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March 29, 2004

Called to account | USM's Jeff Gramlich, an expert in tax fraud, talks about corporate malfeasance, the frustration of regulators and the role of the academy in policing business

Jeff Gramlich arrived at the University of Southern Maine School of Business last August, just as some of the largest corporate scandals in a generation were moving through courts around the country. Gramlich, a tenured USM faculty member and the L.L. Bean / Lee Surace Professor of Accounting, is an expert in corporate tax fraud, meaning the events of recent years have provided him with a rich array of case studies.

A Colorado native, Gramlich studied and taught corporate accounting in Colorado, Missouri, Hawaii and Michigan before coming to USM. A focal point of his research is a convoluted tax credit arrangement in place for more than four decades between Chevron, Texaco and the Indonesian government. Gramlich's work was highlighted in a 2002 New York Times article and was used as a case study in a subsequent book, Perfectly Legal, by a Pulitzer prize-winning Times reporter, David Cay Johnson. A paper published last year by Gramlich and co-author James Wheeler alleges Chevron and Texaco (now merged as ChevronTexaco Corp.) used the arrangement to bilk the federal government, as well as state governments, out of almost $10 billion in taxes.

The bulk of the federal case was settled by the IRS in 1994 and 2000. A 1996 California district court ruling, however, handed the IRS hundreds of documents that a judge said offered evidence of crimes and/or fraud on the companies' part. Gramlich is pressing for release of those documents and for a possible class action suit by states ˆ— including Maine ˆ— that he asserts lost tax revenue in the oil-for-tax-credit exchange.

Mainebiz recently spoke with Gramlich, who offered his perspective on the current tableau of corporate fraud, the surrounding media frenzy and the role of the academy in sniffing out corporate malfeasance. Gramlich will be the featured speaker at a USM School of Business ethics symposium on May 7.

There are a lot of corporate scandals in the news these days, from Enron to Worldcom to Tyco, as well as smaller scandals involving individuals, like Martha Stewart. We really haven't seen this level of attention to illicit corporate behavior since the days of the Keating Five.
Even though that was a huge scandal, it was still fairly focused in the savings and loan area. Now [the scandals are] all over the place. I think what is happening today is unprecedented, [including] the amount of press coverage involved. My question to my classes is, "Do you think we have more fraud, or is it because there is more press coverage?"

How would you answer the question?
The answer I get and the one I tend to agree with is that there has probably been fraud going on for a long time ˆ— it's just that [news of that fraud] has hit the press the past couple of years.

And then the question is, why is that news hitting the press now and not before? That's worthy of some discussion, and it's one that I'll be talking about in the ethics symposium coming up in May ˆ— so I don't really want to give away all the answers.

Do you see a connection between the amount of media attention and the number of high-profile court cases out there?
I don't think the press drives our world, but attitudes do. And I think attitudes toward whistleblowing have changed dramatically. The persons of the year on the cover of Time magazine at the end of 2001 were three women: Cynthia Cooper from Worldcom, Sherron Watkins at Enron and Coleen Rowley from the FBI, who tried to say that we were on to the terrorists before the World Trade Center and Pentagon attacks. And these were whistleblowers. These were people who were speaking up.

In Worldcom's situtation, Cooper was specifically directed by her boss to stop looking at the issue. Her boss said, "Don't look at that any more, I don't want to hear about it." And she went against her boss's instructions. She stayed and worked at night with her team, and they figured it out and blew the whistle. Before, people like this were, and to a large extent still are, considered outcasts or bad people. In my opinion, though, that attitude has changed. You are no longer bad to speak your mind when you see something bad going on.

What is your specific area of expertise?
I've been doing earnings management research since I started my research in 1986. Earnings management research, in and of itself, is a far cry from fraud. It generally looks at incentives managers of publicly owned companies have to adjust their books to meet certain objectives: debt covenants, tax goals, bonus plans, employee stock options, etc. ˆ— none of which are fraudulent within the confines of what we call generally accepted accounting principles. This ChevronTexaco research paper is my only work that even mentions the word "fraud."

Your work isn't exactly everyone's cup of tea. What started you down the path?
I got an A in bookkeeping in high school. Then I took an accounting class in college and it was the only class I got an A in. My dad, who was trying to become financially independent of me, said "Go ahead and keep taking those classes." And that's the direction I went. I went to work for Peat Marwick in Denver, which today is KPMG.

When you returned to school for your doctorate, your dissertation began looking into the gray margins of corporate accounting.
At the time the tax reform act of 1986 was coming out. There were a lot of companies that were reporting a lot of income on their financial statements, yet when they did their tax returns they didn't have any income, they didn't pay any taxes. They were sort of amazing days.

The reform act came out with the corporate alternative minimum tax. The new rule said companies had to take half the difference between their book income, what they reported to shareholders, and their taxable income. If it was positive, then you had to add that to your taxable income and pay a minimum tax rate on it. So if you made a billion dollars for book purposes but zero for tax purposes, you had to take $500 million and pay a 20% tax rate on it. General Dynamics, [the current owner of Bath Iron Works], was a great example: It didn't pay any tax based on its book income.

