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Wednesday, August 31, 2005 - Page updated at 12:00 AM

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Hedge-fund firm could feel fallout from KPMG investigation

Seattle Times business reporter

Over the past 11 years, the Quellos Group has built itself into one of the biggest players in the secretive, fast-growing world of hedge funds, maintaining a low public profile while managing more than $12 billion in assets from its headquarters on the top floor of Seattle's Two Union Square office tower.

But Quellos could face new, unwelcome scrutiny after Monday's unprecedented agreement between federal prosecutors and prominent accounting firm KPMG, which admitted helping rich clients skirt billions in federal taxes through "unregistered and fraudulent tax shelters."

In the mid-to-late 1990s, Quellos helped KPMG structure, market and implement its first tax shelter, according to a U.S. Senate investigation of the tax-shelter industry and the firm's own testimony. After that shelter was discontinued, Quellos played a lesser role in executing a successor product.

A spokesman for Quellos in New York said the firm played a "very different" role from KPMG in the tax shelters, and that KPMG's admission of fraudulent conduct didn't apply to Quellos.

"Investors looked to KPMG for tax advice. They looked to us as an investment adviser to execute a variety of stock and option transactions," said spokesman Michael Gross. He added, "We got out of the business of working with large accounting firms more than five years ago."

Outside tax-law experts, however, say the companies that aided KPMG's tax-shelter business — which also include big international banks such as UBS and Deutsche Bank, prominent law firm Sidley Austin Brown & Wood, and Presidio Group, an investment-advisory firm founded by two former KPMG employees — could face legal action.

"There is potential exposure there," said Daniel Simmons, a professor of tax law at the University of California, Davis. "Whether it's criminal responsibility or not, I can't gauge. Certainly they're ethically responsible, and in terms of civil penalties there's a good chance they'll have to answer to the government."

Several of those companies have said they are cooperating with the U.S. attorney's investigation, according to media reports.

According to charging papers in the KPMG case, at least 80 rich clients bought the first tax shelter, generating $1.9 billion in phony tax losses that were used to offset taxable gains.

All told, federal prosecutors say, the four shelters created and sold by KPMG enabled more than 600 wealthy individuals to post $11.2 billion in phony tax losses, helping them avoid paying $2.5 billion in taxes.

KPMG avoided an indictment by agreeing to pay $456 million in penalties and accept an outside monitor. Concurrently, eight former KPMG partners and an outside lawyer were indicted for conspiracy to defraud the government.

Megan Gaffney, a spokeswoman for the United States Attorney's Office in Manhattan, said the office's broader investigation of the tax-shelter industry is continuing.

Scott Schumacher, who teaches tax law at the University of Washington and formerly was a trial attorney with the Justice Department's Tax Division, said the government's actions Monday suggest new determination to pursue not just the promoters of tax shelters but the people and entities that help carry them out.

"Congress and the government are definitely out to send a message, and one way to send a message is to indict, if not prosecute, the lawyers, hedge funds and bankers," Schumacher said.

But Donald Alexander, who was IRS commissioner in the 1970s and is now a partner at the Washington, D.C., law firm of Akin Gump Strauss Hauer & Feld, said he'd be surprised if the Justice Department pursued criminal cases against KPMG's business associates, though they might be subject to civil proceedings.

Quellos is a defendant in five lawsuits in Arkansas and North Carolina, filed by taxpayers whose shelters were disallowed by the IRS.

Quellos, which has 250 employees, was founded in 1994 as Quadra Capital Management; it adopted its current name in 2000.

The Seattle company — whose backers include Maveron, the Seattle venture-capital company started by Starbucks Chairman Howard Schultz — describes itself as a "financial boutique dedicated to providing integrated financial solutions" to institutional and individual clients. Its services include asset management, financial advice, brokerage activities and tax planning.

Quellos' relationship with KPMG began in the mid-1990s, CEO Jeffrey Greenstein said in testimony before the Senate Permanent Subcommittee on Investigations in November 2003.

KPMG had already developed its first tax-shelter product, known as Foreign Leveraged Investment Program or FLIP, and enlisted Quellos' help in designing the complex, precisely timed financial transactions needed to make the shelter work, Greenstein said.

A report by the subcommittee's minority staff said the Seattle firm "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."

Quellos teamed up with another Big Four accounting firm, PricewaterhouseCoopers, to sell a different version of the FLIP shelter. One of their customers was Spokane-based Metropolitan Mortgage & Securities, which used it to create a $28 million tax credit that helped it show a paper profit in fiscal 1999. (The IRS subsequently disallowed FLIP, one of several events that ultimately led to Met's bankruptcy and the placement of its life-insurance subsidiaries into receivership.)

After KPMG stopped marketing FLIP, Quellos played a lesser role in its successor, the Offshore Portfolio Investment Strategy or OPIS.

Greenstein told the panel Quellos no longer is involved in the tax-shelter business.

Today, Quellos is best known as a leader in the "fund of hedge funds" business, a niche that has boomed in popularity in the past few years.

Hedge funds are huge, lightly regulated investment pools catering to wealthy individuals and big institutions. They employ complex investment strategies in a quest for positive returns, no matter what the broad markets are doing.

After the technology-driven stock-market bubble burst, pension funds and other big institutional investors — deprived of the double-digit returns they had come to rely on — increasingly turned to hedge funds to recharge their portfolios.

But few such institutions had the expertise to pick among the thousands of hedge funds around the world, said David Tsujimoto, director of alternative investments for Russell Investment Group in Tacoma. The "fund of hedge funds" idea addresses that concern: A single investment can be spread among 15 to 20 underlying funds, creating a more diverse portfolio.

Several of Quellos' funds charge a 1 percent management fee and take 5 percent of the profits, according to registration documents filed with state securities regulators. Those fees come on top of the fees charged by the hedge funds themselves.

Quellos has been quite successful in attracting institutional clients to its funds of funds: As reported in trade publications, the firm's clients include the Alaska State Pension Investment Board, the Washington State University Foundation, Seattle City Employees' Retirement System and the Hong Kong Jockey Club.

As of June 2002, Institutional Investor magazine reported, Quellos' funds of hedge funds had total assets of $6.6 billion. Two years later, Quellos had $12.6 billion in assets and ranked seventh in the world in the magazine's ranking.

Drew DeSilver: 206-464-3145 or ddesilver@seattletimes.com

Copyright © 2005 The Seattle Times Company

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