Presumably to head off further unpalatable government action, the law societies moved to deal with the acknowledged problem through internal codes of conduct. Adopting a model rule developed by the Federation of Law Societies of Canada, all provincial law societies have now prohibited lawyers from accepting cash in the amount of $7,500 or greater, subject to limited exceptions, and to adopt more stringent record keeping of cash receipts. The Ontario rules came into force at the end of January 2005.16 The pending constitutional challenge has been adjourned indefinitely, but may be revived if the government again tries to bring lawyers within the reporting system.
The issue remains hot. In June 2003, just months after the Canadian government exempted lawyers from the reporting requirement, the FATF revised the 40 Recommendations to include a provision that “lawyers, notaries, other independent legal professionals and accountants should be required to report suspicious transactions when, on behalf of or for a client, they engage in a financial transaction.” The 2004 Report of the Auditor General of Canada, referring to the 2003 revision of the 40 Recommendations, commented that the new exemption for lawyers “is widely regarded as a serious gap in the coverage of the anti-money-laundering legislation. It means that individuals can now do banking through a lawyer without having their identity revealed, bypassing a key component of the anti-money-laundering system.” The report went on: “The removal of lawyers from the reporting requirements of the legislation in Canada means that our anti-money-laundering system does not fully meet international standards.”
A 2004 study by criminologist Dr. Stephen Schneider of York University reported that of 149 major money-laundering and proceeds-of-crime cases the RCMP solved between 1993 and 1998, lawyers played a role in half of them.17 In most cases, the lawyers were unaware of the criminal source of funds. But, writes Schneider,
some lawyers appeared to offer services that were tailored expressly to satisfy the objectives of money laundering. This included converting substantial amounts of cash into less suspicious assets, concealing the criminal ownership of assets, incorporating numerous companies that carried out no commercial activities, fabricating or falsifying financial or legal documents, and transferring funds between bank accounts or between multiple trust account files established on behalf of client and/or companies beneficially controlled by the client for no apparent commercial reason or financial gain.
A 2005 RCMP report, Lawyers and Complicity in Criminal Conduct—Exploitation of Solicitor-Client Privilege, suggested that by insisting on an exemption from money-laundering regulations, lawyers are left “bearing the brunt of increasingly desperate criminals with vast sums of dirty drug cash needing conversion into something that can be spent without arousing suspicion.” At the beginning of October 2006, the Senate banking, trade, and commerce committee recommended that the federal government should monitor lawyers, among others, for suspicious transactions.18 On October 5, 2006, the Minister of Finance introduced a bill designed to strengthen the Proceeds of Crime (Money Laundering) and Terrorist Financing Act and bring Canada in line with the latest FATF standards, but the proposed amendments did not seriously address the problem with lawyers; indeed, the bill removed the formal requirement that lawyers report suspicious transactions.19
There remain two strongly opposed views. The international community and the Canadian government, including the RCMP and the Auditor General, remain convinced that lawyers should be brought within the official reporting system, as a critical part of the fight against organized crime and for the good of lawyers themselves. The legal profession is overwhelmingly opposed, believing that the reporting of suspicious transactions is unconstitutional and a horrible violation of the traditional and valuable rules governing the lawyer-client relationship.
Who is right? Is it really unconstitutional to require lawyers to report a financial transaction to government if there are reasonable grounds to believe that the transaction is connected to money laundering by organized crime? Would such a reporting requirement seriously erode general principles behind the average lawyer-client relationship? Is involvement by lawyers in suspicious transactions, ones that may promote and protect organized crime, best treated as an internal law society disciplinary matter? Or should we be calling the police?
I’d make that call.
