Wealth International, Limited (trustprofessionals.com) : Where There’s W.I.L., There’s A Way

October 2008 Selected Offshore News Clips

(Especially noteworthy articles’ dates highlighted in gold.)

October 6, 2008

How smart companies create wealth in emerging markets.

Another great article from Forbes on the general subject of generating or doing business in developing countries. With 80% of the world's population and about 40% of the world's GDP, appropriately measured, the business opportunities in the developing world are clearly vast. But the First World mindset is often inappropriate for the levels of development and business cultures of the developing economies.

Harvard Business School professor Clayton M. Christensen and two colleagues supply us with some interesting case studies and insights into what it takes to succeed in economies dramatically different from that of the home base.

The math is clear: more than 80% of the world's population lives in developing countries, and these markets account for 40% of the world economy, adjusting for purchasing-power parity, which takes into account the relative cost of living and inflation rates by country. However, less than 12% of the S&P 500's revenue comes from emerging markets. Even for a global giant like General Electric the figure is a mere 19%.

This imbalance simply cannot hold. The opportunities in the rapidly developing economies of Asia, Africa and Latin America are too big to ignore. They are also very easy to mishandle. A few companies have decided that these markets are too poor to justify investment. Still others have tried to compete by selling the same product they sell in the developed world but for lower prices by shrinking the package size or by stripping out features.

There is another path: designing a profitable business that enables customers in developing economies to be more productive and financially secure. Succeeding with this strategy requires that a company shift its focus away from redesigning its current offerings and toward creating new businesses from a blank slate. Those new businesses will perform jobs that customers in developing countries are struggling to get done. Unless a firm truly comprehends the jobs that developing-country customers want to get done, it risks importing assumptions from abroad that will sink the overseas business.

You can find companies thriving at the bottom of the pyramid in markets as diverse as mobile telephony, chicken farming, banking and brewing. Often the winners are local firms that can see opportunities without the distorting perspective that comes from being headquartered somewhere else. The Tata Group's Ginger discount hotel chain in India is an example of this.

But some multinationals are skilled at finding new markets in poor countries. General Motors, in partnership with the Chinese firm SAIC, has found great success in China with its Wuling Sunshine minivan, a small vehicle with a tiny engine, a top speed of 81 mph and passenger seats that are 1/3 as thick as those found in U.S. models.

For small distributors ferrying goods around China's congested cities, the job is to carry a modest cargo cheaply. The distributors are not much concerned with power, speed, comfort or capacity. They do, however, care about the price, and here GM has it right. The Wuling Sunshine starts at under $5,000, and the vehicle gets 43 mpg. The Wuling has 37% of the small-minivan market.

Entrepreneurship is part of daily life in emerging economies, because often there is no other option. The poor understand that commerce -- selling handmade crafts or running a small shop -- is the way to improve income levels. Some of the most successful firms in emerging markets, such as cellular carriers, have exploited this insight. One African carrier, Celtel, created so much value it was recently sold to Kuwaiti wireless phone company MTC for $3.4 billion. Celtel allowed families and friends in remote countries like Chad to keep in touch, but it also created significant business value. If a repair to a commercial dishwasher is needed, no longer does the restaurant owner have to travel to the township where the repairer lives and hunt for the person. Nor does the owner need to engage middlemen with whom these maintenance laborers contract. Rather, the repairman can be in business himself, responding by mobile as work arises. Partly because of these efficiencies, increasing cell phone penetration by 10% in a country adds half a percentage point of GDP growth, according to a study by McKinsey & Co.

Many firms expanding into emerging markets from developed countries struggle because they are often bound by the business strategy and close operational supervision of their parent companies in the West. As a result, they stand little chance of blazing fundamentally new paths in developing markets.

Citibank has been operating in Zambia since 1979, emphasizing its corporate banking services and opening two branches in Lusaka, the capital, and Ndola, the country's 2nd-largest city. It has reasoned that corporate customers do not need dozens of branches, and therefore it can save on branch operating expenses. The bank also realizes that several multinational customers value one particular job that Citibank helps to get done: simplify financial systems by keeping funds in one global bank, no matter what countries the customer operates in.

Yet there are many functions offered by Citibank, which, while valued by corporate customers elsewhere, have less relevance to Zambians' job requirements. Zambian companies often do not value long-term investment and lending services, and if they do seek loans, they often go abroad to avoid local interest rates that can exceed 20%.

Many Zambian businesses transact in cash, so they benefit little from Citibank's sophisticated reporting systems. Cash transactions could be handled through local Citibank branches, but Citi's emphasis on the corporate market -- and its conclusion from developed countries that branches are of limited value -- severely limits this offering.

In contrast, Zambia's Finance Bank has grown rapidly in recent years with an entirely different business model. The firm has 33 branches in Zambia, drawing long lines of customers depositing or withdrawing as little as $5 at a time. The bank recognizes that its customers often rely on unreliable public transportation and that it can win their business by being close to them. It allows wholesalers of consumer goods such as beer or soda to pay their suppliers through its branches, rather than having to transact large sums in cash with a delivery-truck driver in a busy public market. This service gains the bank a foothold at some of Zambia's largest corporate customers. Finance Bank serves the retail market very profitably, earning $17.3 million last year on $57 million in revenue. Its efficiency ratio, or total operating costs divided by revenue net of interest expense, was an admirable 53% in 2007. Prior to the current banking fiasco, Citibank's ratio was in the mid-50s.

The principle of redesign applies to products as much as to business models. In markets like India where some incomes are rapidly increasing, there is strong demand for products tailored to local market conditions. Air conditioners, for instance, are considered a luxury for most Indian homes, and even those Indians who can afford them rarely turn them on because electricity is costly. LG last year introduced in India an affordable air conditioner with electronic controls that vary the speed of the compressor in accordance with cooling demand. LG claims it can cool or heat a room 50% faster than old models, with 44% less energy usage. Cummins has introduced a low-cost diesel generator with dirt guards to keep the engine running more cleanly in India's dusty towns.

The challenges of distribution in emerging markets can foil even brilliantly conceived ideas. Conversely, effective distribution can give a tremendous leg up to new concepts. Supermarkets are a rare sight in many emerging markets. Small grocers, many operating in the informal economy, serve most of the population. These grocers collect their supplies from entrepreneurs who operate storage trailers in markets spread widely throughout cities, often in the midst of the townships where the poor congregate. Transport being relatively expensive, lengthy and awkward, grocers may simply carry goods by hand from the wholesaler's trailer to their premises, or load them precariously on a bike.

It is not easy to start distributing to these entrepreneurial wholesalers. Existing ones are often locked up by manufacturers in exclusive relationships. Brewer SABMiller ($21 billion in worldwide revenue) has benefited immensely through taking control of distribution systems for beers and soft drinks. SABMiller demands that its distributors work exclusively with its brands or brands SABMiller approves. Any distributor that wants to compete with SABMiller's network has massive obstacles in getting working capital, bank loans and trade credit.

Success at building disruptive growth companies in the poorest countries boils down to four areas on which to focus action. First, gain a deep understanding of the jobs that customers in developing countries need to get done. Twice a year Nokia sends marketing, sales and engineering employees from its entry-level phone group to spend a week in people's homes in rural China, Thailand and Kenya to observe how people use phones. Nokia has the highest market share in phones in India or Africa.

Second, disrupters must develop blank-slate solutions that solve problems better or differently. AllLife is a South African life insurance firm that issues policies to people who are HIV positive, a population of 2 million in South Africa. Competing policies tend to have steep premiums and a $12,000 coverage maximum. AllLife, by monitoring policyholders' health and medicine regimes, is selling cheaper coverage up to $360,000.

Third, subsidiaries must be able to operate freely. Even being dependent on the parent company for IT systems can constrain an in-country manager. In the name of efficiency, banks such as Standard Chartered often centralize emerging market it operations in countries like Malaysia, but when push comes to shove the priorities of relatively large, more developed markets such as the ones in Southeast Asia typically vault ahead of what operations require in some of the smaller, poorest nations such as the countries of Africa.

Fourth, businesses need to be patient for growth, but impatient for profits. The surest sign of a subsidiary's success is whether it makes money, which also signals it is evolving toward a sustainable business model. Managers can adjust their business model many times, but there is a limit to how badly things can go astray if profitability is mandated.

Together these steps can help a company recognize the innumerable inefficiencies and difficulties of developing economies and use those problems to its advantage. Successful firms are those that win the loyalty of frustrated consumers and can turn nonconsumers into new sources of revenue.

Two accompanying sidebar articles are "Cheaper Sleeper: India's ritzy Taj Group has a new hotel chain for the commoners" and "Cleaning Up Cheaply," about a small cleanup operation in Guatemala.

October 6, 2008

Many ambiguous issues clarified in new version of form.

The latest revision Treasury Department Form 90-22.1, "Report of Foreign Bank and Financial Accounts" (aka "FBAR"), is sufficiently complicated that one might take pains to avoid triggering the requirements for having to complete it for that reason alone. The form instructions make explicit interpretations of the relevant law where there has previously been ambiguity. Some interpretations are close to what we at W.I.L. have been advocating all along that people effectively adopt for the sake of prudence.

