Do You Sincerely Want To Be Rich? (48 page)

way that Ed Cowett, Bernie Cornfeld and John King put a 'true worth' on them would have surprised the Due de la Rochefoucauld.

    Nothing in the conduct of an open-end fund is more important than the regular - usually daily - calculation of its net asset value per share. On this is based both the price of fund shares to new investors, and the level of redemptions to old investors. The total value of the fund's assets is checked by reference to quoted stock exchange prices, and the total is divided by the number of fund shares outstanding.

    It is not so easy to check the value of investments like oil exploration permits. They are not quoted on any exchange: if the objection to real estate in any open-end fund is that its value is a matter of opinion, the objection to oil permits is that their value is a matter of the most esoteric opinion. Nevertheless, both Ed Cowett and Bernie Cornfeld were determined that the Arctic holdings should not be undervalued - it would, they said, be unfair to the investors. Surely, the value must have increased in 1969, the year of the Alaskan oil auction, the year when the tanker/icebreaker Manhattan broke through the North-West Passage?
¹

    One technique of revaluing a natural resources holding is to sell part of it: if the buyer pays, proportionately, more than you paid in the first place, it may be fair to apply the increase to the complete holding. But the validity of the technique, obviously depends upon the independence of the buyer and the scope of his purchase: when IOS used it in 1968 to revalue another oil and gas holding, doubts arose in the minds of their auditors, Arthur Andersen & Co. Only 10% was sold on that occasion, and it was sold to a broker.

    In early November 1969, Arthur Andersen (who are also auditors to King Resources) found themselves examining the same technique again. They suggested to King Resources that an increase could be allowed if supported by an arm's length sale to knowledgeable outside parties. If King Resources company sold a 25% interest in all the Arctic permits to Texaco or another major oil company, the auditors believed it would be appropriate to give proportionate value to the 75% retained. Where to draw the line was the problem: the auditors at this stage regarded a 10 % sale as a bare minimum.

    
¹
The Manhattan's voyage led at the time to large hopes of improved access to Arctic oilfields. Later, however, the sponsors of the voyage concluded that a pipeline to the Arctic might be more economic.

    

    Cornfeld clearly had no such reservations about the approaching coup, and he gave his followers several broad hints. On November 14, he addressed the German sales managers at Bad Godesberg. Stock markets might be sagging throughout the world, he said, but fear not: IOS now had an investment policy to transcend such problems. Watch out, he advised them, for a special 10% jump in the Fund of Funds before the year's end.

    Then on December 19, the Fund of Funds published its accounts for the first half of the year: Cornfeld's accompanying report said that there was a 'strong possibility' of a partial Arctic sale, and 'in such an event, the overall holding will be revalued'. The letter, on top of the Bad Godesberg hint, implied that the thing was virtually in the bag. Salesmen (who were absolved from sales loads) rushed into the Fund of Funds. One IOS accountant estimated to us that more than $10 million went into the funds in special transactions during December, and most of that could probably be ascribed to Arctic enthusiasm. Much confusion was caused because salesmen were having the computer run stopped so that their last minute 'buy' orders could be accepted.

    Overnight, from December 29 to December 30, the Fund of Funds' net asset value jumped 12%-and on December 31, Cornfeld sent a jubilant letter to his sales managers. The increase, he said, occurred because just 10% of 'our overall interest' in the Arctic had fetched $15.7 million in a sale to three independent oil companies on December 26. Four pages, and a map with the Sverdrup Basin vaguely indicated, were devoted to what Cornfeld called the 'enormity' {sic) of the Arctic venture. Investments acquired for $1 per acre were already worth $8 per acre on 'conservative' estimates, said Cornfeld, and he ventured that the Canadian Arctic might surpass the Alaskan bonanza, with its values of $2,000 per acre.

    Oil is an unpredictable commodity, and the Archipelago may turn out to be drenched in it. Even so, the letter would still be an investment fantasy. At the time that Cornfeld wrote, FOF had not in fact sold anything to anybody: the actual events of the Arctic 'sale' were very unlike Cornfeld's description.

    The idea of revaluing the Arctic permits developed while the acquisition was still going on. At least the FOF accounts say that a $3.6 million increase was recorded at June 30, 1969: that was over two months beiore the permits had been taken out on lonely Ellesmere Island (covered by a permanent ice-cap according to The Geological Survey of Canada). It was in fact before one tliird of the joint interests had been taken up, according to the King Resources documents filed with the sec. It was also before the interests had been earned. This revaluation occurred before the spectacular auction of Alaskan rights, and before the Manhattan's hopeful voyage.

    During the summer of 1969, it is claimed, IOS was negotiating to sell part of its interest, but the deal fell through, IOS made it clear to King Resources that a sale of some part of the interest was desired as soon as a buyer could be found.

    The transaction which was eventually used to justify the complete revaluation was not negotiated by IOS. It began with a game of golf between Rowland Boucher, president of King Resources, and Harry Trueblood, chairman of another Denver firm, Consolidated Oil & Gas. King Resources owned interests in several wells operated by Consolidated: during the game, Trueblood said that he would like to buy into King's Arctic action.

