effort included 
intensive training on compliance with Treasury and IRS tax 
shelter regulations, compliance with Treasury and SEC auditor 
independence rules, and ethics matters. KPMG also indicated to 
the Subcommittee that the firm had registered a tax transaction 
with the IRS last year, which the Subcommittee understands is 
the first time it has done so.\306\
---------------------------------------------------------------------------
    \305\ Id.
    \306\ KPMG meeting with the Subcommittee (5/12/04).
---------------------------------------------------------------------------
    Tax Leadership Changes. On January 12, 2004, KPMG announced 
changes in its tax leadership. Jeffrey Stein, Deputy Chair of 
KPMG and former Vice Chair of Tax Services, was required to 
retire at the end of January, 2004. Richard Smith, Jr., then 
head of the Tax Services Practice, was removed from office and 
assigned to other duties within the firm. Jeff Eischeid, 
Partner in Charge of KPMG's Personal Financial Planning 
Practice, was placed on administrative leave and later left the 
firm.
    KPMG indicated to the Subcommittee that these cultural, 
structural, and leadership changes reflect a firm-wide 
commitment to restoring KPMG's reputation for professional 
excellence and integrity. The Subcommittee was told that the 
mandate to attain the highest degree of professional trust from 
the firm's clients, regulators, and the public at large came 
directly from Eugene O'Kelly, KPMG's Chairman and Chief 
Executive Officer. KPMG told the Subcommittee, ``we are 
embarrassed, and we are committed to ensuring that the past 
will never happen again.'' \307\
---------------------------------------------------------------------------
    \307\ Id.
---------------------------------------------------------------------------
    Current Legal Proceedings. KPMG continues to be the subject 
of numerous legal proceedings related to its tax shelter 
activities. In February 2004, the media reported that the U.S. 
Attorney for the Southern District of New York had initiated a 
Federal grand jury investigation of KPMG regarding its 
participation in the sale of tax shelters to corporations and 
wealthy individuals used to escape at least $1.4 billion in 
Federal taxes.\308\ KPMG responded in a statement that ``it is 
our understanding that the investigation is related to tax 
strategies that are no longer offered by the firm.'' \309\ KPMG 
also stated that ``KPMG has taken strong actions as part of our 
ongoing consideration of the firm's tax practices and 
procedures, including leadership changes announced last month 
and numerous changes in our risk management and review 
processes.'' \310\
---------------------------------------------------------------------------
    \308\ See, e.g., David Cay Johnson, ``Grand Jury is Investigating 
KPMG's Sale of Tax Shelters,'' New York Times, Feb. 20, 2004, at C5.
    \309\ Id.
    \310\ Id.
---------------------------------------------------------------------------
    The IRS and Department of Justice are continuing to 
investigate KPMG's compliance with Federal tax shelter laws and 
regulations. At the Subcommittee hearing in 2003, IRS 
Commissioner Mark Everson testified that:

      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 Jenkins and Gilchrist, remain in litigation with 
the IRS and have not yet complied with our legitimate documents 
requests.\311\
---------------------------------------------------------------------------
    \311\ See Testimony of Mark Everson, Commissioner, Internal Revenue 
Service, Subcommittee Hearings (11/20/03). The law firm Jenkens & 
Gilchrist allegedly collaborated with The Diversified Group to create 
the COBRA tax shelter and allegedly participated in the sale of at 
least 600 COBRA tax shelters, bringing the law firm substantial fees 
for issuing legal opinions letters. Paul Braverman, Helter Shelter, 
American Lawyer, December 2003, at 65-66.

As of the date of this report, KPMG remains in civil litigation 
with the IRS and Department of Justice over its tax shelter 
activities. In addition, KPMG remains the subject of civil 
suits filed by a number of its former clients who claim that 
KPMG improperly sold them illegal tax shelters.

  B. ERNST & YOUNG

      (1) Development of Mass-Marketed Generic Tax Products

      Finding: During the period 1998 to 2002, Ernst & Young 
sold generic tax products to multiple clients despite evidence 
that some, such as CDS and COBRA, were potentially abusive or 
illegal tax shelters.

    Ernst & Young (hereinafter ``E&Y'') was created after the 
1989 merger of the two firms Ernst & Ernst and Arthur Young & 
Company.\312\ A global firm with 670 locations in 140 different 
countries, E&Y currently employs about 100,000 individuals, 
including 20,000 tax professionals worldwide. In 2002, it 
reported over $10 billion in revenues. It is managed by a 6-
member Global Executive Board, and its current Chairman and 
Chief Executive Officer is James S. Turley. The current head of 
E&Y's global tax practice is Vice Chair for Tax Services, Mark 
A. Weinberger.
---------------------------------------------------------------------------
    \312\ General information about E&Y is taken from information 
provided by E&Y in response to the Subcommittee's investigation and 
from Internet websites maintained by E&Y.
---------------------------------------------------------------------------
    E&Y is organized into nine geographic areas, including the 
Americas Area which encompasses the United States. Like KPMG 
and PwC, E&Y is one of the four largest accounting firms 
operating in the United States, and provides both audit and tax 
services to its clients. E&Y employs more than 23,000 
individuals in the United States, including over 6,000 tax 
professionals. The current Chair of the Americas Area is James 
S. Turley.
    E&Y participated in the U.S. tax shelter industry during 
the periods relevant to the Subcommittee's investigation. 
During that time, E&Y marketed a number of questionable tax 
products to multiple clients, including products known as the 
Contingent Deferred Swap (CDS), Currency Options Bring Reward 
Alternatives (COBRA), SOAP, and PICANTE.\313\ E&Y marketed 
these tax products through a group of five to seven tax 
professionals initially called ``VIPER'' and later renamed the 
``more benign'' and ``less sinister sounding'' Strategic 
Individual Solutions Group (SISG).\314\
---------------------------------------------------------------------------
    \313\ See, e.g., email dated 10/26/99, from Brian L. Vaughn of E&Y 
to multiple E&Y tax professionals, Bates 2003EY011 (describing current 
status of seven E&Y tax products, including CDS, COBRA, SOAP, and 
PICANTE). For more information about COBRA, please see ``Tax Shelters: 
Who's Buying, Who's Selling, and What's the Government Doing About 
It?'' before the Senate Committee on Finance, S. Hrg. 108-371 (10/21/
03) (including prepared statement of Henry Camferdam).
    \314\ See 1/17/00 email from Robert Coplan to numerous recipients 
re: ``CDS Lives!,'' Bates 2003EY011613-14.
---------------------------------------------------------------------------
    E&Y told the Subcommittee that the tax products it sold to 
multiple clients generally were not developed in-house but 
originated with an outside source. E&Y explained that it 
examined each such tax product to ``determine whether it was 
something that SISG would offer to its clients and, if it was, 
would usually take steps to restructure the strategy to enhance 
the likelihood that it would be sustained on the merits.'' 
\315\ E&Y also acknowledged that, during the years in question, 
the SISG review and approval process for new tax products was 
an ``ad hoc, decentralized, and informal process.'' \316\
---------------------------------------------------------------------------
    \315\ Letter dated 5/3/04, from Ernst & Young to the Subcommittee, 
at 1.
    \316\ E&Y meeting with the Subcommittee (5/4/04).
---------------------------------------------------------------------------
    The documents show that E&Y engaged in an aggressive effort 
to develop and market generic tax products to multiple clients. 
For example, an internal E&Y email from October 1999, recites 
seven tax products then under development and closes with the 
statement: ``As you can see, we have a great inventory of 
ideas. Let's keep up the R&D to stay ahead of legislation and 
IRS movements.'' \317\ An E&Y email from September 1999, 
promises the imminent completion of a particular tax product 
and states: ``We will have until 10/31 to market the strategy. 
. . . Once we roll this product out, I will travel to each area 
to help you present this strategy to your clients. . . . Let's 
have fun with this new strategy and kick some KPMG, PWC and 
AA???'' \318\ Still another E&Y email, from May 2000, sets a 
nationwide sales goal for one of the firm's tax products, 
asking its tax professionals to work to generate ``$1 billion 
of loss.'' \319\
---------------------------------------------------------------------------
    \317\ Email dated 10/26/99, from Brian L. Vaughn of E&Y to multiple 
tax professionals, Bates 2003EY011.
    \318\ Email dated 9/8/99, from Brian L. Vaughn of E&Y to multiple 
E&Y tax professionals, ``Capital Loss/Ordinary Loss Technique,'' Bates 
2003EY011349.
    \319\ Email dated 5/10/00, from Brian L. Vaughn of E&Y to multiple 
E&Y tax professionals, ``CDS Update,'' Bates 2003 EY022850 (This email 
also states: ``With your help we can make this goal. As of today, I 
have the following list of leads that have been given to me. Please 
send me your leads and the amount of potential loss. I want to help 
each of you obtain your own CDS goals. Please let me know how I can 
help. Also, please provide me with updates to this list. Thanks and 
good luck!!!'').
---------------------------------------------------------------------------
    Contigent Deferred Swap. E&Y's Contingent Deferred Swap or 
CDS was a particularly lucrative tax shelter for the firm and 
illustrates the firm's flawed process for developing, 
marketing, and implementing potentially abusive or illegal tax 
shelters.
    E&Y first learned of CDS when, in 1998, it was approached 
by The Private Capital Management Group (TPCMG) which was then 
handling CDS transactions for PricewaterhouseCoopers.\320\ The 
tax shelter involved a transfer to a partnership that generates 
a level of trading activity designed to enable the partnership 
to achieve trading partnership status that, in turn, allegedly 
allows swap payments and other first year expenses of the 
partnership to be treated as ordinary losses that can offset 
the client's ordinary income in that year.\321\ Upon 
termination of the transaction the following year, the taxpayer 
allegedly received the additional benefit of capital gains tax 
treatment generated by termination of the swap.\322\ 
Essentially, CDS was a conversion strategy, converting ordinary 
income to capital gains income, with the additional benefit of 
deferral.
---------------------------------------------------------------------------
    \320\ Subcommittee interview of Robert Coplan (5/4/04). The 
Subcommittee was told that David Lippman-Smith of TPCMG made the 
initial contact with Richard Shapiro of E&Y.
    \321\ Email dated 9/15/99, from Robert Coplan to Robert Garner, 
``Subject: VIPER PRODUCTS--IRS Representation, etc.,'' Bates 
2003EY011387-88.
    \322\ See email dated 6/4/00, from Robert Coplan to multiple 
recipients, ``SISG Solution Update--CDS Add-On,'' Bates 2003EY011874-
75; Contigent Deferred Strategy Powerpoint Slide (indicating that the 
$20 million swap payment offsets ordinary income in year paid and that 
termination of the swap produces a $20 million capital gain tax benefit 
in the following year).
---------------------------------------------------------------------------
    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.\323\ UBS was retained for the bank loans and 
swap agreements. \324\ Locke, Liddell & Sapp provided clients 
with a legal opinion indicating that, if challenged by the IRS, 
CDS ``should'' be upheld in court.\325\
---------------------------------------------------------------------------
    \323\ Email dated 1/14/00 from [email protected] to Melinda Merk, 
``Subject: Re: Quick Question re: CDS,'' (describing that David Smith 
``is the Managing Director of TPCMG (which of course is the general 
partner of the partnership). TPCMG has an office in California. David 
Smith is the only person in it. David directed the activities of the 
trading partnership through BOLTON. Bolton is located in Memphis, 
Tennessee.'') Bates 2003EY011612. In 2000, TPCMG ceased its activities 
with the CDS transaction, and Bolton Capital Planning took over as the 
general partner of the trading partnerships. Subcommittee interview of 
Robert Coplan (5/4/04).
    \324\ CDS was apparently approved by UBS's internal tax, legal, and 
regulatory functions. However, the bank created some ``bottlenecks'' 
with executing transactions as each particular transaction was required 
to be submitted to the bank's Chief Credit Officer, Marco Suter, to 
determine whether any specific transaction gave rise to unacceptable 
reputation risk for the bank. See email dated 9/28/99, names withheld, 
``Subject: Re: Fwd: CDS trades for TPCMG,'' Bates 2003EY011416. In 
2000, UBS ceased its activities with CDS. In 2000-2001, Bear Sterns and 
Refco Bank participated as the counter-parties for the swaps and 
provided the loans. Letter dated 5/3/04, from Ernst & Young to the 
Subcommittee, at 6.
    \325\ Email dated 2/29/00, from Robert Garner to Robert Coplan, 
``Subject: VIPER Communication,'' Bates 2003EY011660-61.
---------------------------------------------------------------------------
    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.\326\ In its CDS engagement letters, E&Y 
expressed its fee as a flat dollar amount to avoid contingent 
fee issues; however, internal documents show that this fee was, 
in fact, calculated as 1.25% of the tax loss to be generated 
through the CDS transaction.\327\ In fact, E&Y's sample CDS 
engagement letter stated explicitly: ``Our fee for providing 
the professional services referred to above will be $[Insert 
amount at 1.25% of losses to be generated. If size of 
transaction is not certain at the time this letter is signed, 
add `based on your investing $ million in the Partnership'] and 
it will be paid by the Partnership.'' \328\
---------------------------------------------------------------------------
    \326\ Id.
    \327\ Email dated 9/15/99, from Robert Coplan to Robert Garner, 
``Subject: VIPER PRODUCTS--IRS Representation, etc.,'' Bates 
2003EY011387-88.
    \328\ See Sample Engagement Letter, Bates 2003EY011138 (emphasis in 
original).
---------------------------------------------------------------------------
    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.\330\
---------------------------------------------------------------------------
    \329\ E&Y meeting with the Subcommittee (5/4/04). CDS was approved 
for sale in 1999. Subsequently, in 2000, E&Y required new tax products 
to undergo an independent review by firm tax professionals outside 
SISG.
    \330\ An email from Robert B. Coplan of E&Y to [email protected], 
Bates 2003EY01139, states: ``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.''
---------------------------------------------------------------------------
    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.'' 
. . . \331\
---------------------------------------------------------------------------
    \331\ Email exchange dated 9/8/99, between Mary Sigler of E&Y and 
Brian Vaughn of SISG, ``Re: CDS Transaction,'' Bates 2003EY011351-52.

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. . . .\332\
---------------------------------------------------------------------------
    \332\ Id.

---------------------------------------------------------------------------
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? \333\
---------------------------------------------------------------------------
    \333\ Id.

    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.\334\
---------------------------------------------------------------------------
    \334\ Interview with E&Y representative (5/4/04). While E&Y wrote 
opinion letters supporting its SOAP and PICANTE tax products, it 
apparently did not write opinion letters for its CDS or COBRA products. 
According to E&Y, the firm issued opinions for SOAP and PICANTE because 
these products were less likely to give rise to a challenge by the IRS. 
However, E&Y told the Subcommittee that no investors who purchased a 
SOAP or PICANTE tax product were told that E&Y would be considered a 
promoter and therefore they could not rely on an E&Y opinion if 
challenged by the IRS.
---------------------------------------------------------------------------
    Locke Liddell and Sapp LLP did, however, issue legal 
opinions for CDS.\335\ 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:
---------------------------------------------------------------------------
    \335\ See, e.g., letter dated 10/1/99, from Brent Clifton, Locke 
Liddell & Sapp LLP, to Wolfgang Stolz, UBS, Bates 2003EY011434 
(disclosing that the law firm had ``undertaken a review of the proposed 
contingent deferred swap strategy (``CDS'') offered by the Private 
Capital Management Group (``PCMG'') and is prepared to issue a tax 
opinion in connection with each such transaction executed by a PCMG 
partnership following our engagement by each such partnership and our 
review of all relevant documentation.'').

      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.\336\
---------------------------------------------------------------------------
    \336\ Email dated 9/7/99, forwarded to Patricia Klitzke, ``FW: CDS 
Transaction at Risk,'' Bates 2003EY011345-50.

    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.
    E&Y apparently marketed CDS aggressively. From 1999 until 
2001, E&Y sold 70 CDS transactions involving 132 taxpayers, 
obtaining fees of more than $27.8 millions.\337\ The SISG group 
set an explicit goal in 2000, of using CDS to shelter $1 
billion of losses.\338\ In April 2000, a key E&Y tax 
professional in SISG reported: ``I just wanted to update you on 
the success we are having with the CDS transaction in 2000. 
With the new UDS/Yen model as an option, the sales activity has 
drastically increased. . . . [W]e are well on our way to 
meeting the $1 billion loss goal we set at the beginning of 
this year.'' \339\ E&Y continued to market CDS and other tax 
products at the same time the IRS increased its efforts to stop 
abusive tax shelters.
---------------------------------------------------------------------------
    \337\ Letter dated 5/3/04, from Ernst & Young to the Subcommittee, 
at 8.
    \338\ Email dated 5/10/00, from Brian Vaughn to multiple E&Y tax 
professionals, ``CDS Update,'' Bates 2003EY011850-51.
    \339\ Email dated 4/26/00, from Brian Vaughn of E&Y to Robert B. 
Coplan of E&Y, ``CDS Update,'' Bates 2003EY011830.
---------------------------------------------------------------------------
    In early 2000, PricewaterhouseCoopers announced that, 
because the IRS had listed one of its tax products, the Bond 
and Options Sales Strategy (BOSS), as an abusive tax shelter, 
it would refund all BOSS fees to its clients. When a potential 
client asked whether E&Y would refund fees if the CDS 
transaction was subsequently determined to be abusive, the firm 
answered ``an unequivocal no.'' One E&Y tax professional wrote:

      They are a client of mine . . . I suggested CDS (with 
the option add-on) as an alternative. They would like to move 
forward. However, there are two issues. One, the amount of 
income they wish to offset is $10 to $12 million rather than 
the $20 million. Second, against my advice they did the BOSS 
transaction last year. . . . They got most of their money back 
since PWC could not issue the opinion. They want a similar 
[deal] right here. If the opinion can't be issued because of a 
change in the law they get a refund of the fee (or most of it, 
e.g. trading costs would not be refunded).\340\
---------------------------------------------------------------------------
    \340\ Email dated 7/18/00, from Robert Coplan, ``Re: family-
potential CDS deal,'' Bates 2003EY011938-39.

---------------------------------------------------------------------------
In response, the SISG head wrote:

      Finally, on the big issue of promising to give back the 
fee or some part of it if the deal doesn't work, the answer is 
an unequivocal no. We are not able to do that, and I doubt PWC 
had that built into their engagement letter. WE have a dispute 
resolution procedure in our engagement letters that protects 
the client if he doesn't receive the value he has paid for. 
Obviously, a big 5 firm would not retain a fee if the client 
was never put in a position to obtain the tax benefits on the 
transaction. But that doesn't mean we could insert such a 
provision up front that would clearly make our fee contingent 
on the tax outcome of the transaction. That is nonnegotiable. 
We have been down this road many times before.\341\
---------------------------------------------------------------------------
    \341\ Id.