SIX
A SMALL ARMY
David Cay Johnston is a Pulitzer Prize–winning journalist who covers the tax beat for The New York Times. In his 2003 book, Perfectly Legal,1 Johnston writes that “most tax cheats rely on the accounting and legal firms to craft … complex, hard to find and even harder to understand tax shelters … Like guerrilla soldiers, a small army that moves stealthily in darkness can disrupt and perhaps even destroy a society that operates in the open.” The army described by Johnston knows no borders; it operates in Canada, and other countries, as it does in the United States. As it moves stealthily in darkness, it deprives the public purse of tax revenue and raises fundamental questions about the responsibilities of lawyers and accountants to the society in which they live, work, and prosper.
In the United States, improbably, there is drama in the tax shelter world. In 2003, a Manhattan grand jury began investigating KPMG for its work on shelters sold from 1996 to 2002, complex transactions creating paper losses and bearing endearing and confidence-inspiring names like Blips, Flip, Opis, and SOS. (KPMG is one of the so-called Big Four accounting firms, and is one of the largest professional services firms in the world.) Investigators said these tax shelters created $11 billion in fake losses that cost the U.S. government $2.5 billion in tax revenue. In June 2005, KPMG issued a press release admitting that former KPMG partners had broken the law. In August 2005, the firm came to a deal with prosecutors to avoid a criminal indictment, once more acknowledging wrongdoing, and agreeing to pay almost half a billion dollars and accept an outside monitor of its operations. In a statement issued that August, KPMG acknowledged that “some KPMG tax partners and tax leaders routinely attempted to cloak in the attorney-client privilege communications that revealed the true nature of their conduct … by routinely copying an associate general counsel on e-mail communications and memoranda in an effort to conceal information contained in those communications and memoranda from the I.R.S. and others.” Days later federal prosecutors charged seventeen former employees of KPMG (including an associate general counsel), an outside investment banker, and R.J. Ruble, a former lawyer at Sidley Austin Brown & Wood (one of the world’s largest law firms, with almost two thousand lawyers and multiple offices), with conspiracy to devise and sell fraudulent tax shelters. In September 2005, addressing some of the civil claims against them arising out of legal opinions or representations given to investors, KPMG and Sidley Austin agreed to pay $195 million to about 280 investors who bought questionable shelters. (Negotiations leading to the settlement were led by class action specialist Milberg Weiss Bershad & Schulman, who were paid $30 million for their work. Milberg Weiss itself was indicted on May 18, 2006, on unrelated charges of making secret illegal payments to individuals who served as class action plaintiffs.)
KPMG and its lawyers have not been alone in all this difficulty. In 2003, Ernst & Young, another Big Four accounting firm, paid $15 million to the U.S. Internal Revenue Service to settle claims concerning tax shelters it had marketed. Several prominent law firms have been sucked into the Ernst & Young mess. Jenkens & Gilchrist, which emailed legal opinions on these Ernst & Young tax shelters to potential investors, is in arbitration with investors who paid interest and penalties because the shelters failed. The New York Times reported in January 2006 that “federal prosecutors are investigating three lawyers at a prominent Dallas law firm, Jenkens & Gilchrist, in a widening of an investigation into questionable shelters …”2 Scheef & Stone, a Dallas law firm, is a defendant in a civil action brought by investors who claim that it introduced Ernst & Young to Jenkens & Gilchrist when the accounting firm wanted legal opinions, earning fees that were not disclosed. In 1999, the Texas
law firm of Locke Liddell supplied a legal opinion to Ernst & Young, for $3.5 million, to support a tax shelter known as CDS (Contingent Deferred Swap). In 2005, a U.S. Senate subcommittee said the only purpose of CDS was “the avoidance or evasion of federal, state or local tax in a manner not intended by law.” (At the time Locke Liddell supplied the opinion, Harriet Miers was the co-managing partner. In 2005, Miers was nominated by President Bush for a U.S. Supreme Court seat, but the politically unpopular nomination was later withdrawn.)