    Harry Trueblood and John King, who met in 1959, are neighbours in Cherryville, outside Denver. Over the years their various companies have exchanged with each other many deals in oil, natural gas, and other things. By 1969, their affairs were considerably intertwined. For instance, Holiday Airlines, controlled by Trueblood, had just leased an airliner from King's Regency Income Corporation to serve Lake Tahoe in the Sierra mountains, where King's real-estate arm was developing a project called Innisfree, 'dedicated to the total recreation concept'. Indeed, there was a joint project with King which actually stood in the way of Consolidated's Arctic ambitions: this was a plan to redevelop part of downtown Denver, at considerable expense. Because of this Consolidated was strapped for cash, and any Arctic deal would have to be specially tailored.

    However, the negotiations begun on the golf course ended with a deal on December 26, 1969. Consolidated Oil & Gas agreed to take over i/32nd part of the whole Arctic package which then consisted of permits applying to 22,264,000 net acres. Consolidated agreed to pay a price for being let into the action, and agreed also to assume a proportion of the work obligations.

    The price was $5,218,242. But only $443,550 was cash. Consolidated did not have to pay any of the balance of the price until June 1973, and that was only to be the first of a three-year series of instalments. Yet even on these easy-going terms, Consolidated did not find the deal an easy one to sign. Harry Trueblood's company was unable to make the down payment until someone from King Resources found a bank in Oklahoma which was ready to lend the necessary cash.

    In addition to this price, Consolidated agreed to relieve King of a part of the expenditure necessary to keep the permits active. Consolidated assumed $5,218,242 of the total obligation of $20,872,564. So in order to get into the Archipelago, Harry Trueblood had assumed liabilities up to a total of $10,426,484. As this brought him only 1 /32nd of the whole net interest - or 3.125% - you could say that he would be laying out, over six years, $15 for every net acre of interest which would accrue to Consolidated, Insofar as Cornfeld's rhapsodic letter to his salesmen bore any relation to reality, his price of '$15 per acre' was based on this kind of computation.

    The sale to Consolidated was too small, and too intimate, to pass muster on its own for revaluation purposes. It was, however, buttressed by certain other transactions.

    At virtually the same time as the Consolidated deal, King Resources sold another small slice of the Arctic to John W. Mecom, one of the more colourful oilmen in H

King, who happens to be no relation to John M., was the man who signed the contract for Lake Shore.

    These three fractional sales could be totalled up to make 5.46875% of the Arctic package. It was still a long, long way from looking like a 25 % sale to Texaco. But at this moment, another purchaser came forward to improve the figures.

    This was none other than John M. King, acting this time in his personal capacity. On December 31, 1969, John King bought from King Resources Company i/64th part of the Arctic permit package. Once again, very little cash changed hands: there was a small down payment, plus a set of obligations for the future.

    This set of manoeuvres made it possible to say, in the last hours of 1969, that 9/128ths - or just over seven per cent - of the Arctic interest had been disposed of. Half of the purchase price consisted of a series of easy credit arrangements. The other half consisted of undertakings to relieve King Resources Company of obligations. There was no certainty that those undertakings would ever be carried out, in which case the work obligations would have to be assumed by King Resources if the permits were to be kept alive. (And within twelve months, as it happened, John Mecom and his companies were in deep financial trouble, and Consolidated was in dispute with King Resources over the deal.)

    This pantomine did not remotely resemble the 'arm's length' sale of 25% to a major oil company - which was what the auditors had suggested in November. It was not even the 10 % sale which had then been called a bare minimum. But it was enough for Bernie and Ed.

    IOS promptly transferred a flat 10% of the FOF Arctic holding-5%. that is, of the whole package-back to King Resources. They then said that FOF had sold 10 % of its holding to 'three independent oil companies'. On that basis, IOS re-estimated the 'true worth' of the FOF's remaining interest in the mixed bag of permits. The whole thing had been taken up virtually for nothing by King Resources, IOS now decided that the 45% which the FOF retained had increased in value to a staggering $156 million.

    The figure was not actually taken out of the air, but the computation upon which it was based was more involved than was suggested by the subsequent explanation in the FOF accounts. Altogether, it must have been a difficult judgement for Arthur Andersen & Co - as hard as any they faced in ten years of auditing IOS Ltd and its funds.

    When, rather belatedly, the FOF accounts appeared in summer 1970, there was a note which said that a sale of 10% of the Arctic interest had been made to King Resources, the 'operator' of the interest, on 'the same bases and terms as a December, 1969, sale by such operator of a 9.375% interest to outside third parties'. The percentage 9.375 % of the 'operator's' half-interest is the same thing as a 3/64th part of the whole -namely, the slice taken up by Consolidated Oil & Gas plus John Mecom. Apparently, these two purchasers were the only ones who could be used in actual accounts as 'outside third parties'. The other sales to Lake Shore and to John M. King simply helped to give colour to the claims of Cowett and Cornfeld that an important sale had been made.

