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How a Bid to Boost Profits
Led to a Law Firm's Demise

Tax Shelters Paid Off
For Jenkens & Gilchrist,
Until IRS Took Interest
May 17, 2007; Page A1
The Wall Street Journal

In 1998, Chicago tax lawyer Paul Daugerdas approached a Dallas law firm, Jenkens & Gilchrist, with a proposition. He said he sold tax shelters and advice to wealthy clients, charging them, in part, a percentage of their tax savings. If Jenkens brought him aboard, he said, he could generate as much as $6 million a year in revenue, according to three former Jenkens partners.

To Jenkens, a medium-size firm with big growth plans, that was serious money, much more than any of its lawyers were then bringing in billing by the hour. And the overture came at the right time. Jenkens had recently lost some tax lawyers, and Mr. Daugerdas was offering to bring several others with him.

  The Situation: In March, Dallas law firm Jenkens & Gilchrist shut down for good.
  The Background: An effort to boost profits through tax-shelter work resulted in damaging investigations and lawsuits.
  The Bottom Line: The firm's demise is a rare case of a major law firm being wiped out by a scandal.

Some Jenkens lawyers worried that tax shelters might attract scrutiny from the Internal Revenue Service. "If there was a danger we were crossing the line, there was no sense in going there," Toby Gerber, a former Jenkens partner, recalls saying at one management meeting.

But William Durbin Jr., who sat on the firm's board and later became chairman, championed Mr. Daugerdas to fellow board members, who unanimously approved the hire. "We made the case he would be profitable from day one, which is a rather extraordinary feat, and that this was not a terribly risky" way to give the firm a presence in Chicago, Mr. Durbin recalled in a recent interview.

That risk assessment proved catastrophically wrong. Mr. Daugerdas's tax work attracted lawsuits from tax clients and became enmeshed in a sweeping governmental assault on abusive tax shelters, sparking an exodus of lawyers and clients. In March, after the firm entered into a nonprosecution agreement with federal prosecutors and agreed to pay a $76 million IRS penalty, Jenkens & Gilchrist, which once numbered more than 600 lawyers, closed its doors for good. It was a rare case of a major law firm being entirely wiped out by a scandal.

In the wake of the fiasco, some partners have been wondering aloud whether the firm's hunger for more profits and prestige clouded judgments about Mr. Daugerdas's practice.

"The task of leaders is to say no to what is wrong and evil," says Mr. Durbin. "I wish I could have been more courageous....I played a very large part in bringing about the demise of a firm that I had played a large part of for 23 years, and that I loved."

David Laney, chairman of the firm from 1990 to 2001, says he regrets that the firm didn't part ways with Mr. Daugerdas in 2001, when serious concerns arose about the tax lawyer's temperament and his side business dealings. "If we had taken action, I think the firm would have weathered any issues that followed," he says.

Mr. Daugerdas, 56 years old, declines to discuss the matter. His spokeswoman says he "firmly believes that the tax advice he provided to Jenkens & Gilchrist clients was well within the scope of federal tax law at the time." His tax opinions, she says, "were approved by senior tax lawyers" at the firm. (Former Jenkens lawyers say tax lawyers at the firm's Austin office vetted Mr. Daugerdas's work.)

Texas Oil Tycoon

Jenkens & Gilchrist was formed in 1951, under a different name, as the primary outside law firm for Clint Murchison Sr., the late Texas oil tycoon. As the Murchison family diversified, Jenkens built a real-estate practice and forged ties with local banks. Over the years, the firm helped bring the Texas Rangers baseball team to the city, and served for a time as counsel to the Dallas Cowboys, then owned by Clint Murchison Jr.

[Shifting Fortunes]

By the early 1980s, Jenkens had grown to more than 100 lawyers. It was known as collegial and laid-back, former partners say. Employees would share big buffet lunches on Fridays. On compensation matters, the firm was forgiving, former partners say, typically not cutting back on the pay of partners -- called shareholders within the firm -- whose billable hours fell temporarily due to marital or health problems.

A bust in Texas real estate and banking in the 1980s hit the firm hard, costing it business and leading to the firing of some lawyers. By the early 1990s, as big law firms across the nation focused more on profits, Jenkens did so too, former partners say. It decided it had to diversify beyond its Dallas base. To draw talent, it needed attractive finances. "A lot of recruits would ask us: How stable are you? What is your balance sheet like? How profitable are you?" recalls Roger Hayse, an accountant who functioned as Jenkens's chief operations officer.