Those required to file TDF 90-22.1 are: "Each United States person who has a financial interest in or signature or other authority over any foreign financial accounts, including bank, securities, or other types of financial accounts, in a foreign country, if the aggregate value of these financial accounts exceeds $10,000 at any time during the calendar year, must report that relationship each calendar year by filing this report with the Department of the Treasury on or before June 30, of the succeeding year."

Offshore debit cards and pre-paid credit card accounts are now explicitly deemed to be among the financial accounts covered by the law. Also included are equity interests in comingled accounts such as mutual funds.

Most interestingly, the IRS shows it has been paying close attention to how offshore trusts have been structured to try and circumvent offshore financial account and tax reporting requirements. The form defines financial interest in a foreign financial account to include an account for which the owner of record or holder of legal title is "a person acting as an agent, nominee, attorney, or in some other capacity on behalf of the U.S. person," or "is a trust, or a person acting on behalf of a trust, that was established by such United States person and for which a trust protector has been appointed."

The "or in some other capacity" wording in the agent/nominee criterion seems to grant the IRS wide latitude in deciding whether a de facto agent relationship exists. This looks like a nod towards certain "understandings" where the account controller has no visible formal relationship with a given U.S. person -- for example the person supposedly gave away his assets to some trust for nothing whatsoever in return -- yet the account controller mysteriously obeys the person's every wish and command.

The protector criterion is puzzling. All along we have warned that when a trust protector who can replace a trustee is in place, the status of the trust might be crucially dependent on the protector's status. The TDF protector criterion says if a U.S. person establishes an offshore trust and then appoints a protector, the reporting requirement is thereby triggered. The trust may have a foreign trustee and account signatories, but the existence of a protector -- apparently even if he/she is foreign too -- evidently implies, in the IRS's eyes, that the creator has kept some backdoor control.

This article discusses other important changes embodied in the revised form.

In an unanticipated development, the IRS posted on its website on September 30, 2008, a new version of Treasury Department Form 90-22.1, named "Report of Foreign Bank and Financial Accounts," and known as the "FBAR." The FBAR has been the focus of increasing practitioner attention as a result of IRS efforts to publicize its filing requirements and because of ongoing investigations involving Americans who have undeclared foreign accounts at LGT Bank of Liechtenstein, UBS, and other institutions. This recent activity has included the service of a "John Doe" summons on UBS for a list of American account holders, the plea agreement of a Geneva-based UBS private banker, and hearings held by the Senate Permanent Subcommittee on Investigations into the problem of undeclared accounts.

The FBAR is not a tax form. It is a creation of the Bank Secrecy Act, 31 U.S.C. §5314, which, with its associated regulations, requires any U.S. person with signature authority or a financial interest in a foreign bank or financial account to file an information return with the Treasury Department by June 30 of the succeeding calendar year. The filing requirement applies to corporations and individuals, although there are special rules for large corporations that permit abbreviated filings with an explicit commitment to provide more information on request.

There are criminal sanctions and substantial civil penalties for any "willful" failure to file the FBAR, up to as much as 50% of the balance of an undeclared account, per year, for forms due after a legislative change in October 2004. 31 U.S.C. §§5321, 5322. As it has ramped up enforcement activity against Americans with undeclared offshore accounts, the IRS, which is delegated the authority to enforce the FBAR provisions, has made it a point to publicize the filing requirement. On June 17, 2008, two weeks prior to this year's FBAR deadline, the Service issued I.R. 2008-79, reminding taxpayers and practitioners of the obligation to file the FBAR.

This article will identify substantive changes in the FBAR form and instructions that appear in part to be a reaction to recent enforcement activity.

First, the IRS has clarified the definition of a "financial" account to include "debit card and pre-paid credit card accounts." The prior set of instructions did not contain this explicit provision, and some practitioners questioned whether a filing requirement was imposed on a U.S. person with nothing more than a debit or credit card issued by a foreign bank, perhaps guaranteed with deposited funds. The new instructions now make this clear. This clarification is undoubtedly a result of recent IRS enforcement efforts, including reams of data obtained by the Service earlier this decade after serving John Doe summonses on U.S. credit card processors identifying Americans who used credit and debit cards issued on foreign accounts.

Second, the new instructions wade into the problem area of foreign trusts. The instructions provide that a U.S. person has a financial interest in any foreign account "for which the owner of record or holder of legal title is a trust, or a person acting on behalf of such a trust, that was established" by that person "and for which a trust protector has been appointed." Trust protector is defined as "a person who is responsible for monitoring the activities of a trustee, with the authority to influence the decisions of the trustee or to replace, or recommend the replacement of, the trustee."

Many undeclared foreign accounts are associated with trusts, in some places called "Stiftungs," where a trust protector is in place. These instructions now make it clear that the FBAR filing requirement applies to a U.S. person who has established such a foreign trust or Stiftung, bringing a fairly routine form of tax non-compliance involving undeclared accounts explicitly within the ambit of the serious civil and criminal sanctions noted above.

Interestingly, however, the filing requirement applies only to the U.S. person who has established the trust, not that person's heirs. Many situations involving undeclared accounts emerge after the death of the person who created the account, when that person's children have, only immediately before or after their parent's death, learned of the existence of the account. Under the new FBAR instructions, such heirs or beneficiaries do not appear to have an FBAR filing requirement. Having said that, the new instructions include the previous rule whereby any U.S. person who is more than a 50% beneficiary in a foreign trust has an FBAR filing requirement.

Third, the IRS has clarified a provision involving corporate filings. The FBAR requirement applies not just to corporations, but to individual employees who hold signature authority over corporate accounts, even where, as in most cases, those employees have no financial interest in the account. The IRS previously did not require individual employee filings where an account was included on a company's filing if the CFO of the company certified this in writing to the employee. This "CFO certification" exception, however, did not, at least explicitly, apply in the parent/subsidiary context, for example, where the account may have been included in a parent company filing but the CFO did not so certify to the subsidiary company's employees. The new instructions now clarify that the employee of the subsidiary need not file a separate form where the parent's CFO makes the proper certification to the subsidiary's employees and the account has been included in the parent company filing.

Fourth, of great interest to practitioners who counsel U.S. persons on voluntary disclosures involving undeclared accounts, the new form and the instructions provide for a specially designated amended filing, by including a box on the form noting that it is in fact an amendment. The instructions request that the filer "attach a statement explaining the changes." Similarly, the instructions note that for delinquent filings, the filer should "attach a statement explaining the reason for the late filing."

When taxpayers make voluntary disclosures involving undeclared accounts, they generally file delinquent or amended FBARs in addition to amending their tax returns. They will now need to include statements explaining why the FBAR is late or has been amended. Voluntary disclosures offer some general assurance that the IRS will not proceed criminally, but given the size of the potential civil penalties (possibly 50% of the account balance per year), these statements should be drafted with care, as they will undoubtedly be important factors in any IRS decision to seek any such penalties for prior non-compliance.

There are other changes in the form and the instructions: All in all, the new form makes some significant clarifications, and may impact the advice practitioners give to the growing number of U.S. persons who are seeking to make voluntary disclosures arising from previously undeclared foreign accounts, as well as to clients who annually face this filing requirement. The issuance of the new form and instructions is a significant event, and tax advisors should parse the new rules carefully.

October 17, 2008

The U.S. government infamously outlawed the ownership of gold and forced its conversion to paper money at an artificially low price in 1933. Conventional wisdom is that that would not happen again. Steven LaTulippe is not so sure. If too many people figure out the money printing scam and start trying to protect themselves by buying gold and using it as a store of value, history could repeat itself yet.

I, Franklin D. Roosevelt, President of the United States of America, do declare that said national emergency still continues to exist and pursuant to said section to do hereby prohibit the hoarding gold coin, gold bullion, and gold certificates within the continental United States by individuals, partnerships, associations and corporations ... ~~ President Franklin D. Roosevelt, April 5, 1933

Well, they went and did it.

Proving that they have learned nothing from history, Congress passed the massive $700 billion "bailout" bill that is allegedly going to save our insolvent banking system. I was hoping against hope that a populist rebellion might somehow stop the oligarchy from helping itself to the taxpayers' wallets, but it was not to be. In the end, the plutocrats got their money.

Frankly, the logic behind the House of Representative's final vote was incomprehensible. When the bill was a straightforward handout to the banks, they rejected it. But after the bill went through the Senate -- which added dozens of pork-barrel spending projects and granted new Orwellian powers to the IRS – the House approved it.

How on earth could anyone rationalize voting for the second bill after they had voted against the first one? Beats me.

Either way, our government took a fateful step down the road to perdition. This payment will not be the last, since the solvency problem is much bigger than a mere $700 billion. By some accounts, trillions of dollars of bad mortgage-backed paper is sloshing around in the financial system. Most of it has no market, because no one knows if any of it is actually worth anything.

What is more, the federal government is bankrupt. By any honest accounting, this year's budget deficit was already heading toward the $600–700 billion range. Since the government cannot pay its existing bills, where will it get the money for this bailout?