The law didn't survive very long ˆ— it lasted three years. And strangely enough, not a whole lot has changed. The view in the academic world was that companies subject to this tax would just decrease their book income. And they could just come right out and say they were doing that sort of thing and it presumably wouldn't affect their stock price.

My dissertation was about that topic. I found, and four others who followed me in journals all found, that it didn't look like companies adjusted their book income downward in order to avoid the tax, because it would affect their stock price, their bonuses and some other serious things for management.

What about the accounting component of these cases, the Arthur Andersen aspect of these corporate ill-doings?
There were two things that occurred in the mid-1990s. The Financial Accounting Standards Board, the standard-setting board for generally accepted accounting principles, decided it would be okay for companies not to expense stock options on the face of the income statement. Then there was also a federal law change that said accounting firms would only be liable for their proportionate responsibility for any malfeasance. Up until that act, when a company that had been audited by one of the large accounting firms went bankrupt, the people who got ripped off turned to the deep pockets. It was a simple matter, there was nothing left of the company, so they went for the accounting firm.

Accounting firms lobbied very heavily for reform in the mid-1990s. At the time they were paying out about 10% of their revenues in attorney fees and damages. The new rules limited the liability of those accounting firms to 30% of overall damages. So managers and others were more willing to take risks because there wasn't nearly as much of a downside as there had been before the law.

What were once the Big Eight accounting firms became the Big Five during the 1990s, and there was tremendous growth in the management consulting end of their businesses. Sometimes 80%-90% of revenue from a client came from consulting and tax work, while only 10% came from actual auditing. The margins on that 80% or 90% were much higher than those on the auditing services. Some people would say auditing was a loss leader to get the consulting business.

Those three things ˆ— stock options not being deducted on the face of the statement, the proportionate liability and the increase in management consulting ˆ— all of those could be seen as things that led to Enron and the fall of Arthur Andersen. Now the Big Five are down to four and could quite possibly be three by the end of the year, because KPMG is under the gun for tax shelters, an issue that is just now unfolding. KPMG could very well be the next casualty.

Are the reporting rules for public companies in need of significant reform?
Well, we already have done a fair amount of that. I think it is more a matter of enforcement of existing rules.

How does this all relate to the research you've done on the Chevron case?
We are seeing indictments at the highest levels of companies like Worldcom, Enron, Adelphia, places in corporate America where fraud was unheard of. I don't think it's unheard of that we could see an indictment of fraud in the Chevron case.

A technical advice memorandum from the IRS in 1998 awarded Chevron the withheld foreign tax credit and capped the agency's investigation. Didn't that close the case?
A technical advice memorandum is binding, except where fraud exists. Fraud is difficult to prove, but we are making changes. But the state level is where the action is, including potential action in Maine.

After the story about my research came out in the New York Times, the Honolulu papers got hold of it. The research showed $433 million owed in state taxes around the country, and officials in Hawaii began to wonder how much was owed to the state of Hawaii. [The state hired a Chicago-based law firm and initiated an investigation, but eventually chose not to pursue the case.]

That is effectively where we are right now. What we need is a state attorney general to be a plaintiff. We have a law firm that is willing to sue on a contingency basis. We know the documents are in the hands of the IRS ˆ— they just need to be subpoenaed by an attorney general. It would be a class action suit on behalf of a number of states. If there were an attorney general out there who was interested in making a name for themselves, kind of like Eliot Spitzer, New York's state attorney general, but more on the tax side, there is plenty of room in this particular case.

What other states figure prominently in that $433 million?
It's wherever Chevron or Texaco operate. We've got a number of different states interested in going along, but they don't want to be the lead state. When the department of justice attorney did the attorney-client privilege case against Chevron in San Francisco in 1996, he said he walked in there and it was him and his assistant against 30 Chevron attorneys. I've seen these attorneys general just shake in their boots going up against Chevron. It's just amazing to me how frightened they can be of a major corporation. So I don't know if anybody is going to go against them.

In Hawaii, Chevron basically said if you do this, we are going to take all our stations out of Hawaii. And Hawaii gets something like 70% of its oil from Chevron. These are big boys. They play real tough. Not everybody is up for that level of playing.

Are you at all concerned with pursuing this thing yourself?
Not at all. I've pretty much decided I'm going to give it my best shot. You could argue that if there was ever a good reason for tenure in a university environment, this could be one of them.

I've been told by some IRS employees that they're very upset about the [ChevronTexaco situation], but they can't talk. I'm in a pretty privileged position. I know something about taxes, things newspaper people would probably never just be able to dig up and understand. And I'm protected at least a little bit by this tenure. I would never want anyone to say Gramlich relies on his tenure to keep his job even though he's just sitting on the beach. But to use it as protection, so that I can tell the truth about something like this ˆ— I think that's appropriate.

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