The Madoff Scandal:
Implications and Next Steps
January 14, 2009
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Moderator
Joseph V. Del Raso
Partner
Pepper Hamilton LLP
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Featured Speaker
David M. Fournier
Partner
Pepper Hamilton LLP
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Featured Speaker
Ivan B. Knauer
Partner
Pepper Hamilton LLP
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Featured Speaker
Frank C. Razzano
Partner
Pepper Hamilton LLP
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Featured Speaker
Joel M. Friedman
Managing Partner
Freeh Group International
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Featured Speaker
Gregory J. Nowak
Partner
Pepper Hamilton LLP
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Featured Speaker
Joan C. Arnold
Partner
Pepper Hamilton LLP
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Introduction and Overview
Joseph V. Del Raso
Bankruptcy Implications
David M. Fournier
David M. Fournier
• Partner in the Corporate Restructuring and Bankruptcy
Practice Group.
• 20 years of experience in bankruptcy litigation.
• Has represented both financial institutions and individual
investors in the defense of preference and fraudulent
transfer actions arising out of ponzi schemes
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Bankruptcy Issues
• Involvement of U.S. Bankruptcy Court
– Receivership transferred to U.S. Bankruptcy Court by U.S. District
Court.
• SIPC Trustee enjoys powers of a bankruptcy trustee.
• Clawback Issues for investors
– The Trustee is likely to bring suit against investors who received
distributions from Madoff to recover not only "false profits," but
principal redemptions as well.
– Preferences and Fraudulent Transfers
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Bankruptcy Issues
• Preferences and Fraudulent Transfers
– Preferences are payments made within 90 days prior to the
insolvency proceeding, on account of an existing debt, that allowed
the recipient to receive more than it would have received in a
liquidation.
– Fraudulent transfers include payments made, while the payor was
insolvent, either for less than reasonably equivalent value or with
actual intent to hinder, delay or defraud creditors.
• Six year look-back period for fraudulent transfers here.
• In a ponzi scheme context, it is likely that all repayments to investors
will be deemed to have been made with actual intent to hinder, delay or
defraud creditors.
• Investors may have a good faith defense.
– The good faith defense could be impaired if the presence of "red flags"
created a to duty to investigate further.
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Bankruptcy Issues
• Clawback Issues for investors
– Potential exposure not just for initial transferees, but also for
subsequent transferees.
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SEC Enforcement,
White Collar Implications and Civil
Litigation Implications
Frank C. Razzano and
Ivan B. Knauer
Frank C. Razzano
• Federal prosecutor – AUSA, D.N.J.
• Assistant Chief Trial Attorney
Securities and Exchange Commission
• Defense Counsel – specializing in white collar criminal
defense; S.E.C. enforcement; securities litigation and
broker-dealer regulation
• He has litigated SIPC claims. See, In re Bell & Beckwith,
937 F.2d 1104 (6th Cir. 1991)
• Adjunct Professor University of Maryland Law School
where he has taught Business Crimes; Securities Litigation,
Regulation of Securities Markets, International Criminal
Law, and Evidence
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New Administration Will Force Public
Outrage at:
I. The Magnitude of the Madoff Mess
A. In 1980 the Joint Economic Committee of
Congress estimated that the short term direct
dollar cost of white-collar crime was roughly $44B
B. In 1999, David A. Anderson in “The Aggregate
Burden of Crime”, 42 J.L. & Econ. 611, 636-8
(1999), estimated $36B annual loss for mail fraud.
C. Madoff estimated loss is $50B
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II. The Perception that White Collar Crime has not been
vigorously prosecuted
A. Syracuse U. survey of securities fraud prosecutions
1. 133 – last fiscal year
2. 513 – in fiscal 2002
3. 437 – in fiscal 2000
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III. The Amazing Admission of Chairman Christopher Cox
A. S.E.C. knew and didn’t adequately
respond
B. S.E.C. Opening/Closing Memoranda
1. Opening – investigating Ponzi scheme
2. Closing – no mention of Ponzi scheme
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IV. Public and new administration will demand a refocusing
of the DOJ’s and S.E.C. enforcement efforts
A. Clean house at the S.E.C.
B. Vigorous enforcement
• Not limited to small “pump & dumps”
• Concentrating on investment banking
C. Regulation of hedge funds
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When Eric Holder, New AG and Mary Shapiro, New Chairwoman
of S.E.C. start they
will have to answer two questions
I. Did Madoff act alone? Who are likely targets?
A. Two groups
1. Group I - Family members and employees
a. Did they expressly or impliedly agree to assist
(i) Co-conspirators
b. If not co-conspirators, did they A&A
(i) Knowledge
1. Red-flag
(ii) Reckless
(iii) Willfully blind
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2. Group II - Those who marketed the Madoff investments
by word of mouth and/or personal relationships
a. Did they know?
b. Were they reckless and willfully
blind?
a) Compensation level
c. Duty
a) What was it?
b) Breach?
