Friday, April 17, 2009

Was The IRS As Culpable As The SEC In The Madoff Scam?

April 17, 2009

Re: Was The IRS As Culpable As The SEC In The Madoff Scam?

This posting raises the question whether the IRS may be as culpable as the SEC and FINRA for the continued success of Madoff’s Ponzi scheme. If the possibility raised here turns out to be true, as I suspect will be the case, this would be a disaster for the country. For it would mean that what is perhaps the one agency which above all others must be kept competent and clean as a whistle, the agency that collects taxes, was instead a witting or unwitting facilitator of the worst kind of fraud. The consequences of this might accurately be called incalculable.

It is unknown to most people that, as part of its extensive authority over pension plans of all types, the IRS has the authority to approve so called non-bank custodians for IRAs and various other kinds of accounts (e.g., medical health plans). This goes back to the Employment Retirement Income Security Act of 1974. Congress, greatly concerned over many aspects of pension plans -- it wanted them, for example, to vest and be portable -- passed the 1974 act because

One of the most important matters of public policy facing the nation today is how to assure that individuals who have spent their careers in useful and socially productive work will have adequate incomes to meet their needs when they retire. This legislation is concerned with improving the fairness and effectiveness of qualified retirement plans in their vital role of providing retirement income. In broad outline, the objective is to increase the number of individuals participating in employer-financed plans; to make sure to the greatest extent possible that those who do participate in such plans actually receive benefits and do not lose their benefits as a result of unduly restrictive forfeiture provisions or failure of the pension plan to accumulate and retain sufficient funds to meet its obligations; and to make the tax laws relating to qualified retirement plans fairer by providing greater equality of treatment under such plans for the different taxpayer groups concerned.

Congress had found that problems with pension plans had included, among others, “Inadequate coverage,” “Discrimination against the self-employed and employees not covered by retirement plans,” “Inadequate vesting,” “Inadequate funding,” “Misuse of pension funds and disclosure of pension operations.” Congress determined that “It is time for new legislation to conform the pension provisions [of prior legislation] to the present situation and to provide remedial action for the various problems that have arisen . . . .” (Emphasis added.) Congress provided “additional rules regarding fiduciary requirements,” and relied heavily on the IRS to enforce fiduciary standards:

Your committee believes that primary reliance on the tax laws represents the best means for enforcing the new improved standards imposed by the bill. Historically, the substantive requirements regarding nondiscrimination, which are designed to insure that pension plans will benefit the rank and file of employees, have been enforced through the tax laws and administered by the Internal Revenue Service. As a result, the Internal Revenue Service is already required to examine the coverage of the retirement plans and their contributions and benefits as well as funding and vesting practices in order to determine that the plans operate so as to conform to these nondiscrimination requirements. Also, the Internal Revenue Service has administered the fiduciary standards embodied in the prohibited transactions provisions since 1954.

Your committee believes that the Internal Revenue Service has generally done an efficient job in administering the pension provisions of the Internal Revenue Code. The very extensive experience that the Service has acquired in its many years of dealing with these related pension matters will undoubtedly be of great assistance to it in administering the new requirements imposed by the committee bill.

However, because the bill increases the administrative job of the Service in this respect, your committee believes that it is desirable to add to its administrative capability for handling pension matters. For this reason, the committee bill provides for the establishment by the Internal Revenue Service of a separate office headed by an Assistant Commissioner of Internal Revenue to deal primarily with pension plans and other organizations exempt under section 501(a) of the Internal Revenue Code, including religious, charitable, and educational organizations. In order to fund this new office, the bill authorizes appropriations at the rate of $70 million per year for such administrative activities. [That is $70 million per year in 1974 dollars, which is somewhere in the neighborhood of $250 million to $350 million today.] (Emphases added.)

Congress decreed that, although the trustee or custodian of an IRA account is usually a bank, a nonbank could also be a trustee or custodian if the nonbank provided “evidence,” or “substantial evidence,” that it met the necessary standards.

