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The concept that all people are connected by six degrees of separation seems like something of Hollywood fiction. However, in the business world the theory seems to ring true. In a recent Wall Street Journal article discussing the ramifications of a former Silicon Valley company, it seems clear that the business world may be smaller than we think. A firm called myCFO was founded in 1999 by some of the biggest names in Silicon Valley, who also sat on the board, with the sole purpose of providing wealthy individuals a wide variety of financial services, from wealth management to estate planning. An idea that seemed simple enough, especially at a time when the technology boom resulted in a number of new millionaires looking to minimize taxes. myCFO's main tax shelter was a Custom Adjustable Rate Debt Structure ("Cards"). Each involved an ostensible 30-year bank loan to a foreign party for $50.0 million to $100.0 million. myCFO's client then assumed the loan and after some complex swapping of collateral, claimed a loss for tax purposes of almost the entire amount of the loan. At the time, myCFO was not the only firm to offer such a product, and a product such as Cards was not deemed inappropriate.

In March of 2002, the IRS ruled Cards invalid, citing that the product failed a basic test of legitimacy, in the sense that Cards lacked any real economic purpose other than to lower taxes. The agency added that clients were never really at risk for the supposed $50.0 million or more in loans. So how was the company able to operate and sell a fraudulent product for such a long period of time, without raising suspicions from clients? In typical Silicon Valley fashion, board members were closely involved with strategy and operations of the company, according to documents discovered by The Wall Street Journal directors pushed ahead with the tax-shelter business despite signs that not all was right with product. With the founders of the company looking ahead to an IPO, all of the warning signs, including internal warnings, went unheeded by management. In fact, after a 2000 warning from the IRS stating that "an artificial loss lacking economic substance is not allowable" myCFO signed up 10 new clients for fees totaling $16.0 million. In 2002, when the IRS finally ruled that Cards was an improper tax shelter, rather than closing its tax-shelter business, myCFO sought to revive the business by bringing on additional key personnel with a pipeline of tax deals. Finally, in 2005 the Cards tax shelters began to unwind in the wake of the IRS ruling. A number of key individuals involved were charged with tax evasion and conspiracy to defraud the IRS, including the co-inventor of Cards. The IRS is also investigating several banks involved, which helped arrange some of myCFO's tax shelters.

myCFO is somewhat of a poster child for tax shelter fraud, yet it begs the question of independence. Would the board members have acted the same if they had been independent? Would there have been more red flags raised regarding the business model? Why did they not heed the warnings of the IRS? How are the reputations of their advisors, both internal and external affected today?

Are we going to pay for the sins of 2007 in six to seven years, just like the investors in myCFO? How will the companies we advise today impact our reputation in the next decade? Conflicts of interest cause us all to struggle with 'doing the right thing' and hindsight in the eyes of the IRS is always 20/20. Whether we are talking about an overt tax shelter like myCFO, a less obvious conflict of interest by a board of directors with no independent voice or even the price at which we grant stock options, questions of legitimacy, fair dealing and scrutiny will always be asked.

Category(s): Valuation Thoughts
Posted by Jon Grupp at 08:27 PM | Permalink | Comments (0) | TrackBacks (0)