Hey you, got some money you want to invest? This is a can’t-miss deal; good, no, great returns; stable performance even in bad times; and to top it off, everything is guaranteed.
Unfortunately for many investors, the answer was yes. But what they invested their money in wasn’t some sort of special high-interest CD or high-tech stock trading system that couldn’t lose. It was a Ponzi scheme, a fraud that uses cash from newer investors to pay those attractive returns to older investors.
That is, until the scheme collapses.
In the past several months, thousands of investors who thought they had accounts worth billions of dollars have discovered it was all illusory. Earlier this month, Bernard Madoff pleaded guilty in federal court to running a Ponzi scheme that prosecutors said could involve more than $64 billion, by far the largest such fraud ever. In February, regulators charged Robert Allen Stanford and several of his companies with operating an $8 billion investment fraud.
Government regulators and prosecutors also recently filed civil and criminal cases against a handful of other money managers involving tens to hundreds of millions of investors’ dollars.
“They’re all depressed,” said New York tax attorney Harold Levine of his Madoff investor clients. “Clearly people’s lives have changed. Some people are in denial. Some people understand it. They’re all angry.”
So what do you do if you’ve been caught up in one of these scams? Here are five suggestions that might help.
1. Go to the shoebox. The first thing a victim should do is collect as many records as he or she can find relating to the investment, according to Boyd Page, an attorney who specializes in representing investors at the Page Perry law firm in Atlanta.
That’s important, because those involved in investment schemes often don’t keep records, have destroyed them or the files are in disarray and not complete, Page says. Gather account statements, canceled checks you sent or checks sent to you. Also look for anything acknowledging your investment such as emails or letters that may have trumpeted the alleged performance.
2. Visit the courthouse. You can file a lawsuit to try to recover your money, but there are lots of variables with this avenue that can make a big difference in the end. Much of it has to do with who you sue and how much assets they have.
“Generally speaking, legal actions directly against the perpetrator have little likelihood of being economic,” Page says.
There are several reasons for this. First, chances are good that whoever ran the Ponzi scheme was living life high off the hog — private jet flights, fancy vacations, lots of lavish spending. Second, once a fraud is exposed, the remaining assets of the firm and its operators almost always are seized by the government or court-appointed trustee in bankruptcy court.
However, others who were involved in varying degrees with the fraud may also be liable and have additional assets, says Alan Cosner, a former IRS agent and attorney in East Brunswick, N.J. Perhaps there were people who took part in transactions related to the scheme who knew about it but didn’t act, says attorney Ron Geffner, a partner with Sadis & Goldberg in New York and a former lawyer with the Securities and Exchange Commission.
In the Madoff case, there were “feeder funds” that placed money from their investors with Madoff, perhaps without those investors’ knowledge. Unbeknownst to Loretta Weinberg, a New Jersey state senator, her financial adviser in California invested her money with Madoff. The result: Her life savings, more than $1 million, is gone.
There also may be accounting firms, banks or other individuals who were negligent in not spotting the fraud, Page said. In February, the charitable foundation of Sen. Frank Lautenberg, D-N.J., and two of his children sued Madoff’s brother Peter, who was the chief compliance officer and general counsel of Bernard L. Madoff Investment Securities. Peter Madoff has not been charged criminally in the case.
Some situations may exist in which individual victims have claims unique to them or a small group of investors, depending on how they became involved in the scheme and other factors, Page said. That could be helpful, especially if a fraud impacted hundreds or thousands of investors, all of whom are looking for ways to recover their money.
3. Claim losses for previous tax years. One of the best ways for investors caught in a Ponzi scheme to mitigate their losses is to go to their favorite uncle — Uncle Sam. Federal tax rules offer investors a couple of ways to get money back — in some cases as much as 50 percent of their loss.
“In the Madoff case, probably the greatest recovery is going to come through tax relief,” says Levine, chairman of the tax department at Herrick Feinstein in New York. “The problem is (that) there really is no clear authority on exactly how this is going to work.”
The most popular options are filing an amended income tax return for previous years, and using the “theft-loss” deduction. However, taxpayers can only amend returns for the prior three years no matter how long the scam may have been operating, Levine says.