The feds will either have to find new suckers to loan them more money, or they will have to turn on the printing press and ignite a nasty bout of hyperinflation.

But the scary truth is that still more disasters are lurking just over the horizon.

First, as Senator Harry Reid let slip the other day, our insurance industry is teetering on the brink. AIG has already gone under, and at least one more major company is allegedly about to give up its ghost. Once that domino falls, who knows how many more will follow?

And close on the heels of the insurance meltdown is the impending debacle in commercial real estate. Greenspan's bubble not only inflated residential housing prices far above rational market levels, it also created a similar bubble in office buildings and shopping malls. Many banks and investment houses are just as awash in bad commercial real estate paper as they are in subprime mortgages. Is the federal government going to take on these bad loans too?

If that is not enough to raise the hair on your neck, the horror does not stop there. Since most state governments rely heavily on property taxes, their balance sheets are starting to drown in red ink. When housing prices drop by 25 or 30% and commercial real estate goes belly-up, so do tax receipts. Yet, unlike the federal government, the states do not control the printing press. They cannot inflate their way out of their predicament.

Governor Schwarzenegger of California has already asked the feds for a multi-billion dollar "loan." He will not be the last. (After having thrown huge piles of cash at banks and insurance companies, can the feds refuse to rescue a bankrupt state government? Politically speaking, I seriously doubt it.)

Also waiting in line at the pig trough is a gaggle of corporations. During last week's chaos, not many folks noticed that the big-three automobile manufacturers got a multi-billion dollar handout from the taxpayers. And now that a precedent has been established, look for other industries (the airlines, for starters) to belly up to the taxpayers' bar for a shot of free "liquidity."

Can the government possibly do this? Can it absorb the entire residential and commercial real estate losses, bail out dozens of state governments, resuscitate the insurance industry, and hand out cash to unprofitable corporations?

Not hardly ... at least not without resorting to the printing press, which will set off a tsunami of hyperinflation. As history has shown over and over, governments that spend themselves into a corner will inevitably try to escape their predicament with counterfeit money. Although this scam works in the short run, it causes much bigger problems down the road. Hyperinflation destroys the very basis of economic growth by poisoning the value of money. Without a stable currency, businesses and individuals cannot make long-term plans, since no one knows what anything will cost even weeks or months into the future.

Which brings us to gold.

Libertarians and paleoconservatives have been discussing just such a hyperinflationary scenario for years. For the most part, the consensus opinion has centered on precious metals. Since governments cannot counterfeit metal, gold generally holds its value whenever fiat currency is debased.

While this investment strategy is a good one, it comes with one major risk.

The reason governments inflate their currency is to surreptitiously confiscate wealth from those individuals who store their wealth in that currency. If too many citizens shield their wealth by investing in gold, they nullify the entire scam. Inflation "works" because citizens are forced -- by legal tender laws -- to store their wealth in a medium controlled by the government. As a government counterfeits its currency, it sucks wealth from all of those people who hold that currency.

The government cannot tolerate too many of its citizens successfully evading inflationary confiscation. In a worst-case scenario, a headlong rush into gold would destroy the dollar completely as individuals replaced it with gold as a medium of wealth storage and exchange.

This cannot be permitted under any circumstances, since it would undermine the very foundations of our governing elite's power.

That is not to say that hyperinflation is the government's only option. When faced with bankruptcy, the government could behave responsibly. It could bring its expenditures into balance with its revenue. It could slash the welfare state, defund the military-industrial complex, and withdraw it forces from the overseas Empire.

Unfortunately -- from the plutocracy's perspective -- such a policy would also massively undermine its power and is, therefore, completely unacceptable.

If responsible management of public finances is a non-starter, the only other alternative is to rescue the dollar by banning private citizens from buying or owning gold.

Given these two options, does anyone doubt which one the government will choose?

If history is any guide, those individuals who have correctly predicted that our government's policies will end in disaster -- and who invest heavily in gold -- will be demonized as "hoarders" and "extremists." In keeping with the theme of our age, such investors might even be accused of "terrorism" (Which, in a twisted way, makes sense. After all, if the government is going to continue to fight the "War on Terror," it needs money. And if the only way it can get money is by confiscating gold, then those who resist the confiscation are "aiding and abetting terrorism.")

Ominously, this logic would permit the government to invoke the Patriot Act and the infamous Military Commissions Act.

In practice, actual confiscation would be easy. Most gold is held in ETFs or bank vaults. The government could simply order these institutions to hand their gold over to the U.S. Treasury. In return, the depositors would be issued compensation in the form of increasingly worthless Federal Reserve Notes (probably at an exchange rate that heavily favors the government. After all, the feds could not allow "hoarders" to make "windfall profits").

Those citizens who hold physical gold would be somewhat more problematic. They would presumably be given a "grace period" to hand over their stash. After that, the feds might have to get a bit rough.

Since many folks would probably try to hide their gold, President Obama would ultimately have no choice but to send federal agents into the countryside and seize it. Given the recent demise of quaint Anglo-Saxon legalisms -- such as search warrants and Habeas Corpus -- this enterprise might not be as difficult as one might think. (Maybe this could be a job for those creepy, Mugabe-style youth brigades that have been popping up around the county.)

I realize that a potentially violent government seizure of private property seems farfetched -- or even apocalyptic -- but those who dismiss it out of hand should remember their history. After all, our government has done this before.

October 17, 2008

With the economy imploding and the U.S. federal deficit exploding, figure on the opposite of a kinder and gentler IRS, says the CEO of a company which helps people resolve disputes with the IRS.

With the U.S. economy slowing and the federal deficit rising, a much needed surge in tax revenue means that a growing number of taxpayers can expect to be audited, while Americans already burdened by tax debt will find it harder than ever to resolve their tax disputes with the Internal Revenue Service (IRS), according to one tax expert.

In fiscal year 2007, IRS audit rates were up from the previous year for individuals overall. Additionally, audits of S Corporations were up 26% and audits of partnerships increased almost 25% from 2006.

Tax expert Michael Rozbruch says that the IRS will continue to increase audits of corporations, partnerships and individuals. He recommends, however, that those in receipt of an audit letter should respond by the deadline in order to avoid being placed in the collection department.

"If the IRS garnishes your wages, they can take as much as 75% of your net pay and make you live on $168 a week," warned Rozbruch, founder and CEO of Tax Resolution Services, a company that provides advise to people in dispute with the IRS. "The IRS is the most brutal collection agency on the planet."

While taxpayers can expect renewed IRS compliance efforts, the national credit crisis will make it even more difficult for Americans to pay their taxes. But Rozbruch says that Americans who anticipate having problems with their taxes should know that there are ways to work with the IRS.

"Not filing your taxes is the worst thing you can do because you can incur a 25% failure to file penalty right off the bat," Rozbruch said.

A report by the Transactional Records Access Clearinghouse (TRAC) at Syracuse University revealed that, while the audit rate for the largest corporations in the United States in 2007 plunged to its lowest level in the last 20 years, the number of small corporation audits climbed in the two years to fiscal year 2007.

The TRAC study, which was based on IRS data, found that the audit rate of small corporations which have assets of between $10 million and $50 million increased to 14.7% in 2007, significantly higher than either the 10.9% or 11.5% audit rates for larger firms in each of the next two higher asset brackets ($50 to $100 million, and $100 to $250 million).

"Moving the focus of the corporate auditors away from the large corporations and towards the smaller ones has been quite effective when it came to increasing the overall number of these kinds of audits," the TRAC researchers observed, although they concluded that this was actually a "counter productive" strategy for the IRS in financial terms.

October 17, 2008

Dozens of executives made off with fortunes just before their companies failed. Can the government claw the money back?

A lot of the earnings reported by financial services firms during the credit bubble were based on severely flawed accounting, to say the very least. Those past overstated earnings -- and more -- are being written off in a hurry today. Do those accounting flaws translate to outright fraud, especially when executive bonuses were based on those inflated profits?

Given the size of the unjustified paychecks and the low esteem in which Wall Street is currently held, this is no small question. To us there is clear cause for company shareholders to file suit to recover the overpayments. The Sarbanes-Oxley laws make explicit provision for recovering management bonuses if "misconduct" leads to a restatement of financials, but the failed financial companies managements could argue they were just stupid, not criminal: "Everyone got sucked into the mania. We were just following the crowd." But the fact that the accounting proved to be so egregiously wrong such a short time later could be grounds for civil recovery, without any need to prove willful misconduct.

Another angle of attack mentioned in this Forbes article uses the "fraudulent conveyance" concept. As we mention many places on this site, if you have incurred an actual legal liability, or a prospective one you should be aware of, it is illegal to try and escape it by conveying the assets that would be used for settlement to a third party, e.g., a trust. Do management bonuses made when a company is facing bankruptcy, or management should know that that is in the cards, constitute fraudulent conveyance? Perhaps, although the answer to a "What did management know and when did they know it?" question would involve a subjective judgement.