These tax shelter scandals, and particularly the conduct of accountants and lawyers, have attracted serious attention from the U.S. Senate. In February 2005, the Permanent Subcommittee on Investigations of the U.S. Senate Committee on Homeland Security and Governmental Affairs released a report titled The Role of Professional Firms in the U.S. Tax Shelter Industry.3 Senator Norm Coleman, chairman of the subcommittee, said in a press release, “This Report details how accountants, lawyers, bankers, and investment advisors developed, implemented, and mass-marketed cookie-cutter tax shelters used to rip off the Treasury of billions of dollars in taxes.” The subcommittee found that the law firm of Sidley Austin “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 …” The report noted that Sidley Austin partner R.J. Ruble had spent about 2,500 hours preparing legal opinions for which he was paid $23 million in fees—an average hourly rate of more than $9,000 per billable hour.
On August 1, 2006, the subcommittee issued another report, this one describing a range of sophisticated schemes being used to enable U.S citizens to shift assets offshore and dodge taxes. In a press release, Senator Carl Levin, ranking Democrat on the subcommittee, said, “I’m particularly troubled by an industry of tax professionals, lawyers, trust specialists, bankers, and brokers, that permit, facilitate, promote, and exploit loopholes in the tax code. We need our professional community to be pillars of commerce rather than pillars of circumvention. We need to close these loopholes.”4 Senator Levin was quoted in The New York Times as saying, “We need to significantly strengthen the aiding and abetting statutes to get at the lawyers and accountants and other advisors who enable this cheating.”5
Canada has not enjoyed dramatic investigations of tax shelters, expressions of outrage by prominent politicians at their use and effect (using colourful phrases like “rip off”), and confessions of wrongdoing and contrition by lawyers and accountants. No one seems very interested in this complex subject or sufficiently industrious to tackle it. But one recent high-profile case, Monarch Entertainment v. Strother, has given us a look at the Canadian tax shelter industry and in the process raised fundamental questions about the conduct and principles of the legal profession. Are lawyers pillars of commerce, or pillars of circumvention? How aggressive should lawyers be in helping clients avoid paying tax? What is the extent of a lawyer’s duty to his client, and how long does that duty last? Is it based on contract, or loyalty? How much responsibility does a law firm have for a breach of the duty by one of its members?
At the end of 2006, there has yet to be a final decision in the Strother case answering these questions. The Supreme Court of Canada heard the case in October 2006; we await its judgment.
IMAGINE AN ELEGANT BOARDROOM, on a high floor in a downtown Vancouver office building, on a late autumn afternoon in 1996.6 Soft leather chairs surrounded a granite conference table. Several middle-aged men sat around this table. Some were dressed in expensive casual clothes—colourful silk shirts, designer pants and jackets, Italian shoes worn without socks. These men seemed relaxed. They looked out of the windows. They chatted quietly. The weather was good; perhaps the meeting would end soon and they could go sailing. The other men at this meeting were dressed in suits and ties (although, if you had looked under the table, you would have noticed that one was wearing cowboy boots). Each of the men in suits studied a large red book—an annotated version of the Canadian Income Tax Act. Suddenly the one wearing cowboy boots looked up. “Gentlemen,” he said dolefully. He paused, and then continued, “There is a turd in the punch bowl. There is no technical fix that avoids the new rules. The tax shelter business is over.”
The men in casual clothes liked to describe themselves as being in the movie business, but really they were brokers who sold tax shelters to wealthy Canadians, shelters derived from production services agreements entered into with Hollywood studios that wanted to produce films in Canada. These men made millions of dollars a year, in commissions and fees, selling these shelters. The men in suits were their tax lawyers; they were the ones who structured the enormously complicated transactions that made their clients rich, bobbing and weaving around arcane tax rules that the federal government kept changing in an attempt to close down shelters seen as abusive. The lawyer in cowboy boots was Robert Collingwood Strother, senior partner in the venerable Vancouver law firm of Davis & Company,7 and one of the cleverest and most imaginative tax lawyers in Canada. Strother was normally at least one jump ahead of federal tax officials, to the enormous financial benefit of his clients. But, on this particular day, there was a big problem. Maybe, just maybe, the government had finally found a way to close down film-financing tax shelters.