When Mr. Daugerdas began talking to the firm in 1998, the average Jenkens partner was earning about $380,000 a year, according to one former member of firm management, less than half of what American Lawyer magazine reported partners were earning at many leading firms in big cities.

Mr. Daugerdas, who developed tax shelters and headed the tax department at Chicago's Altheimer & Gray, told Jenkens he was dissatisfied with the compensation arrangements at the Chicago firm, according to Mr. Durbin, who took the lead in recruiting him. (Altheimer later disbanded for reasons unrelated to Mr. Daugerdas's tax work.)

Jenkens had long paid its partners partly based on the firm's overall profitability. Mr. Daugerdas wanted an above-average cut of his own earnings, which "was the subject of a lot discussion," says John Gilliam, a former litigation partner now helping to liquidate the firm. "That was contrary to our normal method of compensation." In the end, the full partnership approved his hiring and his compensation demand, and Mr. Daugerdas joined in late 1998.

Foreign-Currency Options

Some of the tax shelters Mr. Daugerdas helped put together involved the purchase of foreign-currency options, according to a lawsuit filed in New York federal court by former clients. The transactions were designed to generate paper losses that could be used by wealthy clients to offset taxable income. But they were hedged such that clients had relatively little money at risk. The IRS later took the position that such transactions fail a key test for legitimacy -- they lack "economic substance," in part because clients put little money at risk in relation to their sizable tax gains.

The work paid off quickly. In 1999, Mr. Daugerdas's tax-shelter team generated almost $40 million in revenue, about 20% of the firm's total, according to one person with knowledge of the firm's finances. That year, Jenkens averaged almost $600,000 in profits per partner, a record high, this person says. During his seven years at Jenkens, Mr. Daugerdas's total compensation exceeded $90 million, according to three Jenkens sources with knowledge of the firm's finances.

Mr. Daugerdas could be charming, especially when dining with lawyers and clients at Charlie Trotter's, a favorite Chicago restaurant, says Marshall Simmons, a former Jenkens attorney. "He could be as nice a guy as you ever wanted to know," says Mr. Simmons.

But some partners say his behavior in the office could be annoying. "His attitude was that his view was the definitive one, and if you didn't agree with him, it was because you simply didn't understand him," says Mr. Hayse, the former chief operations officer.

Mr. Daugerdas frequently disagreed with the firm's board over compensation, says Mr. Hayse. "Mr. Daugerdas believed our compensation system didn't adequately compensate the people in Chicago who assisted him with opinions," says Mr. Hayse. If Mr. Daugerdas felt that he was getting short-changed, adds Mr. Laney, the former chairman, "it was like the wrath of Khan."

Mr. Daugerdas repeatedly locked horns with Michael Cook, an Austin lawyer who was supposed to make sure Mr. Daugerdas's work accorded with the latest court rulings and IRS pronouncements. "I would regularly get a read that it was increasingly unpleasant dealing with Daugerdas," recalls Mr. Laney. "It was a very difficult interaction, and it grew increasingly difficult. Mike would say, 'No, you can't do it this way.' Paul didn't like to have his opinions tinkered with." Mr. Cook, now at Winstead P.C., an Austin law firm, did not return calls for comment.

In 2000, the Diversified Group Inc., a New York company that sold tax shelters, sued Mr. Daugerdas in New York federal court, accusing him of selling a tax strategy that Diversified had devised, without sharing the profits with Diversified. The litigation was eventually settled for an undisclosed amount.

That lawsuit uncovered something that surprised Mr. Daugerdas's partners. While working at Jenkens, Mr. Daugerdas allegedly had an interest in a company called Treasurex Financial Ltd. that received fees from his tax-shelter clients, according to several former Jenkens lawyers. Mr. Daugerdas hadn't disclosed that when he joined the firm, they say.

The Treasurex issue, coupled with Mr. Daugerdas's difficult personality, prompted the board to discuss whether Mr. Daugerdas should remain at Jenkens, according to three former members of the firm's management. Mr. Laney, who was then chairman, says he took a straw vote in late 2001. Five of the six board members favored asking Mr. Daugerdas to leave, Mr. Laney says. He took another vote about a month later, he says, because "I wanted to have two votes to reassure myself." The result was the same.