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Holder/Shapiro’s Second Question
I. Is this the tip of an iceberg?
A. 9000 hedge funds
B. $2T in assets
C. 20 to 50% trading
D. Already seen two more
1. U.S. v. Forte - $50M
2. U.S. v. Steinger - $1.25B
E. Bayou Fund
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II. If it is, we can expect
A. Massive commitment of resources to investigations of
funds
B. Tighter regulations
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SIPC
I. Only available for the accounts at Bernard Madoff Investment
Securities, the broker dealer
A. Not accounts investing through feeder funds
or advisors
II. Multiple accounts with same name
A. Aggregated
III. Coverage
A. $500,000
(i) $100,000 – up to in cash
IV. Claim forms
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V. SIPC’s Allocation Scheme
A. Not insurance
B. Indemnity
C. SIPC may recapture overpayments
to customers to the extent of
advances
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Ivan B. Knauer
• Focuses his practice on securities enforcement and
litigation.
• Represents financial institutions, public companies, and
their officers and directors, in connection with
investigations by the SEC, FINRA, DOJ and state securities
regulators.
• Regularly conducts internal investigations of possible
violations of the securities laws on behalf of audit
committees or at the request of chief legal officers.
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Ivan B. Knauer
• Formerly Vice President and Managing Trial Counsel at
FINRA (formerly NASD), where he ran the day-to-day
operations of the Litigation Group in the Enforcement
Department.
• Earlier in his career, he served as Senior Counsel in the
SEC’s Enforcement Division.
• Resident in the Washington, D.C. office of Pepper Hamilton
LLP.
• Also admitted to practice in New York and Massachusetts.
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SEC v. Madoff, et al. – filed
December 11, 2008
• Alleges violations of:
– Sections 206(1) and (2) of the Investment Advisers Act of 1940;
– Sections 17(a)(1), (2), and (3) of the Securities Act of 1933; and
– Section 10(b) of the Securities Exchange Act of 1934 and Rule
10b-5 thereunder
• The action relates to the alleged Ponzi scheme by Madoff
and his firm
• It is the only civil enforcement action that has been filed in
court
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SEC v. Madoff, et al. – filed
December 11, 2008
• The Court (SDNY) has ordered:
– A preliminary injunction
– An asset freeze
– A verified accounting
– A receiver be appointed
– A daily mail check to preserve the family jewels
• Undoubtedly, the SEC is currently conducting a broad
investigation into other aspects of the Madoff situation
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Other Likely Targets of SEC Enforcement
• Individuals related to Madoff
– Employees
– Family
– Auditors
• Focus: How did Bernie do it?
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Other Likely Targets
• Firms that fed money into Madoff
– Employees, officers and directors
• Focus:
– What did they know and when did they know it? Did they help
Bernie do it? (aiding and abetting)
• Alternative Focus:
– What did they tell their own investors about how the money was to
be invested? (fraud in the offer and sale of their own securities)
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Other Possible Civil Enforcement
• FINRA
– Broker-dealers and associated persons
– For Madoff, this is the least of his worries
– Could also focus on sales practices and disclosure by
intermediaries if they are B-Ds or affiliated with B-Ds.
• States
– Could bring action to protect investors who are resident in the state
– Will likely defer to the SEC
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Civil Litigation Against Madoff
• Class actions against Madoff and BMIS
– Allegations track SEC and DOJ actions
• Liability will be easy
• Recovery may be more challenging
– Insurance?
– Implications of bankruptcy
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Civil Litigation Involving Others
• Where the action is --- the hunt for deep pockets
• Current focus is on “feeder funds” and advisers who
invested client assets with Madoff
• Allegations include securities fraud, breach of fiduciary
duty and negligence
• Filed in federal and state court
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The Next Wave?
• Litigation between and among intermediaries and service
providers: Funds, Advisers, Custodians, Administrators,
Distributors
– Focus on contracts
– Focus on duties and standards of care
• Negligence?