It is ironic that E&Y rejected a client's request for a 
refundable fee, in part, because it would be a non-permissible 
contingent fee dependent upon ``the tax outcome of the 
transaction,'' when, at the same time it was charging clients a 
CDS fee equal to a percentage of the client's expected tax 
loss.\342\
---------------------------------------------------------------------------
    \342\ E&Y contended to the Subcommittee that its CDS fee was not 
dependent on the actual tax benefits received by the client and, thus, 
was not a contingent fee.
---------------------------------------------------------------------------
    In late 2000, CDS itself began attracting IRS attention, 
but even IRS inquiries did not deter E&Y from continuing to 
market the tax product to new clients. Bolton Capital Planning, 
the investment firm involved in carrying out CDS transactions, 
for example, informed E&Y that it had received an IRS letter 
inquiring about CDS. An SISG tax professional responded in an 
email to his supervisor as follows:

      With regard to CDS, we all knew one day we would receive 
a letter. We told our clients to expect the letter. What we 
don't know at this point is whether the IRS will pursue an IRS 
exam of the strategy. You ask me this afternoon would I buy the 
strategy assuming the IRS was aware of the trade. The answer is 
definitely ``YES.'' Remember, the IRS knew about COBRA, but our 
clients still made the purchase. In fact, the clients continued 
to buy the ``add-on'' trade even though we knew the IRS was 
extremely familiar with the issues. If the IRS pursues and 
audit and we successfully defend the strategy, then why 
wouldn't our clients want to buy the trade. It would be 
premature at this point to assume our clients would not buy a 
strategy that the IRS has knowledge of. Why don't we let the 
clients decide? Therefore, I would like to propose that CDS is 
not ``stopped'' at this point. Brian Upchurch and I have a 
client that is considering CDS and I would be happy to let him 
know that the IRS has issued a notice to Bolton requesting 
information on the trade. My belief is he would say ``so 
what.''

      That is my two cents worth. As I told you, I am a 
fighter. I don't enjoy giving up before I get my chance to 
fight. Remember our opinion on CDS is a should. Let them bring 
their guns!!!! I believe they will turn their tales and run the 
other direction. CDS has economic substance and has the best 
promoter in the business associated with the trade. I think we 
owe it to Belle and ourselves not to give up and stop the sales 
process at this point. Let the clients decide.\343\
---------------------------------------------------------------------------
    \343\ Email dated 12/12/00, from Brian Vaughn to Robert Coplan, 
``Subject: New LLC strategy,'' Bates 2003EY012125.

    E&Y ultimately decided to continue selling CDS in 2001, 
with some revisions designed so that the ``transaction would 
not have to be registered with the IRS.'' \344\ In fact, E&Y 
never registered CDS with the IRS at any time during the 3 
years it sold the product. Instead, according to E&Y, it had an 
oral arrangement with TPCMG in 1999, and with Bolton Capital 
Planning in 2000, that the general partner of the CDS 
partnerships was responsible for registering specific CDS 
transactions with the IRS.
---------------------------------------------------------------------------
    \344\ Email dated 1/5/01, from Robert Coplan to Quickstrike Team, 
``Subject: SISG Update, 1/8 Conference Call,'' Bates 2003EY012139-41.
---------------------------------------------------------------------------
    In May 2002, the IRS listed the CDS transaction.\345\ 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.
---------------------------------------------------------------------------
    \345\ Ernst & Young's CDS transaction is covered by IRS Notice 
2002-35 (2002-21 IRB 992) (5/28/02).
---------------------------------------------------------------------------
    At the time of the E&Y settlement, IRS Commissioner Mark 
Everson commented:

      This represents a real breakthrough and is a good 
working model for agreements with practitioners. . . . [W]e are 
trying to differentiate between those who cooperate with the 
IRS, who try to remedy past mistakes and who seek transparency 
in their dealings with the Service, and those others who simply 
refuse and continue to peddle abusive transactions. Our 
intention is to differ in our approach to them based on their 
behavior.\346\
---------------------------------------------------------------------------
    \346\ See Discussion of the Ernst & Young Agreement with the 
Internal Revenue Service.

    At the November 18, 2003 Subcommittee hearing, Mark 
Weinberger, Vice Chair Tax Services, Ernst & Young, testified 
that the firm has ``taken, and are taking, numerous steps to 
ensure that quality and professionalism are touchstones for 
everything that we do.'' \347\
---------------------------------------------------------------------------
    \347\ Testimony at Subcommittee Hearings (11/18/03).
---------------------------------------------------------------------------

  (2) Ernst & Young's Current Status

      Finding: Ernst & Young has committed to cultural, 
structural, and institutional changes to dismantle its tax 
shelter practice, including by eliminating the tax practice 
group that promoted its tax shelter sales, making leadership 
changes, and strengthening its tax oversight and regulatory 
compliance.

    E&Y, along with their settlement with the IRS, committed to 
a number of cultural, structural, and institutional changes to 
dismantle its tax shelter practice, including by eliminating 
the tax practice group that promoted its tax shelter sales, 
establishing a new tax product review and approval process, and 
strengthening its tax services oversight and regulatory 
compliance. As a first step, E&Y disbanded the VIPER/SISG group 
that had taken the lead within the firm in selling CDS, COBRA, 
and other tax products to multiple clients.
    New IRS Registration and Compliance Monitoring Procedures. 
E&Y, as part of their settlement with the IRS, proposed the 
development and implementation of a Quality and Integrity 
Program (QIP) to strengthen its compliance with specific 
Federal requirements for tax shelter registration, client list 
maintenance, and disclosure of reportable transactions. This 
program, which E&Y said became operational on October 1, 2003, 
is staffed by four E&Y personnel who provide centralized 
national oversight to ensure compliance by E&Y tax 
professionals with compliance with Federal tax shelter 
regulations.\348\
---------------------------------------------------------------------------
    \348\ Subcommittee meeting with Ernst & Young (5/4/04).
---------------------------------------------------------------------------
    E&Y told the Subcommittee that the QIP process requires 
that any tax transaction resulting in a fee in excess of 
$10,000 be recorded in a centralized database, so that the firm 
is aware of and can track all such transactions. The QIP 
database is also tied to the firm's financial system so that, 
for example, if a client billing is in excess of $10,000 and 
does not have a corresponding QIP record, E&Y is able to 
identify this discrepancy and correct it. E&Y said that, for 
all transactions generating fees of $100,000 or more, QIP 
requires a tax shelter registration analysis. A QIP review 
board performs this registration analysis and, in cases where 
the review board cannot reach agreement on the firm's 
obligations, solicits guidance from the IRS.\349\
---------------------------------------------------------------------------
    \349\ Subcommittee meeting with Ernst & Young (5/4/04). According 
to E&Y, the firm recently solicited guidance from the IRS with respect 
to a transaction where the QIP review board was unable to determine if 
a potential transaction triggered registration requirements.
---------------------------------------------------------------------------
    As part of the QIP implementation, 3,100 tax professionals 
were required to participate in a comprehensive review of the 
requirements related to registration and list maintenance as 
well as training on the QIP process. \350\ E&Y requires annual 
certification of compliance with QIP by all partners, 
principals, senior managers, and tax compliance engagement 
managers.\351\
---------------------------------------------------------------------------
    \350\ These tax professionals consist of partners, principals, and 
senior managers, whose responsibilities include the engagement of 
clients for tax services.
    \351\ Letter dated 5/3/04, from Ernst & Young to the Subcommittee, 
at 5.
---------------------------------------------------------------------------
    Institutional Changes. Aside from the settlement, Ernst & 
Young has instituted firm-wide policies and actions to improve 
E&Y professionalism. For example, E&Y established the position 
of Americas Vice Chair of Quality and Risk Management, charged 
with enhancing quality and compliance across all E&Y product 
lines in the United States, including tax services. The current 
Vice-Chair, Susan Friedman who, with a twenty person staff, 
reports directly to the E&Y Chairman.\352\
---------------------------------------------------------------------------
    \352\ Id., at 1.
---------------------------------------------------------------------------
    E&Y also established a new position, Americas Director for 
Tax Quality, charged with ensuring that all new tax products 
sold by E&Y in the United States meet high standards for 
professionalism and do not run afoul of Federal tax shelter 
prohibitions.\353\ To correct problems identified with E&Y's 
past procedures for approving new tax products, which E&Y told 
the Subcommittee had been ad hoc, decentralized, and informal, 
this new position was created to ensure a centralized review 
processes and high standards.\354\ E&Y told the Subcommittee 
that, to assist in this effort, the Director for Tax Quality 
had recently created Tax Technical Review Committees for each 
of E&Y's tax product functional areas, such as International 
Tax, Partnerships, and Mergers and Acquisitions. E&Y explained 
that these committees were charged with reviewing and approving 
technical tax issues in their areas of expertise.\355\ In cases 
where a Tax Technical Review Committee cannot reach consensus 
on a product or issue, E&Y said that the committee is required 
to notify the Director for Tax Quality to resolve the matter at 
issue. The current Americas Director for Tax Quality is Joseph 
Knott who reports directly to both the Vice Chair of Tax 
Services and the Vice Chair of Quality and Risk 
Management.\356\
---------------------------------------------------------------------------
    \353\ Id.
    \354\ Subcommittee meeting with Ernst & Young (5/4/04).
    \355\ Letter dated 5/3/04, from Ernst & Young to the Subcommittee, 
at 8-9.
    \356\ Subcommittee meeting with Ernst & Young (5/4/04).
---------------------------------------------------------------------------
    In addition, in 2003, E&Y established a senior advisory Tax 
Review Board, whose members include senior executives from 
outside the firm's Tax Practice to review the firm's tax 
policies and procedures for current or proposed services and 
products. The Tax Review Board is supposed to conduct an annual 
review of all E&Y tax practice offerings in conjunction with 
the firm's tax leadership; it may also discuss any matter 
warranting review on an interim basis. The Board is advisory to 
the Americas Vice Chair of Tax Services.\357\
---------------------------------------------------------------------------
    \357\ Letter dated 5/3/04, from Ernst & Young to the Subcommittee, 
at 1, 8.
---------------------------------------------------------------------------
    Still another step taken by E&Y is the establishment of a 
Tax Quality Review program to review compliance by individual 
E&Y tax professionals with firm policies. E&Y told the 
Subcommittee that this review is supposed to be supervised by 
its National Tax Quality and Standards Group and that the 
review itself is to be performed by tax professionals from a 
practice unit other than the one of the individual being 
reviewed.\358\ E&Y indicated that every E&Y tax partner, 
principal, and senior manager providing tax advice will be 
reviewed at least once every 3 years by this program, separate 
and apart from E&Y's annual performance evaluation process.
---------------------------------------------------------------------------
    \358\ Letter dated 5/3/04, from Ernst & Young to the Subcommittee, 
at 8-9.
---------------------------------------------------------------------------
    E&Y indicated to the Subcommittee that all of E&Y's 
cultural, structural, and institutional changes reflect a firm-
wide commitment to quality and professionalism with the 
``mandate coming directly from James S. Turley, Chairman and 
Chief Executive Officer.'' \359\ E&Y communicated that these 
changes are part of an on-going process designed to ensure the 
highest professional standards.\360\
---------------------------------------------------------------------------
    \359\ Subcommittee meeting with Ernst & Young (5/4/04).
    \360\ Id.
---------------------------------------------------------------------------
    Current Legal Proceedings. Although E&Y has settled with 
the IRS with respect to its tax shelter registration and client 
list maintenance obligations, it remains the subject of other 
litigation over its tax shelter activities. In May 2004, the 
U.S. Attorney for the Southern District of New York apparently 
initiated a Federal grand jury investigation of E&Y regarding 
its sale of tax shelters to corporations and wealthy 
individuals to escape or reduce Federal taxes. That criminal 
inquiry is on-going. In addition, several former E&Y clients 
have sued the firm for improperly selling them illegal tax 
shelters.\361\
---------------------------------------------------------------------------
    \361\ See, e.g., Camferdam v. Ernst & Young, (USDC SDNY) Case No. 
02 Civ. 10100 (BSJ) (alleging breach of fiduciary duty, fraud, 
negligence, and other misconduct by E&Y for selling COBRA to the 
plaintiff).
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  C. PRICEWATERHOUSECOOPERS

      (1) Mass-Marketed Generic Tax Products

      Finding: During the period 1997 to 1999, 
PricewaterhouseCoopers sold general tax products to multiple 
clients, despite evidence that some, such as FLIP, CDS, and 
BOSS, were abusive or potentially illegal tax shelters.

    PricewaterhouseCoopers International Ltd., was created in 
1998 from the merger of two firms, Pricewaterhouse and Coopers 
& Lybrand.\362\ PricewaterhouseCoopers International Ltd. 
encompasses an international network of member firms using the 
PricewaterhouseCoopers name. It operates in over 140 countries 
with more than 750 offices worldwide. As of June 2004, it 
employed more than 120,000 individuals and reported global net 
revenues totaling about $16.3 billion. The company is managed 
by a 19-member ``Global Board.'' The current chief executive 
officer of PricewaterhouseCoopers International Ltd. is Samuel 
A. DiPiazza, Jr., who is based in New York.
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    \362\ General information about PwC is drawn from documents 
produced to the Subcommittee and Internet websites maintained by PwC.
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    PricewaterhouseCoopers LLP (hereinafter ``PwC'') is a U.S. 
limited liability partnerhip and a member of 
PricewaterhouseCoopers International Ltd. Like KPMG and Ernst 
&Young, PwC is one of the four largest accounting firms 
operating in the United States, and provides both audit and tax 
services to its clients. PwC is managed by a U.S. Executive 
Board. The current Chairman and Senior Partner heading PwC's 
U.S. operations is Dennis M. Nally. The current head of PwC's 
U.S. Tax Practice is Richard J. Berry who oversees more than 
6,500 tax professionals.
    PwC participated in the U.S. tax shelter industry during 
the period relevant to the Subcommittee's investigation. With 
respect to generic tax products marketed to multiple clients, 
PwC was involved in selling its version of the Foreign 
Leveraged Investment Program (FLIP), Contingent Deferred Swap 
(CDS), and the Bond and Options Sales Strategy (BOSS). PwC sold 
about 50 FLIP transactions to clients in 1997 and 1998, sold 26 
CDS transactions in 1998 and 1999, and was in the process of 
selling about 120 BOSS transactions in 1999, when the firm 
halted product sales and later refunded all BOSS fees.\363\ 
Each of these tax products has been identified by the IRS as an 
abusive tax shelter.\364\
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    \363\ PwC prepared statement for Subcommittee Hearings (11/18/03).
    \364\ FLIP is covered by IRS Notice 2001-45 (2001-33 IRB 129). CDS 
transaction is covered by IRS Notice 2002-35 (2002-21 IRB 992) (5/28/
02). BOSS is covered by IRS Notice 1999-59 (1999-52 IRB 761).
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    PwC told the Subcommittee:

      In the 1990's there was increasing pressure in the 
marketplace for firms to develop aggressive tax shelters that 
could be marketed to large numbers of taxpayers. This had not 
been a traditional part of our tax practice, but regrettably 
our firm became involved in three types of these 
transactions.--Although the total number of transactions that 
were done was limited to 76 over a 3-year period, we 
acknowledge that we should not have done any. Since late 1999, 
we have taken strong action to prevent our involvement in 
transactions like these again.\365\
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    \365\ PwC prepared statement for Subcommittee Hearings (11/18/03).

    Review and Approval Process in General. According to PwC, 
the firm's development and sale of abusive tax products such as 
FLIP, CDS, and BOSS occurred due to a lack of a centralized 
review process with proper authority, accountability, and 
oversight.\366\
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    \366\ Subcommittee meeting with PricewaterhouseCoopers (5/27/04).
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    PwC told the Subcommittee, that during the 1997-1999 time 
frame, its review and approval process for new tax ideas, 
including FLIP, CDS, and BOSS, occurred on a decentralized and 
ad hoc basis.\367\ PwC indicated that, at that time, to analyze 
and develop a new tax product, individual business units within 
the firm typically established an internal, ad hoc review 
committee whose members were typically senior tax partners 
selected by the tax partners advocating the new tax idea.\368\ 
PwC explained that this committee then conducted a technical 
review of the proposed tax product to determine whether it 
complied with Federal tax law, but did not consider such 
factors as reputational risk or ethics considerations.\369\ PwC 
indicated that it now recognizes that this process lacked 
independence from the business unit which stood to profit if 
the product was approved.
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    \367\ Id.
    \368\ Id.
    \369\ Id.
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    PwC explained that the review committee was supposed to 
reach a consensus on whether ``it was more likely than not'' 
that the proposed tax idea would be upheld in court, if 
challenged by the IRS. PwC explained further, however, that 
individual committee members were not required personally to 
determine that the tax product met the requirements of the law; 
the standard was whether each member could reasonably see that 
others could reach a ``more likely than not'' conclusion on the 
technical merits.\370\ PwC told the Subcommittee that once a 
review committee approved a new tax product, the individual 
business unit that established the committee was then free to 
market it, without obtaining the approval of any other PwC 
authority, including PwC's tax leadership or senior PwC 
partners outside of the tax practice.
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    \370\ Id.
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    PwC told the Subcommittee that the review committee 
typically did not consider any issues related to the firm's 
compliance with the IRS tax shelter registration or client list 
maintenance obligations and that, during the 1997-1999 period, 
these issues had, at times, received little or no attention in 
connection with the approval of a new tax product.\371\ PwC 
explained that while it had assigned these issues to its 
Practice and Procedures group, that group was focused primarily 
on handling audit controversies, obtaining private letter 
rulings from the IRS, and assisting clients resolve accounting 
issues.\372\ PwC also indicated that the Practice and 
Procedures group had been subject to little oversight, and the 
firm then lacked a centralized process for reviewing decisions 
regarding its tax shelter registration and list maintenance 
obligations.\373\
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    \371\ Id.
    \372\ Id.
    \373\ Id.
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    Developing, Marketing, and Implementing FLIP. PwC's 
handling of the FLIP tax product demonstrates the firm's flawed 
process for developing, marketing, and implementing potentially 
abusive or illegal tax shelters.
    FLIP, which was first developed by KPMG, apparently 
migrated to PwC after a KPMG tax partner familiar with the tax 
product took a position with one of PwC's predecessor firms, 
Coopers & Lybrand. The Subcommittee was told that, in 1997, 
Michael Schwartz, a former KPMG tax partner and member of the 
KPMG development team for FLIP, \374\ was hired by Coopers & 
Lybrand as an international tax partner to run the Foreign Bank 
Group.\375\ The Subcommittee was told that, after the merger 
between Coopers & Lybrand and Pricewaterhouse in 1998, Mr. 
Schwartz worked in the resulting firm's Finance and Treasury 
Group.\376\
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    \374\ Subcommittee interview of John Larson (10/3/03).
    \375\ Subcommittee interview of Michael Schwartz (5/26/04).
    \376\ Id.
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    PwC told the Subcommittee that Mr. Schwartz introduced the 
FLIP product to various partners at the firm and was 
responsible for presenting the tax product to potential 
clients.\377\ By 1998, the Personal Financial Services group 
within PwC had assumed the lead in marketing FLIP to potential 
clients and implementing FLIP transactions.\378\ PwC told the 
Subcommittee, that, altogether, in 1997 and 1998, led by Mr. 
Schwartz, Coopers & Lybrand participated in 12 FLIP 
transactions and PwC participated in 38, for a total of 
50.\379\
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    \377\ Id. While Mr. Schwartz introduced partners to FLIP at Coopers 
& Lybrand and later PwC, these activities were apparently in addition 
to his primary duties serving clients within the Foreign Bank and 
Finance and Treasury Groups. Id.
    \378\ Id. The Subcommittee was told that, from 1998 to 1999, PwC 
assigned additional staff, three managers and a tax partner, to assist 
Mr. Schwartz in explaining generic tax products to potential clients. 
Id.
    \379\ Prepared statement of Richard J. Berry, Senior Tax Partner, 
PricewaterhouseCoopers LLP during Subcommittee Hearings (11/18/03).
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    Like KPMG, PwC enlisted other professional firms in its tax 
shelter activities. For example, in addition to identifying 
potential FLIP clients on its own, PwC entered a client 
referral arrangement with First Union National Bank, which 
later merged with Wachovia National Bank. Under this 
arrangement, First Union agreed to refer its banking customers 
to PwC for a FLIP presentation. PwC also had an informal 
agreement with an investment firm called Quadra Investments, 
later renamed the Quellos Group, to carry out the complex 
financial transactions called for by the FLIP transaction. 
Quellos helped set up the offshore partnerships required by 
FLIP, for example, and also worked with various banks to 
arrange millions of dollars in required financing. Quellos 
performed similar services for KPMG.
    Among other actions to ensure the smooth implementation of 
FLIP transactions, PwC issued opinion letters to its clients, 
stating that it was ``more likely than not'' that FLIP would be 
upheld, if challenged by the IRS.\380\ PwC apparently continued 
to issue these favorable opinion letters even after learning 
that the FLIP transactions was the subject of Federal 
legislation. As PwC explained in a letter to First Union:
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    \380\ Letter dated 2/17/99 from Michael Schwartz, PwC, to Diane 
Stanford, Senior Vice President, First Union National Bank, Bates SEN-
014602.