But the board didn't act. It was the fourth quarter of the year, and the firm was concerned about collecting on clients' unpaid bills, Mr. Laney says. The board feared that firing Mr. Daugerdas would have disrupted the tax lawyer's own collection efforts and distracted the entire firm, he says. "We wanted to wrap up the year in good shape," then take action the following year, he says.

[David Laney]

In January 2002, Mr. Laney stepped down from the board, and Mr. Durbin, 51, became chairman. (Mr. Laney left the firm the following year.) Mr. Durbin had joined Jenkens in 1983, working first as a real-estate lawyer, then for banking clients. "He would say that a law firm's stock price is its profits per partner," says David Cibrian, a former member of the management committee. Says Mr. Durbin: "I had a reputation for being bottom-line oriented."

The new board did not act on the earlier straw vote. Around that time, the IRS moved to clamp down on abuses in the booming tax-shelter industry, which had been fueled by new fortunes made in the bull market of the late 1990s. Since then, the IRS has collected more than $4 billion of unpaid taxes through a series of settlements involving improper shelters, according to the agency.

In late 2002, former tax-shelter clients began suing the firm in New York federal court, accusing it of peddling fraudulent tax shelters. In court papers, the former clients say they were notified in 2002 that the IRS planned to audit them. They claim that the IRS had previously issued notices calling into question tax shelters similar to ones promoted by Jenkens. Many of the lawsuits were consolidated in a class-action suit, which accused Jenkens of failing to warn clients about the IRS concerns so that the firm could continue collecting fees. The IRS and the U.S. attorney in Manhattan launched investigations.

Mr. Durbin says he had Mr. Daugerdas shut down his tax-shelter practice soon after the suits started flying. As the firm responded to the accusations, Mr. Daugerdas remained, arguing that the shelters were valid. Many lawyers wanted him fired to "avoid the bad publicity precipitated by the civil litigation," says Mr. Simmons, the former Jenkens lawyer. But if any cases went to trial, the firm figured it would need Mr. Daugerdas. "You don't want to be at war with someone who is a primary witness in defending yourself," Mr. Simmons explains.

Mr. Daugerdas's earnings started to decline in 2002, says Mr. Durbin. Former partners say Mr. Durbin pressed other lawyers to work harder and to take on more profitable work. At a partnership retreat in 2003, Mr. Durbin said in a speech that the firm could boost profits per partner by cutting partners, recalls Mr. Cibrian, the former management-committee member.

In 2004, some partners threatened to leave if Mr. Durbin was not replaced as chairman, in part because of his relentless focus on the bottom line, former partners say. Thomas Cantrill, a veteran partner, took over. Top partners began leaving anyway.

Jenkens settled the class-action lawsuit for about $81 million in early 2005, and its insurance covered most of it. In late 2005, under pressure from his partners, Mr. Daugerdas left.

Recruiting New Lawyers

The ongoing IRS and criminal investigations made it difficult to recruit new lawyers and clients. "You had these two huge swords of Damocles hanging over our head every day," Mr. Simmons says.

By last fall, the firm's management had decided that Jenkens could not survive intact. The firm tried in vain to arrange a merger. Eventually, groups of lawyers from various offices began cutting their own deals with other firms.

The end came in late March. The U.S. attorney in New York agreed not to prosecute the firm for criminal tax violations, in exchange for its "acceptance of responsibility" for fraudulent shelters that purported to "eliminate hundreds of millions of dollars in taxes owed by wealthy clients," the prosecutors said.

Jenkens admitted in a statement that "certain attorneys developed and marketed fraudulent tax shelters....Those responsible for overseeing the Chicago tax practice placed unwarranted trust in the judgment and integrity of the attorneys principally responsible for that practice, and failed to exercise effective oversight."

The IRS simultaneously announced its $76 million penalty, asserting that an estimated 1,400 investors had underpaid their taxes. It assessed no fines against individual lawyers. Jenkens clients had to pay some back taxes, but none have been prosecuted, according to a lawyer who represented them.

As part of its deal with prosecutors, Jenkens agreed to close its doors by the end of March.

Mr. Daugerdas is pursuing a claim in arbitration that Jenkens owes him additional compensation. "We are contesting his position," says Mr. Gilliam, the former partner.

Mr. Durbin says he has undergone an "interior change" and gotten out of corporate law. "I emphasized economics too much," he says. "There's a lot more that people bring to a law firm than profitability." He says he is now studying Spanish with the intention of helping underprivileged Latino children.