Securities Law Blog

The Internal Revenue Service finally offered guidance this week to Ponzi scheme victims that it would allow them to claim a tax deduction related to the bulk of their losses-even losses related to ficticious profits carried on phony statements. The matter has been a point of debate and anxiety for many of the victims I have spoken to over the last few weeks, given the lack of clarity in the tax code about how it should be handled.

The plan, which applies to victims of all Ponzi schemes, is likely to provide major relief to victims of Mr. Madoff. It is also likely to provide clarity for victims as they prepare to file federal income tax returns by the April 15 deadline, and help the I.R.S. avoid an unwanted avalanche of amended returns from victims.

The commissioner of internal revenue, Douglas Shulman, announced the plan in testimony before a Senate Finance Committee hearing on Ponzi schemes, tax evasion and offshore banking fraud. Later, in a briefing, Mr. Shulman said that “clearly the Madoff case is tragic as so many people were victims of this fraud, but the case also raises a staggering array of tax issues.”

Under the plan, the I.R.S. will allow investors, including those who are suing Mr. Madoff, to claim a theft loss equal to 95 percent of their investments, minus any withdrawals, reinvested gains and payouts from SIPC. Investors who are suing third-parties involved in such a scheme, and who, as a result, may have some prospect of recovery, are permitted to claim a deduction equal to 75 percent of their investments.

Current theft loss rules typically allow losses to be carried back three years and forward 20 years, but the I.R.S plan will allow carrybacks of as many as five years, generally if the loss is for a small business with gross annual receipts of less than $15 million. Under the plan, investors must claim the loss as having happened in 2008.

For people who invested with Mr. Madoff through retirement plans, like 401(k)s and individual retirement plans, the picture is more complicated because such money was already invested on a tax-free basis. Mr. Shulman, the commissioner, said that generally, if the investment was deductible when it was made, such investors “can’t take a loss.”

When computing losses, investors are not permitted to include any taxes they paid on what turned out to be fictitious income.

But the plan affords relief to such investors by allowing them to include fictitious income in their loss computations — a measure that might allow them to recoup taxes paid. It also will keep scammed investors from “owing taxes on income that they never received,” said Senator Charles E. Schumer, Democrat of New York and a member of the Senate Finance Committee. Presumably, Investors will need to produce copies of the fraudulent statements to show Madoff's phony inflated account values.

People who invested with Mr. Madoff through so-called feeder funds that placed client money with him will also get relief. These funds will be allowed to claim the theft-loss deduction but will allot those losses proportionally to individual investors.

The I.R.S. said it did not know how much money in taxes investors had paid in recent years on Madoff-related income. It said that investors who had already filed 2008 returns should file amended returns claiming the theft-loss deduction.

Bernie Madoff's accountant was arrested on fraud charges Wednesday as authorities blamed him for failing to make the most basic auditing checks that would have exposed an epic fraud that cost investors billions of dollars.

David Friehling is the first person to be arrested in the scandal since Madoff turned himself in, and his prosecution signals that the government is intent on bringing Madoff's associates to justice as they try to figure out who helped him carry out the fraud.

According to prosecutors, the 49-year-old Friehling essentially rubber-stamped Madoff's books for 17 years, serving as Madoff's auditor from 1991 through 2008 while operating from a discreet building in suburban New York.

Authorities said that if Friehling had done his job, Madoff's financial statements would have shown his company owed tens of billions of dollars to his customers and was insolvent.
"Mr. Friehling's deception helped foster the illusion that Mr. Madoff legitimately invested his clients' money," said acting U.S. Attorney Lev L. Dassin.

The relationship between the accountant and Madoff was so cozy that Friehling and his family pulled $5.5 million from accounts with Madoff since 2000 and had a balance of more than $14 million as recently as November. Prosecutors said it's a conflict for accountants to have such large sums invested with clients.

Friehling did not comment as he left the courthouse after being released on bail
Prosecutors now believe that Madoff received help--even if only in the category of malfeasance as opposed to misfeasance--from Friehling as he carried out his fraud, although Friehling is not charged with knowing about his Ponzi scheme.

The government says Friehling did not meaningfully audit Madoff's business or confirm that securities purportedly held by Madoff's company on behalf of its customers even existed.
The Securities and Exchange Commission said Friehling instead pretended to conduct minimal audit procedures of certain accounts to make it seem he was conducting an audit and then failed to document his purported findings and conclusions as he was required to do.

Prosecutors said he even failed to examine a bank account through which billions of dollars flowed.

"He did little or no testing, no verification of the `facts' he certified," said Joseph M. Demarest, head of New York's FBI office. "His job was not merely to rubber-stamp statements he didn't verify."

The SEC said Friehling took steps to hide his personal investment with Madoff, including replacing his own name on his Madoff account with his wife's name and later naming the account the "Friehling Investment Fund" to conceal the conflict of interest.

The SEC also accused Friehling of lying to the American Institute of Certified Public Accountants for years, denying he conducted any audit work, because he was afraid that his work for Madoff would be subject to peer review.

The accounting industry organization said Wednesday it had completed its ethics investigation of Friehling's conduct as an auditor of a brokerage firm and had expelled him for "failure to cooperate."

If convicted, Friehling faces up to 105 years in prison. He is charged with securities fraud, aiding and abetting investment adviser fraud and four counts of filing false audit reports with the SEC.
The fraud charges against Friehling come just days after the founder of his auditing firm, Jerome Horowitz, died of cancer last week at the age of 80, a family friend said.

Horowitz handled Madoff's books for many years before turning the business over to Friehling, who is his son-in-law.