The Tax Views Of Deadeye, The SEC's Customary Action, And Losses of Non Madoff Investors.

March 24, 2009

Re: The Tax Views of Deadeye, The SEC's Customary Action,
And Losses Of Non Madoff Investors.



Last Friday I received a phone call from a friend of 45 years standing. I'll call him Deadeye. Deadeye is a brilliant fellow. He is a crackerjack bridge player, finished first in his class in a significant eastern law school, and has spent 47 years as a tax lawyer. Most important of all, in our youth Deadeye had one of the three best "sandlot" jump shots I ever saw. The form was beautiful, the shot was true, he made a tremendous percentage. Hence, Deadeye.

Before he went elsewhere for law school, Deadeye and I had been in college at the same time in Ann Arbor, in different Jewish fraternities which had a real sports rivalry going. So we have actually known each other for about 53 years though we have been good friends for only 45 years, starting with the time we both practiced tax law together in the Department of Justice in Washington, D.C. (I lasted only about four months in tax law, before giving it up for antitrust.) So, not having spoken for about a year, when he called, Deadeye and I engaged in some of the reminiscences and banter in which we find such pleasure, everything from people we knew, to touch football games on the mall in the mid 1960s, to all the guys and their wives from the old days whom he, luckily, unlike me, manages to see frequently even now, decades and decades later.

But reminiscences were not the reason he called. Deadeye wanted to talk about an aspect of my recent post on the guidance the IRS presented last week for victims of Ponzi schemes.

Deadeye's point was tax-profound, albeit simple -- so many great ideas are really very simple, yet are great because, simple though they are, they have long managed to go unrecognized.

I had used the following example in the post. An investor puts one million dollars into Madoff 20 years ago, had paid $900,000 in tax on phantom income, and on November 30th received a statement showing $2.5 million in his account. I had worked through what the investor lost in real economic terms, in arithmetic terms, and how much he "recouped" under the IRS' guidance ($875,000). But, said Deadeye the tax lawyer, shouldn't the matter be viewed as follows? The investor's actual investment was one million dollars. His actual amount of taxes paid was $900,000. In a just world, he would receive back $900,000 in tax paid on phantom income, and $350,000 from a theft deduction on the one million dollars of stolen principal. His total restitution via taxation would therefore be $1,250,000 -- whereas under the IRS' safe harbor provisions it is only, as said, $875,000.

I said to Deadeye that, putting aside the crucial idea that under the principle of legitimate expectations the theft deduction should be for the full two million dollars in the account on November 30th, I agreed with him. One million dollars of actually invested principal was stolen and should qualify for a theft deduction. Nine hundred thousand dollars of taxes was paid on income that never existed and should be returned. Simple. True. The way it should have been if one does not use the legitimate expectations principle. Deadeye is still shooting dead-on.

Which leaves a question. Why didn't the IRS use these simple ideas when giving guidance, instead of creating the cockamamie Rube Goldberg contraption it called guidance. Here one can only speculate. The answer surely cannot be that the people in the IRS were not aware of the simple, true propositions put forth by Deadeye.

If I had to make a guess -- and I suppose I do -- it is because using Deadeye's dead-on ideas would require the IRS to allow refunds of taxes paid on phantom income -- on non-income which the IRS has no constitutional right to tax -- all the way back to the beginning of the time when the investor began paying the unconstitutional tax on non income. Judging by the IRS' outright rejection in the guidance of use of the claim of right doctrine and its condition requiring that to use the safe harbor provisions one must give up all right to use the claim of right doctrine or the doctrine of equitable recoupment to recover prior taxes paid on the non income, and judging as well by the IRS' additional demand that one also must give up all right to claim a refund even for the three year period currently allowed by statute, a desire not to have to give up the tax it collected over the years on the phantom income, on the non income which it had no right to tax, coupled with a desire to do at least something to help the Ponzi victims, almost surely has to be the motivating force behind the IRS' Rube Goldberg scheme.

This is only the more true when one recognizes that the underlying motivation, both legislatively and judicially, for these rights the IRS is forcing investors to give up in order to use the safe harbor rule -- as also of the tax benefit rule which, in reverse, requires taxpayers to pay tax when something happens that makes a deduction taken in a prior year improper -- is to correct the situation so that it will reflect what the tax should have been rather than what it mistakenly was. It seems to me that the IRS is terrified that, whatever technical objections it might be able to throw up in court in order to argue that investors should not be allowed to use rules like the claim of right doctrine or equitable recoupment, the courts might allow those rules to be used because it has now been revealed to have been so wholly wrong in the end for the IRS to have collected an income tax -- an income tax on what turned out to be non income, an income tax on non earnings that never would have existed were it not for a fellow government body, the SEC.