      We have determined with the help of our Washington 
National Office that the effective date [of the proposed 
legislation barring FLIP transactions] should occur well after 
any transactions currently contemplated have been completed. As 
well we have taken precautions that will allow us to accelerate 
the completion should we learn that the effective date could 
occur in advance of our expectations. . . . I can guarantee 
that we will be able to write an opinion letter for any of your 
clients that engage in this transaction. . . .\381\
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    \381\ Id.

    Similar to KPMG and other promoters, PwC failed to register 
FLIP with the IRS as a tax shelter. The Subcommittee was told 
that, instead, PwC advised Quellos Group to register the tax 
shelter with the IRS.\382\ The 1998 and 1999 FLIP transactions, 
based upon the advice of PwC, were registered with the 
IRS.\383\ At the same time, however, Quellos failed to register 
KPMG's FLIP transaction, even though the transactions were 
substantially the same, because, according to Quellos, KPMG had 
advised it not to register the product. Under questioning by 
Subcommittee Chairman Coleman at the November 20, 2003 hearing, 
the Quellos Chief Executive Officer testified that his firm had 
asked KPMG about registering FLIP and KPMG's response was that 
``[w]e have done our analysis and it is our opinion that it 
does not need to be registered.'' \384\ The end result was that 
two substantially similar tax products, both called FLIP, 
received different registration treatment by Quellos, based 
upon differing advice provided by the two accounting firms 
using Quellos to help implement the FLIP transactions. In 
addition, neither accounting firm ever completed its own 
registration of FLIP, despite, in the case of PwC, advising 
another party to do so.
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    \382\ Subcommittee interview of Quellos representative (11/7/03).
    \383\ Letter dated 5/10/04, from PricewaterhouseCoopers to the 
Subcommittee, at 2.
    \384\ Quellos testimony at Subcommittee Hearings (11/20/03).
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    Developing, Marketing, and Implementing BOSS. The Bond and 
Options Sales Strategy or BOSS tax product provides a second 
illustration of PwC's flawed process for developing, marketing, 
and implementing potentially abusive or illegal tax shelters.
    The BOSS transaction was a so-called ``loss generator'' 
intended to produce either capital or ordinary income losses at 
the end of a 2-year transaction which a client could then use 
to offset other income and shelter it from taxation.\385\ It 
required a series of complex financial transactions to be 
undertaken in certain ways and at certain times to generate the 
promised tax losses.\386\
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    \385\ See ``An Overview of the Bond & Option Sales Strategy 
(`Boss'),'' Bates SEN-016966-7.
    \386\ Suppose, for example, that a client's target income to be 
sheltered was $10 million. The BOSS transaction required the client to 
invest $850,000 from personal funds and obtain a $10 million recourse 
loan from a cooperating bank. The client would then use these funds to 
purchase common shares of a newly created offshore entity, referred to 
here as Newco. A cooperating investment firm would then purchase 
preferred shares of Newco for $10.9 million. At the same time, Newco 
would borrow $10 million from the bank. Newco would then use its $31 
million in capital ($10 million from the clients, $10.9 million from 
the investment firm, and $10 million from the bank) to invest in two 
portfolios consisting of secure investments, such as 2-year money 
market obligations from the cooperating bank. Newco would also enter 
into two financial transactions known as ``swaps'' involving the $10.25 
million and $21.1 million portfolios. In the end, only $450,000 out of 
the $30 million would be actually invested into a hedge fund with a 
chance to earn profits. All $450,000 would be taken from the personal 
funds contributed by the client, while the remaining $450,000 
contributed by the client would be spent on fees paid to PwC, the bank, 
and the investment firm. At the conclusion of 2 years, Newco would 
distribute its $10.25 million portfolio to the client subject to the 
bank loan. The client would claim a $10 million capital loss upon the 
sale of his investment in Newco, while the client's loan of $10 million 
would ultimately be paid by Newco's portfolio of secure investments.
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    Like KPMG's BLIPS transaction, the BOSS transaction 
appeared to involve millions of dollars in at-risk investments 
when, in fact, the vast majority of funds used in the 
transaction were held in secure investments that posed little 
or no risk to the participating client, investment firm, or 
bank, while allegedly yielding multi-million dollar paper 
losses. The transaction typically required an out-of-pocket 
cash investment by the client equal to 8.5% of the target 
income to be sheltered or tax loss to be achieved. About half 
of that amount was used to pay fees to PwC; the investment 
advisor known as The Private Capital Management Group; the 
investment manager of the hedge fund trading account for the 
transaction, Bolton Asset Management; and Refco Bank which 
provided financing.\387\ While the transaction also required 
the client to take out a large bank loan equal to the target 
income to be sheltered, the transaction was structured so that 
``all debt can be repaid without the advance by [client] of 
additional personal funds.'' \388\ In short, the BOSS 
transaction was structured to allow the client to claim 
millions of dollars in tax losses, while limiting the actual 
funds at risk to the initial 8.5% cash contribution minus 
fees.\389\
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    \387\ ``Capital BOSS attributes,'' Bates SEN-016968. The evidence 
indicates that the typical BOSS fees for a $10 million capital loss 
transaction were as follows: PricewaterhouseCoopers--$150,000; The 
Private Capital Management Group--$150,000; Bolton Asset Management--a 
performance based fee; and Refco Bank--$100,000.
    \388\ ``Capital BOSS attributes,'' Bates SEN-016968.
    \389\ Id.
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    Like the FLIP shelter, PwC used First Union to obtain 
referrals and access to the bank's clients. In April 1999, 
senior PwC tax professionals presented the BOSS tax product to 
First Union's Financial Advisory Services Due Diligence 
Committee. The meeting minutes attest that both First Union and 
PwC understood that ``[t]his strategy will be a tax shelter due 
to the high level of leverage.'' \390\ First Union ultimately 
referred 25 investors to PwC for BOSS presentations.\391\
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    \390\ Minutes dated 4/22-23/99, of a meeting of First Union's 
Financial Advisory Services, Enhanced Investment Strategies, Risk 
Management Process/Due Diligence Committee, (``Basis Offset Strip 
Strategy (`BOSS') strategy minimizes ordinary income and/or capital 
gains. . . . The strategy will be in place by July to give as much time 
as possible between the steps of the strategy. This strategy will be a 
tax shelter due to the high level of leverage.''), Bates SEN-014588-89.
    \391\ Letter dated 5/10/04 from PricewaterhouseCoopers to the 
Subcommittee, at 1.
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    In 1999, PwC was in the process of selling 120 BOSS 
transactions in exchange for substantial fees.\392\ The 
evidence suggests that, at the time of these sales, PwC knew 
that this shelter was highly questionable. For example, a 
critical issues outline for BOSS indicates that ``there exists 
no statutory or regulatory authority under Section 301 that 
illustrates a `reduction for liabilities' '' as assumed by the 
tax product.\393\ The document also shows PwC was aware of 
legislative efforts to bar further use of the BOSS tax product. 
It notes ``efforts underway in Congress to clarify the 
definition of `subject to a liability' as opposed to 
`assumption of a liability' '' which would have caused problems 
for BOSS, although ``PWC views the current strategy--as being 
outside the scope of legislation being proposed.'' \394\ 
Despite the lack of statutory provisions supporting key 
elements of the BOSS strategy and pending legislative concerns, 
PwC continued to sell BOSS to its clients.
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    \392\ Prepared statement of Richard J. Berry, Senior Tax Partner, 
PricewaterhouseCoopers LLP, Subcommittee Hearing (11/18/03).
    \393\ BOSS--Basis Offset Strip Strategy, Critical Issues, May, 
1999, Bates SEN-014599-600.
    \394\ Id.
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    In December 1999, prior to any legislative change, the IRS 
issued Notice 1999-59 identifying the BOSS transaction as an 
abusive tax shelter.\395\ For many customers, the ``lynchpin of 
the BOSS strategy was the issuance of a PwC opinion, reflecting 
PwC's interpretation, on which customers could rely.'' \396\ 
PwC also declared in a prepared statement issued at the time of 
the IRS notice that it was providing ``advice to our clients 
with regard to legitimate tax-saving opportunities.'' \397\ 
However, after IRS Notice 1999-59 was published, PwC apparently 
declined to issue new opinion letters for BOSS.\398\
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    \395\ PricewaterhouseCooper's BOSS transaction is covered by IRS 
Notice 1999-59 (1999-52 IRB 761).
    \396\ Letter dated 9/28/00 from Donald McMullen, First Union Vice 
Chairman, Capital Management Group to James Schiro, Chief Executive 
Officer, PricewaterhouseCoopers, Bates SEN-016757-58.
    \397\ See John D. McKinnon, ``IRS Moves to Disallow a Tax Shelter 
That Generates Paper Investment Losses,'' Wall Street Journal, December 
10, 1999 at A6.
    \398\ Id.
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    Moreover, in early 2000, unlike other tax shelter 
promoters, PwC decided to refund clients approximately 85% of 
the cash they had invested in the BOSS transaction. That 
amount, according to PwC, included all fees paid by the client 
to PwC in connection with the BOSS transaction.\399\
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    \399\ Letter dated 1/5/00, from PricewaterhouseCoopers to Dear 
Investor, ``Re: Bond & Option Sales Strategy Investment,'' Bates SEN-
020060.
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    According to PwC, its negative experience with the BOSS tax 
product convinced the firm to abandon its abusive tax shelter 
activities. A senior PwC Tax Partner testified at the 
Subcommittee hearing as follows:

      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. . . .

      We got out of this business immediately. We established 
an independent and centralized quality control group. We 
strengthened our procedures ensure that we would never again 
engage in this activity. . . .

      We take responsibility for our actions, and we have 
learned from our mistakes.\400\
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    \400\ PwC prepared testimony at Subcommittee hearings (11/18/03), 
at 54-55.

    In response to questioning by Chairman Coleman, Mr. Berry 
testified that, ``with respect to the BOSS transaction, . . . 
that in my judgment is an abusive shelter, . . . With respect 
to FLIP and CDS, if not abusive, they come very close to that 
line. . . . We regret that we ever got involved in those 
transactions, and we would not do them today.'' \401\
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    \401\ Id., at 59.
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    On June 26, 2002, PwC settled with the IRS regarding the 
compliance and registration requirements of the tax law for the 
promotion of abusive tax shelters. PwC told the Subcommittee 
that it was the first accounting firm to settle with the IRS. 
PwC entered into a settlement agreement with the IRS in which 
PwC agreed to make a $10 million payment to the IRS, turn over 
certain client lists, and allow the IRS to review not only its 
quality control procedures but over 130 tax planning strategies 
intended for sale to multiple clients.\402\ According to PwC, 
the IRS reviewed their quality control procedures and told PwC 
that they were comprehensive, thorough, and effective.\403\
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    \402\ According to PricewaterhouseCoopers, none of these tax 
strategies were determined by the IRS to require tax shelter 
registration. Letter dated 5/10/04 from PricewaterhouseCoopers to the 
Subcommittee, at 5.
    \403\ Id.
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  (2) PricewaterhouseCoopers' Current Status

      Finding: PricewaterhouseCoopers has committed to 
cultural, structural, and institutional changes intended to 
dismantle its abusive tax shelter practice, including by 
establishing a centralized quality and risk management process, 
and strengthening its tax services oversight and regulatory 
compliance.

    According to PwC, after BOSS was identified by the IRS in 
December 1999, as an abusive tax shelter, PwC's senior 
management recognized that BOSS, CDS, and FLIP represented an 
``institutional failure'' and undertook a number of reforms to 
ensure that similar abusive tax shelters would not be marketed 
by PwC in the future.\404\
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    \404\ Subcommittee meeting with PricewaterhouseCoopers (5/27/04).
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    Leadership and Institutional Changes. PwC stated that, as a 
first step in late 1999, it disbanded the group of tax 
professionals responsible for the sale of FLIP, CDS, and 
BOSS.\405\ In 2000, PwC appointed a new head of its U.S. Tax 
Practice, Richard Berry, and charged him with establishing a 
centralized quality and risk management function for the firm's 
tax practice. As Head of Tax Services, Richard Berry reports 
directly to the Chief Executive Officer of PwC.
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    \405\ PwC prepared statement at Subcommittee Hearings (11/18/03), 
at 4.
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    In the summer of 2000, PwC created a new Quality and Risk 
Management group to oversee the development of new PwC tax 
products and services, prevent PwC's participation in abusive 
tax shelters, and protect PwC from reputational risk.\406\ The 
Quality and Risk Management Group (Q&RM) was established as an 
independent administrative unit within the Tax Practice 
separate from its other business units.\407\ The Q&RM head 
reports to the head of the U.S. Tax Practice. The Q&RM group 
currently has seven full-time partners and five other 
professional staff.\408\ In addition, nine tax partners in PwC 
regional offices spend one-third to one-half of their time on 
Q&RM duties, advancing quality and risk management policies and 
procedures across the firm's nine U.S. regions.\409\
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    \406\ See id., at 4.
    \407\ Subcommittee meeting with PricewaterhouseCoopers (5/27/04).
    \408\ Id.
    \409\ Id.
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    PwC told the Subcommittee that the Q&RM head was also made 
a member of PwC's Tax Core Leadership group. This group 
includes the leaders of each of PwC's tax services business 
units, and PwC indicated that the Q&RM head was included to 
ensure that Q&RM was aware of the tax products and services 
being offered by each business unit and to place the Q&RM head 
on an equal footing with PwC's other tax leaders.\410\ 
According to PwC, the Tax Core Leadership has weekly conference 
calls, face-to-face meetings once a month, and meetings with 
tax professionals three times a year.\411\
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    \410\ Subcommittee meeting with PricewaterhouseCooopers (5/27/04).
    \411\ Id.
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    Centralized Product Development Process. In addition to the 
Quality and Risk Management group, PwC established a new 
centralized tax product development process for all tax 
products and services.\412\ PwC explained that this ``quality 
review process is comprehensive and has differing levels of 
review depending upon the complexity of the issues involved.'' 
\413\ As part of this process, PwC created a new PINNACLE 
database as a centralized repository for tax service offerings 
that the firm may provide to more than one client.\414\ PwC 
requires every proposed new tax product intended to be offered 
to more than one client be entered into the database so that 
senior PwC leadership could track and monitor all product 
development. PwC also requires that its business unit leaders 
affirm annually that all of the tax products implemented for 
more than one client have been included in the PINNACLE 
database.\415\ PwC further requires the authors of specific tax 
products to review the PINNACLE database on a semi-annual basis 
to identify any compliance problems, changes in the law, or 
other matters.
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    \412\ Letter dated 5/10/04, from PricewaterhouseCoopers to the 
Subcommittee, at 6-7.
    \413\ PwC prepared statement at Subcommittee Hearings (11/18/03), 
at 5.
    \414\ Subcommittee meeting with PricewaterhouseCoopers (5/27/04).
    \415\ Id.
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    In addition, PwC established a centralized review and 
approval process for all new PwC tax products. For tax products 
that may be applicable to more than one client but not widely 
applicable, so-called ``Shared Solutions,'' PwC requires the 
proposed product to be reviewed and approved by a senior tax 
partner or recognized tax expert prior to submission into the 
PINNACLE database. Once included in the database, PwC requires 
Q&RM to review the products and determine whether Q&RM approval 
or Tax Core Leadership approval is required.
    For tax products deemed potentially suitable for national 
distribution, so-called ``Distributed Solutions,'' PwC requires 
additional levels of review. PwC told the Subcommittee that the 
proposed product must first undergo a technical analysis by 
``appropriate specialists,'' a preliminary ``qualification'' 
review by a Q&RM partner, and a preliminary review by a member 
of Tax leadership to identify potential problems. PwC indicated 
that Q&RM also has the authority to establish an independent 
review panel of experts to review the proposal further. PwC 
indicated that this panel typically consists of three tax 
partners who must be independent of the tax professionals 
developing the tax product and who must reach unanimous 
agreement on its technical merits in order for the proposal to 
advance. PwC indicated that Q&RM could also require approval of 
Tax Core Leadership which considers such factors as tax policy, 
firm ethics, and the risk of adverse publicity. PwC then 
requires final approval of the proposed ``Distributed 
Solution'' by both Q&RM and its Federal Tax Policy group.
    PwC also implemented a system requiring mandatory Q&RM 
training for all PwC tax professionals lasting 2 days every 4 
months. The required course includes computer-based training 
regarding IRS registration and list maintenance obligations.
    At the Subcommittee hearing on November 18, 2003, PwC 
testified:

      Our experience almost 4 years ago served as a wake-up 
call to the Tax practice. Our partners were adamant that we get 
out of this business immediately. We shut down the largest 
transaction and returned all of our fees. We settled with the 
IRS. We implemented comprehensive quality control procedures to 
ensure that the firm would never again be engaged in the 
marketing and development of potentially abusive tax products. 
As a firm, this was the best thing that could have happened to 
us. We acknowledge our actions and we have learned from this 
regrettable mistake.

VI. ROLE OF LAWYERS

    Accounting firms were far from the only professional firms 
active in the U.S. tax shelter industry. Some large, respected 
law firms also played a prominent role as illustrated by the 
following two case histories.\416\
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    \416\ For more information on the role of law firms in abusive tax 
shelters, see e.g., ``Helter Shelter,'' American Lawyer (12/03), at 65 
(Jenkins and Gilchrist's tax partner Paul Daugerdas wrote legal 
opinions and participated in the sale of at least 600 COBRA tax 
shelters promoted by E&Y and the Diversified Group).
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  A. SIDLEY AUSTIN BROWN & WOOD

      Finding: Sidley Austin Brown & Wood, through its 
predecessor firm Brown & Wood, provided legal services that 
facilitated the development and sale of potentially abusive or 
illegal tax shelters, including by providing design assistance, 
collaboration on allegedly ``independent'' tax opinion letters, 
and hundreds of boilerplate tax opinion letters to clients 
referred by KPMG and others, in return for substantial fees.