Under the governing instrument, the trustee of an individual retirement account generally is to be a bank (described in sec. 401(d)(1), [FN71]. In addition, a person who is not a bank may be a trustee if he demonstrates to the satisfaction of the Secretary of the Treasury that the way in which he will administer the trust will be consistent with the requirements of the rules governing individual retirement accounts. It is contemplated that under this provision the secretary of the Treasury generally will require evidence from applicants of their ability to act within accepted rules of fiduciary conduct with respect to the handling of other people’s money; evidence of experience and competence with respect to accounting for the interests of a large number of participants, including calculating and allocating income earned and paying out distributions to participants and beneficiaries; and evidence of other activities normally associated with the handling of retirement funds.

* * * * *

Although the bill generally requires that a trustee administer an individual retirement account trust, the bill also provides that a custodial account may be treated as a trust, and that a custodian may hold the account assets and administer the trust. Under the bill, a custodial account may be treated as a trust if the custodian is a bank (described in sec. 401(de)(1)) or other person, if he demonstrates to the satisfaction of the Secretary of the Treasury that the manner in which he will hold the assets will be consistent with the requirements governing individual retirement accounts. Again, it is contemplated that the Secretary will require substantial evidence (as described above) to determine if a person other than a bank may act as custodian. (Emphases added.)

Congress further required the trustee of an IRA to file annual reports:

The bill provides that the trustee of an individual retirement account (or issuer of a retirement annuity) is to report annually to the Secretary of the Treasury regarding contributions to the account or annuity and regarding other matters as prescribed by regulations. Your committee intends that the regulations will include a requirement that the trustee or issuer file annual information returns with the Internal Revenue Service (with copies to each individual for whose benefit a retirement account or a retirement annuity is maintained) on the amount of contributions to and distributions from the account or annuity.

So, it is clear beyond peradventure that Congress enacted the 1974 law in order to be certain that pensions, IRAs and similar kinds of arrangements are safeguarded -- that “individuals who have spent their lives in useful and socially productive work will have adequate incomes to meet their needs when they retire.” Subsequently, the IRS established regulations -- carrying out Congress’ purposes -- that had to be met for an institution to be approved as a nonbank custodian (NBC). Among the regulations are ones which ensure continuity of the NBC by providing “Sufficient diversity in the ownership of an incorporated applicant,” diversity requiring that any person who owns more than 20 percent of the voting stock in [an NBC] cannot own more than 50 percent of it. An NBC applicant also has to “demonstrate in detail its experience and competence with respect to accounting for the interests of a large number of individuals,” and must have a “separate trust division” in which “the investments of each account will not be commingled with any other property.” Also, “Assets of accounts requiring safekeeping will be deposited in an adequate vault” with “A permanent record . . . of assets deposited in or withdrawn from the vault.” As well, the NBC “must keep its fiduciary records separate and distinct from other records.”

In addition, by an IRS General Counsel Memorandum that was “Date Numbered: April 13, 1984” (but that also bears the date October 11, 1983), the IRS insisted that, in carrying out the duties Congress gave it, “The legal authority for the inspections of books and records of . . . [an] approved nonbank trustee for individual retirement accounts . . . is inherent in the language of the [statutory section] which allows substantive discretion to the Commissioner in the setting of standards for nonbank trustees as well as the method of enforcement of those standards.” Because the IRS had reason to believe that various nonbank trustees “may not be in compliance with the applicable requirements for nonbank trustees,” the Internal Revenue Service “propose[d] to institute a program to verify compliance of specific nonbank trustees with the applicable requirements of the regulations.”

Thus, to carry out Congress’ desire for the safeguarding of pension plans and IRAs, the IRS established rules limiting percentages of ownership in NBCs, requiring NBCs to show expertise in relevant accounting, requiring a separate trust division, requiring a separate vault and separate records, and demanding access to an NBC’s books and records.

All of this raises an overarching question with regard to Madoff, to wit, how in the hell did Madoff become an approved nonbank custodian for IRA accounts in 2004?