    Although they shyly declared themselves 'not competent' to pronounce upon the actual valuations produced on the basis of these sales, the auditors did say that they had checked over the procedures involved to make sure that they were as described in the accounts. Yet even so, the description does not tally properly with the actual events of FOF's sale back to King Resources.

    The accounts say that 'sales proceeds consisted of $779,300 cash down-payment and $7,570,000 payable in six semiannual instalments beginning in 1973…' These figures would have been correct if King Resources had contracted to pay the FOF for its 10% in exactly the same way that King Resources was to be paid by Consolidated, Mecom, Lake Shore and John M. King personally. This was not so. King Resources was proposing to take the same credit, but the payments were different.

    King Resources' down payment to the Fund of Funds was actually $606,618 and 59 cents, rather than the $779,300 given in the accounts. And the amount that King Resources contracted to pay off in instalments was not $7,570,000 - but $5,795,726 and 96 cents. The difference sprang from the fact that King Resources had a 12% 'net operating profits interest' on all the FOF holdings in the event oil should be found. When buying back, King Resources 'lost' this interest on the FOF customers' investment, and a valuation was added to the price to account for this loss.

    For the purpose of revaluing, however, IOS and its auditors assumed that King Resources had actually paid FOF the same price as it had received when selling to Consolidated. The Fund of Funds' remaining 45% was declared to be worth $14.1 per net acre - and it was this which produced the new gross value of $156 million. This was then solemnly discounted: first, by taking off an apparently arbitrary $17 million to account for King Resources' 12% on the holdings retained. Further allowances were made to allow for the interest FOF would lose by not collecting the full purchase price for six years, and for the fact that the work obligations would only be paid over three years. These were reckoned at a round $20 million, which reduced the new 'valuation' to $119 million.

    These mathematical gymnastics were taken to mean that the Fund of Funds' investment had appreciated by a sum of $102 milhon, prudently discounted.
¹
At this point there occurred the first serious cash transaction in the whole enterprise, IOS took $9.7 million out of the Fund of Funds and paid the money to itself as a 'performance fee': a reward for having procured the increased value of the Natural Resources Account.

    Elaborate as it was, the whole operation was not really an adequate excuse for removing nearly $10 million of the

    
¹
A small part of the Arctic interest had been placed in the IOS Growth Fund, a new promotion in Germany. It was allocated $2.7 million of the appreciation.

    customers' money for the profit of IOS itself. And the effect upon the Fund of Funds was so dire that it requires a special brand of chutzpah to defend it in the name of 'fairness to the investors'.

    Although the net asset value of the Fund of Funds was bumped up 12% on December 29-30, 1969, the actual transfer of 10 % to King Resources did not occur until early January. The object of this manoeuvre was to avoid taxation, but all the same a provision against tax of about $18 million had to be put on the books. This chopped the 'revaluation' down to $74 million - IOS, naturally, having taken its fee on the larger sum - and as a result the Arctic permit interest was left on the books at a figure of $8.01 per acre. This meant that the Natural Resources Account, having paid out a large sum of cash for the privilege of recording notional gains, jumped to 22% of the whole valuation of the Fund of Funds. Within eight months, that whole section had to be removed from the Fund of Funds and closed to redemptions.

    It was understandable, in the aftermath of this grotesque deal, that Cornfeld and other IOS luminaries should scan the Arctic horizon eagerly for signs of gushers. During 1969, the most exciting event had been a 'blowout' of natural gas encountered by a Panarctic team on Melville Island: ironically, King/FOF drills nearby found oil seepage, but the permits held there were only for sulphur exploration.

    By summer 1970 King Resources was frantically trying to raise money on its part of the Arctic interest - or even just to get rid of its work obligations. But the major oil companies, the only ones with ready money, were in no mood to speculate indiscriminately. British Petroleum took over, for a small sum, King's obligation to drill a well on Graham Island, one of the more promising spots. BP also took an option on another set of permits but even so the total acreage involved was minute in comparison to the total King/FOF interests. Sun Oil came in on this deal, and took on additionally some of King's obligations on much wider acreages. But Sun still avoided the large, un-drillable offshore acreage, which was left to King and the IOS investors. The terms of those deals do not justify in retrospect the extraordinary liberties that IOS took with the investor's money: even a real discovery of oil would not do so.

    The version of the Arctic deal that IOS announced to the press did not contain anything like the same details as Cornfeld's glowing dispatch to his sales managers, 'IOS Funds Receive Late Yule Present From Polar Regions,' was the Wall Street Journal headline, and the story said that IOS had declared a sale, but refused to reveal the identity of the purchasers. The news delighted the IOS Associates, but not the international financial community. Those doubts about IOS, which had been smoothed over by the public offering, began to creep back into people's minds.

    Once the elixir of confidence evaporated, abruptly, at the end of March, the Arctic deal became a magnet for bitter and destructive questions - but in February, it did not spoil Bernie Cornfeld's last triumph before the Institutional Investor seminar. At that point, the inner ruin of IOS was still pinned back behind the gleaming facade, although it needed all of Ed Cowett's cool nerve to keep it so. At the beginning of February, it was suggested in the pres