    Sidley Austin Brown & Wood (hereinafter ``Brown & Wood'') 
provided legal services that included design assistance on 
potentially abusive or illegal tax shelters as well as 
collaboration on opinion letters representing to clients that a 
tax product could withstand an IRS challenge. In return, Brown 
& Wood received substantial fees. According to the IRS, Brown & 
Wood provided approximately 600 opinions for at least 13 
``listed'' or other potentially abusive tax shelters, including 
KPMG's FLIP, OPIS, BLIPS, E&Y's COBRA, and PwC's BOSS.\417\ 
Brown & Wood's participation was coordinated and directed 
largely through the efforts of one Brown & Wood tax partner, 
R.J. Ruble.\418\
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    \417\ See ``Declaration of Richard E. Bosh,'' IRS Revenue Agent, In 
re John Doe Summons to Sidley Austin Brown & Wood (N.D. Ill. 10/16/03).
    \418\ Id.
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    The evidence shows, for example, that Brown & Wood had a 
close relationship with KPMG that lasted at least 5 years and 
involved at least three key KPMG tax products, FLIP, OPIS, and 
BLIPS. One of the earlier communications uncovered by the 
Subcommittee is a December 1997 email sent by R.J. Ruble to a 
KPMG tax partner informing KPMG that Mr. Ruble knew various 
people in the ``tax advantaged product'' area.\419\ While Brown 
& Wood and KPMG both deny entering into a formal agreement to 
develop or market tax products, \420\ some documents suggest 
that an alliance did exist in practice. One 1997 KPMG email 
states, for example, that KPMG and Brown & Wood had formed an 
alliance or agreement ``to jointly develop and market tax 
products and jointly share in the fees.'' \421\ Another 1997 
KPMG memorandum proposes that a Brown & Wood strategic alliance 
``can make significant contributions to the product development 
process and would allow immediate brand recognition.'' \422\ 
Still another KPMG memorandum, in 1998, discusses an upcoming 
meeting with R.J. Ruble to ``institutionalize the KPMG/B&W 
relationship.'' \423\ A 1999 Brown & Wood memorandum indicates 
that the law firm's management committee had specifically 
approved BLIPS as a new client matter for tax advice services 
to KPMG.\424\
---------------------------------------------------------------------------
    \419\ See email dated 12/24/97, from R.J. Ruble to Randall S. 
Bickham, ``Confidential Matters,'' Bates KPMG 0047356-57.
    \420\ See, e.g., letter dated 1/16/04, from Sidley Austin Brown & 
Wood to the Subcommittee at 4; Subcommittee interview of Randall 
Bickham (11/17/03).
    \421\ See email dated 12/15/97, from Randall Bickham at KPMG to 
multiple KPMG tax professionals, ``Joint Products,'' Exhibit 116.
    \422\ Memorandum dated 12/19/97, from Randall S. Bickham to Gregg 
Ritchie, ``Business Model--Brown & Wood Strategic Alliance,'' Bates 
KPMG 0047228-30.
    \423\ See Memorandum dated 3/2/98, from Randall S. Bickham to Gregg 
Ritchie, ``B&W Meeting,'' Bates KPMG 0047358-59.
    \424\ Brown & Wood New Matter Memorandum dated 1/6/99, Bates SIDL-
SCGA082444.
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    Other evidence details the nature of the interactions 
between Brown & Wood and KPMG. Some suggest that R.J. Ruble 
participated in the development of KPMG tax products like 
BLIPS. For example, an email regarding BLIPS sent on December 
3, 1998 from KPMG to various KPMG employees states:

      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. . . . [W]e are currently working 
on the document and expect to circulate it next week.\425\
---------------------------------------------------------------------------
    \425\ Email dated 12/3/98, from Randall Bickham to numerous 
recipients including R.J. Ruble, ``RE: Blips meeting,'' Bates KPMG 
0037336.

A memorandum dated December 3, 1998, from R.J. Ruble to KPMG 
demonstrates the detailed technical nature of the assistance 
contributed by Mr. Ruble to the development of BLIPS. Mr. Ruble 
---------------------------------------------------------------------------
writes:

      In looking at the bond premium rules in another context 
(i.e. a legitimate deal), I found an issue that we need to 
address for BLIPS. As I read it, the treatment of bond premium 
received by an issuer is governed by Treas. Reg. 161-12(c) and 
Treas. Reg. 1.163-13. The latter treats the premium as an 
offset to the issuer's interest deduction. The former provides 
that it not included in income when received and by reference 
to the latter. . . .

      LWhen the investor transfers the assets subject to the 
loan to the partnership, I have always assumed that the 
partnership's acquisition of the property is governed solely by 
section 721 etc. Is this true? Could 1.61-12 over ride. Even if 
it did could we also say that the drop down of [the] amount 
equal to the premium would create an offsetting deduction. Am I 
worrying too much? \426\
---------------------------------------------------------------------------
    \426\ Memorandum dated 12/3/98, from R.J. Ruble to Randy Bickham, 
George Theofel, ``Re: BLIPS,'' Bates SIDL-SCGA083244.

    Such communications indicate that Mr. Ruble was part of the 
development team for BLIPS at its earliest stages. In fact, the 
advice offered by him in his December 1998 email was provided 3 
months before KPMG initiated its formal internal review and 
approval process for BLIPS in February 1999.
    In addition to development assistance, Brown & Wood 
provided a steady steam of concurring legal opinions to 
purchasers of KPMG's FLIP, OPIS, and BLIPS tax shelters. The 
evidence also suggests that the opinion writing for these tax 
products was a collaborative rather than independent process. 
For example one Ruble email to KPMG on BLIPS asks: ``[D]id 
Shannon [KPMG employee] ever do the side by side comparison to 
make sure our legal analysis were compatible? Any changes she 
might suggest would be important.'' \427\ Another KPMG email on 
BLIPS and OPIS states:
---------------------------------------------------------------------------
    \427\ Email dated 2/3/00, from R.J. Ruble to Jeffrey Eischeid, 
``RE: RJ Ruble's email.'' Bates KPMG 0033591.

      Client just called, do we have an ETA on when we should 
be seeing the Brown & Wood OPIS opinions? It is my 
understanding the [SIC] for both BLIPS and OPIS, B&W is using 
our opinion as the starting point for their opinion? \428\
---------------------------------------------------------------------------
    \428\ Email dated 2/22/00, from Jean Monahan to Jeffrey Eischeid, 
``Subject: OPIS opinions,'' Bates KPMG 0033585.

Still another KPMG email on FLIP states: ``Brown & Wood 
requested a copy of the [FLIP] opinions to issue their 
opinion.'' \429\ Eventually, in the case of BLIPS, KPMG and 
Brown & Wood actually exchanged copies of their drafts, 
eventually issuing two allegedly independent opinion letters 
that contained numerous, virtually identical paragraphs. The 
evidence suggesting side-by-side comparisons and Brown & Wood's 
use of KPMG opinions to write its own supposedly 
``independent'' legal opinions shows that Brown & Wood and KPMG 
were close collaborators, rather than independent actors.
---------------------------------------------------------------------------
    \429\ Email dated 11/9/98, from numerous authors to numerous 
recipients, ``Subject: FLIP opinions for,'' Bates KPMG 0033447.
---------------------------------------------------------------------------
    Brown & Wood received lucrative fees for writing opinion 
letters supporting tax products like FLIP, OPIS, and BLIPS. 
Brown & Wood told the Subcommittee that it estimates that that 
the firm wrote 62 opinions for FLIP, 72 opinions for OPIS, and 
180 opinions for BLIPS.\430\
---------------------------------------------------------------------------
    \430\ Letter dated 1/16/04, from Sidley Austin Brown & Wood to the 
Subcommittee, at 2.
---------------------------------------------------------------------------
    Brown & Wood documents show that the firm was paid at least 
$50,000 for each of these legal opinions. 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 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 \431\
---------------------------------------------------------------------------
    \431\ Email dated 5/15/00, from Angie Napier to Jeffrey Eischeid 
and others, ``B&W fees and generic FLIP rep letter,'' Bates KPMG 
0036342.

Brown & Wood estimates that the firm received $3,418, 290 in 
fees from FLIP, $6,427,637 from OPIS, and $13,286,790 from 
BLIPS for a grand total of more than $23 million.\432\
---------------------------------------------------------------------------
    \432\ Letter dated 1/16/04, from Sidley Austin Brown & Wood to the 
Subcommittee, at 2.
---------------------------------------------------------------------------
    It is also important to note that most of the 
``independent'' Brown & Wood opinions apparently did not 
require extensive effort, but could be produced quickly. For 
example, an email states: ``[i]f 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.'' 
\433\ In fact, Brown & Wood reported to the Subcommittee that, 
in December 1999 alone, it issued 65 BLIPS opinions totaling 
approximately $9,290,476.\434\ This data indicates that the law 
firm issued an average of two or more BLIPS opinions per day, 
at a cost of $142,000 per opinion--very quick and lucrative 
work. Brown & Wood also estimated that, altogether, Mr. Ruble 
spent about 2,500 hours preparing legal opinions for KPMG tax 
products, a pace that, in light of the firm's overall $23 
million in fees, generated an average hourly rate of more than 
$9,000 per billable hour.\435\
---------------------------------------------------------------------------
    \433\ Email dated 7/20/97, from Angie Napier to Jeffrey Eischeid, 
``FW: brown & wood,'' Bates KPMG 0036577.
    \434\ See Billing Records, ``Cash Receipts,'' Bates SIDL-
SCGA039315; SIDL-SCGA037620; SIDL-SCBA063485; and SIDL-SCGA006056.
    \435\ Letter dated 1/16/04, from Sidley Austin Brown & Wood to the 
Subcommittee, at 2 (``it appears that approximately 2,500 hours were 
recorded by Mr. Ruble with respect to KPMG transactions.'').
---------------------------------------------------------------------------
    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.'' Brown & Wood charged the same minimum fee--more in 
cases of larger transactions--for each legal opinion it issued 
to a FLIP, 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. These fees, with few costs after the prototype 
opinion was drafted, raised questions about the firm's 
compliance with ABA Model Rule 1.5.
    At the Subcommittee hearings, Mr. Ruble, invoked his Fifth 
Amendment right against self-incrimination in response to 
questioning by the Subcommittee.\436\ Thomas R. Smith, Jr., 
former managing partner of Brown & Wood, testified that Mr. 
Ruble was virtually the only lawyer within the firm engaged in 
providing concurring opinions for generic tax products sold to 
multiple clients.\437\ He also testified that the firm Brown & 
Wood was unable to produce a copy of the firm's written 
procedures for reviewing tax opinion letters prior to 2000, and 
did not, until recently, maintain a central file of the letters 
actually sent to clients.
---------------------------------------------------------------------------
    \436\ In October 2003, Sidley Austin Brown & Wood terminated R.J. 
Ruble for breaches of fiduciary duty and violations of its partnership 
agreements.
    \437\ Prepared statement of Thomas R. Smith, Jr., Tax Partner, 
Sidley Austin Brown & Wood, at Subcommittee Hearings (11/20/03).
---------------------------------------------------------------------------
    Mr. Smith testified at the hearing that, before a tax 
opinion letter was issued by the firm, Brown & Wood had 
required approval of the draft opinion by a second tax partner, 
but the firm had no procedures for tracking compliance with 
that requirement. After the hearing, a letter provided by the 
law firm stated that none of the partners in the tax department 
considered themselves to have functioned as the requisite 
reviewing partner for the Ruble opinions.\438\ The letter also 
indicated that although the firm had made the decision to 
discontinue the practice of issuing generic tax product 
opinions in May 2001, after Brown & Wood merged with another 
law firm, Sidley Austin, the firm discovered that additional 
opinions by Mr. Ruble had been issued after the date of the 
merger, in clear violation of the firm's policy decision.\439\
---------------------------------------------------------------------------
    \438\ Letter dated 1/16/04, from Sidley Austin Brown & Wood to the 
Subcommittee, at 4.
    \439\ Id.
---------------------------------------------------------------------------
    Sidley Austin Brown & Wood told the Subcommittee that to 
correct the problems uncovered in connection with Mr. Ruble, 
the firm hired in 2003, a tax attorney whose principal 
responsibility is to monitor internal procedures respecting tax 
matters and compliance with IRS requirements.\440\
---------------------------------------------------------------------------
    \440\ Id. at 3.
---------------------------------------------------------------------------

  B. SUTHERLAND ASBILL & BRENNAN

      Finding: Sutherland Asbill & Brennan provided legal 
representation to over 100 former KPMG clients in tax shelter 
matters before the IRS, despite a longstanding business 
relationship with KPMG and without performing any conflict of 
interest analysis prior to undertaking these representations.

    Sutherland Asbill & Brennan is a law firm that played a 
very different role in the U.S. tax shelter industry. It did 
not help develop, promote, or implement tax shelters; nor did 
it write legal opinions supporting tax shelters. Instead, 
Sutherland Asbill & Brennan's role was to defend clients 
accused by the IRS of buying illegal tax shelters and 
understating their tax liabilities. Because many clients bought 
the same or similar tax shelter products from the same 
promoter, Sutherland Asbill & Brennan at times represented 
multiple clients in IRS and court proceedings, and at times 
attempted to negotiate ``global settlement agreements'' with 
the IRS that would allow multiple taxpayers to resolve their 
desputes.
    Sutherland Asbill & Brennan was one of a number of so-
called ``friendly'' law firms to which KPMG referred tax 
shelter participants for legal representation after the IRS had 
initiated enforcement action against them. KPMG apparently 
considered Sutherland Asbill & Brennan a ``friendly'' law firm 
due to the firm's longstanding and ongoing representation of 
KPMG in business litigation matters unrelated to cases 
involving tax shelters. In most of these cases, Sutherland 
Asbill & Brennan had defended KPMG against claims of 
malpractice by former clients. In fact, Sutherland Asbill & 
Brennan told the Subcommittee that, for the 4-year period from 
1998 to 2002, KPMG had paid the firm $13.9 million for legal 
representation in matters unrelated to tax shelters.\441\ In 
light of the law firm's longstanding close relationship with 
KPMG, one of the issues examined by the Subcommittee was 
whether a potential conflict of interest existed regarding this 
law firm's representation of former KPMG clients in tax shelter 
matters raising questions about the quality of advice rendered 
by KPMG to those clients.
---------------------------------------------------------------------------
    \441\ Letter dated 12/19/03, from Sutherland Asbill & Brennan to 
the Subcommittee, at Exhibit B.
---------------------------------------------------------------------------
    Sutherland Asbill & Brennan told the Subcommittee that it 
had engaged in 39 ``matters,'' involving a total of 113 
separate clients, in connection with KPMG tax products such as 
FLIP, OPIS, or BLIPS.\442\ The firm also told the Subcommittee 
that at least 17 of these ``matters'' had come from KPMG 
referrals, while an additional 8 referrals came from Quellos 
Group, which was the investment advisor for KPMG's FLIP and 
OPIS transactions, or Wachovia Bank, whose subsidiary, First 
Union National Bank, had referred bank customers to KPMG for 
tax products.\443\ This data indicates that the majority of the 
law firm's KPMG clients resulted from direct referrals by KPMG 
or other professional entities affiliated with the KPMG tax 
products.
---------------------------------------------------------------------------
    \442\ Id.
    \443\ Id., at Exhibits A and B.
---------------------------------------------------------------------------
    While both KPMG and a former KPMG client have an immediate 
joint interest in defending the validity of the tax product 
that KPMG sold and the client purchased, the interests of these 
two parties could quickly diverge if the suspect tax product is 
found to be in violation of Federal tax law. This divergence in 
interests has happened repeatedly since 2002, as more than a 
dozen lawsuits have been filed by former KPMG clients seeking 
past fees paid to the firm and additional damages for KPMG's 
selling them an illegal tax shelter.
    A lawyer has a professional responsibility to analyze 
whether a conflict of issue may impede his or her ability to 
zealously assert a client's interest. Sutherland Asbill & 
Brennan, in response to the Subcommittee's request, was unable 
to produce any written procedures for undertaking this type of 
conflict of interest analysis prior to accepting a client 
engagement. It was also unable to produce any analysis prepared 
prior to entering into its representation of former KPMG 
clients in matters involving KPMG tax products.\444\
---------------------------------------------------------------------------
    \444\ Id., at 5.
---------------------------------------------------------------------------
    The firm did produce, however, engagement letters signed by 
former KPMG clients, informing these clients of a possible 
conflict of interest should they wish to sue the accounting 
firm that sold them the illegal tax shelter. For example, each 
engagement letter signed by a former KPMG client, in which the 
client agreed to pay Sutherland Asbill & Brennan to represent 
him before the IRS in connection with a KPMG tax product, 
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).\445\
---------------------------------------------------------------------------
    \445\ See, e.g., engagement letter dated 7/3/02, between Sutherland 
Asbill & Brennan LLP and the client, Bates SA 001964.

    According to one KPMG client interviewed by the 
Subcommittee, he had not understood at the time that the above 
statement meant that Sutherland Asbill & Brennan 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.\446\ This client told the 
Subcommittee that he had hired the law firm solely on the 
recommendation of KPMG--he had never employed the firm before, 
and it did not even have an office in his state. The client 
told the Subcommittee that when he finally understood that the 
law firm was already representing KPMG in other matters, he 
switched counsel from Sutherland Asbill & Brennan to another 
firm and eventually decided to sue KPMG for selling him an 
illegal tax shelter.\447\
---------------------------------------------------------------------------
    \446\ This client asked Sutherland Asbill & Brennan LLP about the 
merits of suing KPMG and was told that the firm could not represent him 
in such a legal action. Subsequently, the client switched to new legal 
counsel.
    \447\ KPMG has told the Subcommittee that this is the only instance 
it knows in which a former KPMG client has ended up suing KPMG for 
selling an illegal tax shelter. Letter dated 12/9/03, from Sutherland 
Asbill & Brennan to the Subcommittee, at 5.
---------------------------------------------------------------------------
    This former KPMG client was apparently not the only client 
unclear about the significance of the disclosure in the 
engagement letter. For example, Sutherland Asbill & Brennan 
wrote the following to another KPMG tax shelter participant to 
clarify the significance of the disclosure:

      All this paragraph is meant to tell you is that because 
of a conflict, we could not represent you in the pursuit of any 
claim against the parties who advised you in connection with 
the transaction. It was meant to alert you to this in case you 
wanted to retain someone who was not conflicted to advise you 
of your rights in that respect.

      LThis paragraph clearly was not meant to waive any rights 
that you might have against any of the parties who advised you 
to enter into the transaction. . . .\448\
---------------------------------------------------------------------------
    \448\ Letter dated 2/13/02, from Sutherland Asbill & Brennan LLP to 
client, at 1. Bates SAB0035.