• Fiduciary duty?
• Scienter-based fraud?
• Derivative actions against officers?
– Goes back to: what did they know and when did they know it?
– And…how much money did they make?
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What to Do Now?
• Offensively:
– Do the easy stuff: file claim in bankruptcy; seek SIPC recovery
– Check other insurance
– Check relevant documents for possible claims against others
• Defensively:
– Check insurance, employment agreements and relevant corporate
law re: indemnification and advancement of fees
– Don’t talk to the press!
– Lawyer up --- it may take time, but the SEC will run down all
avenues that lead to Madoff
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Special Investigative Expertise
Recommended
Joel M. Friedman
Joel M. Friedman
• Investigative Prosecutor for 28 years.
• Deputy US Attorney.
• Investigated and tried security fraud cases.
• Co-founder law firm, specializing defense of security fraud
allegations.
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Need for Specialized Expertise
• Freeh Group International
• World Wide Investigative Intelligence.
• Expertise necessary to bring focus to International fraud
investigation.
• Efficiency in marshaling facts.
• Revealing patterns and meaning from facts created to hide
criminal activity.
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Fiduciary Implications of Investing in
Alternatives When They Fail
Gregory J. Nowak
Gregory J. Nowak
• Head of the alternative investment management practice at
Pepper.
• Wrote two books on hedge funds.
• Frequent speaker at industry conferences and
commentator in industry publications.
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The “Inducement”
• The rise — and fall of the great bull market
– 52 week high on the Dow — 13,136.69 on 5/19/08
– 52 week low on the Dow — 7,449.38 on 11/21/08
• The “failure” of market rate/benchmark cognizant
investment theory — i.e., performance measured against a
benchmark that is down 43.29% from its high is still 43.29%
down!
• Move to total return and “back seating” of income/capital
distinctions
• Credit default swap contract growth
– Peak at $62 trillion net notional amount
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Definitions
• Separate Accounts
– Investor must have a prime broker who will hold assets in
custody, and extend credit for the shorts
– No “commingling” risks
• Day traders are not an issue
• Administrative costs are lower
• But, no limited liability either…
– The investor signs the prime broker contracts
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Definitions
• Leverage
– Financial parlance
• Bank or broker credit (margin account)
• The “borrow” to support short sales
– Tax parlance
• Debt only
• Margin to support short sales does not give rise to acquisition
indebtedness
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Definitions
• Swaps, Options and Derivatives
– Contracts to “trade” one risk for another either bilaterally (investor
and prime broker) or trilaterally (investor, prime broker, target
investment).
• Blocker Corporations
[Off-shore
US Blocker
Corporation]
Investment Caribbean
“Tax Haven”
Net Total
Charity Corporation
Return
nt rn g
e Retu h o l d i n
estm Tot al ith
Inv t a x w ends
30% d
Fund L e s s on Divi
US Equities
US Debt
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Legal Standards Applicable to
Investment Decision Making
• Pennsylvania, New Jersey and Delaware Fiduciary
Standards
• Federal Tax Standards
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Pennsylvania Law
• Trustees
– Prudent investor rule
– Fiduciary must invest and manage property held in trust as a prudent
investor would (fact-specific inquiry)
• Consider purposes, terms and other circumstances of the trust and
• Pursue an overall investment strategy reasonably suited to the trust.
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Pennsylvania Law (continued)
• Trustee must consider, to the extent relevant
a. Size of trust
b. Nature and estimated duration of the trust
c. Liquidity and distribution requirements of the trust
d. Expected tax consequences and distributions of income and
principal
e. The role of each investment or course of action in the overall
investment strategy
f. An asset’s special relationship to: trust purpose or beneficiary(ies)
or economic impact of trust as a business enterprise on its
community
g. Needs of current and future trust beneficiaries for distributions, to
the extent reasonably known to the fiduciary
h. Income and resources of the trust beneficiaries and related trusts,
to the extent reasonably known to the fiduciary
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Pennsylvania Law (continued)
• Prudent investor rule is a standard of conduct and not of
outcome or performance
– Poor performance is “ok” provided trustees comply with the rules on
decision-making.
– Conversely, good performance does not cure an investment that
violates the rule: but it is a question of remedy – where is the harm
and damage? How much will the trustee be surcharged?
– No specific investment or style is inherently prudent or imprudent.
– Compliance with rule is determined as of the time of the fiduciary’s
decision or action not with the benefit of hindsight.