It has been widely believed, of course, that Madoff’s firm refused to handle IRA accounts itself -- that, if one desired an IRA account, one had to work through FISERV or its predecessors (like Retirement Accounts Incorporated). Lately, however, we are beginning to hear of people who say they had an IRA account directly with Madoff, not through FISERV. And, in any event, since FISERV and its predecessors never had in their custody any securities purchased by Madoff for customers (they couldn’t have had them, since Madoff never bought securities), Madoff was what I have heard referred to as a subcustodian for FISERV (at least he would have been a subcustodian had he actually bought securities for the accounts). So, one way or another Madoff was a nonbank custodian -- or at least would have been had he bought securities instead of faking it.

Alright, so here is a guy who comes to the IRS and says he wants to become an approved nonbank custodian of securities, and who gets approved by the IRS in 2004. How did that happen? Did the IRS simply ignore its own regulations? For instance, did it ignore its own requirement that he not own more than fifty percent of the company? Did it not check to see whether he had a separate trust division. Did it not check to see whether securities were kept in an adequate vault and not commingled, and whether there was a permanent record of assets put into and taken out of the vault? Did it not check to see whether fiduciary records were kept separate from other records? Did the IRS not examine Madoff’s books and records, as it had been claiming a right to do for two decades, since 1984?

Had the IRS done these things to determine compliance with its own regulations regarding becoming an approved nonbank custodian for IRAs, had it done these things which it seems that it must not have done, it almost surely would have discovered Madoff was a fraud. Madoff’s game almost surely would have been up. The IRS would have found, for example, no vault with securities. It would not have found any securities. It would have found no separate trust division. It would have found no books and records of the kind needed to be a nonbank custodian of IRAs. It would have found that Bernie Madoff owned almost the whole damn business, not a “mere” 50 percent.

But since the IRS approved Madoff as a nonbank custodian in 2004, it must not have done these things. Its approval of Madoff, moreover, raises additional questions. Why did Madoff seek IRS approval in 2004? What did he gain from it, especially since he was telling people that he would not accept IRA accounts (except through FISERV). (Was he afraid of lawsuits for being a nonapproved nonbank subcustodian?) And knowing in advance, as he must have, what the IRS regulations required, how did Madoff even dare to apply for approval as a nonbank custodian? Was the fix in somehow?

Or did the impetus for seeking approval from the IRS not come from Madoff, but from the IRS itself? Did the IRS, for example, learn that Madoff was acting as an unapproved nonbank custodian of IRAs, tell him this is not permissible, and tell him to apply for approval? And if this is what occurred, how did the IRS not know for 20 years that Madoff was acting as an unapproved nonbank custodian and how did the IRS approve Madoff despite his failure to follow its regulations? Also, if the IRS learned he was acting as an unapproved nonbank custodian and told him to apply for approval, then the IRS had to have known or at least have suspected that he had been acting as an unapproved nonbank custodian for years, yet all it did, apparently, was to require him to submit a few pieces of paper whose veracity it did not check, and it then approved him without even looking at his books and records apparently? (Just as the SEC, after finding out in 2006-2007 that he had been acting as an unregistered investment adviser for years, did nothing except require him to register.)

One bottom line on all this is that there seems to be a plausible case – maybe even an overwhelming case -- that the SEC is not the only government agency deeply at fault here. The IRS may also be deeply at fault. If so, the losses sustained by the thousands of small people, often in their 60s, 70s and 80s, who have been wiped out, who are having to sell their homes, who are trying to find even the most menial work in order to live, are due not just to the fault of one government agency (as well as to Madoff himself), but to the fault of two government agencies (as well as Madoff). This would make only the more compelling than it already is the case for extensive governmental restitution to compensate for the extensive governmental fault that wreaked disaster here.

Indeed, not only would the case for governmental restitution be even stronger than it already is, but the IRS’ restitutionary action to date will look even less generous than some of us already recognize to be the unhappy fact. When the IRS came out with its new revenue ruling and its safe harbor procedure, there was widespread approbation, a widespread feeling that it had been generous. This was in significant part due to sheer relief that the IRS would do something, and in part due to the traditional American unwillingness and inability to look facts in the face and to recognize what is right in front of one’s nose. For those of us of a certain age, this American unwillingness and inability have repeatedly been thrust in front of us since at least 1965 and the start of truly heavy American participation in the Viet Nam war. It was manifest in Viet Nam, in Nixon’s and Kissinger’s enlargements of that war, in Iraq, in the promotion of stock market and real estate bubbles (and in adjustable rate mortgages and their packaging, which fueled a bubble) that common sense and economics warned couldn’t last, in the still continuing unwillingness to look torture and its perpetrators in the face, in the belief, starting with Reagan, that greed can serve as a philosophy of life, in the failure to recognize, as people like Andrew Bacevich and Robert Kaiser have now started to write in marvelous books, that our public life is thoroughly and almost uniformly corrupt at the federal level (and often below that too). Paul Krugman has often made clear the American unwillingness to recognize reality, the drastic failure of intelligence in a democracy whose health requires intelligence.