    A review of Sutherland Asbill & Brennan attorney notes to 
client files of other KPMG clients indicates that other KPMG 
clients seemed to have expressed interest in exploring the 
merits of suing KPMG and to be unaware of the law firm's 
inability to pursue such claims on the client's behalf. One 
attorney's notes state: ``I advise[d] him that I cannot advise 
[the former KPMG client] about any rights he has vis a vis 
KPMG.'' This statement was made after the former KPMG client 
had signed an engagement letter with Sutherland Asbill & 
Brennan.\449\ Another attorney's notes disclose: ``They also 
asked [about] suits against promoters. I told them that `I need 
to duck my head in the sand on these.' I purposefully try not 
to know anything.'' \450\ Later, the same client ``asked again 
about suing KPMG.'' \451\ Both of these conversations took 
place after the former KPMG client had signed an engagement 
letter with the law firm. In short, the firm's ``blanket 
disclosure'' in its engagement letter seemed to leave at least 
some clients uninformed about Sutherland Asbill & Brennan's 
longstanding relationship with KPMG and the inability of the 
law firm to consider filing suit against KPMG for selling 
illegal tax shelters, due to its duty of loyalty to its 
longtime client, KPMG.
---------------------------------------------------------------------------
    \449\ Sutherland Asbill & Brennan LLP attorney notes to file, dated 
7/14/02. Bates SAB0174.
    \450\ Id., Bates SAB0052.
    \451\ Id., Bates SAB0053.
---------------------------------------------------------------------------
    In another matter involving a former KPMG client, 
Sutherland Asbill & Brennan ``engaged KPMG'' itself to assist 
the law firm in its representation of the former KPMG client, 
including with respect to ``investigation of facts, review of 
tax issues, and other such matters as Counsel may direct.'' 
\452\ This engagement meant that KPMG, as Sutherland Asbill's 
agent, would be given 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. Sutherland Asbill & Brennan told the 
Subcommittee that, despite this engagement letter, the law firm 
never actually utilized the services of KPMG in this case. In 
still another matter, the law firm's notes suggest that a 
former KPMG client wanted to exclude all KPMG participation 
from their case, but the law firm demurred: ``The only reason I 
see to cut KPMG out completely is if they want to sue. And we 
cannot advise on that.'' \453\
---------------------------------------------------------------------------
    \452\ Engagement letter dated 9/3/02, from Sutherland Asbill & 
Brennan and KPMG, Bates SAB0180-82.
    \453\ Sutherland Asbill & Brennan LLP attorney notes to file, dated 
11/24/03. Bates SAB0024.
---------------------------------------------------------------------------
    Still another disturbing document is a 2002 email from one 
KPMG tax professional to another, later forwarded to numerous 
additional KPMG tax professionals stating that KPMG had been 
given notes taken by a Sutherland Asbill & Brennan attorney 
during a meeting with the IRS.\454\ The email states: ``Notes 
from Jerry Cohen's meeting w/IRS on the 9th. You may distribute 
this. Please not[e] the comments on Flip/Opis.'' This email 
suggests that the law firm was sharing information with KPMG 
about tax shelter discussions that the law firm held with the 
IRS while representing KPMG's former clients. This information 
was of such interest that KPMG sent it to more than three dozen 
of its tax professionals. Such information sharing--obtained on 
behalf of one client and shared with a party that is not being 
legally represented by the firm in the same manner \455\--
raises additional questions about the law firm's dual 
loyalties.
---------------------------------------------------------------------------
    \454\ Email dated 7/11/02, from Ken Jones to Jeffrey Eischeid, then 
forwarded to multiple KPMG tax professionals, Bates KPMG0027990.
    \455\ See, e.g., letter dated 11/18/03, from Sutherland Asbill & 
Brennan LLP to the Subcommittee, at 2. Bates XX-002186.
---------------------------------------------------------------------------
    The preamble to the American Bar Association (ABA) Model 
Rules states ``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 with the Sutherland Asbill & Brennan 
representation is the conflict of interest that arises when a 
law firm attempts to represent an accounting firm's former 
client at the same time it is representing the accounting firm 
itself in other matters, and the issue in controversy is a tax 
product that the accounting firm sold and the former client 
purchased. In such a case, the issue is how the attorney can 
zealously represent the interests of both its clients in light 
of potential 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.\456\ The CRS analysis concluded 
that, under ABA Model Rule 1.7, a law firm should decline to 
represent an accounting firm's 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.''
---------------------------------------------------------------------------
    \456\ 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.''
---------------------------------------------------------------------------
    Alternatively, 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. Clearly, some Sutherland Asbill & Brennan clients were 
less than fully aware of the firm's conflict of interest in 
relation to KPMG, and did not seem to receive additional 
information prior to signing an engagement letter with 
Sutherland Asbill & Brennan.

VII. ROLE OF FINANCIAL INSTITUTIONS

      Finding: Deutsche Bank, HVB Bank, and UBS Bank provided 
billions of dollars in lending critical to transactions which 
the banks knew were tax motivated, involved little or no credit 
risk, and facilitated potentially abusive or illegal tax 
shelters known as FLIP, OPIS, and BLIPS.

    The tax shelters examined in this Report could not have 
been executed without the active and willing participation of 
major banks. Banks provided the requisite loans for hundreds of 
these tax shelter transactions. Three major banks investigated 
by the Subcommittee participated in KPMG's FLIP, OPIS, and 
BLIPS.\457\ Deutsche Bank participated in 56 BLIPS transactions 
in 1999, providing credit lines to KPMG clients totaling $7.8 
billion.\458\ Deutsche Bank also participated in 62 OPIS 
transactions from 1997 to 1999, providing credit lines that 
totaled $3 billion.\459\ HVB Bank participated in 29 BLIPS 
transactions in 1999 and 2000, providing BLIPS credit lines 
that totaled about $2.5 billion.\460\ UBS AG participated in 
100 to 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.\461\
---------------------------------------------------------------------------
    \457\ NatWest apparently also participated in a significant number 
of BLIPS transactions in 1999 and 2000, providing credit lines totaling 
more than $1 billion. 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.
    \458\ See prepared statement by Deutsche Bank at Subcommittee 
Hearings (11/20/03), at 2.
    \459\ Id.
    \460\ See prepared statement by HVB Bank at Subcommittee Hearings 
(11/20/03), at 5.
    \461\ 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).
---------------------------------------------------------------------------
    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 makes it plain that the banks were aware that the tax 
products were potentially abusive and carried a risk to the 
reputation of any bank choosing to participate in it. In 
exchange for their active and knowing participation, the banks 
obtained lucrative fees. For example, Deutsche Bank obtained 
$44 million in bank fees from the BLIPS transactions, and $35 
million from OPIS, for a grand total of $79 million.\462\ HVB 
obtained 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.'' \463\
---------------------------------------------------------------------------
    \462\ See prepared statement by Deutsche Bank at Subcommittee 
Hearings (11/20/03), at 2.
    \463\ 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.
---------------------------------------------------------------------------

  A. DEUTSCHE BANK

    The critical role played by major banks in KPMG's tax 
shelter activities is illustrated by Deutsche Bank's 
participation in 56 BLIPS transactions in 1999.
    A number of Deutsche Bank documents show 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 affairs. 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 [Risk & Resources] 
Committee to approve reputation risk on BLIPS. This will be 
dealt with directly by the Tax Department and [Deutsche Bank 
Americas Chief Executive Officer] John Ross.\464\
---------------------------------------------------------------------------
    \464\ Email dated 7/30/99, from Ivor Dunbar of Deutsche Bank, DMG 
UK, to multiple Deutsche Bank professionals, ``Re: Risk & Resources 
Committee Paper--BLIPS,'' Bates DB BLIPS 6554. 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.\465\
---------------------------------------------------------------------------
    \465\ 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.'' \466\
---------------------------------------------------------------------------
    \466\ 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 Deutsche Bank Americas' Chief Executive Officer John Ross, 
who made the final decision on the bank's participation.\467\ 
Minutes describing the meeting in which Mr. Ross approved the 
bank's participation in BLIPS state:
---------------------------------------------------------------------------
    \467\ 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.\468\
---------------------------------------------------------------------------
    \468\ 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 was fully aware of 
the nature of the financial product they would be financing.
    Additional evidence shows that Deutsche Bank was aware that 
the BLIPS loans it had been asked to provide were not standard 
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, 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.'' \469\ 
When the bank declined to make the requested representation, 
the KPMG's 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.'' 
\470\ He tried a third time and reported: ``I've pushed really 
hard for our original language. To say they are resisting is an 
understatement.'' \471\ 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.'' \472\
---------------------------------------------------------------------------
    \469\ Email dated 3/20/00, from Jeffrey Eischeid to Mark Watson, 
``Bank representation,'' Bates KPMG 0025754.
    \470\ Email dated 3/27/00, from Jeffrey Eischeid to Richard Smith, 
``Bank representation,'' Bates KPMG 0025753.
    \471\ Email dated 3/28/00, from Jeffrey Eischeid to Mark Watson, 
``Bank representation,'' Bates KPMG 0025753.
    \472\ 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.\473\
---------------------------------------------------------------------------
    \473\ Email dated 6/20/00, from William Boyle to multiple Deutsche 
Bank professionals, ``Updated Presidio/KPMG trades,'' Bates DB BLIPS 
03280.

    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. At the Subcommittee hearing on November 
20, when asked about this proposal, the Deutsche Bank 
representative seemed to deny that the bank had actually 
presented it to HVB, while HVB testified that Deutsche Bank 
had, in fact, made the proposal to HVB which declined to accept 
it.\474\
---------------------------------------------------------------------------
    \474\ See Subcommittee Hearings (11/20/03), at 114.
---------------------------------------------------------------------------
    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.'' \475\ The 
presentation listed as the bank's ``strengths'' its ability to 
lend funds in connection with BLIPS and its ``relationships 
with [the] `promoters' ''\476\ later named as Presidio and 
KPMG.\477\ An internal bank email a few months earlier asked: 
``What is the status of the BLIPS. Are you still actively 
marketing this product[?]'' \478\
---------------------------------------------------------------------------
    \475\ Email dated 4/3/02, from Viktoria Antoniades to Brian McGuire 
and other Deutsche Bank personnel, ``US GROUP 1 Pres,'' Bates DB BLIPS 
6329-52, attaching a presentation dated 11/15/99, entitled ``Structured 
Transactions Group North America,'' at 6336, 6346.
    \476\ Id. at 6337.
    \477\ Id. at 6346.
    \478\ Email dated 7/19/99, involving multiple Deutsche Bank 
employees, ``Update NY Issues,'' Bates DB BLIPS 6775.
---------------------------------------------------------------------------
    In light of the bank's concerns regarding the reputational 
risk associated with BLIPS, the bank discussed using attorney-
client privilege to conceal its activities. In an internal 
email, one Deutsche Bank employee wrote to another regarding 
the BLIPS risk analysis documents: ``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).'' \479\ 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'':
---------------------------------------------------------------------------
    \479\ 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.\480\
---------------------------------------------------------------------------
    \480\ Email dated 7/30/99, from Ivor Dunbar of Deutsche Bank, DMG 
UK, to multiple Deutsche Bank professionals, ``Re: Risk & Resources 
Committee Paper--BLIPS,'' Bates DB BLIPS 6554.

    Despite the bank's apparent 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.\481\ At the 
Subcommittee hearings, although the Deutsche Bank 
representative testified that, ``it was very clear from the 
opinions and everything that there were significant tax 
benefits that the investor may report on its return'' from the 
BLIPS transaction, he resisted characterizing BLIPS as a ``tax-
driven'' transaction, as set forth in an internal bank 
document.\482\
---------------------------------------------------------------------------
    \481\ Subcommittee interview of Deutsche Bank (11/10/03).
    \482\ See Subcommittee Hearings (11/20/03), at 107-112.
---------------------------------------------------------------------------
    Deutsche Bank told the Subcommittee that, in October 2000, 
it reorganized and refocused the business strategy of the 
Structured Transaction Group that had been handling tax 
products like BLIPS. According to Deutsche Bank, the group is 
now called the Structured Capital Markets Group and does not 
execute tax advantaged transactions such as BLIPS to multiple 
clients. Instead, the bank provides investment and borrowing 
services to meet specific client requirements.\483\
---------------------------------------------------------------------------
    \483\ Letter dated 1/9/04, from Deutsche Bank's legal counsel to 
the Subcommittee, at 2.
---------------------------------------------------------------------------

  B. HVB BANK

    HVB Bank participated in 29 KPMG BLIPS transactions during 
1999 and 2000, providing credit lines totaling about $2.2 
billion and generating millions of dollars in bank fees. 
According to HVB, Robert Pfaff first approached HVB Bank in 
late August or early September 1999 to solicit their 
participation in BLIPS.\484\ Mr. Pfaff, a former KPMG tax 
professional, was then an employee of Presidio, the investment 
firm assisting KPMG with BLIPS transactions. During that 
initial meeting, Mr. Pfaff told HVB that KPMG and Presidio 
worked together to develop the structure of the investment 
transaction and wanted HVB to provide financing.\485\
---------------------------------------------------------------------------
    \484\ Subcommittee interview of HVB Bank (10/29/03).
    \485\ Id.
---------------------------------------------------------------------------
    According to HVB, as a result of that meeting, HVB Bank was 
put in touch with Deutsche Bank which provided HVB with copies 
of draft loan documentation.\486\ Presidio then arranged a 
meeting in which its staff explained the BLIPS transaction and, 
according to HVB, emphasized that BLIPS was an investment 
strategy. HVB told the Subcommittee, however, that it was clear 
to HVB at this meeting that BLIPS had inherent tax 
benefits.\487\ In addition, HVB told the Subcommittee that 
Presidio had indicated that Stage I of BLIPS was to start and 
end within the same calendar year, requiring HVB to participate 
in the transaction by no later than October 1999.\488\ 
Handwritten notes stemming from this meeting with Presidio also 
characterize the 7% fee charged to KPMG clients for BLIPS as 
``paid by investor for tax sheltering.'' \489\
---------------------------------------------------------------------------
    \486\ Id.
    \487\ Id.
    \488\ Id. HVB told the Subcommittee that, although BLIPS was 
represented as a 7-year investment program, HVB knew that BLIPS was a 
60-day transaction driven by tax benefits. In fact, HVB's credit 
request documentation given to senior management for approval of BLIPS 
states: ``HVB has been approached by Presidio to make the series of 7-
year premium term loans noted above to the investment vehicles of 
individuals interested in investing in Presidio's product. . . . HVB 
will earn a very attractive return if the deals 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% 
. . .),'' BLIPS credit request dated 9/14/99, Bates HVB 000148.
    \489\ Undated one-page, handwritten document outlining BLIPS 
structure entitled, ``Presidio,'' which Alexandre Nouvakhov of HVB 
acknowledged during his Subcommittee interview had been written by him, 
Bates HVB 000204.
---------------------------------------------------------------------------
    At the Subcommittee hearing, when asked whether the bank 
knew that BLIPS was a transaction that had been designed to 
avoid taxes, HVB's representative stated, ``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.'' \490\ He also denied learning 
later that BLIPS was primarily a tax avoidance scheme.\491\ HVB 
Bank indicated further that, at the time it became involved 
with BLIPS, KPMG had provided the bank with an opinion stating 
that BLIPS complied with Federal tax law and the bank felt it 
could rely on that opinion. 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:
---------------------------------------------------------------------------
    \490\ Subcommittee Hearings (11/20/03), at 102.
    \491\ Id. at 103.

      LDisallowance 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.\492\
---------------------------------------------------------------------------
    \492\ Credit request dated 9/26/99, Bates HVB 001166.

    A year later, when it became clear that the IRS would list 
BLIPS as an abusive tax shelter, an internal HVB memorandum 
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 believes 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.\493\
---------------------------------------------------------------------------
    \493\ 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 that the 
apparent bank risk in lending substantial sums to a shell 
company 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.\494\ The bank explained, for example, 
that from the time the loan was issued, 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 low-risk bank-approved investments.\495\ 
These requirements 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.'' \496\ HVB also wrote: ``The Permitted Investments . . 
. are either extremely conservative in nature . . . or have no 
collateral value for margin purposes.'' \497\ 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.'' \498\ As indicated earlier, both Deutsche Bank and 
HVB received lucrative fees in exchange for providing the low-
risk loans KPMG clients needed.
---------------------------------------------------------------------------
    \494\ Subcommittee interview of HVB representative (10/29/03).
    \495\ 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 60 days at its option.'').
    \496\ 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.'')
    \497\ BLIPS credit request dated 9/14/99, Bates HVB 000155.
    \498\ Document dated 3/4/99, ``BLIPS--transaction description and 
checklist,'' Bates KPMG 0003933-35.

    Documents related to two transactions that allegedly took 
place in 1999, involving HVB clients, raise further questions 
about the investments allegedly undertaken by HVB in connection 
with the BLIPS transactions. 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 Mobile 
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.\499\
---------------------------------------------------------------------------
    \499\ 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, HVB then 
``reversed'' the referenced 1999 currency trades and executed 
them the next month in early 2000.\500\ When asked about this 
matter, HVB told the Subcommittee that they had been unaware of 
this email exchange, that the bank could not make currency 
trades ``look as though they did not occur at all,'' and they 
would research the transactions to locate the paperwork and 
determine whether, in fact, the trades or paperwork had been 
altered.\501\
---------------------------------------------------------------------------
    \500\ 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.
    \501\ Subcommittee interview of HVB bank representatives (10/29/
03).
---------------------------------------------------------------------------
    HVB later told the Subcommittee that it had been unable to 
``locate any tickets documenting the original or reversing 
trades.'' \502\ In fact, HVB said that trade tickets had not 
been created for many of the currency transactions associated 
with the BLIPS transactions.\503\ HVB explained that the lack 
of documentation meant that the bank was unable to evaluate 
either the specific trades or the paperwork. In a letter to the 
Subcommittee dated January 12, 2004, HVB theorized that the 
original transactions had been executed in error and the bank 
had executed another foreign currency transaction to offset the 
results of the first trade. HVB also told the Subcommittee 
that, because the bank is not a tax advisor, it could not 
explain the email's assertion that the original trades had 
negative ``tax consequences'' requiring correction.\504\
---------------------------------------------------------------------------
    \502\ Letter dated 1/12/04 from HVB's legal counsel, Caplin & 
Drysdale, to the Subcommittee, at 3.
    \503\ Subcommittee interview with HVB's legal counsel, Caplin & 
Drysdale (2/20/04).
    \504\ Id.
---------------------------------------------------------------------------
    HVB's inability to find any of the trade tickets 
documenting the currency trades discussed in the email is 
disturbing. Its admission that the bank often failed to prepare 
documentation for BLIPS-related currency trade raises added 
concern, since such paperless trades are not only contrary to 
normal banking and securities practice, but raise questions 
about whether the trades actually took place or were simply 
bookkeeping shams undertaken to justify a BLIPS client's 
alleged tax losses.

  C. UBS BANK

    UBS AG, one of the largest banks in the world, participated 
in 100 to 150 FLIP and OPIS transactions in 1997 and 1998, 
providing credit lines for KPMG clients which, in the 
aggregate, were in the range of several billion Swiss francs. 
UBS told the Subcommittee that it became involved with these 
tax products after being contacted by KPMG and the Quellos 
Group and asked to assist in KPMG's FLIP and OPIS transactions, 
referred to collectively by UBS as ``redemption transactions.'' 
\505\
---------------------------------------------------------------------------
    \505\ Subcommittee interview of UBS representative (10/28/03).
---------------------------------------------------------------------------
    UBS documentation clearly and repeatedly describes these 
transactions as motivated by tax considerations. 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 emphasized 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''].\506\
---------------------------------------------------------------------------
    \506\ 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 UBS000009-15.

At another point, the UBS document explains the ``Economic 
Rationale'' for redemption transactions to be: ``Tax benefit 
for client,'' \507\ while still another UBS document states: 
``The motivation for this structure is tax optimization 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.'' 
\508\
---------------------------------------------------------------------------
    \507\ Id. at Bates UBS000010.
    \508\ UBS internal document dated 11/13/97, ``Description of the 
UBS `Redemption' Structure,'' Bates UBS000031.

    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.

      LMy 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. . . .

      LP.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.\509\
---------------------------------------------------------------------------
    \509\ Letter dated 2/12/98, addressed to SBC Warburg Dillon Read in 
London, Bates UBS000038.

In response to the letter, UBS halted all redemption trades for 
several months.\510\ UBS apparently examined the nature of 
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.\511\
---------------------------------------------------------------------------
    \510\ 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.'').
    \511\ 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.

  D. FIRST UNION NATIONAL BANK

      LFinding: First Union National Bank promoted to its 
clients generic tax products which had been designed by others, 
including potentially abusive or illegal tax shelters known as 
FLIP and BOSS, by introducing and explaining these products to 
its clients, providing sample opinion letters, and introducing 
its clients to the promoters of the tax products, in return for 
substantial fees.

    Deutsche Bank, HVB Bank, and UBS helped KPMG implement its 
tax products by providing KPMG clients with substantial 
financing and securities transactions necessitated by the tax 
products. Other banks, such as, Wachovia Bank, acting through 
First Union National Bank, played a different role, assisting 
KPMG by providing client referrals and marketing assistance for 
its tax products, in return for substantial fees. The 
Subcommittee investigation determined that First Union provided 
this same assistance to other tax shelter promoters, including 
PricewaterhouseCoopers, and, in fact, had implemented a 
systematic review and approval process for offering a variety 
of third-party tax shelter products to First Union clients.
    The manager of First Union's Financial Advisory Services 
Group describes the development of this review and approval 
process in a 1999 email:

      The Financial Advisory Services Group (FAS), 
specifically the Personal Financial Consulting Group within FAS 
began introducing Enhanced Investment Strategies 
(``Strategies'') to qualified First Union clients under the 
direction of my predecessor, Ralph Lovejoy in 1997. Ralph left 
First Union in April 1998 to join Quadra Investments and later 
TPCMG. Both firms have been heavily involved in the creation of 
leading edge strategies.

