They met because the Internal Revenue Service disallowed a tax shelter that the economist, Myron S. Scholes, acquired for Long-Term Capital Management, the hedge fund with such complex investing strategies that its collapse five years ago required government intervention to avert a worldwide financial panic.
The government is seeking $40 million in taxes and $16 million in penalties and interest, in an important test of the government’s resolve in its battle against tax shelters.
Under questioning by his own lawyer on Tuesday, Dr. Scholes, a partner in the hedge fund, coolly explained that he knew the tax shelter must have had real economic substance to survive I.R.S. review.
Given that the shelter could provide $375 million in tax benefits but cost the fund about $4 million, Dr. Scholes said, he worked hard to make it viable. For nearly three hours, he parried questions from Charles P. Hurley, the government lawyer, who step by step sought to show from Dr. Scholes’s own words and actions that the tax shelter could not have turned a profit apart from the tax benefits.
Then, after he answered a question showing that the shelter could not have turned a profit, and with no question pending, Dr. Scholes revealed what was on his mind. “I’m being trapped here,” he blurted out.
A few moments later, he stepped down for a break, and his wife, Jan, an executive of the investment bank that brokered the shelter deal with Long-Term Capital, stood. She had been fidgeting nervously in the fourth row.
The couple looked at each other for a long moment at the courtroom door and exchanged some whispered words. He then took her arm, and they walked into an anteroom and shut the door.
The questioning that led to that moment had begun more than two hours earlier when Mr. Hurley, a career Justice Department litigator, opened an aggressive line of questioning aimed at impeaching Dr. Scholes’s testimony the day before, in which he minimized his expertise about taxes.
“I said I was not an expert with regard to taxes,” Dr. Scholes said.
Mr. Hurley held up a copy of “Taxes and Business Strategy,” a $130 text used at Stanford’s graduate school of business; the primary author is Dr. Scholes.
Many of Mr. Hurley’s questions were framed to elicit a simple yes or no.
Often Dr. Scholes would argue with the question, then navigate a maze of potentials, prospects, possibilities and expectations before coming to a one-word conclusion.
Mr. Hurley: “I think the answer I wanted was in there ・no.”
Dr. Scholes: “Yes, and I wanted to explain why.”
At another point, Dr. Scholes parsed a seemingly simple question into three parts, two of which had two subpoints each, and turned it all into a seamless soliloquy that lasted more than two minutes ・without a single pause or “um” ・before boiling his own words down to one: yes.