Of course we are including the U.S. government in the discussion here, so things like objective consideration of the facts and relevant laws are not actually constraints. One can easily imagine federal prosecutors threatening targeted executives with double-digit counts of fraud, conspiracy, money laundering, and what have you, and quickly eliciting an extortion payment ... we mean settlement. We doubt the properly aggrieved shareholders will end up with their proper share of the recovery in those cases.

It is now clear that much of the bonus pay awarded to executives on Wall Street in the past two years was richly undeserved. In the three years that led up to the recent collapse of seven big financial institutions, the chief executives of those firms collected a total of $80 million in performance bonuses and raked in $210 million in severance pay and earnings from stock sales.

The recently signed bailout bill limits future pay to bank bosses selling toxic assets to the government. Those new rules attempt to block future inequities but do not address the absurdities of the past.

What if the government got creative? Could it use existing laws to confiscate past paychecks? Maybe. And with a Main Street mob howling about Wall Street parachutes, the motive is there. The Feds could try out a rarely applied provision of Sarbanes-Oxley, the Enron-inspired legislation intended to criminalize accounting chicanery. A public company can recoup bonuses paid to its chief executive and financial officers if "any misconduct" causes the firm to restate its financials.

The Securities & Exchange Commission has applied the law only six times. Five of the cases were civil actions involving firms that backdated stock options and misreported their executive pay expense. To settle his case with the feds, former UnitedHealthcare chief executive William McGuire agreed to pay $468 million in bonuses and equity compensation back to the company.

But applying the Sarbox strategy to failed banks is a long shot, says Nader Salehi, partner in the securities practice at law firm Bingham McCutchen in New York. No court has ever ruled on exactly what "misconduct" means, he says. In the backdating cases companies knowingly falsified the date of stock grants. Here bank executives can argue that holding risky mortgage assets was simply a bad business decision.

Another tricky legal weapon can be found in bankruptcy code and federal bank insolvency laws. The feds could argue that a payment to an executive constituted a "fraudulent conveyance." That is the fancy way of describing a transfer of property out of a firm as it teeters on insolvency, to the detriment of creditors. As the conservator to IndyMac, the Federal Deposit Insurance Corporation would claim it was defrauded when the bank lavished pay on executives while already in the process of collapsing. Proving that the bank was already insolvent or that the executives intended to transfer assets out of the reach of creditors could be tough, says Edward Janger, who teaches commercial and bankruptcy law at Brooklyn Law School.

Faced with the iffy prospects, will federal prosecutors resort to more draconian -- and ethically dubious -- tactics? There is nothing like the threat of jail time to get an executive to write a big check to the government. The FBI is investigating Countrywide, IndyMac, American International Group, Fannie Mae and Freddie Mac.

Prosecutors have already secured indictments against Bear Stearns hedge fund managers Ralph Cioffi and Matthew Tannin, claiming that they defrauded the investors in their funds by failing to advise them of coming losses. (Cioffi and Tannin have pleaded not guilty.) The government could level charges of fraud against any executives who spoke in overly glowing terms about their company's prospects while privately acknowledging a different reality. Do you suppose an investigator could turn up an embarrassing e-mail or two in the files of a failed institution?

Judges may not sit still for this. Former Broadcom chairman Henry Samueli recently pleaded guilty to one count of false statements in a case stemming from the options-backdating investigation. In exchange for no jail time he agreed to pay the U.S. Treasury $12 million on top of the $250,000 maximum fine available by law. But U.S. District Judge Cormac Carney in Santa Ana, California rejected the agreement. "The court cannot accept a plea agreement that gives the impression that justice is for sale," Carney wrote.

A noble sentiment -- let us see how long it holds up.

October 25, 2008

Huge entitlements are the real threat to the U.S.

The cascading financial crisis has been dominating headlines the last few months. The dramatic bailouts of Fannie Mae and Freddie Mac, AIG, et al, and the notorious $700 billion bad loan fund sound large. A trillion here ... a trillion there ... pretty soon you are talking real money.

The fact is that even if the worst-case estimates of those expenditures come to pass, their total is dwarfed by promised entitlements to retirement and medical benefits for future generations of retirees. This has been pointed out many times by many, and been met with indifference each time -- probably because the numbers are too big for the human mind to take in.

Add it up, if you dare: $30 billion to facilitate JPMorgan Chase's embrace of Bear Stearns; $85 billion for AIG; $200 billion for a federal conservatorship for Fannie Mae and Freddie Mac; $700 billion for buying bad loans, bad loan securities and stock in bad lenders; $100 billion of pork-barrel spending tacked on to the bailout bill to win swing votes; another $37 billion for AIG; $20 billion for the national flood-insurance program. And the Federal Reserve has expanded the money supply by something like $1.2 trillion, though we cannot say where it has gone.

Add the bailouts not yet borrowed: Virtually unlimited deposit insurance for banks and money-market funds; $50 billion or more for car companies; a similar sum for their pensioners; covering the new holes in the federal Pension Benefit Guaranty Corp.; Treasury guarantees that back the mortgages that Fannie and Freddie and the Federal Housing Administration own or guarantee (where 20% losses could cost $1 trillion).

If we missed some bailouts, no matter. We can be sure that in the past few months, the U.S. government has put itself in further hock to the tune of at least $1 trillion or maybe $2 trillion or maybe $5 trillion, depending on who does the estimating, who does the administering and who takes the bailouts offered now and in the future.

In Proper Perspective

Americans are likely to ignore the whole mess. They have ignored a much bigger mess that has been growing for decades.

The debts we are creating on the books this year are nothing compared to the debts we already have piled up off the books. Americans owe a great and unaffordable intergenerational transfer, from Generations X and Y and Z to the Baby Boom Generation, then from Y and Z and the as-yet-unnamed next generation to Gen X, and so on.

Even Social Security's much-discussed funding gap is not our biggest problem. All Americans who are working or will be working owe more than $12 trillion to support the present and future beneficiaries of Social Security's old-age and disability pensions. But we have set ourselves up to owe more than $140 trillion for Medicare as it is currently legislated, to pay for most of the medical care for persons over 65 or disabled. Even bigger is the looming cost of Medicaid, which guards the health of indigents. No realistic estimate can be made for the future cost of Medicaid services because its benefits, under the control of state governments, are difficult to evaluate. But its combined costs to federal and state governments have been running 20% greater than Medicare in recent years, so add another $170 trillion.

These figures, derived from the fine print in federal reports, are present values: If the U.S. were able to borrow $322 trillion now and invest the money in private markets at 3% more than inflation, the three big programs would be fully funded forever. Of course, we cannot and will not borrow everything at once, so the eventual cost will be greater.

If We Make It That Far

Another way of looking at the size of the three programs is to consider their costs in a far-off future year as a percentage of that year's projected Gross Domestic Product. Fortunately for our sanity, the trustees of Social Security and Medicare picked 2082, a year when most of us will be safely dead. Medicare will be costing 10.8% of GDP, up from 3.2% of last year's GDP. The Medicare trustees' report, however, cautions that cost estimates for paying doctors are unrealistically low because current law mandates some unlikely pay cuts. A better estimate might be 12% of GDP in 2082. If Medicaid grows like Medicare, that is another 14.4% of GDP. The cost estimate for Social Security is 5.8% of GDP, up from 4.5% last year.

In round numbers, we have promised ourselves that at least a third of the nation's annual output in 2082 will be spent on health care and pensions for the aged, infirm and indigent.

As some Americans used to say to minimize the importance of a much-smaller binge of borrowing, "We owe it to ourselves." So we do, and yet that does not mean that we will pay it to ourselves.

None of these obligations are guaranteed by the full faith and credit of the U.S., such as it may be. When their size becomes clearer, Americans will have to face their government head on. We have trusted political promises that do not add up.

With Fingers Crossed

If all goes really well, the Great Bank Bailout may add less than a trillion dollars to the debt of the country. Some of the assets and shares of questionable value may be sold eventually at higher prices than the Treasury will pay right now. That does not seem likely at this point, since the essence of a bailout is to pay the price the seller needs to receive, rather than to drive a hard bargain and pay the least the seller will accept. Hard bargains are available in the free market.

If all goes very badly, not just in banking but in our silent entitlement crisis, a cost of trillions of dollars will be insignificant compared to the cost to the dollar of all our money-creation. When Germany had to pay reparations to the Allies after World War I, it effectively paid in marks printed for the purpose.

At first, the inflation created a boom. German workers, blinded by what John Maynard Keynes later called "money illusion," produced as if they were being paid in old marks, rather than in new marks that were quickly losing value. Germany could export the goods thus produced and pay Britain and France their reparations in gold. Later, of course, people refused to work for worthless money.

As our founder, Clarence W. Barron, said in the first issue of this magazine, dated May 9, 1921: "A country so highly organized industrially as Germany and with its workers so highly trained under civil and military discipline can for a considerable time force billions of paper into circulation, especially under a unified credit system and government control of transport, rents, housing and food prices."

"For a considerable time" is not forever, and we should hope the U.S. never has such dictatorial discipline.

The U. S. has advantages, also. It has not lost a Great War. It does not owe trillions of dollars to conquering nations -- only to trading partners. We can be masters in our house. We have time and freedom to mend our policies and our finances.

