November 21, 2019

The Tax Provisions of the New York False Claims Act: How Far Can They Go?

 

“The Tax Provisions of the New York False Claims Act:  How Far Can They Go?  Rulings on New Case Alleging Tax Fraud Against New York City by Wall Street Will Show the Limits, and Will also Provide Additional Post-Escobar Guidance on “Materiality” as well as “Reckless Disregard.

By Joel Androphy

The New York False Claims Act (“New York FCA”)[1] was originally enacted on April 7, 2007 and was modeled after the Federal False Claims Act (“Federal FCA”).[2] At the time of passage, the provisions were nearly identical to the then-1986 version of the federal False Claims Act.  An important similarity is that each find liability in the face of either fraud or “reckless disregard” of such fraud.[3]

However, in 2009 and 2010, Congress amended the Federal FCA. New York followed suit, amending the New York FCA in August 2010. While substantially identical to the Federal FCA, the New York FCA differs in some critical respects, adding tax fraud if the amount is substantial.[4]

The ability of a Relator to bring a private action under the New York FCA has resulted in an interesting case which has raised many issues relevant to false claims cases.   The case involves a “reverse false claim”, which involves a defendant submitting a request for payment, while failing to disclose a “material” condition related to the claim, which condition, had it been disclosed to the government, would result in the claim being denied. It raises the issue of what is material in the context of the policy of taxing jurisdictions of automatically withholding claims for refunds in the fact of a pre existing deficiency.

Outside of the tax context, the case raises an important issues as to how the word “imperative”, cited in a 2016 Supreme Court Federal FCA case interpreting the meaning of the language “reckless disregard”  It proposes, for a corporation, standards for the “reckless disregard” of fraud as violation of either the applicable rules of professional conduct for lawyers, or the Sarbanes-Oxley Act, which governs the duties of corporate employees to report credible evidence of accounting fraud internally to their superiors.

On September 25 2019, the New York State Supreme Court unsealed City of New York Ex Rel Thomas C. Willcox v. Credit Suisse (USA) LLC et al.[5]  Mr. Willcox, the Relator, a Washington DC lawyer, seeks treble damages for tax refunds claimed by the Defendants from New York City during the ten years prior to the filing of the complaint, contending that the defendants were on notice of tax fraud they committed in 1999.  The Relator alleges that this fraud defrauded the United States, New York City and New York State of taxes on $46.5 million in fees earned in two 1999 transactions. Willcox II sought the present value of the unpaid taxes, penalties and interest, alleged to be approximately $21 million, trebled under the New York FCA to approximately $63 million.

The background facts for the case, taken entirely from the papers filed in the action, are set forth as follows:[6]

In 2002, the Relator sued Credit Suisse Securities (USA) LLC and several other investment banks (the “NY Affiliates”), and their corresponding United Kingdom Affiliates (the “UK Affiliates” in two cases (the “2002 Litigation”).[7]  The Relator sued on behalf of a liquidating company of a defunct internet company, (“Liquidating”), alleging violations of New York State usury laws[8] in two 1999 transactions (the 1999 Transactions”) in which the Defendants raised approximately $2 billion in bonds for the predecessor of Liquidating and earned in exchange $46.5 million in fees.[9]

The NY Affiliates claimed that they were not the proper parties, and therefore that the case belonged in federal court.  The NY Affiliates maintained that the UK Affiliates were the proper and only principals to the 1999 Transactions.[10]

In response, the Relator argued that the NY Affiliates were the proper parties, and that the collection of funds in New York City by the NY Affiliates, then transmission overseas to the UK Affiliates constituted tax evasion (the “Tax Fraud”). The Relator contended that the tax fraud in the 1999 transactions was demonstrated by, inter alia:

  1. The relevant documents showed that the NY Affiliates collected $46.5 million in fees in New York City for $1.8 billion in funds they raised there, then transmitted those fees overseas to the UK Affiliates, with no explanation as to why the NY Affiliates would perform all this work for no compensation;[11]
  2. In numerous documents, the NY Affiliates identify themselves as principals in the transactions and in fact sign some key documents;[12]
  3. The front and back of the private placement memoranda shown to investors in both countries identify the US Affiliates as the lead bankers for both the US and UK offerings, with no reference to the UK Affiliates;[13]
  4. The absence of an agency agreement and/or opinion letter, explaining the justification for and lawfulness of the unusual structure of these transactions;[14]
  5. In 1998 and 2000, the predecessor in interest to Liquidating used the NY Affiliates to raise over $2 billion in capital. No explanation was proffered as to why the entity at issue chose to use the UK Affiliates for its two 1999 fundraising transactions, especially when only 15% of each of the transactions were in fact raised in the UK[15] and;
  6. Two comparable international fundraising transactions, involving not just the same lead underwriter, but the same manager (and which took place in the same time period as the 1999 Transactions), appear to demonstrate the proper way of allocating fees in similar underwritings. In these deals, the fees appear to have been allocated to the respective affiliates in proportion to the funds raised in the country of that affiliate.[16]

The 2002 Litigation was dismissed and the dismissal upheld on appeal.[17]  However, none of the court’s ruling on the cases mentioned the allegations of tax fraud[18] leaving the issue of their validity (and the defendants’ duty to pay them) unresolved.