      When I was appointed manager of FAS in April 1998, 
Personal Financial Consulting was in the process of being 
introduced to certain strategies offered by KPMG. KPMG was 
offering these strategies through Quadra Investments. The law 
firm of Pillsbury Madison had written a tax opinion letter on 
both, but we wanted a Big 5 firm to write one if we were going 
to consider introduction of these strategies to any of our 
clients. As the year progressed, KPMG could not reach a 
decision as to whether or not to write the tax opinion letter 
on each strategy so Quadra (Ralph Lovejoy) introduced us to 
PriceWaterhouseCoopers, who was also familiar with both 
strategies and had been writing a tax opinion on them.

      As I learned more and more about these strategies, it 
was evident that a due diligence process needed to be 
established to more formally evaluate and select which 
strategies and/or strategy providers should be considered 
before introducing any strategies to future clients. As a 
result, in early 1999 we established a Due Diligence Committee 
(see attached) and sent an RFP to contacts we or our integral 
partners with First Union had with four of the five Big 5 
firms. (see attached). We met with these firms (KPMG, PWC, 
Deloitte & Touche and Arthur Andersen) and received formal 
responses from KPMG and PWC indicating their interest in 
presenting their strategies to the newly formed Due Diligence 
Committee. After review of each strategy and strategy provider 
(including review of both financial and non-financial facts), 
the committee approved KPMG and PWC as strategy providers on 
April 9, 1999 and, the use of three strategies for 1999, one of 
which included [PwC's] BOSS. For each strategy reviewed and 
approved by the Committee, the strategy provider agreed to 
write a tax opinion of at least ``More likely than not.'' \512\
---------------------------------------------------------------------------
    \512\ Letter dated 12/17/99, from Diane Stanford to Gail Fagan, 
``RE: BOSS,'' Bates SEN-016895-6.

This document shows that First Union began introducing banking 
clients to third-party tax products as early as 1997. In 
addition, it shows that, in 1999, the bank set up a formal 
procedure to evaluate specific tax shelter promoters and their 
tax product offerings. As a result, in April 1999, First Union 
formally approved making client referrals to KPMG and PwC and 
offering these firm's tax products to its clients.\513\
---------------------------------------------------------------------------
    \513\ First Union also provided referrals to strategy providers 
other than KPMG and PwC. According to a former First Union employee, 
the due diligence process was designed in part to centralize referrals 
of various strategies and strategy providers to banking clients. 
Multiple banking groups were providing referrals of various strategies 
and strategy providers designed by law firms and investment advisors. 
Subcommittee interview with former First Union employee (5/27/04).
---------------------------------------------------------------------------
    First Union explained to the Subcommittee how its new 
procedure worked in practice. It said that its relationship 
managers or trust specialists who dealt with wealthy bank 
customers typically identified suitable potential clients for 
third-party tax products.\514\ These bank employees then 
referred the clients to First Union's Financial Advisory 
Services Group. The FAS Group, in turn, assigned senior 
advisers within its Personal Financial Consulting Group to 
explain the particular tax products to the clients and arrange 
introductions to KPMG, PwC, or other tax shelter promoters such 
as Quellos Group.\515\
---------------------------------------------------------------------------
    \514\ Subcommittee interview with First Union representatives (5/
21/04).
    \515\ Id.
---------------------------------------------------------------------------
    First Union told the Subcommittee that, with respect to 
KPMG and PwC tax products, First Union typically received 
$100,000 for each client referral.\516\ This fee was then split 
between the relationship manager or trust specialist who had 
identified the client and the Financial Advisory Services group 
that had arranged the referral to KPMG or PwC.\517\ First Union 
estimated that, for the 5-year period 1997 to 2002, the 
revenues it obtained for providing client referrals on tax 
products totaled about $13 million.\518\
---------------------------------------------------------------------------
    \516\ Id.
    \517\ Id. First Union indicated that the senior advisors in 
Personal Financial Consulting were compensated indirectly through 
bonuses.
    \518\ These revenues included First Union referrals related to 
eight other tax products provided by entities other than KPMG and PwC. 
Subcommittee meeting with First Union representatives (5/21/04).
---------------------------------------------------------------------------
    First Union told the Subcommittee that its Financial 
Advisory Services Due Diligence Committee, also known as the 
Capital Management Group Risk Review Subcommittee, met 
periodically with various tax shelter promoters to discuss and 
approve specific tax products that could be presented to First 
Union clients. For example, according to the Due Diligence 
Committee's minutes, the committee met on April 27, 1999 to 
review five new tax products being promoted by KPMG and 
PricewaterhouseCoopers:

      The committee reviewed five strategies and scored each 
strategy as a committee . . .:

            KPMG PWC
          Name    Score
        --TRACT   3.85
        --IDV      2.825
        --CREW   3.52

               PWC
          Name    Score
        --BOSS    3.66
        --PACT    3.64

      Because IDV did not score a 3.0 or higher, it was 
eliminated for further consideration. Reasons for the low score 
included (a) long term time frame and the transaction causes 
high economic risk to the client and bank, (b) projected low 
demand of the product mostly due to economic risk.\519\
---------------------------------------------------------------------------
    \519\ First Union Due Diligence Committee Minutes, Bates SEN-
014577-78.

    Tax products which received the committee's initial 
approval were then sent to First Union's Capital Management 
Group (CMG) Risk Review Oversight Committee, which periodically 
met to discuss them and provide the final approval necessary 
before a tax product could be presented to First Union clients. 
For example, a CMG Risk Review Oversight Committee memorandum 
---------------------------------------------------------------------------
discusses the approval of the KPMG BLIPS transaction:

      The CMG Risk Review Oversight Committee (``committee or 
OC'') met on September 1. . . .

      Senior PFC Advisor and CMG Risk Review Subcommittee 
(``subcommittee or SC'') member Tom Newman presented an 
overview of an enhanced investment strategy for OC vote to be 
able to present it to selected First Union clients. KPMG 
brought the BLIPS strategy (referred to hereafter as the 
``Alpha'' strategy) to First Union. . . .

      Before the Alpha strategy was discussed, each member of 
the committee signed a confidentiality agreement at KPMG's 
request. In general, signing the agreement confirmed the 
understanding that committee members would hold the information 
about the strategy in the strictest of confidence and specific 
details of Alpha would not be discussed outside the meeting. . 
. .

      Highlights of the Alpha discussion:

         LThe Alpha strategy is a highly leveraged 
investment strategy that could be used to generate either a 
capital gain offset or an ordinary income offset.

         LThe strategy is to be considered only for 
individuals with more than $20 million in capital gains or 
ordinary income in either 1999 or future year. . . .

         LFirst Union's fees would be determined and 
outlined in an engagement letter entered into directly with the 
client and would approximate 50 basis points for non-KPMG 
clients who implement the strategy (minimum fee of $100,000) 
and 25 basis points for existing KPMG clients (minimum fee 
amount of $50,000). . . .

      When discussion concluded, members of the committee 
immediately and unanimously approved the strategy.\520\
---------------------------------------------------------------------------
    \520\ Memorandum dated 9/3/99, from Karen Chovan, Financial 
Advisory Services to CMG Risk Review Oversight Committee, ``Meeting 
Minutes of September 1. . . .'' Bates SEN-008629-31.

These and other documents demonstrate that First Union had an 
active and elaborate structure for the review and approval of 
third-party tax shelters to be marketed to First Union clients. 
The evidence also demonstrates that First Union was well aware 
that it was promoting products intended to reduce or eliminate 
taxes and was willing to keep these products confidential, 
perhaps in an attempt to evade IRS detection. It is also worth 
noting that First Union's due diligence process for approving 
third-party tax products nowhere required either the bank's 
legal counsel or an outside tax expert to review the technical 
merits of the proposed products to ensure compliance with the 
law.\521\
---------------------------------------------------------------------------
    \521\ Subcommittee meeting with First Union representatives (5/21/
04). First Union's legal department was apparently limited to drafting 
and approving engagement letters to banking clients.
---------------------------------------------------------------------------
    Once a KPMG or PwC tax product was approved by First Union, 
\522\ the bank appears to have expended considerable effort to 
interest its banking clients, arrange a meeting with the 
promoter, and facilitate sales. The extent of First Union's 
efforts is illustrated in this letter written by a First Union 
banking client who purchased a FLIP tax product but never 
received a promised legal opinion supporting it. The client 
wrote:
---------------------------------------------------------------------------
    \522\ First Union approved KPMG's BLIPS, FLIP, and SC2 tax products 
for their banking clients. See memorandum dated 9/3/99, from Karen 
Chovan, Financial Advisory Services to CMG Risk Review Oversight 
Committee, ``Meeting Minutes of September 1 . . .'' Bates SEN-008629-
008631 (approving BLIPS); memorandum dated 6/12/00 from Karen Chovan, 
Financial Advisory Services to CMG Risk Review Oversight Committee, 
``Meeting Minutes of June 2 . . .,'' Bates SEN-008637-39 (approving 
SC2); letter from Thomas Newman to First Union customer, Bates SEN-
021020 (``we [First Union] brought to your attention a transaction 
referred to as the Bond & Option Sales Strategy (`BOSS') developed by 
Pricewaterhouse Coopers LLP (`PwC') and The Private Capital Management 
Group. . . . In connection with that transaction, First Union earned a 
fee as a selling agent.''). According to First Union, the total number 
of bank customers that actually implemented KPMG products is as 
follows: 23 FLIP; 1 OPIS, 1 BLIPS; 3 FOCUS; 3 SC2; 25 SOS. For the SOS 
strategy, First Union indicated that KPMG was involved but did not 
issue opinions. According to First Union, the following number of bank 
customers that actually implemented PwC products is as follows: 19 
BOSS; 6 CDS. Subcommittee interview of First Union representatives (5/
21/04).

      [T]he Bank [First Union] prior to the Engagement Date 
introduced the partnership to the investment counseling firm of 
QA Investments of Seattle Washington (``Quadra''). The Bank and 
Quadra together presented an Investment Strategy (the 
``Strategy'') . . . which involved the organization of an off 
shore partnership with a foreign entity for the purpose of 
making investments in foreign corporations. The Bank and Quadra 
represented the Strategy as having the foremost potential to 
make a significant profit while having in a circumstance or 
situation of an investment loss a significant income tax 
advantage. The Bank and Quadra represented that they would 
assist the Partnership in its latter efforts to engage the 
services on an independent accounting firm to provide the 
Partnership with tax advice and opinion which would address the 
Partnership's concerns pertaining to Internal Revenue Code 
---------------------------------------------------------------------------
6662.

      The Bank and Quadra represented that they would cause to 
have issued in a timely manner to the Partnership a Legal 
Opinion which could provide the Partnership with a defense in 
the event that the whole or certain aspects of the Strategy 
were ever challenged by the Internal Revenue Service (the 
``IRS'') or in the event that the tax returns of the 
Partnership were examined as regards the transaction of the 
Strategy. The Legal Opinion was to be issued by the law firm of 
Pillsbury, Madison & Sutro, LLP, its successor being: 
Pillsbury, Winthrop. LLP. The Bank and Quadra even supplied 
Partnership council with a sample draft opinion. Needless to 
say the Partnership does rely upon its receipt of the reference 
Legal Opinion and did rely upon the representations made 
regarding receipt of same in arriving at its decisions to 
engage the services of both the Bank and Quadra. The 
partnership would most likely not have invested in the Strategy 
in the absence of these representations. To the best of its 
knowledge at no time has the Partnership ever received a Legal 
Opinion from the law firm referenced nor does the Partnership 
have any knowledge of the existence of such a Legal 
Opinion.\523\
---------------------------------------------------------------------------
    \523\ Letter from Partnership to Thomas D. Newman dated 4/6/01, 
``Re: Engagement of First Union National Bank to provide financial 
advisory services,'' Bates SEN-008750-52.

    This letter as well as other evidence indicate that First 
Union expended significant effort introducing and explaining 
tax products designed by others to the bank's clients, 
providing sample opinion letters, and introducing financial 
advisors and accountants to their clients. Without these 
activities, First Union clients might not have purchased KPMG 
or PwC tax products. The $13 million in tax product fees 
obtained by First Union indicate that, because of the bank's 
activities, more than one hundred First Union clients purchased 
these and other tax products promoted by the bank.
    Because KPMG was the bank's auditor, First Union's multi-
year participation in the promotion of KPMG tax products also 
raises disturbing auditor independence issues. In 2003, the SEC 
opened an informal inquiry into whether the client referral 
arrangement used by KPMG and Wachovia violated the SEC's 
auditor independence rule. In its second quarter filing with 
the SEC in August 2003, Wachovia provided 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 had issued a ``formal order of 
investigation'' into this matter, and the bank is continuing to 
cooperate with the inquiry.
    The SEC's Business Relationship rule states: ``An 
accountant is not independent if, 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. . . .'' \524\ 
KPMG's Tax Services Manual states: ``Due to independence 
considerations, the firm does not enter into alliances with SEC 
audit clients.'' \525\ 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.'' \526\ KPMG policy is that ``[a]n oral business 
relationship that has the effect of creating an alliance should 
be treated as an alliance.'' \527\
---------------------------------------------------------------------------
    \524\ 17 C.F.R. Sec. 210.2-01(c)(3).
    \525\ KPMG Tax Services Manual, Sec. 52.1.3 at 52-1.
    \526\ Id., Sec. 52.1.1 at 52-1.
    \527\ 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 73.
---------------------------------------------------------------------------
    In Subcommittee interviews, KPMG denied any alliance with 
First Union with respect to tax product referrals, but evidence 
uncovered by the Subcommittee suggests otherwise. For example, 
an interoffice memorandum dated May 25, 1998, from First Union 
to KPMG states: ``Ted, I thought I'd write to confirm our 
discussions by phone on Friday regarding the alliance that 
[First Union National Bank] FUNB has with KPMG/Peat Marwick on 
offering Enhanced Investment Strategies (Tax Strategies) to 
selected clients. . . .'' \528\ Another First Union document, 
also in May 1998, sent by a First Union manager to other bank 
professionals, shows the bank working directly with KPMG on an 
ongoing basis to promote KPMG tax products, and its insistence 
that KPMG personnel be included in all tax product 
presentations to the bank's clients:
---------------------------------------------------------------------------
    \528\ Memorandum dated 5/25/98, from Diane Stanford to Ted 
Beringer, ``KPMG Tax Strategies,'' Bates SEN-014862-63.

      As you know . . . [w]e have agreed to a process that 
requires that our Personal Financial Consultant Sr. Advisors 
(Castrucci, Rudolph, Newman, and Martin) be introduced to the 
client FIRST and then after making a further assessment of the 
client's qualification, will bring in KPMG. It is our 
understanding that our ability to be paid a planning fee (which 
is generally in the range of $100,000) is dependent on this 
agreement with KPMG. We have been aware of some instances where 
Trust Specialists and/or Trust admin are going directly to 
Quadra, cutting out KPMG AND our planners. PLEASE COMMUNICATE 
TO YOUR SENIOR PEOPLE THAT A PLANNER MUST BE INVOLVED IN THIS 
PROCESS TO ENSURE THAT OUR ONGOING RELATIONSHIP AND AGREEMENT 
WITH KPMG IS PRESERVED.\529\
---------------------------------------------------------------------------
    \529\ See email dated 5/19/98, from Diane Stanford to multiple bank 
personnel, ``Subject: IMPORTANT UPDATE--TAX STRATEGIES,'' Bates SEN-
014864 (emphasis in original).

    Still another First Union document, written in 1999, by 
First Union's Capital Management Group, to provide an overview 
of the bank's client referral services states: ``CMG has 
entered into agreements with outside investment advisors in 
order to bring leading edge investment techniques to First 
Union customers (and prospects). . . . [A]s part of this 
relationship, KPMG Peat Marwick LLP will serve as the `Tax 
Strategist and Consultant' with respect to all the investment 
strategies to protect the interests of First Union and its 
customers.'' \530\
---------------------------------------------------------------------------
    \530\ Capital Management Group Enhanced Investment Strategy Series 
Overview, Bates SEN-014700-02.
---------------------------------------------------------------------------
    Another internal First Union document, describing a 1999 
meeting between KPMG and First Union's Financial Advisory 
Services Due Diligence Committee, shows that both firms were 
fully aware that a formal alliance between the two businesses 
raised auditor independence concerns:

      Present from KPMG were Sandy Spitz and Jeff Eischeid. 
Sandy answered questions regarding their proposal to be a 
strategy provider, specifically regarding fee sharing and 
internal overlap. Regarding a fee sharing arrangement, Sandy 
stressed that KPMG and FUNB can never appear to be involved in 
a joint venture. The two organizations must always be 
independent, due to the audit relationship.\531\
---------------------------------------------------------------------------
    \531\ Minutes dated 4/23/99, of Financial Advisory Services 
``Enhanced Investment Strategies,'' ``Risk Management Process/Due 
Diligence Committee Meeting,'' Bates SEN-014588-89.

    While First Union and KPMG claim that each client paid 
First Union directly, and there was no fee sharing arrangement 
nor referral fee paid by KPMG to First Union, the evidence 
suggests that such claims attempt to elevate form over 
substance. The overwhelming evidence is that KPMG and First 
Union had an on-going alliance to promote the sale of KPMG tax 
products to First Union customers.\532\ In the Subcommittee's 
view, this relationship comprised a ``direct or material 
indirect business'' relationship between the bank and its 
auditor.
---------------------------------------------------------------------------
    \532\ First Union denies any formal agreement or alliance despite 
the language used in these documents. Subcommittee meeting with First 
Union representatives (5/21/04).
---------------------------------------------------------------------------

VIII. ROLE OF INVESTMENT ADVISORS

      Finding: Some investment advisors, including Presidio 
and Quellos, assisted in the development, design, marketing, 
and execution of potentially abusive or illegal tax shelters 
such as FLIP, OPIS, and BLIPS.

    Investment advisors also played a major role with respect 
to the development, marketing, and implementation, of generic 
tax shelters sold to multiple clients. The Subcommittee's in-
depth examination of KPMG tax shelters provided a detailed view 
of this role with respect to two investment firms: Presidio 
Advisory Services and the Quellos Group, formally known as 
Quadra.
    Both Presidio and Quellos assisted in the development and 
design of potentially abusive or illegal tax shelters sold by 
KPMG. Both assisted in the marketing of these tax shelters to 
multiple clients. In addition, both assisted KPMG in the 
implementation of these tax shelters by establishing 
partnerships, participating in loans, and executing some of the 
currency or security trades required to produce the claimed tax 
benefits for KPMG clients. In addition, each had relationships 
with banks that were instrumental in providing the client loans 
necessary for the tax shelters, as well as certain investment 
services. Presidio and Quellos were far from alone in providing 
such services in the tax shelter industry. Many other 
investment advisors such as the Diversified Group, Bolton 
Capital Planning, The Private Capital Management Group, and 
Bricolage Capital have provided similar services with respect 
to tax shelters that were developed and promoted by others.

