The New York attorney general’s investigation of the insurance industry isn’t the only cloud hanging over Arthur J. Gallagher & Co.
Thousands of miles away in a courtroom in Provo, Utah, the nation’s fourth-largest insurance broker is locked in a contract dispute that enters its fourth week of trial.
Losing the trial could cost Itasca-based Gallagher at least $140 million, or nearly one year’s worth of net income. The lawsuit involves counterclaims from Gallagher.
The litigation offers a glimpse into the legal and financial risks that can occur when companies stray far afield from their core business.
In late 1996 Gallagher signed a contract with a Utah start-up to license its fledgling technology that turns tiny coal particles into an alternative fuel that looks a lot like lumps of coal.
At the time the Utah company touted the technology’s environmental benefits because it involved recycling coal products that otherwise would be discarded into a resource that could be burned to make electricity. But Gallagher wasn’t looking to save the earth.
The fuel, known as synthetic coal, generates federal tax credits that companies use to lower their tax bills. In 2004 businesses are expected to claim about $3 billion in tax subsidies from the production of about 130 million tons of synthetic coal.
With billions of dollars at stake, the synthetic fuel industry has attracted a lot of investors outside of the energy sector, such as Marriott International Inc., the hotel operator–and lots of critics.
The tax credits have been subject to multiple Internal Revenue Service reviews and a congressional investigation looking into potential abuses. Some say the subsidies have done little to improve the environment or reduce the country’s dependence on foreign oil as was intended when the tax credits were passed in 1980.
Gallagher is one of the biggest non-energy benefactors. The company says it got $54.8 million in tax credits last year, which represented nearly one-fourth of its pretax income of $235.5 million. The company has other tax-advantaged investments, but they made up less than 3 percent of the total subsidies last year, according to Gallagher regulatory filings.
The synthetic coal tax credits helped lower Gallagher’s tax rate to 20 percent last year, well below the 35 percent federal tax rate on corporate income. In total, the company says it has received $160.4 million in coal-related tax credits, most of that coming in the last four years.
The $54.8 million in tax credits last year was more than the $39.5 million Gallagher received in contingent commissions from insurers. These fees, which are based on the volume or profit of the insurance placed with carriers, are central to New York Atty. Gen. Eliot Spitzer’s probe of conflicts of interest in the industry. Gallagher is among several brokers and insurers under investigation.
As of January Gallagher is no longer making contingent-commission agreements with insurers. The lawsuit could wipe out significant of earnings.
“It’s hard to asses how much merit [the suit] has,” said Adam Klauber, an analyst at Cochran, Caronia Securities in Chicago. “It’s just so non-traditional for this company. Early on, I remember, investors weren’t really comfortable with the nature [of the tax credits].”
But investors changed their mind when the tax subsidies started rolling in.
Taxes are a killer for insurance brokers because they have few hard assets they can depreciate. Depreciation shows up as an expense on an income statement.
As Gallagher grew in the 1990s it hunted for tax-advantaged investments to sock away the commissions and fees it earned by assisting companies to purchase property, casualty and other types of commercial insurance. Over the years it has invested in Florida real estate, low-income housing and an aircraft leasing company that leases two cargo planes to the French Postal Service.
In 1996 Gallagher thought it had struck gold.
The year before, the IRS approved a technology to manufacture synthetic coal that would qualify for the tax credits. The subsidies had been available for years but few used them because scientists had not come up with an inexpensive way to turn plentiful domestic coal into a gas or liquid that could replace oil.
But Headwaters Inc., based in South Jordan, Utah, had invented a process that compresses waste coal into larger briquettes, using sticky binding agents.
The method passed the IRS test that the coal undergo a “significant chemical change,” and not just a physical change.
Gallagher was one of the first to license Headwaters’ technology. The agreement called for the broker to pay a base license fee of $500,000 for each synthetic coal facility it built as well as a royalty equal to about 50 cents for each dollar of tax credit the company received, according to court documents. The agreement was later changed to lower the royalty, which Gallagher would have to pay until the tax credits expired at the end of 2007 as required by law.
Gallagher went ahead and built two facilities. But the lawsuit, filed in October 2000, claims Gallagher never paid the license fees nor any royalties.
Headwaters, formerly known as Covol Technologies, seeks $140 million for breach of contract, unjust enrichment and other claims, as well as payments related to future production of synthetic coal.
Both sides declined to comment on the case because of the ongoing trial. In a conference call with analysts on Jan. 26 Doug Howell, Gallagher’s chief financial officer, said it was “surprised” by the $140 million demanded by Headwaters at the start of the trial on Jan. 11.
“Headwaters is asserting we have been using their chemistry and production process in our coal plants and not paying them for using it,” he said. “We know that we have not been using their chemistry or production process, and the jury hopefully will see these facts during the trial. In the end, we believe their claim lacks merit.”
In fact, Gallagher turned around and sued Headwaters, saying the company misrepresented its technology. Gallagher claims Headwaters’ manufacturing methods produced a briquette that wouldn’t hold together and retained too much moisture for efficient burning.
After investing more than $40 million in a project, Gallagher says in court papers, it has been unable to sell any significant amount of synthetic fuel produced with Headwaters’ technology. It ceased using the technology and switched to an alternate manufacturing method.
Gallagher seeks $71 million plus punitive damages in its counterclaim. In regulatory filings Headwaters has denied the allegations in the countersuit.
It continues to receive revenues from 28 licensed plants and the sale of chemical binding agents used in the production of synthetic coal.
In the fourth quarter, the company said, revenues from licenses and chemical sales increased 26.9 percent to $51.4 million. It also reported that licensees sold 11.1 million tons of synthetic coal in the quarter, about one-third of the average quarterly production in the United States.
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Taking credits
Arthur J. Gallagher & Co. has reduced its income taxes by investing in synthetic fuels that generate government subsidies. At the end of 2004 the company had recorded a total of $160.4 million in synthetic-fuels tax credits.
%% Tax credits* Tax rate
1995 $778,000 37.8%
1996 $2.2 million 34
1997 $2.7 million 33.6
1998 $4.8 million 32.5
1999 $4.9 million 35
2000 $26.3 million 30
2001 $40.1 million 11.7
2002 $20.4 million 30
2003 $31.8 million 24.3
2004 $54.8 million 20
%% * Figures include credits from investments in low-income housing developments.
Source: Arthur J. Gallagher & Co. SEC filings