So it was with the general reaction to the IRS’ action regarding Madoff. Largely lost in the handclapping for the IRS was recognition that its safe harbor procedure was the result of intense, immediate, behind the scenes lobbying by the superrich who were heavy donors to the Democratic party and who would benefit to the tune of deductions worth many score and even hundreds of millions of dollars, while small people (especially those who are older) who had had to take money out of Madoff every year to pay basic living expenses as well as to pay the tax on their very Madoff income itself would receive very little benefit and would instead continue to be subject to their “new- found inability” to afford food and shelter.

Largely lost was that the IRS’ tax relief, designed to greatly benefit the superrich while the small man and woman got screwed, did not provide any restitution for people who invested through IRAs, through pension funds, through feeder funds -- these emphatically were not the private investment vehicles of the superrich Democratic donors who strongly pressed behind the scenes for the IRS’ action.

Largely lost in the unconsidered gratitude and approbation was that, to take advantage of the IRS’ safe harbor theft deduction provision, one had to agree to give up all claims to refunds of taxes paid on phantom income -- on taxes that the government never had any right to -- neither under the constitution nor the statutes -- because there was no income, but which the government now was going to keep anyway.

Largely lost was that, if one were to use the safe harbor provisions -- as many would out of sheer desperation to get something back quickly in order to be able to pay everyday living expenses, at least for awhile -- one was required to give up the right to use legal doctrines that, if pressed in court, could conceivably result in refunds of taxes unconscionably being kept by the government: to give up the right to assert the claim of right doctrine, the equitable tolling doctrine, the equitable estoppel doctrine, the negative tax benefit doctrine.

All of this was lost in the cheers, cheers resulting from the typically American refusal to look facts in the face and possibly resulting here as well from an analog to what I believe is called the Stockholm syndrome.

And on top of all that, now it begins to look as if the IRS, which has done so little to help the small man and woman while kowtowing to the superrich who are heavy donors to the Democratic Party, may itself be one of the causes of the disaster, just like the SEC and Madoff himself. For it looks like the IRS, by ignoring Congress’ desire that it safeguard those who had IRAs, and by ignoring its own regulations on the subject as well, approved of Madoff as a nonbank custodian of IRAs when, had it carried out Congress’ desire and its own regulations, it would have discovered and thereby caused a stop to be put to the fraud which was occurring. And beyond this, for at least 20 years the IRS somehow ignored and/or did not learn that Madoff was acting as an unapproved nonbank custodian although, had it not ignored and/or failed to learn of this, and had it followed Congress’ wishes and its own regulations, it would have rung the bell on Madoff in the 1980s or 1990s.

Does it not go without saying that the IRS’ actions and inactions need to be extensively investigated by Congress, by the media, by Madoff investors, by litigants, by the FBI?

And there is one other point, too, one that might be called earth shaking in its implication. If the IRS acted with the extreme negligence and incompetence, if not complicity, that seems all too possible here with regard to Madoff, did it do the same with regard to other Ponzi schemes or frauds in which companies might have sought to elide suspicion by becoming an approved nonbank custodian? Almost daily, it seems, we hear of more frauds and more Ponzi schemes. Did the perpetrators of those frauds likewise seek and obtain IRS approval to shield themselves from suspicion? The thought is almost too terrible to contemplate. But it cannot be ignored. Just how many Ponzi schemes and frauds, if any in addition to Madoff, may have hidden behind some form of negligent or complicitous IRS approval?*

* This posting 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, 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

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