You know, maybe it was neither ignorance nor oversight that caused the IRS, in its guidance, to not even mention a rule that I learned of only a day ago and would bet even most tax lawyers don't know (just as they knew very little on December 10th about what is beginning to be revealed to be a raft of tax rules that are extant but rarely used). There is a doctrine called the equitable tolling doctrine, which essentially means that, if serious consideration of justice and equity require it, the statute of limitations on seeking refunds will not apply. That doctrine would certainly seem to fit the Madoff matter, and would enable people to sue for refunds back to the beginning of their investment.

The IRS simply does not want to "open up" prior tax years back to the early 2000s, the 1990s or, for some people, even earlier, and this is true even though it had no constitutional right to collect the tax in the first place. If the prior years were opened, it would simply have to give up too much money that it had no right to collect, and whose collection was co-caused, co-enabled, by a fellow government agency. It has thus created a Rube Goldberg scheme to force people to give up their rights in return for at least some tax relief, particularly people who cannot afford to hold out and, perhaps, at the opposite pole, people so rich that they are willing to call it a day in return for scores of millions of dollars they will get back under the guidance, either immediately or in tax carry-forwards.

That, anyway would be my guess.

* * * * *

Now let me turn to the SEC's public statement in 1992 that "Right now, there is no evidence of fraud," a statement which sucked in thousands of people and billions of dollars to Madoff, a statement the SEC never retracted, not even after it began receiving extensive evidence of fraud.

I have wondered for a long time whether such statements by the SEC were as rare as I thought them to be. Somewhat neglectfully, I fear, I failed to inquire into the answer to this question. But now some of us have found out the answer in conversations with, or emails from, securities lawyers. Such statements are never made, the professionals tell us. Never. Oh, on rare occasions, when a party tells it that public knowledge (via leakage?) that he is being investigated is threatening to ruin his reputation, the SEC will give a no action letter to an investigated person and let him use it as he pleases. But that is as far as the SEC goes, and is itself rare. Usually the SEC simply closes its investigation.

So . . . . . . . why did a high SEC functionary announce in 1992 that there was no fraud, why did the SEC do this extraordinary thing? Two possible answers have been suggested. One is that dear old avuncular Uncle Bernie had been so good to the SEC, was such a buddy of the SEC, and was such a huge big deal at NASDAQ, that the SEC did him a special favor, and thereby sucked thousands of people and scores of billions of dollars into his Ponzi scheme. And that is the "innocent" explanation. The other explanation dovetails with the idea, held by many, that the existence and extent of drastic, years-long, continuing malfeasance by the SEC here could not conceivably have been the product of mere negligence or possible ineptitude. Such horrible conduct of such duration, they feel, had to be the result of corruption in high places, and the 1992 statement was the product of and reflects that corruption.

In regard to "mere" horrible negligence versus possible corruption, I recently was sent, as were others, the 1/24/2006 "Case Opening Narrative" from the SEC -- a narrative which explicitly reveals that it in fact was written well after the case was opened. For it talks about what already had been done (e.g., requesting voluntary production of documents), and about what conclusions had already been drawn (e.g., that Uncle Bernie himself had personally misled the staff about the strategy implemented for certain hedge funds and other customers' accounts, had withheld information about certain customers' accounts, and was active as an investment adviser to other hedge funds.)

But the real shocker in the putative "Case Opening Narrative" (emphasis added) was this: The complaint given to the SEC by the person who had complained, the "Narrative" said, the complaint given to the SEC by the person who obviously was Markopolos, "did not contain specific facts about the alleged Ponzi scheme." However, the staff "is trying to ascertain whether the "complainant's allegation that [Uncle Bernie] is operating a Ponzi scheme has any factual basis." The "Closing Recommendation Narrative," dated a year later, 1/21/2007, subsequently said "The staff found no evidence of fraud."