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Pennsylvania Law (continued)
• 20 PA C.S §7212 – Trustee must exercise appropriate
degree of care; a trustee with “special skills” as an investor
must apply those skills. (Same as NJ rule)
• Proper remedy for a violation of the rule is a surcharge
action by the fiduciary account against the fiduciary
– A question of fact
– Very expensive
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Pennsylvania Law (continued)
• Unitrust election
– Total return is from appreciation of capital, earnings and
distributions from capital or both
– Income = 4% of net fair market value
• 20 PA C. S. § 8113 – Charitable Trust total return election
– Elect % return between 2 and 7%
• 20 PA C. S. § 8104 – Non Charitable Trust Equivalent =
“Power to Adjust”
• PA non-profit corporations adopt the same standards
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New Jersey Law
• Trustee of unincorporated charitable trust
– Prudent investor rule applies
– “Special skills” of a trustee as an investor must be applied by that
trustee (same as Pennsylvania rule)
• Charitable corporation trustees
– Must act as the statutory equivalent of a corporate director
– UMIFA codified = ordinary business care and prudence under the
facts prevailing at the time of the action or decision; i.e. “the
business judgment rule”
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New Jersey Law (continued)
• Court decisions
– Application of the business judgment rule in the non-profit
corporation context “means nothing more” than a comparison to an
ordinary person in similar circumstances – apply New Jersey
corporate law standards.
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Delaware Law
Uniform Prudent Management of Institutional Funds Act
(UPMIFA) – outlines managing and investing standard of
conduct for all “institutions” of “institutional fund”
- “Institution” is very broad; includes any corporation, trust,
partnership, LLC, etc. organized and operated exclusively for
charitable purposes
- “Institutional fund” is any fund held by an institution exclusively for
charitable purposes
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Delaware Law (continued)
• In managing and investing institutional fund, must:
– Consider the charitable purposes of the institution
– Comply with duty of loyalty
– Act in good faith and with the care an ordinarily prudent person in a
like position would exercise under similar circumstances
– Incur only costs that are appropriate and reasonable in relation to
its assets, purposes and skills available to it
– Make reasonable effort to verify relevant facts
– Adhere to specific rules (summarized below)
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Delaware Law (continued)
• Specific rules:
– Factors considered in managing and investing institutional fund:
• General economic conditions
• Possible effect of inflation/deflation
• Expected tax consequences
• Role each investment plays in overall investment portfolio
• Expected total return from income and appreciation
• Other resources of institution
• Needs of institution and fund to make distributions and to preserve
capital
• An asset’s special relationship or special value to charitable purposes
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Delaware Law (continued)
• Specific rules (cont’d):
– Decisions about an individual assets must be made in context of
entire fund portfolio and as part of overall investment strategy
having risk and return objectives reasonably suited to institution
– Must diversify investments, unless special circumstances apply
– Person of “special skills or expertise” has duty to use those
skills/expertise
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Delaware Law (continued)
• Delegation of management and investment functions of
institutional funds
– Institution may delegate to the extent that it can do so prudently
under circumstances
– Institution must act in good faith, with the care of an ordinarily
prudent person in:
• Selecting an agent
• Establishing scope and terms of delegation, consistent with the
purposes of the institution
• Periodically reviewing agent’s actions to monitor performance and
compliance
– Institution may delegate to its committees, officers or employees
– If prudently delegated in good faith, institution not liable for
decisions or actions of agent
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Federal Tax Considerations
• On making the investment decision
– Investment to any insider can cause loss of exemption
– Must avoid private benefit and inurement
– So long as there is no “self dealing,” intermediate sanctions
probably don’t apply (for public charities); private foundations are
subject to the excise taxes on self-dealing
• On holding an investment (remember, the decision to hold
an investment is itself an investment decision)
– Can charity tolerate UBTI
• Charitable remainder trusts – recent law change no longer disqualifies
the trust but the UBTI is subject to a 100% excise tax.
• Others, maybe
• Compliance issues
• Return filing; UBTI taxed at highest rate
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Federal Tax Considerations
(continued)
• If leverage is present, UBTI will apply
• Failure to file means statute never runs
• Special regime for Private Foundations
– § 4944 imposes excise taxes on “jeopardizing” investments —
Form 990PF
– Did the organization invest during the year any amount in a manner
that would jeopardize its charitable purposes?
– Did the organization make any investment in a prior year (but after
December 31, 1969) that could jeopardize its charitable purpose
that had not been removed from jeopardy before the first day of the
current tax year.