A. PRESIDIO ADVISORY SERVICES

    Robert Pfaff and John Larson are two former KPMG employees 
who left the firm in 1999, to form Presidio Advisory 
Services.\533\ While at KPMG, Mr. Pfaff was a partner and Mr. 
Larson was a senior manager. Evidence uncovered by the 
Subcommittee shows that Mr. Pfaff played an instrumental role 
in formulating KPMG's business plan for promoting generic tax 
shelters to multiple clients. For example, in July 1997, a 
month before he left KPMG, Mr. Pfaff wrote a memorandum to the 
top two officials in KPMG's tax practice with a number of 
suggestions for KPMG's Tax Advantaged Transaction Practice.'' 
\534\ The memorandum stated, for example, that KPMG needed to 
reward ``idea-generators'' for tax products, a suggestion later 
carried out by KPMG's Tax Innovation Center.\535\ It 
recommended that KPMG ``gain entrance to the international 
banking, investment and leasing community and have an alignment 
with the `handful' of law firms who are skilled and respected 
in this area.'' \536\ KPMG eventually formed relationships with 
Deutsche Bank, HVB, First Union, Sidley Austin Brown & Wood, 
and others, as chronicled in this Report.
---------------------------------------------------------------------------
    \533\ Messrs. Larson and Pfaff 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'').
    \534\ See email dated 7/29/97, from Larry DeLap to multiple KPMG 
employees, ``Subject: Revised Memorandum,'' Bates KPMG JAC331160-69.
    \535\ Id.
    \536\ Id.
---------------------------------------------------------------------------
    Mr. Pfaff also recommended that KPMG establish a 
relationship with an investment firm, such as Presidio, to 
market its tax products. He explained: ``To avoid IRS scrutiny, 
KPMG had to market its tax products as investment strategies, 
but if it characterized it services as providing investment 
advice to clients, it could attract SEC scrutiny and have to 
comply with Federal securities regulations. . . . [I]t was this 
dilemma that led me to the conclusion that KPMG needs to align 
with the likes of a Presidio.'' \537\ He expressed his desire 
for a close relationship between KPMG and Presidio with the 
``goal of developing mutually-beneficial products.'' \538\
---------------------------------------------------------------------------
    \537\ Id.
    \538\ Id.
---------------------------------------------------------------------------
    In fact, since Presidio's inception in 1997, the vast 
majority of its work has involved developing, marketing, and 
implementing tax products with KPMG.\539\ The basis for this 
working relationship was a formal operating agreement that 
Presidio and KPMG entered into in September 1997, with respect 
to the FLIP tax product. Under the terms of this agreement, 
KPMG offered Presidio the right of first refusal to present 
FLIP to KPMG clients.\540\ KPMG also committed to using its 
best efforts to introduce Presidio to its clients, on a right 
of first refusal basis.\541\ In return, Presidio offered KPMG a 
right of first refusal to promote all other tax-based products 
Presidio developed.\542\ In addition, Presidio committed to 
using its best efforts to assist KPMG in developing tax 
products that KPMG brought to Presidio's attention.\543\ KPMG 
committed to using its best efforts to assist in developing and 
distributing new tax products with Presidio.\544\ Also, KPMG 
committed that its development costs in jointly developing tax 
products with Presidio would be borne by KPMG.\545\ In July 
1998, KPMG and Presidio modified and again executed this 
agreement.\546\
---------------------------------------------------------------------------
    \539\ Subcommittee interview with Presidio representative (6/20/
03). The Presidio representative told the Subcommittee that 95% of the 
company's revenues had come from its work with KPMG.
    \540\ See Letter dated 9/19/97, from Gregg Ritchie to John Larson, 
Bates P41292-94.
    \541\ Id.
    \542\ Id.
    \543\ Id.
    \544\ Id.
    \545\ Id.
    \546\ See memorandum dated 7/2/98, from Gregg Ritchie to Larry 
DeLap, ``Subject: Presidio Operating Agreement,'' Bates KPMG 0047221-
23. KPMG later determined that the original agreement was a ``Level II 
alliance,'' as defined in KPMG's Tax Manual due to each of the parties 
``right of first refusal'' and the provisions to ``jointly develop 
products.'' See email dated 6/5/98, from Larry DeLap to Gregg Ritchie, 
``Subject: Re[2]: Presidio Alliance Form,'' Bates KPMG 0047208-17 
(stating that removal of provisions would create a Level I alliance not 
requiring Management Committee approval). This statement implies that 
the original agreement did not get the necessary Management Committee 
approval in contravention of KPMG procedures. The modified 1998 
agreement removed the two provisions.
---------------------------------------------------------------------------
    Presidio played a key role in three of the KPMG tax 
shelters examined by the Subcommittee, FLIP, OPIS, and BLIPS. 
While at KPMG, both Robert Pfaff and John Larson were part of 
the development team for FLIP. After they established Presidio, 
they implemented six FLIP transactions for KPMG.\547\ According 
to an internal KPMG email, Mr. Pfaff was also part of KPMG 
discussions to re-design FLIP, which eventually led to 
development of the OPIS tax product.\548\ The email indicates 
that, for about 6 weeks, a senior KPMG tax professional and 
Robert Pfaff 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.
---------------------------------------------------------------------------
    \547\ See email dated 6/5/098, from Larry De DeLap to Gregg 
Ritchie, ``Subject: Re[2]: Presidio Alliance Form,'' Bates KPMG 
0047208-17, at 13.
    \548\ Email dated 3/14/98, from Jeff Stein to Gregg Ritchie, 
``Subject: Simon Says,'' Bates KPMG 0034380-88.
---------------------------------------------------------------------------
    Presidio took an even more substantial role in developing 
BLIPS. According to Presidio, it initiated the development of 
this product in the fall of 1998.\549\ Whereas the idea for 
FLIP started within KPMG, and Presidio and KPMG co-developed 
OPIS, Presidio alleges that the idea for BLIPS originated in 
discussions involving Messrs. Pfaff, Larson, and two San 
Francisco based attorneys.\550\ To develop the idea further, 
Presidio told the Subcommittee that it hired Amir Makov, 
formerly with Deutsche Bank, to provide economic and investment 
expertise.\551\ Presidio told the Subcommittee that it had 
wanted to present KPMG with a polished ``turn-key'' tax product 
that could be easily sold to multiple clients.\552\ The 
evidence suggests that, at some point in 1998, Presidio formed 
a working group which also included KPMG tax professionals 
Randy Bickham, and Jeff Eischeid, and Brown & Wood's R.J. 
Ruble.\553\
---------------------------------------------------------------------------
    \549\ Subcommittee interview with Presidio representative (10/3/
03).
    \550\ Id. One attorney is believed to be George Theofel. See 
Memorandum dated 12/3/98, from R.J. Ruble to Randy Bickham, George 
Theofel, ``Re: BLIPS,'' Bates SIDL-SCGA083244; email dated 4/28/99, 
from Francesco Piovanetti to Nancy Donohue, ``Subject: presidio--
w.revisions, I will call u in 1 min.,'' Bates DB BLIPS 6911-13 (stating 
that ``Presidio, in conjunction with ICA, have developed a new product 
called BLIPS.''). George Theofel was affiliated with Jackson Tufts Cole 
& Black, a law firm in San Francisco, and later Integrated Capital 
Associates. According to Martindale-Hubbell, George Theofel is 
currently an attorney based in San Rafael, CA.
    \551\ Subcommittee interview with Presidio representative (10/3/
03).
    \552\ Id.
    \553\ See email dated 12/3/98, from Presidio Advisors to Randy 
Bickham, Jeff Eischeid, Tracie Henderson, George Theofel, and R.J. 
Ruble, ``Subject: RE BLIPS meeting,'' Bates KPMG 0037336.
---------------------------------------------------------------------------
    In addition to contributing to the development of the BLIPS 
concept, Presidio played a critical role in KPMG's internal 
evaluation of BLIPS' viability. KPMG documentation indicates 
that, at a critical meeting in May 1999, Presidio described 
BLIPS as presenting only a remote probability of producing a 
profit for the clients who bought it, thereby causing several 
KPMG tax professionals to recommend against approving the 
product for sale to clients.\554\ KPMG subsequently determined 
to approve BLIPS sales despite the concerns of its tax 
professionals, but only after also requiring Presidio and each 
BLIPS purchaser to represent in writing that BLIPS provided a 
reasonable opportunity to produce a profit. At the 
Subcommittee's hearing on November 18, 2003, a former KPMG tax 
partner, Mark Watson, testified that Presidio had essentially 
changed its analysis of BLIPS' profitability, while at the 
hearing on November 20, a Presidio representative, John Larson, 
testified that Mr. Watson may have misunderstood the firm's 
earlier analysis. Upon further questions by Subcommittee 
Chairman Coleman, however, Mr. Larson also acknowledged that 
none of the BLIPS transactions executed by KPMG clients ever 
actually made a profit. KPMG nonetheless claims to have relied 
on Presidio's representation about BLIPS' profitability in 
reaching its conclusion that BLIPS met the requirements of 
Federal tax law and could be sold to KPMG clients.
---------------------------------------------------------------------------
    \554\ See Levin Report, reproduced in the Senate hearing record, at 
178-184.
---------------------------------------------------------------------------
    In addition to contributing to the development of KPMG tax 
products, Presidio also played a key role in marketing and 
implementing them. For example, Presidio made numerous 
presentations to KPMG clients related to FLIP, OPIS, and BLIPS. 
Presidio also undertook many actions to implement the 
transactions called for by the tax products, including by 
forming partnerships, executing trades, and working with banks 
to secure client loans and develop the trading strategies for 
the tax shelter transactions. With respect to BLIPS, for 
example, Presidio initiated contact with HVB Bank in the fall 
of 1999, \555\ and then worked with HVB to help structure loan 
terms and refine the investment strategy.\556\ Earlier in 1999, 
while KPMG was still vetting BLIPS through its Washington 
National Tax review and approval process, evidence indicates 
that Presidio was already talking to Deutsche Bank about the 
product. For example, a Deutsche Bank email dated February 28, 
1999, mentions that Presidio has ``developed a new product 
called BLIPS,'' and urges the need for Deutsche Bank to get 
``TOP Level Global Markets Go Ahead to proceed.'' \557\ Another 
Presidio document, detailing the strategic business plan for 
the year 2000, suggests ``schedule[ing] a meeting with Deutsche 
Bank the week of November 15, 1999 to discuss the 2000 business 
plan and to introduce the `specs' for the `1001' product'' and 
scheduling a ``meeting with UBS in November 1999 with the goal 
of securing their buy-in as the `co-lead' bank.'' \558\
---------------------------------------------------------------------------
    \555\ Subcommittee interview of HVB Bank (10/29/03).
    \556\ See memorandum dated 9/14/99, from Robert Pfaff to Dom 
DiGiorgio, ``Subject: BLIPS loan test case,'' Bates HVB 000202.
    \557\ Email dated 4/28/99, from Francesco Piovanetti to Nancy 
Donohue, ``Subject: presidio--w.revisions, I will call u in 1 min.,'' 
Bates DB BLIPS 6911-13.
    \558\ See Presidio Year 2000 Strategic Plan, Bates KPMG 0042855-59.
---------------------------------------------------------------------------
    A final point concerns the legal obligation of tax shelter 
promoters to register their tax products with the IRS and 
maintain lists of the clients who bought them. At the 
Subcommittee hearings, a former senior tax official at KPMG, 
Larry DeLap, testified that he thought the BLIPS transaction 
should have been registered with the IRS and that Presidio 
should have completed the registration. Presidio told the 
Subcommittee in an interview, however, that while it did 
conduct activities rising to a level of a promoter, Presidio 
did not believe the KPMG transaction met the definition of a 
tax shelter under IRS regulations.\559\ Presidio failed to 
register FLIP, OPIS, or BLIPS.
---------------------------------------------------------------------------
    \559\ Subcommittee interview of Presidio representative (10/3/03).
---------------------------------------------------------------------------

B. QUELLOS GROUP

    The Quellos Group, formerly known as Quadra Capital 
Management, provided investment advisory services similar to 
Presidio with respect to KPMG's FLIP and OPIS transactions. In 
addition, Quellos promoted PwC's version of FLIP. According to 
Quellos, it began its relationship with KPMG in 1994, when 
structuring a portfolio for a mutual client. \560\ In May 1996, 
John Larson, then still employed by KPMG, called Quellos for 
assistance with structuring the investment aspects of FLIP. 
Quellos told the Subcommittee that KPMG gave it specific 
criteria under which to develop the financial transactions. 
Quellos told the Subcommittee that it had understood at the 
time that designing financial transactions with criteria such 
as using a foreign corporation's stock and options, setting up 
an offshore corporation, completing the transaction within a 
short time frame (i.e., 51 days), purchasing a warrant, and 
hedging to limit downside risk, were intended to produce 
beneficial tax consequences. Quellos also noted that the tax 
structure was developed first, and the investment strategy was 
then incorporated into the tax structure--facts which further 
demonstrate that FLIP was primarily intended as a tax 
transaction.
---------------------------------------------------------------------------
    \560\ Subcommittee interview of Quellos representative (11/7/03).
---------------------------------------------------------------------------
    Like Presidio, Quellos also helped KPMG convince a major 
bank, UBS AG, to provide financing to FLIP clients and 
participate in specific FLIP transactions.\561\ Quellos told 
the Subcommittee that, among other tasks, it worked with UBS to 
fine-tune the FLIP financial transactions, helped KPMG make 
client presentations about FLIP and, for those who purchased 
the product, helped complete the required paperwork and 
transactions, using Quellos securities brokers.
---------------------------------------------------------------------------
    \561\ See, e.g., memorandum dated 8/12/96, from Jeff Greenstein to 
Wolfgang Stolz, Bates UBS 000002 (stating with respect to FLIP, ``this 
tax motivated transaction is designed for U.S. companies requiring a 
tax loss.'').
---------------------------------------------------------------------------
    In addition to serving as the investment advisor for KPMG's 
FLIP and OPIS transactions, Quellos also served as the 
investment advisor for PwC's version of FLIP, a transaction 
which was substantially similar in all material respects to the 
KPMG version. At the Subcommittee hearings, however, Quellos 
testified that it had taken action to register with the IRS the 
FLIP transaction promoted by PwC, but not the FLIP transaction 
for KPMG. When questioned by Chairman Coleman about this 
disparate treatment, Quellos explained that it acted in 
accordance with the guidance provided by the two accounting 
firms, one of which advised it to register and the other of 
which advised it that registration was unnecessary.
    Quellos also told the Subcommittee that it subsequently 
raised the registration issue again with KPMG. On October 9, 
1997, Quellos wrote a memorandum to KPMG seeking ``a letter 
confirming earlier discussions that the redemption transaction 
[FLIP] was not required to be registered as a tax shelter.'' 
\562\ In response, KPMG wrote a memorandum on October 10, 1997, 
stating that the tax shelter registration requirements 
applicable to Quadra ``must be made by your Firm in conjunction 
with your own tax counsel,'' and that KPMG ``has determined 
that it will not register this engagement as a tax shelter.'' 
\563\ Quellos testified at the Subcommittee hearings that it 
``deferred again to their decision, viewing [KPMG] 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.'' Quellos also stated that they viewed KPMG's 
statement that Quellos had to make its own registration 
decision as an attempt by KPMG ``to absolve them of any 
liability that they may have for our decision.'' \564\
---------------------------------------------------------------------------
    \562\ Memorandum dated 10/9/97, from David L. Smith to Gregg 
Ritchie, Bates KPMG JAC 329291.
    \563\ Memorandum dated 10/10/97, from Gregg Ritchie to David L. 
Smith, Bates KPMG JAC 328964.
    \564\ Quellos testimony at Subcommittee Hearings (11/20/03), at 
127.
---------------------------------------------------------------------------

IX. ROLE OF CHARITABLE ORGANIZATIONS

      Finding: Some charitable organizations, including the 
Los Angeles Department of Fire and Police Pensions and the 
Austin Fire Fighters Relief and Retirement Fund, participated 
as counter parties in a highly questionable tax shelter known 
as SC2, which had been developed and promoted by KPMG, in 
return for substantial payments in the future.

    In the case of the SC2 tax shelter examined in this Report, 
KPMG and its clients could not have executed any SC2 
transaction without the active and willing participation of a 
special type of charitable organization, such as a governmental 
pension plan, that is authorized to own S Corporation stock and 
receive distributions or allocations of income from that stock 
without incurring a tax on unrelated business income.\565\
---------------------------------------------------------------------------
    \565\ For a more detailed description of the SC2 shelter, see the 
Levin Report, Appendix B, at 122-125.
---------------------------------------------------------------------------
    KPMG encountered difficulties in locating and convincing 
appropriate charitable organizations to participate in SC2 
transactions, but eventually convinced several tax-exempt 
entities to do so.\566\ KPMG refused to identify to the 
Subcommittee any of the tax-exempt entities it contacted in 
connection with the SC2 or any of the tax-exempt entities that 
actually participated in SC2 transactions by accepting S 
Corporation stock, claiming their identity was Atax return 
information'' that it could not disclose. The Subcommittee was 
nevertheless able to identify and interview two tax exempt 
organizations which, between them, participated in 33 of the 58 
SC2 transactions KPMG arranged.\567\ Both turned out to be 
municipal pension funds: the Los Angeles Department of Fire and 
Police Pensions, and the Austin Fire Fighters Relief and 
Retirement Fund.
---------------------------------------------------------------------------
    \566\ For more information about KPMG's efforts to locate qualified 
tax-exempt entities willing to participate in SC2 transactions, see 
Section V(A)(1) of this Report.
    \567\ Subcommittee interviews with the Fire and Police Pensions of 
Los Angeles (10/22/03) and the Austin Fire Relief and Retirement Fund 
(10/14/03) confirmed their participation in the SC2 transactions. The 
Subcommittee also learned of a fire fighter's pension fund in West 
Virginia that participated in SC2 transaction by accepting S 
Corporation stock donations.
---------------------------------------------------------------------------
    The evidence indicates that both of these pension funds 
knew that they were participating in transactions whose primary 
purpose was to provide tax benefits to each person who 
``donated'' S Corporation stock to the fund.\568\ Both pension 
funds also knew that the shares they received were intended to 
be in their possession on a temporary basis, to be followed in 
a few years by their re-sale of the shares to the original 
owners. Both pension funds agreed to participate in the 
transactions in exchange for what they hoped would be 
substantial payments in the future. The Los Angeles pension 
fund, for example, as of November 2003, had participated in 28 
SC2 transactions over 3 years, re-sold ``donated'' stock to 11 
of the original ``donors,'' and obtained $5.9 million in 
exchange, while the ``donors'' themselves attempted to shelter 
from taxation many millions of dollars in S Corporation income 
earned during the period in which the pension funds held the 
shares.
---------------------------------------------------------------------------
    \568\ While documents provided by KPMG to the pension funds made it 
clear that the persons providing stock would be able to shelter income 
through the SC2 transaction, the Los Angeles Department of Fire and 
Police Pensions indicated that it had not realized the SC2 transactions 
were elaborate tax avoidance schemes until contacted by the 
Subcommittee staff about them.
---------------------------------------------------------------------------
    On April 1, 2004, the Internal Revenue Service declared SC2 
and similar transactions to be abusive tax shelters that did 
not legally exempt S Corporation income from Federal 
taxation.\569\
---------------------------------------------------------------------------
    \569\ IRS Notice 2004-30 (4/1/04).
---------------------------------------------------------------------------

