You Can't Cheat an Honest Man (10 page)

Despite the carefully laid foundation, there were parts of Sherbondy’s story that should have raised warning signs for his investors.

Most pointedly, Sherbondy made no effort to appear low-key or conservative. He boasted about his wealth and international connections. He claimed to control a British bank and several mortgage companies in Texas. He talked vaguely about a millionaire father who ran a European investment trust. He said that the Teamsters pension fund had invested in his tax shelters. And, as his scheme was beginning to unravel, he insisted that the Gulf War had frozen assets he’d invested with the Emir of Kuwait.

But even the Emir couldn’t help Sherbondy avoid the inevitable.

By 1991, Sherbondy was desperate to raise money to keep the scheme going. He tried the usual tactics—increasing his promised returns to even more unlikely heights and offering existing investors finder’s fees for bringing in new money. But he needed more than he could raise, so dividend checks started bouncing.

In 1992, a group that included most of Sherbondy’s investors sued him in civil court for embezzlement and fraud. Tom Laube, the attorney handling the case, was able to produce a $4.5 million verdict in the group’s favor—but Laube was unable to enforce the award because Sherbondy didn’t have enough money to pay it.

When Laube tried to collect the judgment, he discovered that Sherbondy’s father was not a jet-set financier. The old man was a penniless former laborer living in a trailer on the outskirts of Las Vegas.

In late 1993, the U.S. Attorney in San Diego filed a 51-count indictment against Sherbondy for the various frauds he committed in the course of operating his scheme. The indictment also included charges of filing false tax returns—an ironic conclusion to a story that began with promises of besting the IRS.

The Outlaw Mentality

People who have a strong aversion to paying taxes often are attracted to investments shrouded in secrecy. These people have an outlaw mentality which plays into the Ponzi perp’s plans. As one attorney says, “People who feel the government is stealing their money are easy prey for swindlers. They’re predisposed to cloak-and-dagger antics.”

Despite the outlaw mentality and cloak-and-dagger approach, the basic parameters that apply to tax shelters are—relatively—straightforward.

In order to take a depreciation deduction with respect to an asset, the asset must be used in a trade or business or held for the production of income. Furthermore, the asset must be
ordinary and necessary
to carrying on a trade or business or producing income.

While a profit is not required (and, in many cases, not desired), a business must enter activities with the
intent
of making a profit. This rule applies to most Ponzi schemes, because they are not created with the intent of making a profit. They are, by definition, frauds created to steal money.

Another IRS rule that limits the effectiveness of Ponzi or pyramid schemes as tax shelters states that activities which serve no “purpose, substance or utility apart from their anticipated tax consequences” are disregarded for tax purposes. The tax code states, in relevant part:

In the case of an activity engaged in by an individual..., if such activity is not engaged in for profit, no deduction attributable to such activity shall be allowed.

So, even if a particular pyramid scheme is not illegal, it may have no purpose other than to be a tax dodge. If the Feds find this out—and they scrutinize pyramid schemes—they’ll deny any benefit.

The last tax rule to consider is the most general. Federal law prohibits anyone from claiming a deduction for personal, living or family expenses which are
not
incurred in the conduct of a trade or business or in the production of income.

So, aside from all the other problems a pyramid scheme poses, it isn’t as safe a place to hide expenses as a more traditional business. Since the things are suspect mechanisms to start, it’s not a good idea to load up tax-shelter pyramid schemes with questionable write-offs.

Federal courts have relied on a number of factors—the legal term is
indicia
—to determine that tax fraud exists in an investment scheme. Although no single factor is necessarily sufficient to establish fraud, the existence of several can be persuasive. These factors include:

•
understatement of income,
•
maintenance of inadequate records,
•
failure to file tax returns,
•
implausible or inconsistent explanations of behavior,
•
concealment of assets, and
•
failure to cooperate with tax authorities.

As you can see, all of these factors can apply to a pyramid or Ponzi scheme at the same time. As a result, the IRS will often have identified a Ponzi scheme as suspicious before it collapses.

Unfortunately, the Feds have a hard time moving on a scheme before it crashes. This is partly because federal regulators have so much ground to cover that they move slowly on any one case; but it’s also partly because Ponzi schemes tend to collapse quickly—often in less than two years.

To help the regulators—and, in turn, investors—some federal courts have added other warning flags to identify illegal schemes. The U.S. Ninth Circuit Court of Appeals (which includes Ponzi-heavy states like California and Nevada) has been active in this regard. Indicia that it has offered include:

•
a history of illegal activity on the part of principals,
•
a preference for cash transactions of less than $10,000,
•
failure to make estimated tax payments, and
•
offering any “guarantee” of tax-advantaged status.

Case Study: Home-Stake Mining

Despite the IRS’ efforts to identify the characteristics of an illegal tax scheme, tax-advantage Ponzi schemes have continued to flourish.

In late December 1996, a federal judge in Tulsa, Oklahoma, approved a settlement in a case that had started in 1973. It involved one of the biggest and most protracted tax shelter Ponzi schemes in American history.

During the early 1950s, Robert Trippet organized Home-Stake Energy Co. to develop oil and gas properties. He raised money for socalled “wildcat” exploration by selling percentage interests or units of participation to investors through private placements.

Home-Stake organized separate annual programs, units which were registered with the SEC and sold to the public. Each of the programs was supposed to develop a particular oil and gas property or properties in the Midwest, California or Venezuela.