October 21, 2008

“The Axis of Arrogance” runs amuck.

PrudentBear.com guest commentator Christopher Grey recites a laudry list of items for which we owe "thanks" to our ignorant/arrogant leaders and string-pullers. Among the questions he raises is one that has been gnawing at us during all the debates in Washington about how to "solve" the "crisis": Ron Paul predicted the current disaster years ago. His warnings were not the gloom and doom naysaying characteristic of much of the goldbug/permabear/anarcho-capitalist fringe types, but well articulated and grounded in economic theory and, most importantly, history -- much of it pretty recent at that. So why is everyone still ignoring Congressman Paul??

In a time of universal deceit, telling the truth becomes a revolutionary act.” ~~ George Orwell

How is a meeting of bankers and politicians similar to a country and western song? Afterward, you have probably lost your house, your job, your car, and, with any luck, your wife or husband. Seriously, every time I see "fat cat" bankers and political hacks hard at work trying to "help" me, I cannot sleep at night with the gripping fear that this image brings to mind. Here are just a few examples of the great things Washington, the Federal Reserve, and Wall Street (aka "The Axis of Arrogance") have brought us in the past few years.

1) The highest inflation, and the lowest real interest rates, since the late 1970s. For responsible citizens who work hard, play by the rules, and save their money, these past few years has been one of the greatest transfers of wealth in history from savers to debtors.

2) Record trade and budget deficits that have mortgaged the future of this country and almost guaranteed that your children will have a lower standard of living that you do. No country in history has ever borrowed and spent its way into prosperity. Somehow this basic concept is too difficult for our financial and political leaders to understand.

3) A historic bubble in housing that made buying a house at the same time totally unaffordable for most people and also incredibly easy due to loans that required no income, assets, documentation, or credit. The aftermath of this bubble is now forcing millions of homes into foreclosure, penalizing whole neighborhoods for the irresponsible behavior of those among us who were suckered into the mania either because of greed or ignorance.

4) An enormous credit bubble in toxic derivatives, credit default swaps, and collateralized debt obligations that has lead to a near total destruction of our private banking and insurance system, has frozen credit markets and our credit dependent economy, and thereby forced even more government intervention, at least in the short run. There is no telling what other unintended disasters will result from this latest round of attempts at central planning.

5) A hedge fund bubble that made a few star investment managers wildly rich and is now contributing to the most extreme stock market collapse since the 1930s as investors rush to the exits after waking up to the reality that a hedge fund is simply a highly leveraged speculation game with other people's money.

6) A shameful and transparent effort to cover up the obvious insolvency of Citigroup and Morgan Stanley by requiring all of our country's largest banks, even the one who did not need or want the money, to take similar preferred stock investments from the government. Do they really think that anyone is fooled by this stuff? All this kabuki theater does is further erodes any remaining credibility of regulators and government officials in the eyes of market players.

7) A vicious exit from mortgage debt, driving up mortgage rates for homeowners and buyers in an already severely distressed housing market, that was a direct result of the government's recent announcement that it was effectively guaranteeing unsecured bank debt. Sorry Hank (Paulson) and Ben (Bernanke), this central planning stuff is harder than it looks. Stalin and Mao could not make it work, and they had people at gunpoint. What makes you think that you guys can pull it off? Nothing but sheer arrogance and ignorance.

8) The worst market for corporate and municipal bonds in decades caused directly because the government allowed Lehman to go bankrupt instead of placing it in a conservatorship like the GSE's (Fannie Mae and Freddie Mac). Lehman's bankruptcy created chaos among their bank, hedge fund, broker, and insurance counterparties. This had a cascading effect that led to the near failure of AIG, which was only saved by another extremely costly lifeline from the Feds. Many other large insurance companies, such as Hartford, Prudential, and Met Life, have also suffered extreme collateral damage from this unwinding of Lehman and AIG that is still playing out in the markets.

9) Making matters worse, investors are now running away from even the strongest municipal and corporate credits and flocking to the growing list of investments, such as GSE mortgage debt, bank debt, money market accounts, and deposits, that have virtually unlimited guarantees from the Feds. Way to go Hank and Ben. You saved Citigroup and Morgan Stanley, but you may cause California and other states to have no choice but to either raise taxes during a recession or eviscerate basic services such as police, fire, infrastructure, and education due to lack of funds caused directly by these idiotic and poorly conceived governments actions.

Further, due to the unavailability of typical commercial paper, corporate debt, and DIP (debtor in possession) financing, tens of thousands of people may now lose their jobs. Even many healthy companies, such as General Electric, will have no choice but to severely downsize, and weaker companies will be forced to liquidate rather than restructure. All of this is a direct result of government constantly changing the rules and picking winners (big banks, GSE's, automakers, and Wall Street) and losers (everybody else) instead of establishing clear rules and providing liquidity on a priority basis to those entities that were most essential to maintaining basic services and productive jobs at real businesses on Main Street rather than to those businesses with the best lobbyists and political connections.

10) All of the arrogance and ignorance on Wall Street and in Washington has created an entire generation of Americans that now sees the stock market, credit markets, and housing markets as rigged. This cynicism is justified by the events of the past few years, but it will probably take decades to be forgotten. During that time, all of us will suffer from the general public's unwillingness to believe that capitalism can work for regular people instead of just the insiders and the "fat cats." What does it say about confidence in our markets that some of the most sophisticated investors in the world, such as SAC's (billionaire hedge fund manager) Steve Cohen, have recently gone almost entirely into cash?

People on Main Street in this country are now so desperate for a way out of this financial mess that they will believe anything, even the emptiest political rhetoric that promises nothing more than a free lunch. Unfortunately, there is no free lunch. That is exactly the kind of thinking that got us into this mess in the first place.

The way out of this mess involves sacrifice and character, which needs to start at the top. Executives, investment managers, regulators, and politicians need to demonstrate competence and take responsibility for failure. Why do Hank and Ben and Chris (Cox) still have their jobs? Why are people not burning an effigy of Alan Greenspan in the street? Why is everyone still ignoring Congressman Ron Paul, one of the very few politicians who predicted this disaster many years ago and tried, without success, to stop it from happening? Why are people not listening to responsible career regulators like Sheila Bair at the FDIC and David Walker, former head of the Government Accounting Office? This country needs more hedge hogs (workers) and fewer peacocks (show offs). We need to start saving again. We need to stop borrowing so much money. We need to start creating more goods and services that people at home and all over the world want to buy. That is what makes a great country. This is not rocket science, but it is also not easy. It is not fun. It will be a painful and slow process of reorienting the economy away from borrowing, spending and speculating and towards saving and producing, but if we do not start changing our profligate ways our problems will continue to get worse.

October 21, 2008

Commodities bull Jim Rogers says that what is going on now is blanket liquidation of all assets without regard to fundamentals -- one of "eight or nine periods of forced liquidation over the past 100 to 150 years." On the other side those things with unimpaired fundamentals will do the best. Commodities demand has been cyclically dampened by the economic problems of the day, but secular supply, Rogers maintains, has been crimped as well. This means the commodities bull market will last longer and go further.

The commodity bull market will last longer as a consequence of the global financial crisis, Jim Rogers CEO of Rogers Holdings, told Commodity Online in an exclusive interview.

"We have had eight or nine periods of forced liquidation over the past 100 to 150 years wherein everything was liquidated without regard to fundamentals. This is such a period," Rogers said.

Rogers, said the commodities market is these days hit by the prospects of growth slowdown in countries like China and economic pessimism in the U.S. and Europe.

"Historically the things which have come out best on the other side are things where the fundamental have been unimpaired. Commodities are the only thing I know with unimpaired fundamentals," he said.

"The cyclical demand for commodities may slow, but the secular supply will be badly affected so the commodity bull market will last longer and go further in the end," he added.

"I have an enormous amount of cash and I have been using it to buy more Japanese Yen, more Swiss Francs, more agricultural products. ... There is a liquidation phase going on, where everything is being liquidated. They are selling everything in sight," Rogers said last week speaking on CNBC.

"In a period like this the way you make money coming out of it is to own the things were the fundamentals have not been impaired."

October 23, 2008

Throw away the Blackberry and get a life, he advises.

In an “It’s over. Don’t slam the door on your way out” signoff worthy of a celebrity relationship breakup, hedge fund manager Andrew Lahde has announced his retirement by thanking all the "idiot" traders who were on the other sides of his wildly successful bets against subprime mortages. He also disses the top managements of the leading U.S. financial companies which have gone down in flames, essentially calling them idiots in chief.

On a more sober note, Lahde said he planned to repair his "stress-damaged health," and advised his fellow financial go-go types to slow down and get a life that "sucks" less.

The boss of a successful U.S. hedge fund has quit the industry with an extraordinary farewell letter dismissing his rivals as over-privileged "idiots" and thanking "stupid" traders for making him rich.

Andrew Lahde's $80 million Los Angeles-based firm Lahde Capital Management in Los Angeles made a huge return last year by betting against subprime mortgages.