• These are “self-assessed” taxes
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Jeopardizing Investments
• No categories of investments are per se violative
• Those that will be “closely scrutinized” include:
– Trading on margin
– Trading in commodity futures
– Investments in working interests in oil and gas wells
– Purchase of puts, calls and straddles
– Purchase of warrants
– Selling short (see Excise Tax Reg. § 53.4944-1(a)(2)(i))
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Jeopardizing Investments
(continued)
• The determination of whether an investment is
“jeopardizing” is made at the time of investment and not
later with the benefit of hindsight. But if a determination is
made that it is not jeopardizing, it will never be treated as
jeopardizing even if the foundation realizes a loss.
• This rule does not supersede other federal or state law and
no state law can relieve any person of its duty or
responsibilities under these rules.
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Jeopardizing Investments
(continued)
• The standard which Board members must meet for all
investments decisions, whether they are “closely
scrutinized” or not, is whether “prudent trustee” would
have made the investment
– A(n) investment shall be considered to jeopardize the carrying out
of the exempt purposes of a private foundation if it is determined
that the foundation managers, in making such investment, have
failed to exercise ordinary business care and prudence, under the
facts and circumstances prevailing at the time of making the
investment, in providing for the long- and short-term financial needs
of the foundation to carry out its exempt purposes.
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Jeopardizing Investments
(continued)
• Examples
– Jeopardizing - paying interest on a loan agreement on a donated
insurance policy where the life expectancy of the insured was too
long so that more money would have been paid than the policy was
worth. Rev. Rul. 80-133
– Not jeopardizing - insurance policy with no loan outstanding -
PLR8134114
– Jeopardizing - borrowing to buy non-blue chip stock where loan
was 75% of foundation’s asset-GCM 39537 (3/11/86)
• Debt too large
• No diversification
• Weak- collateral
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§ 4944 Penalties
• Initial Taxes
– On the Private Foundation
10% of the Jeopardizing Investment
– On Management
10% of the Jeopardizing Investment
– Assessed for each year (or part thereof) from the dates of its
investment to the earliest of its mailing of a deficiency notice by the
IRS, the assessment of the § 4944 penalties or the dates of
removal from jeopardy, unless participation is not willful and is due
to reasonable cause.
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§ 4944 Penalties (continued)
• Additional Taxes
– On the Private Foundation
25% of the Jeopardizing Investment
– On Management
5% of the amount so invested
• Limit on Management Penalty
– $10,000 for additional taxes and $20,000 for additional taxes per
investment.
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Conclusions
1. Do appropriate review (i.e., due diligence) of manager and
investment program
2. Diversify
3. Be prudent and reasonable and consider all factors (donor
intent, does investment meet past needs and future plans
of organization)
4. Don’t pursue outrageous claims or too-good-to-be-true
track records
5. Don’t buy anything you can’t understand or explain to your
Board Chair in 3 sentences or less
6. Don’t be too cautious (cash positions may not be prudent
in certain circumstances)
7. There is no such thing as free lunch and Santa Claus
comes but once a year: be skeptical
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Tax Refund Implications
Joan C. Arnold
Joan C. Arnold
• Chair of the Tax Practice
• Successfully represented victims in Slatkin Investment
Ponzi scheme to achieve theft loss deductions in year of
theft.
75
Tax Issues
• Hypo – No distributions
– 2000 Invest $50MM
– 2001 – 2007 $5MM “income” per year
– 2008 $5MM “income reported”
– 2008 Theft
• 2007, 2006, 2005 – Amend returns to exclude annual $5MM
“income,” claim refund.
• 2008 – Report “income”?
• 2008 – Claim theft loss?
– $50 MM principal
– $20 MM “income” 2001-2004(?)
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Tax Issues
• Refund for 2005 must be filed by April, 2009
• Theft loss
– Allowed year loss is discovered
– Unless there is a “reasonable prospect of recovery”
• Claim deduction vs. filing for refund
– Litigation planning
• Coordinated approach to IRS
– Involve Treasury, LMSB, Chief Counsel
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The Madoff Scandal: Implications
and Next Steps
Question and Answer Session
78
The Madoff Scandal: Implications
and Next Steps
Email Brian Dolan at
dolanb@pepperlaw.com for a copy
of today’s presentation or with
questions for any of our speakers.
79
The Madoff Scandal: Implications
and Next Steps
Thank You!
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