The benefit comes from recharacterizing what previously was considered profit from the scheme, profit that an investor paid taxes on. Now, it’s considered phantom income, meaning the investor overstated their taxable income and would be eligible for a refund.
The theft-loss deduction is a bit more complicated. Richard Lehman, a tax attorney in Boca Raton, Fla., says investors who have unreturned principal or phantom profit from a fraud are in many cases entitled to deduct that amount from other income they earned.
Earlier this week, the IRS issued guidance on the tax issues related to Ponzi schemes following IRS Commissioner Doug Shulman’s testimony before the Senate Finance Committee. In essence, the IRS will allow victims of a Ponzi scheme to claim a theft loss, which is the investors’ unrecovered investment, including income reported in prior years.
In addition, the IRS provided what it calls two simplifying assumptions for taxpayers regarding what qualifies as a theft loss and how much of their loss they can deduct if they expect to recover some money from the fraud. For more information, see Shulman’s prepared testimony and guidance details on the IRS Web site.
Individual circumstances and facts ultimately determine whether a taxpayer can apply the theft-loss deduction. And if the losses exceed a taxpayer’s income for a particular year, those losses can be applied to tax returns from the previous three years and forward 20 years, Levine says. Tax law prohibits taking a theft loss until there no longer is a reasonable expectation of recovery from elsewhere such as the Securities Investment Protection Corp. or a trustee, he says.
The tax benefit won’t help everyone. Lehman, who is working with about two dozen former Madoff clients, says victims of a Ponzi scheme who used money from their retirement accounts, such as an IRA, are out of luck when it comes to taking tax deductions.
4. Follow the herd. When a Ponzi scheme collapses, a receiver or bankruptcy trustee generally is appointed. Part of that person’s job is to collect as much money and other assets as possible to eventually distribute to creditors.
These receivers or trustees establish a claims process requiring victims to file paperwork asserting how much they lost. When a trustee is finished, whatever assets have been accumulated, minus administrative fees, are distributed to creditors, but the recovery is often pennies on the dollar.
With Madoff, some investors are eligible to file claims with the SIPC, a government-created institution that keeps a reserve to pay investors who lose money with failed brokerage firms. But there’s a $500,000 cap for each customer, $100,000 of that is for cash; the rest for securities, and SIPC’s fund is only about $1.6 billion.
The SIPC and the court-appointed trustee in the Madoff case mailed out more than 8,000 claim forms in January. Cosner says he’s advising clients who were Madoff investors to file claims through the SIPC rather than pursue lawsuits on their own.
In other frauds where the SEC has sued scammers, the agency establishes procedures for harmed investors to file claims. Last year, a receiver working with the SEC distributed about $4 million to victims of an $11 million Ponzi scheme called Premium Income Corp., which the government took action against in 2005.
The bottom line: In most cases, it doesn’t hurt to submit a claim with the receiver or trustee overseeing the process. It might lead to some recovery.
5. Take the money and run? Not so fast. If you’re thinking you dodged a bullet because you took your investment — and profits — out before an investment fraud was exposed, think again. Generally, if records exist, a receiver or trustee will sue to get money back from investors who received profits before things went bad.
In legal circles, it’s quaintly called a “clawback provision.” The trustee in the Madoff case already has said he’ll pursue claims against investors who received substantial profits from the scheme. Geffner says New York law allows a trustee to go back six years.
“If you got more money than what you put in, you are at risk of being the subject of clawback provisions,” says Page, the Atlanta attorney. “A lot of times, it is smart to consider being a small dog in tall grass.”
That means don’t file a claim with the trustee or anyone else or a lawsuit, and hope you’ll get overlooked, Page says. If account records of the fraud are in disarray, it may be difficult to document which investor received how much money.
Attorneys also say there are defenses investors can use if a trustee comes knocking. “If you took out your own money, chances are you’ll be able to keep that,” says Cosner.
As is the case with most of these options, it’s best to consult with an attorney or tax professional who is knowledgeable about the specific issues.