HMC Tax Concerns Aided Federal Inquiries

He says he was told it was simply a difference in investment policy.

But to Steven M. Rose, then a tax director for Harvard Management Company, the deceptive financial reporting and pervasive ethical deficiencies he says he witnessed there were far from benign. And while the University commissioned an investigation into the issues he raised, he says he quickly reached the point where he felt his concerns had been brushed aside.

“The general disregard for the rules, procedures and compliance—it was ridiculous,” Rose said in an interview with The Crimson. “You had to be quiet and do it and put blinders on. If you were doing work in other aspects of the company, you could just do your job. But in [my] part of the job, you couldn’t ignore things.”

Harvard Management Company—which oversees Harvard’s multi-billion dollar endowment—was plagued by a culture of ethical laxity, Rose said. Special relationships with funds run by former employees and the use of offshore investment companies—both used to boost HMC’s once-legendary returns—may not be illegal, but are considered to be ethically questionable by some, particularly in light of Harvard’s non-profit status.

“Some people think that even if you’re [using offshore companies] legally, there’s something...unethical about it,” said Benjamin Leff, a visiting professor at Harvard Law School who specializes in taxes and regulation of non-profit organizations. “Would there be totally legal and proper things that an investment company with a Cayman subsidiary would be doing? There could be. Could there be illegal [things]? Definitely. Are there some things in between? Yes.”

In Sept. 2001, Rose resigned after deciding he could no longer subordinate his judgment to others at the company, and he sent a four-page memo to then-University President Lawrence H. Summers outlining his concerns, causing the University to hire an external legal counsel to investigate. But whether the move led to substantive changes in Harvard’s investment policies remains unclear.

According to tax filings for the year ending in 2007, the most recent one available, Harvard maintains investments in various foreign entities—including several that had been listed in previous filings as Cayman Islands companies. Harvard has ceased to list the specific locations of its related companies in the most recent tax filings.

When asked about these companies’ current locations, University spokesman John D. Longbrake declined to comment. He also would not elaborate on whether Harvard continues to have special reduced-fee arrangements with external investment managers, writing only in an e-mailed statement that Rose’s complaints were “the subject of a thorough review by an external expert” that ultimately concluded they were “without merit.”

But Rose was not alone in voicing such concerns. A 2004 New York Times article raised questions about HMC’s advantageous relationships with firms run by former employees, and quoted then-Chief Executive Jack R. Meyer as saying the special agreements had yielded $125 million in savings for the University up to that point.

After his resignation, Rose said his concerns only deepened, fueled in part by Enron’s high-profile implosion due to unethical accounting practices—including the liberal use of offshore accounts. He says he noticed disturbing similarities in Enron’s and HMC’s investment strategies, which prompted him to file a disclosure in early 2002 detailing his concerns with the Internal Revenue Service and the U.S. Senate Finance Committee.

All the documents and correspondence in this article were provided by Rose, and many of the entities and people mentioned declined to discuss the exchanges, citing policies not to comment on their relationships with clients.

The Finance Committee took notice, according to Dean A. Zerbe, then-senior counsel on the Committee for Senator Charles E. “Chuck” Grassley. Rose said he discussed possible legislative action to curb abuses by public charities with Zerbe after the Committee received the disclosure. Zerbe said in an interview that Rose was “certainly knowledgeable” about his area of work and that his early input to the Committee was of “extraordinary value” in shaping the ongoing review of rules governing university endowments.

But though recent changes could bring more transparency to non-profits, Rose questions whether new disclosure requirements will be enough to curb the widespread unethical practices he says he saw at HMC.

“The switch was on for all sorts of indiscretions,” Rose said. “I’ve never been that close to unabashed, raw greed in my life, up to and since then.”

‘NO TAX AUTHORITY’

Before joining HMC, Rose lectured in taxation at Northeastern University and worked as a tax manager for what is now PricewaterhouseCoopers.

While Rose only served as a tax director for a year at HMC before resigning, he previously helped prepare the company’s taxes for ten years as an independent contractor. Although he had never noticed any suspect activity at HMC before—he said he was simply given data from which to produce returns—his new position’s oversight and personnel access provided him with information that gradually coalesced into broader—and more disturbing—insights into the company’s complex network of operations.

According to Rose, HMC frequently under-reported its income from outside money management firms by “netting” it, or cancelling it out, with management fees paid out by the University. This practice, which reduces HMC tax obligations, is questionable because much of the income that Harvard receives from the firms actually derives from management fees that the firms collect from other investors—activities unrelated to the University’s tax-exempt purpose.

Daniel Halperin, an HLS professor who specializes in tax policy and non-profit organizations, said that an evaluation of the proper tax treatment for the income would also depend on whether Harvard’s share of the management fees is collected from regularly conducted trade or business, and the reasons why Harvard is making special arrangements with the money managers. He added that resolving these issues conclusively is difficult without access to more detailed information.

Rose said that when he raised concerns to HMC lawyers about netting, they said they had “no tax authority,” or legal precedent, to be engaging in the practice—but continued nonetheless.

Leff, the visiting HLS professor, said that while he did not have enough understanding of Rose’s specific concerns to make an informed judgment, “a lawyer asked by an auditor about the legal authority for the treatment of a transaction should be able to give at least the legal reasoning under which the treatment is proper.”