Yesterday (October 17) the 37-year-old told his clients that he had hated the business and had only been in it for the money. And after declaring he would no longer manage money for other people, because he had enough of his own, Lahde said that instead he intended to repair his stress-damaged health. He made it clear he would not miss the financial world.

"The low-hanging fruit, i.e., idiots whose parents paid for prep school, Yale and then the Harvard MBA, was there for the taking," he wrote. "These people who were (often) truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government," he said.

"All of this behavior supporting the aristocracy only ended up making it easier for me to find people stupid enough to take the other side of my trades. God bless America."

Lahde became one of the biggest names in the investment industry when one of his funds produced a return of 866% last year, largely by forecasting the U.S. home loans industry would collapse.

In his farewell letter, which concluded with an appeal for the legalization of marijuana, Lahde said he was happy with his rewards and did not envy those who had made even more money.

"I will let others try to amass nine, 10 or 11 figure net worths. Meanwhile, their lives suck," he wrote, citing a life of back-to-back business appointments relieved only by a two-week annual holiday in which financiers are still "glued to their Blackberries."

Lahde's retirement came amid an implosion among the hedge fund industry -- some 350 of the funds have liquidated this year, according to Hedge Fund Research.

His final words of advice? "Throw the Blackberry away and enjoy life."

October 27, 2008

Costa Rica is a retirement heaven – unless some squatters steal your land.

Costa Rica has a notorious reputation for not protecting the property rights of foreigners, especially in the countryside where squatters can occupy untended land when the land owner is away and then be very hard to evict. The World Bank recently ranked Costa Rica 164 out of 181 economies in the world for protecting investors, so this is not just hearsay based on odd cases. This piece from Forbes provides a gallery of examples of exactly such instances. It is caveat emptor in spades.

This is the deeper lesson we take away: If your wealth visibly exceeds those of the people that surround you, plan on being a target. The mechanisms for theft take different forms in different countries, but always to the same end. It is human nature that the large holdings of rich landlords -- especially foreign landlords who are away a good part of the year -- will be inviting targets for the poor and landless. Beware of this wherever you might move. Personally, we would not live any place in a manner where our lifestyle sticks out. It just seems like common sense.

The check from Banco de Costa Rica for $157,202 cleared in August. But after 12 years of legal wrangling it was not much consolation to H. Craig Carter and a small group of investors from Utah, who had hoped to turn their 180 acres in this Central American Shangri-la into luxury condos. In 1993 the group paid $50,000 for the dirt in hopes of spending another $12 million to develop Rincón Golf & Country Club Community. "They are not giving us a fair price on the land we own," insists Carter, 78, who with his associates has spent an additional $200,000 on travel and court fees. Based on the rise of property values in Costa Rica's Guanacaste Province, he argues the plot is worth $4 million and is hoping for additional compensation.

Good luck. Today the place is occupied by 20 families of squatters, a series of tin-roof shacks and small plots of corn and beans hemmed in by barbed wire. Carter and his group, HEC Estados de Flora, won a suit in 1997 affirming ownership. But squatters -- claiming the land had not been continuously occupied -- appealed to the Institute for Agrarian Development, which expropriated the property "by virtue of the public interest." For decades the Costa Rican government has encouraged homesteading to cultivate land and thereby reduce poverty.

Welcome to Eden -- after the fall. An estimated 50,000 Americans and 15,000 Canadians spend more than four months a year in Costa Rica, a tiny, peaceful democracy (population 4 million) with heart-stoppingly beautiful mountains, rain forests and beaches. Every year 2 million visitors pump $2 billion into a stable economy.

It may be a great place to visit, but as a retirement spot? Think hard -- particularly as an absentee landlord. The agrarian law says that squatters cannot be booted off unoccupied land without a court order. Moreover, if they stick around for a year they get the right to stay indefinitely, if no one evicts them, and after 10 years of such de facto possession they can file for title on the land.

The World Bank ranks Costa Rica #164 out of 181 economies, alongside Iran and Haiti, for protecting investors.

There is not much recourse for owners who encounter uninvited guests. They can sue based on recorded title, but cases can drag on for years. As far as protecting investors, the World Bank ranks Costa Rica near the bottom -- number 164 out of 181 economies -- alongside Iran, Senegal and Haiti.

Many landowners simply give up. Max Dalton did not. A decade ago Dalton, 78, complained to the U.S. Embassy and the Costa Rican authorities about squatters before a confrontation with a dozen campesinos on property he had bought near Pavones in the southwest. In the resulting shootout, he and one of the protesters died. The case provoked a U.S. congressional resolution and pressure on the Costa Rican government to tighten protection of property rights.

Yet ownership remains as sketchy as ever. Jean Marie Meadows, a 55-year-old massage therapist from Inglis, Florida, bought two parcels five years ago for $50,000. Turned out that one property was on public park land and the other belonged to Californian Daniel Fowlie, a felon convicted of drug charges, who himself has spent years trying to get back 3,000 acres he bought in the 1970s. When Meadows pressed the real estate agent about the problem, she says, he sold her another parcel, which, after she left Costa Rica, was apparently sold to someone else. "It is the most beautiful place I have ever seen," says Meadows, who intended to raise her kids in Pavones. "But do not buy property there. The land has been bought and sold many times."

It sounds like there is a need for American-style title insurance here. Since that is a staple of property buying in America we find it surprising that people would proceed without such an assurance in a distant market.

Miguel Angel Ortiz Morales, 66, lives in an open-air shack, lit by candles in tuna cans, on land that HEC's Carter says once belonged to his group. "If it had been occupied, we would not have entered," Ortiz insists. Ortiz surely is not blind to the possibility of making a tidy profit in Guanacaste, where vans labeled turismo cruise the dusty back roads. "A house on this hill, looking at that," Ortiz says pointing to a view of Rincón de la Vieja Volcano National Park. "How beautiful would that be?"

Robert Sprague, 65, retired six years ago from a job as Latin America senior analyst at the U.S. military's Southern Command in Miami. In 1982 he bought 2.5 acres of rolling pasture in Escazú, a San José suburb. Since then, Sprague says, he has kept up on the property tax (0.25% of recorded value) and visited often. To keep off intruders, he lets a family live on his land in a wood shack. "Being an Intel type you are always leery of something," he says. (Former Intel head Andy Grove wrote a book titled Only the Paranoid Survive.) "Then, all of a sudden, a little rat slips through the back door and shorts out the whole system."

As Escazú became an incorporated, ritzy locale for foreigners and embassy residences, real estate values soared. When Sprague readied to sell in February, he discovered the property had already been sold. The land registry pointed to a document in which he had supposedly signed over power of attorney authorizing the sale -- and a receipt claiming he had been paid $300,000 for the land. Sprague says the documents are fake and his signature is forged. His civil and criminal suits are pending.

Title insurance would usually not defend against that.

No one is immune to land grabs -- not even large companies. In 2001, 600 or so squatters invaded a 2,000-acre bamboo farm owned by Standard Fruit Co. de Costa Rica, a wholly owned subsidiary of the privately held Dole Food (2007 sales: $7 billion). Standard Fruit found out and immediately pounced, evicting some squatters five times. Dozens of them fled to the San José cathedral, where they staged demonstrations for weeks. The company hired a former Supreme Court judge, an authority on agrarian law. Still, the fight lasted seven years. "The law prevailed at the end," says Juan Carlos Rojas Zeldón, head of legal affairs for Standard Fruit. "It cost a lot of money" -- $5 million, by one estimate, for land worth roughly $10 million -- "but the company wanted to defend the property."

Some properties, including those on the Pacific Coast boomtown of Playa Herradura, have become too valuable not to defend. Over the last decade sprawling developments like Los Sueños Resort & Marina, where even the stop signs are in English, have mushroomed. A 5,000-square-foot house recently sold for $1.3 million. Everything but the cemetery seems to be for sale. Hillsides have been razed for residential and commercial projects. Strip malls bulge with U.S. franchises like Pizza Hut.

In the 1970s Herradura was just farmland near a pristine beach. Then expats, mainly from California, bought 60 or so 12-acre lots for around $30,000 apiece. The land was supposed to be cultivated as a giant mango and avocado cooperative, but that did not happen. Many original buyers stopped visiting; some never did. In 1989 squatters appeared, planted their own crops and started raising families. When the guard overseeing the land made a complaint to police 10 months later, he claimed that it had been a violent takeover. But, complicating matters, the squatters accuse the guard of selling off pieces of the foreign-owned property. (He denies the accusation.)

Today the 700 acres "belong" to squatters and to 3rd- and 4th-time buyers. Carlos Umaña Umaña, one of the original squatters, sold pieces to people like Jorge Robles, an accountant from San José who wanted a weekend getaway. His 1992 contract says Umaña was a peaceful farmer and sold the land on the authority of 3 1/2 years of possession rights. Now Robles and his wife have retired there, enjoying the fruits of their orchard, if not of legitimacy. A sign at the end of their long grassy driveway reads "Paradise."