A. LOS ANGELES DEPARTMENT OF FIRE AND POLICE PENSIONS

    The Los Angeles Department of Fire and Police Pensions 
(referred to as ``Los Angeles pension fund'' or ``pension 
fund'') is a $10 billion pension fund that serves the police 
and fire departments in the city of Los Angeles, 
California.\570\ The Los Angeles pension fund participated in 
28, or nearly 50 percent, of the 58 SC2 tax products sold by 
KPMG between 1999 and 2002.
---------------------------------------------------------------------------
    \570\ Information about the Los Angeles pension fund and its 
participation in SC2 transactions is taken from documents supplied to 
the Subcommittee by the pension fund; Subcommittee staff interviews 
with representatives of the pension fund; a Statement for the Record by 
Thomas Lopez, Chief Investment Officer of the Fire and Police Pensions 
of Los Angeles, reprinted in the Subcommittee hearings (11/18/03) at 
3016 as Hearing Exhibit 153 (hereinafter ``Los Angeles pension fund 
statement''); and Responses to Supplemental Questions for the Record by 
the pension fund, reprinted in the Subcommittee Hearings at 3017-24 
(hereinafter ``Los Angeles pension fund supplemental response'').
---------------------------------------------------------------------------
    At the time of the Subcommittee hearings in November 2003, 
the pension fund held $7.3 million worth of S Corporation stock 
received through 16 SC2 transactions, and had sold back stock 
to 11 S Corporation shareholders in exchange for payments 
totaling $5.9 million.\571\ Subsequently, in December 2003, 
three more donors redeemed their S Corporation shares from the 
pension fund, while one donor revoked a gift of stock that had 
been made in an SC2 transaction.\572\
---------------------------------------------------------------------------
    \571\ See Los Angeles pension fund statement; documents supplied to 
the Subcommittee by the pension fund. In two of the instances, the 
pension fund had participated in the SC2 transactions by accepting S 
Corporation stock from KPMG clients on December 31, 1999, 3 months 
prior to KPMG's approving SC2 as a generic tax product in March 2000. 
See e-mail dated 3/30/2000, from William Kelliher to Larry DeLap and 
other KPMG personnel, ``SC2,'' Bates KPMG 0049901-03, reprinted in the 
Subcommittee Hearings at 1861-63. The pension fund also told 
Subcommittee staff that one of the 28 SC2 transactions, implemented on 
December 31, 2001, was subsequently revoked by the taxpayer on June 18, 
2002. The redemption agreement specified that redemption period did not 
begin until December 31, 2004, but the pension fund returned the stock 
without remuneration.
    \572\ Los Angeles pension fund Supplemental Response at 8.
---------------------------------------------------------------------------
    The Los Angeles pension fund told Subcommittee staff that 
KPMG had contacted it ``out of the blue'' about the SC2 tax 
shelter in the fall of 1999, and that although it willingly 
participated in the SC2 transactions, it would not have done so 
absent being approached, convinced, and assisted by KPMG.\573\ 
The pension fund also told the Subcommittee that it never 
conducted its own due diligence review into whether the SC2 
transactions complied with Federal tax law.\574\ Instead, the 
pension fund had relied upon representations made to it by KPMG 
that the transaction met the requirements of the tax code.\575\
---------------------------------------------------------------------------
    \573\ See Los Angeles pension fund statement; Los Angeles pension 
fund Supplemental Response at 2; and other documents supplied to the 
Subcommittee by the pension fund. The Los Angeles pension fund was 
contacted by Lawrence E. Manth, then a partner in KPMG's Los Angeles 
office, and Douglas P. Duncan, then a manager in the same Los Angeles 
office.
    \574\ Subcommittee staff interviews with representatives of the Los 
Angeles pension fund. The pension fund also sought and received legal 
guidance from Seyfarth, Shaw, Fairweather & Geraldson, its legal 
counsel. See letter dated 12/30/99, from Sayfarth, Shaw, Fairweather & 
Geraldson to the pension fund, reprinted in the Subcommittee Hearings 
as Hearing Exhibit 155 at 3757-66. The advice sought by the fund and 
provided by the law firm did not, however, address the tax consequences 
of the SC2 transaction, but merely the narrow issue of whether the fund 
had the legal authority to accept a donation of S Corporation stock. 
The letter stated in part:
      LIt 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 on 
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. Id. at 2. The law firm's letter to 
the pension fund also characterized the transaction as ``very 
unusual.'' Id. at 1.
    \575\ Subcommittee staff interviews with representatives of the Los 
Angeles pension fund. At the same time KPMG was marketing SC2 to tax 
exempt organizations, as explained earlier in this Report KPMG tax 
professionals were expressing uncertainty within the firm as to whether 
SC2 would withstand IRS scrutiny. See, e.g., e-mail dated 12/20/01, 
from William Kelliher to David Brockway, Bates KPMG 0012720-24 (``. . 
.In my opinion, there was (and is) a strong risk of a successful IRS 
attack on SC2 if the IRS gets wind of it.''), reprinted in Subcommittee 
Hearings as Hearing Exhibit 59, at 604-608; and e-mail dated 4/11/00, 
from Larry DeLap to KPMG's Tax Professional Practice Partners, AS-
Corporation Charitable Contribution Strategy (SC2),'' Bates KPMG 
0015631 (``This is a relatively high risk strategy.''), reprinted in 
the Subcommittee Hearings as Hearing Exhibit 50 at 584.
---------------------------------------------------------------------------
    The Los Angeles pension fund's lack of due diligence 
extended to other matters as well. For example, the pension 
fund relied upon KPMG to make sure that specific donations were 
from legitimate businesses, and frequently depended upon KPMG 
to screen donors and companies prior to its accepting 
donations.\576\ The pension fund told Subcommittee staff that 
KPMG often did not disclose the names of specific donors and 
companies to the fund until shortly before a transaction was 
entered into by the parties.\577\ Over a 3-year period, the Los 
Angeles pension fund accepted stock donations from S 
Corporations located in Arizona, California, Delaware, Georgia, 
Hawaii, Kansas, and North Carolina, relying primarily on the 
representations and due diligence conducted by KPMG.\578\
---------------------------------------------------------------------------
    \576\ Los Angeles pension fund Supplemental Response at 2-3.
    \577\ Id. at 3; Subcommittee staff interviews of representatives of 
the Los Angeles pension fund.
    \578\ Subcommittee staff interviews with representatives of the Los 
Angeles pension fund; and documents supplied to the Subcommittee by the 
pension fund related to particular transactions. The Los Angeles 
pension fund also told Subcommittee staff that, after September 2002, 
it dealt with a second professional firm, Meritage Financial Partners, 
LLC (``Meritage''), in connection with the SC2 transaction. The 
founding members of Meritage include former KPMG employees Lawrence 
Manth, Douglas Duncan, Andrew A. Atkin, and Robert E. Huber, all of 
whom had worked on the SC2 tax shelter. The California Secretary of 
State indicates that Meritage Financial Partners, LLC, filed for 
certification with the state on August 2, 2002. Meritage remains listed 
as an active business.
---------------------------------------------------------------------------
    On paper, in each SC2 transaction, the Los Angeles pension 
fund generally received 90% of an S Corporation's outstanding 
shares and was entitled to 90% of the corporation's 
distributions. Yet the pension fund did not manage or oversee 
its S Corporation holdings as if it were a true shareholder 
with a substantial financial interest in the performance of the 
corporation. For example, the pension fund indicated to the 
Subcommittee that it did not know whether the distributions, if 
any, that were made to it while it owned the S Corporation 
stock were consistent with the historical distributions of the 
S Corporation; the pension fund did not keep track of the 
annual income allocated but not distributed to it; and it did 
not know what happened to any unallocated funds after it re-
sold the shares to the original owners. When the owners of 
shares in one S Corporation asked the pension fund to redeem 
their shares earlier than the time period specified in the 
redemption agreement, so that the S Corporation could be 
purchased by another company, the pension fund relied on KPMG's 
assertion that the per share redemption price paid to the 
pension fund reflected the new, higher value of the S 
Corporation's shares.\579\
---------------------------------------------------------------------------
    \579\ Los Angeles pension fund Supplemental Response at 4-5, 7; 
Subcommittee interviews with representatives of the Los Angeles pension 
fund.
---------------------------------------------------------------------------
    Further, the Los Angeles pension fund told the Subcommittee 
that it did not expect to obtain significant amounts of money 
from the S Corporations during the period in which it was a 
shareholder, but expected instead to obtain a substantial 
payment when it re-sold the shares to the original owners or 
their S Corporation.\580\ In fact, the pension fund disclosed 
that, in many instances, the S Corporations in which it was a 
shareholder had suspended all distributions during the period 
of time in which the pension fund held its stock. The Los 
Angeles pension fund told the Subcommittee that only nine 
corporations, less than one-third of the 28 S Corporations in 
which it had holdings through SC2 transactions, had made any 
distributions to the pension fund while it was a 
stockholder.\581\ The pension fund also disclosed that at least 
six of these nine S Corporations had apparently made a 
distribution to the pension fund only to take advantage of an 
extension clause in the redemption agreement enabling the S 
Corporation owners to shelter income for an additional year if 
a distribution was made to the pension fund.\582\
---------------------------------------------------------------------------
    \580\ Los Angeles pension fund Supplemental Response at 1-2; 
Subcommittee staff interviews with representatives of the Los Angeles 
pension fund.
    \581\ In its Supplemental Response to the Subcommittee, the Los 
Angeles pension fund reported eight corporations had made 
distributions. The pension fund later informed the Subcommittee that an 
additional S Corporation had subsequently made a distribution of income 
to the fund.
    \582\ Documents supplied to the Subcommittee by the pension fund 
related to particular transactions; and Subcommittee staff interviews 
with representatives of the Los Angeles pension fund. The six instances 
in which a distribution was made by an S Corporation to the pension 
fund are as follows:
    (a) A redemption agreement between the pension fund and one S 
Corporation extended the redemption date from June 15, 2003 to June 15, 
2004, if the S Corporation made a dividend payment in the amount of 
$50,000. Although the S Corporation paid a dividend of only $9,000, the 
pension fund extended the redemption date to July 15, 2004. (b) A 
redemption agreement automatically extended the beginning of the 
redemption period date from June 30, 2002 to June 30, 2003, if the S 
Corporation made dividend payments in the amount of $75,600, before 
June 30, 2002, which it did. The S Corporation made a second dividend 
payment of $7,600 before June 30, 2003, and the pension fund again 
extended the redemption date to June 30, 2004. (c) A redemption 
agreement automatically extended the beginning of the redemption period 
date from June 30, 2002 to June 30, 2003, if the S Corporation made a 
dividend payment of $114,975. On June 25, 2002, the corporation made a 
distribution of exactly $114, 975. The S Corporation had a further 
option to extend the redemption date from June 30, 2003, to June 30, 
2004, if it made another distribution of $144,900, before June 30, 
2003. On June 27, 2003, it made a distribution of exactly $144,900. (d) 
A redemption agreement automatically extended the beginning of the 
redemption period date from June 30, 2002 to June 30, 2003, if the S 
Corporation made distributions of $144,900, to the pension fund before 
June 30, 2002. On June 26, 2002, the S Corporation, in fact, made a 
distribution of exactly $144,900. (e) A redemption agreement 
automatically extended the beginning of the redemption period date from 
July 15, 2003, to July 15, 2004, if the S Corporation made a dividend 
payment in the amount of $135,000. The S Corporation had a further 
option to extend the redemption until June 30, 2004, if it made an 
additional dividend payment of $114,975, before June 30, 2003. It paid 
dividends of $114,975, before June 30, 2003, and extended the 
redemption agreement until June 30, 2004. (f) A redemption agreement 
automatically extended the beginning of the redemption period date from 
January 2004 until January 2005, as long as the S Corporation paid the 
pension fund $30,000 in dividends. The pension fund did not provide the 
Subcommittee with the amount of dividends it received from the S 
Corporation. The pension fund did not provide information to the 
Subcommittee about the redemption agreement between the pension fund 
and a seventh S Corporation.
---------------------------------------------------------------------------
    The pension fund told the Subcommittee that, in all of the 
28 SC2 transactions in which it participated, it had expected 
to retain ownership of the S Corporation stock only for a 
specified period of time, generally 2 to 4 years, as 
established in a redemption agreement which it entered into 
with the original stock owners at the time of the stock 
assignment.\583\ The pension fund indicated that every SC2 
transaction had included an executed redemption agreement, and 
every one of the redemption agreements had enabled the pension 
fund, after holding the S Corporation stock for a specified 
period of time (typically 2, 3, or 4 years), to require the 
original stock owners or their S Corporation to redeem the 
shares.\584\ The pension fund further indicated that the SC2 
transactions had unfolded as planned, ending in a re-sale of 
stock to the owners or their S Corporation, unless the owner or 
corporation had asked the pension fund to return the shares 
earlier or later than the specified period or had otherwise 
revoked the gift. The evidence shows that there were no 
instances in which the Los Angeles pension fund sold S 
Corporation shares to any party other than the original owners 
of the stock.\585\ In addition, in all instances in which the 
pension fund returned shares to the original owners earlier or 
later than the period originally established in the redemption 
agreement, it was the owners who had requested the change.\586\
---------------------------------------------------------------------------
    \583\ Subcommittee staff interviews with representatives of the Los 
Angeles pension fund.
    \584\ Subcommittee staff interviews with representatives of the Los 
Angeles pension fund; Los Angeles pension fund Supplemental Response at 
1-3; documents provided to the Subcommittee by the pension fund related 
to specific transactions. The redemption agreement also required that 
if the tax exempt received a purchase offer from an outside party for 
the shares, the S Corporation and its shareholders had a right of first 
refusal. While none of the redemption agreements entered into by the 
pension fund explicitly required the pension fund sell its non-voting 
shares back to the original owners, there were no instances in which 
the pension fund sold S Corporation shares to any party other than the 
original owners of the stock.
    \585\ Documents supplied to the Subcommittee by the Los Angeles 
pension fund related to particular transactions; Subcommittee staff 
interviews with representatives of the Los Angeles pension fund.
    \586\ See documents supplied to the Subcommittee by the Los Angeles 
pension fund related to particular transactions. In seven of the 28 SC2 
transactions, the original owners of the shares or the related S 
Corporation had sought an early redemption (in five instances) or 
revoked the gift outright (in two instances). The pension fund 
indicated that, in some instances, Douglas Duncan from KPMG's Los 
Angeles office, acting on behalf of the original stock owners, had 
approached the pension fund about early redemption or revocation of the 
stock donation. The pension fund told Subcommittee staff that it had 
agreed to these early redemptions because ``a dollar in the hand is 
worth two in the bush.'' In other instances, the pension fund had 
agreed to an extension of the redemption period at the request of the 
original owners of the shares or the related S Corporation. In one 
other instance, the pension fund indicated that the S Corporation had 
asked the pension fund to retain ownership of the stock after the 
redemption period had lapsed, because the original owners of the shares 
did not have sufficient funds at that time to redeem the stock at fair 
market value. The pension fund then retained the stock for 11 months 
beyond the time period established in the redemption agreement. See Los 
Angeles pension fund Supplemental Response at 4.
---------------------------------------------------------------------------

B. AUSTIN FIRE FIGHTERS RELIEF AND RETIREMENT FUND

    The Austin Fire Fighters Relief and Retirement Fund 
(referred to as ``Austin pension fund'' or ``pension fund'') is 
a $400 million pension fund that serves the fire departments of 
Austin, Texas.\587\ Like the Los Angeles pension fund, the 
Austin pension fund told the Subcommittee that KPMG had 
contacted the pension fund ``out of the blue'' about the SC2 
transaction. The pension fund administrator told Subcommittee 
staff that he was ``uncertain why anyone out-of-state would be 
interested in contributing to the Austin pension fund . . . but 
that the fund could not look a gift horse in the mouth.'' \588\ 
The Austin pension fund participated in five SC2 transactions 
and received stock from S Corporations in California, 
Mississippi, New Jersey, and New York. The first transaction 
occurred in October 2000, and the last in March 2001.
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    \587\ Information about the Austin pension fund and its 
participation in SC2 transactions is taken from documents supplied to 
the Subcommittee by the pension fund; and Subcommittee staff interviews 
with representatives of the pension fund.
    \588\ Subcommittee staff interviews with representatives of the 
Austin pension fund.
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    The Austin pension fund told the Subcommittee staff that 
documents it received from KPMG in connection with the SC2 
transaction were referred to its legal counsel for review prior 
to accepting any stock donations. The pension fund indicated 
that its legal counsel conducted a due diligence review only 
with respect to the materials KPMG had provided, and concluded 
that KPMG had found a ``loophole'' or ``wording'' in the 
Internal Revenue Code which enabled the pension fund to accept 
S Corporation stock donations.\589\ However, legal counsel did 
not provide the pension fund with a written legal opinion, and 
the pension fund did not seek further legal advice from another 
outside firm before accepting S Corporation stock. The pension 
fund told the Subcommittee staff that, regardless of the advice 
it had received from legal counsel, it remained skeptical that 
such S Corporation stock donations would ever result in future 
income to the pension fund.\590\ The pension fund nonetheless 
participated in five SC2 transactions over a 6-month period.
---------------------------------------------------------------------------
    \589\ Id.
    \590\ Id., the Austin pension fund told the Subcommittee staff 
during a telephone interview conducted on May 11, 2004, that ``it 
[referring to SC2] appeared to be a tax loophole, but from the 
standpoint of our members we couldn't overlook a donation.''
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    Like the Los Angeles pension fund, the Austin pension fund 
conducted little, if any, due diligence related to the specific 
SC2 transactions presented to the fund by KPMG. For example, 
the Austin pension fund told the Subcommittee that it had 
relied on KPMG or the relevant S Corporation to determine the 
fair market value of the non-voting stock that was donated to 
the pension fund and for the value of that same stock several 
years later when the fund re-sold it to the donors or their S 
Corporation. The Austin pension fund administrator told the 
Subcommittee staff that the pension fund did not conduct any of 
its own valuations, but simply ``took KPMG's word'' regarding 
the value of the donated stock.\591\ Moreover, the fund 
administrator characterized the S Corporation stock as 
``basically useless'' and stated that he believed the fund 
would only receive income from the stock when the original 
owner repurchased it. He indicated, however, that the sentiment 
at the pension fund was not to ``look a gift horse in the 
mouth.'' \592\
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    \591\ Id.
    \592\ Id.
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    The Austin pension fund told the Subcommittee that the SC2 
transactions were, in fact, carried out as planned by KPMG. Of 
the five SC2 transactions in which the pension fund had 
participated, the Austin pension fund administrator indicated 
that one original stock owner had redeemed the shares at the 
conclusion of the period specified in the redemption agreement; 
in two instances, shares were redeemed by the original owners 
earlier than the period established in the redemption 
agreement, at their request; and two transactions remained 
outstanding.\593\
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    \593\ Id. With respect to the two transactions still outstanding, 
the Austin pension fund indicated that the redemption date for one of 
the transactions had been extended in a similar fashion as in the 
examples cited earlier with the Los Angeles pension fund, and in the 
second transaction, the original stock owner was seeking to extend the 
redemption date to a future year after the distribution of dividends to 
the Austin pension fund.
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    On April 1, 2004, the Internal Revenue Service issued a 
notice declaring the SC2 shelter and similar transactions to be 
abusive tax avoidance transactions and deeming them ``listed 
transactions.'' \594\ In addition, the IRS declared that tax 
exempt parties in the transactions would be treated as 
participants in the transactions. According to an IRS release 
accompanying the 2004 notice, it was ``the first time the IRS 
has exercised its authority under the tax shelter regulations 
to specifically designate a tax exempt party as a participant 
in a tax avoidance transaction.'' \595\
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    \594\ IRS Notice 2004-30 (4/1/04).
    \595\ ``Treasury and the IRS Issue Guidance on S Corporation, Tax 
Exempt Entity Transaction,'' IRS 2004-44 (4/1/04).
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    KPMG stopped marketing new SC2 transactions in 2002, but 
many of the 58 SC2 products it had sold previously remained 
active in 2003 and 2004. Similarly, while the Los Angeles and 
Austin pension funds told the Subcommittee that they had 
stopped entering into new SC2 transactions, both continued to 
hold S Corporation stock from earlier transactions and planned 
to re-sell their S Corporation holdings to the original stock 
owners for additional, substantial sums.

                                 
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