Davis & Company was founded in 1892. Its main office is in Vancouver, but it has smaller offices across Canada, and one in Tokyo. Today the firm has about a hundred partners. Davis has the reputation of being a solid, if somewhat dull, law firm—reliable, but not very exciting or innovative. Robert Strother’s reputation is the opposite: He is regarded as brilliant and flamboyant, but—in the eyes of some, at least—as too clever by half. A native of Calgary, son of a medical doctor, Strother graduated from Dalhousie law school in 1974 (winning the gold medal), and obtained a master’s degree in law from Harvard the following year. Before arriving at Davis, Strother moved around more than most lawyers. He practised in England and Texas between 1975 and 1977 (as an employee of Vinson & Elkins, a major Texas-based law firm that later acted as counsel to Enron Corporation); articled with Jones, Black and Company in Calgary in 1977/78; practised with Parlee Irving in Calgary from 1978 to 1980; practised in Vancouver with Lawrence and Shaw from 1980 to 1985; was a partner of Ladner Downs from 1985 to 1990; and then joined Davis & Company. Those who know Strother say that he regards himself as a member of the Canadian establishment and wants others to think of him that way.
In 1993, Strother acquired a client called Monarch Entertainment Corporation (now called 3464920 Canada Inc.). Created in 1992, Monarch’s business was the creation and sale of tax-assisted production services financing, known by the abbreviation TAPSF, which offered tax shelter to people with big incomes. “Investors” bought units in a limited partnership that theoretically was charged with producing a film. Accounting principles produced a loss to the partnership because of a carefully designed mismatch between the large expenses incurred in producing the film, mostly incurred early on, and the small fee the partnership received at the outset of the investment’s life. This loss could then be deducted by investors from other income.8 Between 1993 and 1997, Monarch closed TAPSF transactions totalling almost $460 million and had operating profits of more than $13 million. Davis was paid fees of close to $10 million, which made Monarch the firm’s second-biggest client. Largely on the strength of the Monarch billings, Strother became an important and highly paid partner of Davis & Company.
Monarch Entertainment was owned and run by Harry Knutson and Steve Cheikes, who had been introduced to each other by Strother. Knutson is a long-time West Coast investment banker, who normally acts through Nova Bancorp Group, a private investment company he founded in 1982. People consider Knutson to be smart and tough. Before creating Nova Bancorp, Knutson worked for Peter Pocklington, the controversial entrepreneur and onetime owner of the Edmonton Oilers. In a lengthy 1986 newspaper article by well-known business wr
iters Patricia Best and Ann Shortell, describing Pocklington’s unsavoury business dealings of the 1970s, Knutson was referred to as Pocklington’s “corporate lieutenant and backgammon partner.” Best and Shortell describe him as “the balding, bearding Knutson, who favored fast cars, European tailoring and $40 bottles of wine … described variously as the brains behind Pocklington and a hotshot …”9 Cheikes, a 1974 graduate of Cornell law school and originally a Los Angeles entertainment lawyer, moved to Vancouver in 1987 and began creating and operating film industry tax shelters, originally as a principal in the Beacon Group of Companies.
For some years, the Government of Canada was intent on shutting TAPSF down. It regarded the shelter as contrived, unfairly benefiting the rich and depriving the government of legitimate tax revenue. It was not swayed by the argument that TAPSF created employment in Canada by luring U.S. film production to the country (Hollywood studios took a share of the tax benefit achieved by the deferral enjoyed by individual investors), believing that other less objectionable policies could accomplish the same effect. In 1995, David Anderson, then federal Minister of National Revenue, described tax shelters like TAPSF as “abusive.”10 On November 18, 1996, as part of the government’s move against shelters, the so-called matchable expenditures rules were announced, to come into effect some months later by amendment to the Income Tax Act (the rules finally came into force on October 31, 1997). These rules were intended to defeat the mismatch of expenditures and revenue by requiring the prorating of expenditures over the life of the right to receive income. This requirement apparently destroyed the technique at the heart of TAPSF.
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