Many of the California owners wrote off the properties as losses. Others, as land values jumped, kept trying to reappropriate their assets -- with little to show for it. "Every Tom, Dick and Harry is jumping in on this thing," says Sheldon Haseltine, 61, of Clinton Corners, New York, who is making common cause with five other original buyers. Over a decade of Kafkaesque legal entanglements, he has tried repeatedly to pin down people like Umaña, the squatter. In addition to selling to Robles years ago, Umaña last year unloaded some land to Armando González Fonseca, president of an AMPM convenience store franchise and a Citibank Costa Rica board member, who is filing for title of the land through Umaña's original squatter claim. González says it is perfectly kosher, since the former owners left and did not come back. "The guy I bought from, he stayed for 20 years, and he used this land for things like cows and farming." If Haseltine has an issue with that, González opines, he should file a complaint and stop harassing him. (Haseltine has dragged his complaints to Citibank, which says it is looking into questions of unethical practices but has found no wrongdoing and considers it a private matter.)

Larry W. Long, 61, a Canadian who sells real estate in Costa Rica, last year sold his 3 acres of land in Herradura for $90,000. That is three times what he paid for property in 2000 or so, but he says it would be worth $450,000 with a clear title. Over seven years, Long says, he begged the prosecutor's office to evict squatters. "It was driving me crazy," he recalls. "I had dreams about going over there and shooting all these guys."

Drawn by the warm surf, Texas native Edward Sides, 37, moved to Herradura after college in 1996 and opened a convenience store. Like many of his neighbors, he bought a small piece of land and a house from a squatter on rights of possession, but he managed in 2000 to track down the titleholder's surviving sister in Vista, California and paid perhaps as little as $5,000. But even as he stayed put on his property, he contended with squatters. Title in hand, he and attorneys repeatedly trudged to the Puntarenas court, spending hundreds of thousands of dollars until a judge finally granted eviction orders in 2007.

That decision was a miracle, Sides says. But he still had to get rid of 50 squatters living in structures that ranged from shacks to vacation homes with swimming pools. Sides bussed in and fed 350 police. Not enough. He hired a private security detail of 70, built a metal barricade around the property and put up a half-dozen guard towers. He rented bulldozers to knock down the homes. When protesters rushed, throwing rocks and molotov cocktails, the guards who did not flee in horror fired into the mob. More than a dozen people were injured.

Cloistered behind barricaded walls with a few guards, Sides is still haunted by the specter of violence -- and maintaining the integrity of the paperwork: "I am nervous all the time about my property -- and who is going to try to scam it." He intends to put the land on the market as soon as prices firm, he says. The property might fetch $2.5 million -- from a courageous buyer.

October 27, 2008

In theory and in law, China provides very little protection for property rights. In practice, there are three levels of protection – foreigners get the most, peasants the least.

Economic growth is strongly correlated with the rule of law, i.e., consistent and objective enforcement of property rights and other contracts, freedom from arbitrary decrees imposed by those ranging from petty bureaucrats on up to the upper reaches of government (hello, Mr. Putin), and a non-stifling regulatory regime. So how to explain China, with its absolute rule by a central committee which has been historically headed by the likes of Mao? For one, it turns out that no foreigner investor has had property expropriated during the past 50 years.

Such cannot be said for the Chinese peasants. It is a situation analogous to Western governments who offer big tax breaks to attract wealthy and mobile expats while heavily burdening their local, immobile, peasant equivalents. The Chinese know the foreigners can go elsewhere, and treat them accordingly. But the peasants are starting to rebell. Some are rioting. Whether this forces institutional change is an open question.

Most experts on economic growth agree that the rule of law -- with secure property rights, enforcement of contracts, and freedom from regulation and special privilege favoring one group over others -- are important prerequisites for prosperity. This makes China, in the eyes of most, an exception.

Since the mid-1980s, an estimated 40 million peasant farmers have had their land expropriated for commercial development, for a tiny fraction of the land's value. The Washington-based Property Rights Alliance constructed an International Property Rights Index last year, ranking China 46th of 70 countries, right after Colombia. The Wall Street Journal's 2008 "Index of Economic Freedom" also ranks China well toward the bottom, 126th on a list of 165, with its lowest score (ranking at the 20th percentile) in the area of property rights.

Yet China's economy has boomed, and foreign direct investment continues to pour into the country, rising from $2 billion in 1990 to $90 billion in 2007. This raises a compelling question: Why are foreign investors taking such risks without secure property rights? What makes China different?

The answer is that China is not different. Its economic growth has depended upon a property-rights system with varying degrees of security. There appears to be a 3-tier system of property rights, depending on where the property is located and who owns it. Peasant farmers have the least protection, city residents have better protection, and foreign investors have the most secure property rights.

There has not been a single case of a foreigner investor losing property during the past 50 years. Foreigners have developed a high level of trust with the Chinese. Foreigners often build in rural areas, but they do not negotiate with individual farmers over the purchase of land, since farmers work under the auspices of so-called Town Village Enterprises.

A TVE is a land collective that lets farmers receive the fruit of their labors, but decides from year to year how land will be allocated. The mayors or managers of the TVEs are directed by China's central government to be self-supporting. No one expects government bailouts from Beijing.

Town Village Enterprises act as if they were for-profit corporations, with peasants in the role of de facto employees, rather than property owners. TVEs compete with each other in wooing foreign investors, promising them tax breaks and land. A foreign company can generate far more tax revenue and many more jobs than a rice-paddy farmer.

The property-rights system is thus centered on the interlocking relationship between the TVE and the foreign investor, and it has worked with a brutish efficiency that has not been thwarted by special interests, such as environmental or health organizations, or by labor unions. Foreign investors rely on TVEs to enforce land rights, while TVEs depend on foreigners for tax revenue. This goes far to explain why foreign companies do not hesitate to invest in China and have few worries about losing their investment by government expropriation.

China nurtures this relationship for other good reasons as well. Although laborers in China's foreign-owned companies make up only 3% of the workforce, they are eight times more productive, and contribute some 40% of overall GDP growth, according to a 2006 analysis published by the National Bureau of Economic Research.

Yet the plight of the peasant farmer is becoming increasingly hard for China to ignore. It is not uncommon for a farmer to discover bulldozers readying his land for a new factory. His compensation, perhaps $5,000, is a fraction of the hundreds of thousands of dollars that the Town Village Enterprise may receive from the foreign investor for rights to the property. The displaced farmer must then find a job in the city or at the factory. Across the countryside, peasant farmers are more openly rebelling against such actions, and anger is rising. Last year, farmers led 80,000 riots or protests.

The property-rights protections for city dwellers are significantly greater. City residents often receive a special designation, known as "urban dweller" status. Upon getting this designation, a city resident may enter into the housing market and purchase a long-term lease (typically 70 years) on a property. Such leases are fully transferable and can be used as collateral for borrowing. Although city dwellers are still subject to eminent-domain types of land claims, they must be compensated with fair market value, or allowed to buy property at another, similar location. Perhaps the government recognizes, from a pure profit-motive perspective, that there is far more to lose by expropriating, say, office buildings, rather than rice paddies. The potential for foreign-capital flight would be very high indeed.

China's version of protection for property rights is different from the Western model, but it does the job: Business investors are provided security from expropriation. While the current system efficiently fuels China's growth, it remains to be seen how long China can trample peasant farmers rights in order to achieve its economic goals.

November 1, 2008

Offshore banks may be forced to choose between obedience to their home country laws or to the IRS.

The Sovereign Society's Bob Bauman comments in his blog about the IRS's new rules about what it takes for a foreign bank to meet the criteria as a "qualified intermediary."

The IRS, naturally, would like to know about all offshore financial accounts owned or controlled by a U.S. person, natural or artificial (corporations et al). Fairly tight requirements already exist for U.S. persons reporting such accounts, but the IRS also demands information from offshore financial institutions to provide them with a crosscheck that everyone who should be reporting is doing so. Those institutions that meet those demands are deemed qualified intermediaries. Those that do not, yet accept U.S. clients, can be denied access to the U.S. banking system. Thanks to the U.S. dollar's continued dominance in the world financial system, this would effectively ostracize the offending institution from the world financial community at large, and effectively put it out of business.

A look through the latest revisions to the IRS QI rules shows them to be similar in intent to IRS and other U.S. financial police agency rules about "knowing your customer" or reporting "suspicious activity." QIs should have a big compliance departments, etc., etc., yada yada. As Bauman notes, how intrusive these rules are in practice remains to be determined. We are inclined to agree with him that the IRS ultimately will press the rules to the point where countries will have to compromise on their privacy/secrecy laws in order to stay connected to the U.S. financial system. At long last the gloves will come off entirely. At that point we suspect most will just choose to stop servicing U.S. clients entirely.

As I predicted months ago, the U.S. Internal Revenue Service wants to clamp down with greater long-distance oversight of foreign banks that provide banks accounts or sell offshore services to American clients. The goal? Thwarting what IRS agents claim -- without offering any proof -- to be rampant tax evasion.

New IRS rules, issued [October 13], toughen up the little known, IRS "qualified intermediary" (QI) program that currently allow participating foreign banks to maintain accounts on behalf of American clients without disclosing their names to the IRS. Until now the IRS has allowed the banks to promise to identify clients, withhold any taxes due on U.S. securities in their accounts, typically 30%, and send the tax money owed to the IRS.