In the 2004 Times article, former HMC CEO Meyer—who later left the company with 30 employees and a $500 million initial investment from the University to start his own hedge fund—said none of the relationships were deceptive and that he had an “outside legal opinion [on netting], which he declined to share.” But the story cited two former high-ranking IRS officials who disputed Meyer’s interpretation of netting, as well as concerns from accounting firm PricewaterhouseCoopers that caused one firm to report their fees in full instead.

PricewaterhouseCoopers declined to comment for this story, citing their policy not to discuss individual clients, and Meyer, through an assistant, also declined to comment.

‘TAX-ADVERSE’

A further point of contention was HMC’s use of complex “structured finance agreements,” which created and linked so many investment entities that tax reporting became nearly impossible to conduct without attending planning discussions among the managers and HMC lawyers, Rose said.

And many of the entities that Harvard owned and invested in, both for- and non-profit, were directed and staffed by former University employees who continued to receive millions of dollars in management fees from Harvard, presenting what he saw as a conflict of interest.

In one particularly infuriating incident, Rose said that after he repeatedly inquired about a seemingly purposeless investment vehicle, a lawyer informed him that the company was actually set up to help a former employee defer his income to a Cayman Islands entity—thereby avoiding substantial tax payments. He also mentions another instance in his disclosure in which HMC officials adamantly opposed the reporting of a foreign entity—likely because the form used would have been attached to the publicly visible IRS Form 990, exposing Harvard to questioning about its use of offshore accounts.

Offshore tax havens can help organizations avoid federal taxes of up to 39 percent, according to a 2007 story in the Chronicle of Higher Education. A 2008 Senate report estimated that the United States loses up to $100 billion a year in tax revenue to offshore havens.

Eventually, Rose said that the culture of silence and the “creativity” that managers encouraged among employees to circumvent tax payments became so disruptive that he could no longer properly conduct his work. The culture of HMC, Rose said, was such that managers consciously avoided providing him with necessary reporting information. He recalls one incident in particular in which a lawyer told him he was “rocking the boat” after he raised a legitimate tax issue.

“They were really tax-adverse, and they did anything possible to reduce taxes,” Rose said, pointing to the individual greed of HMC’s executives. “I had to deal with the money managers’ mindset [that] if Harvard somehow has to pay a tax, that would reduce their take-home pay as well.”

‘THE ROAD TO HELL’

In an Oct. 2001 letter responding to Rose’s concerns, Summers wrote that he took the issues “very seriously” and that Harvard was hiring an independent counsel to ensure that Harvard maintained “the highest level of legal and ethical compliance.”

Jerome Kurtz, the independent attorney retained by Harvard to investigate the HMC practices and a former Internal Revenue Service commissioner, said he does not recall Rose or his concerns, though “that doesn’t mean it didn’t happen.” He added that he only remembers being hired to examine compensation arrangements with some of the investment managers, though he verified that  signatures on correspondence with Rose regarding the concerns were indeed his.

Shortly after his resignation, Rose said he became increasingly concerned that Harvard may have had ethically questionable ties to Enron, which went bankrupt in late 2001. Herbert S. Winokur ’65 served both on the secretive Harvard Corporation and on Enron’s board of directors, a dual commitment that Rose said he found disconcerting. He also found ethically troubling Harvard’s 49 percent ownership interest in former Enron affiliate Cook Inlet Energy Supply—which he said made substantial profits from the debilitating California energy crisis of 2000 and 2001.

In a phone interview, Winokur said that legal investigations have since concluded that Harvard had no improper relationship with Enron.

But despite the University’s internal investigation, Rose said he feared his ethics concerns were not being taken seriously by the administration. So he decided to go to the federal government, where he found sympathetic listeners.

“The road to hell is paved with bricks that are stamped with ‘it’s legal,’” said Zerbe, Senator Grassley’s chief counsel. “But particularly for a leading charity like Harvard, I think there’s an expectation of better behavior than just ‘it’s legal,’ as opposed to ‘it’s best practice.’”

Now, seven years later, changes in non-profit tax reporting have finally been made—and many of the revisions reflect Rose’s concerns.

For the tax year ending 2009, the IRS is phasing in the use of a new Form 990, which is filed by non-profit organizations. As the first major revision in 30 years, the report will include more detailed questioning of company governance and policies, compensation, foreign activities, and organizational structuring. And since previous filings asked organizations to report some information in unstructured attachments—which often led to incomplete or missing information—the new revision increases the number of additional reporting forms from two to 16.

In recent years, Harvard has included increasing amounts of disclosures on its tax forms. And in 2006, then-HMC chief Mohamed A. El-Erian hired a “chief compliance officer,” echoing a suggestion Rose made in a letter to Kurtz four years earlier. El-Erian, who succeeded Meyer and pledged to “rebuild and reinvent” the company, said at the time that the move was not prompted by regulatory requirements, but merely a desire to stay “at the forefront of the industry.”

Rose says he hopes that the improved Form 990 will “open the blinds” on Harvard’s practices, though he says he wishes the changes had come earlier.

“I don’t know what I could have done differently, and I keep thinking about it,” Rose said. “Lots of people that work for Harvard enjoy working there, and I would have liked to have that. But it was not possible for me given the environment.”

—Staff writer Peter F. Zhu can be reached at pzhu@fas.harvard.edu.