The complaint given to the SEC by Markopolos "did not contain specific facts about the alleged Ponzi scheme"? Are you kidding me? Markopolos told the SEC how Madoff was paying feeder funds outlandish fees. He told it that Madoff demanded utter secrecy from the feeder funds as to whom their investment manager was. He told it that rather than Madoff covering his trades with puts and calls, as he claimed to be doing, there were, by far, not enough puts and calls in the whole country to even begin to cover his claimed securities trades. He told it to check with firms with which Madoff supposedly was dealing in puts and calls to check out whether they had trade tickets verifying the dealings. He told it that Madoff did not allow outside performance audits by firms that wanted to perform due diligence. He told it that Madoff appeared to subsidize down months and to have incredibly perfect market timing. He told it that Madoff was giving up what would have been huge fees it would otherwise have made. He told it that Madoff's brother-in law was the auditor and that only Madoff's family knew what the strategy was. He told it that others who were using the split strike conversion strategy were unable to replicate Madoff's results, and he could not replicate the results on "retroactive" computer runs. He told it the names of high level Wall Street officials to talk to -- whom it never contacted. Yet, the SEC memo says that Markopolos' complaint "did not contain specific facts about the Ponzi scheme" (let alone about expert opinions regarding it)? Gimme a break. Plus, when the opening "Narrative" say Markopolos gave it no specific facts, is it any wonder that the closing "Narrative" says the staff "found no evidence of fraud."?

You know, all this seems to me to indicate something far worse than "mere" horrible negligence. Alleged negligence, alleged incompetence, of this magnitude fairly screams not "mere" negligence, not "mere" incompetence, but outright corruption of some type.

* * * * *

I want to conclude by assailing a point that is being taken for granted as true, but seems to me often not true.

It seems to be accepted, even among Madoff's victims, that they can get no empathy from others because even those others who could afford to and did invest elsewhere, including average working Joes who invested through pension vehicles of one type and another, lost half their money invested in the market in the last year. But, you know, things quite often -- not always, but quite often -- look quite different if you look, as investment soundness dictates, at longer time horizons than just the last year. For example, the Madoff investor who began with Uncle Bernie in 1978 (a time period when many did begin with him) had zero at the end of 2008. The Dow was at 805 at the end of 1978 and at 8776 at the end of 2008, over 1,000 percent higher even after the great collapse of 2008. If you use the year 1992, when the SEC became a co-cause of damages, the Dow was at 3301, with it again being 8776 at the end of 2008, or very roughly 240 percent higher. If you use the year 2000, when Markopolos sent his complaint to the SEC, the Dow was at 10786 at the end of December, so there is a loss of roughly 20 percent. But if you use 2002, when the Dow was at 8341, there is a small gain.

So, ceteris paribas as the economists say, and assuming in all cases that over the years, over time, you kept all your money in the investment instead of withdrawing principal or income, you generally did ok on the basis of the Dow, and you never even came close to losing all your money, as investors in Madoff did.

If you run the numbers against the S&P, the results are of the same type. The S&P stood at 277 at the close of 1978, at 435 at the close of 1992, at about 1320 at the close of 2000 and at a closing price of 903 the day after Madoff was arrested. So in two of the three cases you did fine.

If you look at a straight compound interest table, you find that someone who invested $1,000 at a mere 4 percent in 1988 had 2191 at the end of 2008. Those who invested at 4 percent at the end of 1992 or 2000, respectively, had $1,872 and $1,368 at the end of 2008 -- and did not lose half or so of their money in 2008, as people in the market did. If you invested $1,000 at 5 percent or 6 percent at the end of 1988, 1992 or 2000, at the end of 2008 you had, at 5 percent, $2,653, $2,182, and $1,447, and at 6 $3,207, $2,540, and $1,593. So you did fine and once again, you did not lose half your money in the meltdown of 2008.

The same holds true for mutual funds. The Morningstar 500 annual edition gives five, ten and fifteen year figures for mutual funds. The 2009 edition, which covers the year 2008, is not out yet, and I don't use a computer so I am not going to check things that way. But if you go to the 2008 edition which covers the year 2007, look up the five, ten and fifteen year dollar figures at the end of 2007, and then arbitrarily cut the 2007 figure in half to account for 2008, you will find that investors in good funds did fine over the long haul unto the end of 2008. And they did not, of course, have their investments wiped out in 2008, as Madoff investors did.

So the idea that other investors should have no sympathy for Madoff investors because the others lost half their money in 2008 is probably a good soundbite and therefore an attractive "political" statement, but, like so many soundbites and attractive "political" statements, does not stand up to analysis. Over longer terms than 2008 alone, others did fine and were, of course, not wiped out in 2008. Madoff victims were wiped out in 2008.*


* Thisposting represents the personal views of Lawrence R. Velvel. If you wish to comment on the post, on the general topic of the post, or on the comments of others, you can, if you wish, post your comment on my website, VelvelOnNationalAffairs.com. All comments, of course, represent the views of their writers, not the views of Lawrence R. Velvel or of the Massachusetts School of Law. If you wish your comment to remain private, you can email me at Velvel@VelvelOnNationalAffairs.com.

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