VICTIMS OF FINANCIAL FRAUD MAY HAVE A VARIETY OF RECOVERY OPTIONS AVAILABLE TO THEM
In late 2010, the United States Financial Fraud Enforcement Task Force announced the results of “Operation Broken Trust”. The task force reported that it had pending enforcement actions against 500 defendants involving over $10 billion of losses in 2010 alone, and claimed that the frauds harmed more than 120,000 investors throughout the United States.
While Operation Broken Trust is a good start, the reality is that thousands of investors across the country will face the devastating realities of being victimized by financial fraud. Unfortunately, in many cases, defrauded investors have little to no prospect of recovery through traditional means, such as litigation or arbitration.
However, investors and the professionals advising them should be aware of other, less known recovery options available to them. Let’s examine those options and highlight the intricacies of each.
Theft Loss Tax Deduction
Under Section 165(e) of the Internal Revenue Code, investors who have suffered losses as a result of a Ponzi scheme or other financial fraud may be eligible to take a “theft loss” tax deduction for the losses that they suffered. Although the theft loss tax deduction is not new, following the Madoff scandal the IRS created a “safe harbor” under Section 165 for victims of Ponzi schemes.
Revenue Ruling 2009-20 provides that victims of financial fraud who have no reasonable prospect of recovery and who are not seeking recovery from third parties may immediately deduct 95% of their investment in the Ponzi scheme, including any fictitious income reported on prior tax returns. Victims who intend to pursue or who currently are pursuing recovery from a third party still are eligible to deduct up to 75% of their investment. Both of those deductions are deductable as ordinary losses as opposed to capital losses.
Thus, victims of financial fraud may be able to deduct the majority of their investment loss as an ordinary loss. This will help victims offset any past or future taxable income, and may significantly lower their overall tax liability.
Another means of recovery for fraud victims may be through a receivership. A receivership is created by a court at the request of the United States Securities and Exchange Commission (the “SEC”). Receivers typically are appointed in securities fraud cases involving a sufficiently large number of investors and a sufficiently large enough amount of money.
A receiver is charged with marshalling the assets of the fraud and holding them in trust for the SEC to distribute to aggrieved investors. Receiverships often are created in Ponzi scheme cases to freeze the assets of the Ponzi scheme before it collapses and to ensure proper distribution of the remaining assets to the victims.
To receive a distribution from the receivership, defrauded investors must submit a claim with the receiver. For example, the SEC recently shuttered USA Retirement Management Services, a Ponzi scheme involving over 120 individual investors and $20 million in assets. At the request of the SEC, a receiver was appointed. Our firm was engaged to guide an investor through the claims process, involving the submission of forms and supporting documents, which was too confusing for her to manage alone.
Another common recovery mechanism for investors is by way of a “Fair Fund”. This is a fund created by the SEC to distribute to investors disgorgements (returns of wrongful profits) and penalties that have been recovered as a result of a successful SEC enforcement action.
Fair Funds typically are created as a result of a securities fraud that on an individual level does not necessarily cause large losses (but in the aggregate is harmful to maintaining efficient capital markets). Public companies misstating their financial statements, or mutual funds engaged in market timing, are examples of the types of frauds for which a Fair Fund would be created.
Like a receivership, investors must submit a claim with the Fair Fund to receive a distribution. However, unlike a receivership a Fair Fund may establish certain parameters outlining which investors are eligible to submit a claim.
A good example of an SEC Fair Fund is the $800 million fund created in 2007 to distribute the penalties levied against American International Group, Inc. (“AIG”) for reporting materially false and misleading information about its financial condition. Eligible investors were able to submit a claim with the Fair Fund and receive a distribution in proportion to their ownership interest in AIG.
Due to the confusing eligibility rules and the relatively complex claims process, investors are encouraged to seek counsel to help guide them through the Fair Fund claim submission process.
Victims of financial fraud and the professionals advising them should consider all of the available recovery options, even when the prospect of recovery through traditional means seems unlikely. Taking a comprehensive approach may help victims move past the dramatic impact of financial fraud and recover something, in money or by way of tax breaks, rather than nothing at all.