Under the newly proposed IRS rules, foreign banks in the QI program must now actively investigate, determine and report to the IRS whether United States investors or their legal entities are the holders of the foreign accounts they open. (U.S. persons already are required by law to report offshore accounts on the annual IRS Form 1040).

... When the account value exceeds $10,000 at any point during the year, we assume he meant to add. Moreover, if the total value of all offshore accounts is in excess of $10,000 at any point during the year then all offshore accounts must be reported. These reporting requirements apply to legal entities such as trusts and corporations as well as citizens, resident aliens, etc.

No Americans Wanted

In the last year numerous offshore banks, wary of increasing IRS pressures, have begun refusing to accept any new American clients. These latest IRS rules will only increase this unfortunate anti-American trend. (Ask us: we know where the still American-friendly offshore banks are).

The new rules, to take effect in 2010, will also require foreign banks to alert the IRS to any potential fraud, whether detected through their own internal controls, complaints from employees or investigations by regulators. The IRS will also begin auditing small samples of individual bank accounts in the program, without knowing the clients' names, to determine whether American investors actually have control over foreign entities with bank accounts.

Qualified Intermediary (QI) Rule

More than 7,000 foreign banks participate in the program, which was established in 2001, to help the IRS keep track of American offshore investors. Under current rules, foreign banks need only report to the IRS U.S. clients' investments in American securities.

According to the IRS, foreign banks in the QI program hold more than $35 billion abroad in accounts for U.S. individual investors, partnerships, trusts, family foundations and corporations, but withheld taxes of only 5% on that amount in 2003. The IRS argues entities receiving the offshore income claimed exemptions under foreign double taxation treaties with the United States, but if U.S. investors controlled those entities, some were not entitled to the tax exemptions.

Note that $35 billion is a tiny drop in the ocean relative to all U.S. financial assets, cross-border funds flows, or any other metric you care to choose. So the IRS focus here is not rational on the face of it, but undoubtedly quite rational from a broader perspective, e.g., when the possibility of future capital controls is considered.

The clear threat to offshore banks underpinning the QI rules is the possibility that an uncooperative foreign bank would be denied access to the entire American banking system, meaning they and their clients could not to do business with the major banking system of the world.

Alleged Tax Evading Bank Gets $54 Billion U.S. Loan

The tightened QI rules are said to be the result of allegations that the world's largest private bank, the Swiss UBS, assisted an unknown number of their American account holders to evade U.S. taxes.

(To show just how schizophrenic is U.S. government policy, the Swiss government announced [on October 16] that the U.S. Federal Reserve has joined with the Swiss National Bank to loan up to $54 billion from the Fed to buy "illiquid securities" from subprime-loaded UBS!)

The IRS claims that since 2001 it has halted the participation in the QI program by about 100 foreign banks that were accused of violating QI rules. But in my observation, far fewer banks were embargoed and those tended to be banks located in backwater places such as Vanuatu and the Solomon Islands where Russian criminal elements had established a financial presence.

U.S. Rule Imposed Worldwide

In 2001 the IRS first imposed extraterritorial tax enforcement burdens on foreign banks that were forced to meet IRS established anti-money laundering and "know your customer" standards in order to get the "QI" stamp of approval.

But IRS QI approval comes loaded with onerous conditions that now might end customer confidentiality for American offshore investors. It also gives the IRS leverage over foreign nations when demanding exchange of tax and financial information. Some nations, such as Switzerland, Liechtenstein and Panama that have strict financial privacy laws, until now have been able to escape the worst anti-privacy parts of the QI rules.

Tougher New QI Rules

Douglas H. Shulman, the IRS Commissioner, said the goal of the new QI changes "is to get a clear line of sight into the owners of the bank account, and to know where there is fraud." Inherent in such an overreaching statement is the misguided IRS belief that everyone with an offshore bank account is engaged in tax evasion -- and that offshore banks have a duty to act as IRS informers.

I will repeat what I have said before: It is the duty of the American government to investigate and indict anyone suspected of violating laws -- on an individual case basis. It is not the government's duty or right to coerce offshore bankers to act as IRS agents, or to presume tens of thousands of Americans legally engaged in offshore financial activity are therefore criminals.

Conflict of Laws

It remains to be seen how any new QI rules can be made to square with strict laws guaranteeing financial and banking secrecy in many nations, such as Switzerland, Liechtenstein, Andorra, Monaco, Singapore, Belize or Panama. Typically those laws make it a criminal act to reveal any information about bank account holders, foreign or domestic, unless order to do so by a court.

Offshore banks may be forced to choose between obedience to their home country laws, or to the grasping long arm laws of the IRS.

November 1, 2008

Top personal income tax rates around the world have fallen by an average of 2.5% over the past six years in the face of increasing global labor mobility.

"Tax competition" has led to incremental reductions in top tax rates, which apply to those earning the most income, in many countries around the world. It is very reasonable to guess that this is due to governments' understanding that this is an effective active step towards attracting the high earners.

KPMG has documented the reduction in tax rates, and cites a variety of anecdotal evidence that supports the idea of overt recognition by governments that lowering taxes might attract desirables, such as the competition between Hong Kong and Singapore, and the incidental effects this has had on Australia. Economic theory would predict that this would happen once labor became a sufficiently mobile factor. Ultimately the best protection against predatory government is the capacity to move the target, whether that be your wealth or your body, at reasonably low cost.

Top personal income tax rates around the world have fallen by an average of 2.5% in the past six years, as governments strive to balance their need for revenue with the impact of increasing global labor mobility, a new study from KPMG International has found.

Worldwide, top personal tax rates have fallen from an average of 31.3% in 2003 to 28.8% in 2008. But European Union (EU) taxpayers still pay the highest rates, at an average of 36.4%, followed by taxpayers in the Asia Pacific countries with an average of 34.6% and those of Latin America at 26.9%, KPMG said.

At a country level, the highest tax rates in the world are paid by the people of Denmark, with a top rate of 59% for the whole six years, followed by those of Sweden, whose rate came down last year from 57% to 55%, and those of the Netherlands, who have paid 52% for the whole period.

Excluding those countries which levy no tax at all, the lowest EU rate is in Bulgaria, with a newly introduced flat rate of 10%, down from 24%. In Asia Pacific the lowest is in Hong Kong, with 16% and in Latin America it is in Paraguay with 10%. Of the 87 countries surveyed, 33 have cut their rates in the past six years and only seven have a higher top rate in 2008 than they did in 2003.

Among the large western European economies, France has made the most significant cut in its rates, from 48.1% in 2003 to 40% in 2007. Germany has gone from 48.5% to 45%, having briefly stood at 42% in 2005 and 2006.

But across the EU it has been the introduction of flat rate taxes in the Eastern European states that has had the most impact, KPMG said. As well as Bulgaria's new flat rate of 10%, Estonia has cut its rates from 26% in 2003 to a flat 21% in 2008; Slovakia has gone from 38% to a flat 19%; Lithuania last year fell 6 points to 27% and this year a further 3 points to a flat 24%; Romania has cut rates from 40% to a flat 16%; and the Czech Republic, this year, introduced a flat rate tax set at 15%.

In the Asia Pacific region, tax competition between Hong Kong and Singapore has led Singapore to cut its rate from 22% for 2003 to 21% in 2006 and 20% in 2007. However, both the Hong Kong and Singapore governments offer their citizens tax rebates when public finances allow. For 2007/08, these rebates were 20% in Singapore, capped at SGD2,000 (US$1,400) and 75% in Hong Kong, capped at HKD25,000 (US$3,200).

"Australia also cut its personal tax rate by two points to 45% last year," said Rosheen Garnon, head of KPMG's International Executive Services practice and a partner in the Australian firm, "but if the intention was to attract back high value Australian workers who have temporarily moved to Hong Kong or Singapore, it may not be enough."

"It is common to hear from foreign workers that once families have become accustomed to the huge increase in spending and saving power that low tax rates provide, it can be very difficult to justify going home," Garnon added.

In Latin America, personal tax rates have generally stayed low but stable. There is an increase in the average, from 25.6% in 2003 to 26.9% in 2008, but this is entirely due to the introduction of a 10% income tax in Paraguay and a 25% tax in Uruguay, both effective from 2007.

Elsewhere in the region, tax movements have all been down, the survey found. Mexico and Panama stand out for their steady, year-on-year reductions. In the past six years, Panama has gone in stages from 33% to 22%, while Mexico has gone from 34% to 28%.

"Given that the share of national wealth taken by tax revenue in many countries is static, or has increased in the past five years, the fall in personal and corporate tax rates raises the question of how governments are now raising funds," observed Garnon. "We think the answer may lie in increases in indirect taxation, through value added taxes, goods and services taxes, customs duties and fees for specific services."

"We do not foresee a time when personal income taxes will fall so far that they become irrelevant to people moving from country to country. But it is entirely possible that the relative level of indirect taxes will begin to play a much greater part in people’s decisions on where in the world to go for work," Garnon concluded.