Home-Stake’s salespeople pushed the things hard. They told prospective investors that they would reap big profits from proven oil reserves and that the tax deductions for intangible drilling costs and oil depletion allowances were advantageous. An investor could shelter as much as $700,000 of $1 million in income in one of Home-Stake’s yearly programs.

The Home-Stake salespeople also tailored each pitch to each investor or prospect. Often, the salesperson would find out the details of an investor’s tax situation and then offer participation in a Home-Stake program as a perfect solution.

This customized tax planning was of dubious legality but had an outstanding effect on sales.

Home-Stake investors included the rich and the famous, such as entertainers Bob Dylan, Liza Minnelli, Barbra Streisand, and Walter Matthau. Also involved were some captains of industry, such as the entire board of General Electric Co.

Home-Stake salespeople closed their deals with written sales materials, which included unregistered “black books.” For all practical purposes, a black book served the same sales function as a prospectus. It provided a general description of the program, explained the nature of participating interests, and contained engineering reports for the properties, descriptions of the various tax advantages, and projections of substantial profits.

At first, Home-Stake’s operation seemed successful. Its quarterly progress reports indicated that substantial oil was being produced and early investors received large payments which were supposedly proceeds from the oil drilling program. In truth, however, very little oil was being produced. The payments came from money paid for units by later investors. And, as a tax shelter, Home-Stake was useless. Even with the Ponzi payments, there were some investors who complained that their returns did not match Home-Stake’s promises. This was due in part to the fact that Home-Stake was going broke from the day it started. Since there was no real profit from oil operations, each succeeding year reaped less bogus profit for investors than the salespeople had promised.

The dwindling return on investment (to use that term loosely, since no real investments were ever made) led to a number of complaints to Home-Stake management. Various efforts were made to deal with those complaints. In some cases, Home-Stake repurchased program units from dissatisfied investors; in others, it offered investors the opportunity to “roll over” their units, typically exchanging units in a past program for units in a program that was currently being marketed.

Nevertheless, these efforts couldn’t keep up with the growing number of complaints. In March 1973, two investors who were dissatisfied with their investment returns and one who’d been told that the IRS was going to disallow his intangible drilling deductions filed a lawsuit in California on behalf of all participants in the Home-Stake programs.

These investors alleged that Home-Stake management and its professional advisers engaged in “an unlawful combination, conspiracy and course of conduct that operated as a fraud and deceit.” They also charged that Trippet and his salespeople made untrue statements and failed to disclose material facts.

By July 1973, the investors sought to inspect Home-Stake’s documents. The federal court in California ordered that they be allowed to begin discovery. At this point, the collapse of Home-Stake accelerated. Within weeks, new management had taken over Home-Stake and discharged Trippet, investigators from the SEC had arrived at Home-Stake’s offices in Tulsa, and Home-Stake had filed bankruptcy. After the collapse of Home-Stake in September 1973, numerous other lawsuits were filed in federal courts around the country.
¹

¹
For more details on these Home-Stake lawsuits, see Chapter 19.

Home-Stake had done many of the things that a Ponzi scheme often does at various points in its life cycle. These included:

•
paying illegal commissions to various persons in connection with the sale of participation units;

•
entering a management contract with Trippet that granted him 50 percent of Home-Stake’s interest in any oil and gas drilling programs sponsored by Home-Stake;

•
financing equipment receivables which were listed as assets when there was no reasonable probability that this asset would be realized; and

•
including various loans receivable when there was no reasonable probability that the loans would be collected.

However, because the Home-Stake scheme was so complicated...and involved so many investors...it would take more than 20 years to litigate all of the issues surrounding the mess.

In the mid-1990s, Trippet had an opportunity to invest again in several companies related to Home-Stake but he passed. The 77-year old said, “I have a bad reputation in Tulsa, and it would not have been good for me to surface” in the deal.

You could say that.

CHAPTER 6
Chapter 6:
Sure-thing Investments and Sweetheart Loans

Managing financial investments is a complicated mix of science and art. Regulatory standards take this complexity into account—the SEC, IRS and state investment rules allow a fair amount for leeway in which good faith and trust are supposed to rule. So, investments remain an appealing market to con men and Ponzi perpetrators. After all, it’s the market that attracted Carlo Ponzi in the first place.

According to the North American Securities Administrators Association, which conducts surveys of fraud in the financial planning business, some 22,000 investors lost about $400 million in financial planning frauds between 1986 and 1988. That’s a stunning 340 percent increase in the investments lost to fraud between 1983 and 1985.

Some people are surprised that so many wealthy investors are drawn into these old-fashioned schemes. But they shouldn’t be surprised. For generations, bogus deals have been a staple of idiot sons from successful families who talk about doing business in vague terms besuccessful families who talk about doing business in vague terms be Q filings.

People who know investments—like people who know any business— talk about their interests in detail. They will welcome the chance to explain the mechanics of what they do, because they know there are no secret recipes for success.

But the 1980s and 1990s have generated armies of loosely-defined “investment advisers” and “financial planners.” Many of these have come out of the insurance industry—former agents looking for new markets. They can pose a considerable risk of promoting—knowingly or not—pyramids and Ponzi schemes.

Who is an Investment Adviser?
In relevant part, the federal Investment Advisors Act provides that an investment adviser is:

[A]ny person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities.

In defining the business standard for investment advisers, the SEC notes:

The giving of advice need not constitute the principal business activity or any particular portion of the business activities of a person in order for the person to be an investment advisor.... The giving of advice need only be done on such a basis that it constitutes a business activity occurring with some regularity.