In 2005, the Relator sought to report the fraud to the IRS.[19]  As the Amended Complaint alleges, the Relator had difficulty reporting the claim, and did not receive any reward for his efforts. Further, due to IRS confidentiality provisions, the Relator cannot provide the formal results of any investigation.   However, according to the Relator, an IRS Attorney told him that there had been a recovery of funds based on his efforts.[20]

In late 2012, the Relator brought suit against the NY Affiliates in New York State Supreme Court, alleging violations of the New York FCA, and seeking recovery of the New York State taxes allegedly due.[21]

As the tax returns at issue were filed no later than early 2002, and the statute of limitations for the New York FCA is ten years, the Relator sought to seek the value of the refunds claimed from the start of the ten-year limitations period.

In so doing, the Relator invoked the above-referenced “reverse false claims theory”, contending that the submission of a refund with knowledge of, or in reckless disregard of, the fact that the taxpayer owed money to the taxing entity constituted an FCA violation.[22]

The Relator did not have an expert at that time, but believed discovery would provide his IRS file, which would demonstrate that the Defendants had paid the federal taxes in 2006, therefore compelling the conclusion they should also pay state and federal taxes on the 1999 transactions.[23]

In 2015, the New York State Supreme Court dismissed the case largely on the concern that that the application of the reverse false claims theory would vitiate the statute of limitations.[24]

In 2016, the First Department dismissed, contending the Relator’s allegations of tax fraud were “speculation”, and expressing the view the term “materiality” should not be “applied expansively”.[25]

Also, in 2016, the Relator obtained a letter from Reuven Avi-Yonah, Irwin M. Cohn Professor of Law at the University of Michigan.  Professor Avi-Yonah opined that the 1999 transactions were apparently structured to evade federal, state and city taxes. Professor Avi-Yonah invoked the same facts and primarily the same reasoning presented by the Relator to the defendants in the 2002 Litigation and the Willcox I case. [26]

Further, in 2016, the Relator filed the action referenced above under seal in New York State Supreme Court, seeking from the Defendants payment of the New York City taxes (which had grown, with interest and penalties, from $4 million to over $21 million).   As with Willcox I, the case proceeded on the reverse false claims theory, as, based on the timing of the defendants’ New York State returns, the ten year limitations on the tax returns for the 1999 transactions had run.

Finally in 2016, the United States Supreme Court issued Universal Health Services, Inc. v. US ex rel Escobar, 136 S. Ct. 1989  (2016) (“Escobar”), which resolved several circuit splits by affirming the validity of the reverse false claims doctrine and discussed the requirement of materiality in connection with that doctrine in detail, commenting that the requirement ignored should be, using a reasonableness standard, “imperative” to the claim.[27]

The Escobar case also set forth the standard for “scienter,” holding that noting where “a reasonable person would realize” that the misrepresentation concerned an ‘imperative’ aspect of the good or service, “a defendant’s failure to appreciate the materiality of that condition would amount to `deliberate ignorance’ or `reckless disregard’ of the `truth or falsity of the information’ , , , .” Id. at 2001-02.

On January 18th 2019, New York City gave notice it would not intervene in the case.  On October 18th 2019, shortly after the unsealing of Willcox II noted above, the Relator filed an Amended Complaint.

The Amended Complaint invoked the opinion of Professor Reuven Avi -Yonah as to whether or not the Defendants committed tax fraud in the 1999 transactions.[28]

As to materiality, the Relator contended that New York City law permitted the City to withhold claims for refunds.[29]  However, New York City would not provide proof of a written policy that mandated that refunds be withheld automatically be used to offset a pre existing deficiency.[30]  Therefore, the Relator surveyed the 43 states with income taxes, and determined that the standard of care for US taxing jurisdictions is that a claim for a refund is automatically withheld in the event of a pre existing deficiency for the taxpayer in question.[31]  Therefore, on the assumption that New York City is in compliance with the applicable standard of care, the Relator contended the materiality standard under Escobar had been met.[32]

As to the standard for “reckless disregard”, the Relator invoked two bodies of law.

First, the Relator contended that the failure of the defendants to report the Tax Fraud upward under the standard of the Sarbanes-Oxley Act (“SOX”).[33] constituted reckless disregard.  SOX requires, inter alia, senior management and signing officers shall “have disclosed to the issuer’s auditors and the audit committee of the board of directors (or persons fulfilling the equivalent function – any fraud, whether or not material, that involves management or other employees who have a significant role in the issuer’s internal controls”.[34]

The Relator contended that the 2002 litigation, the IRS Reporting Efforts and the Willcox II litigation all gave the Defendants ample notice of credible evidence that accounting fraud occurred.  According to the Relator, any claims for refunds in the face of such notice constitutes “reckless disregard” of the Tax Fraud which, had it been disclosed, would have resulted in New York City using any refunds claimed from the start of the Limitations Periods to offset the deficiency created by the Tax Fraud.

The Relator further alleged that the Defendants violated SOX by failing to report credible information of accounting fraud to the Board of Directors and the Audit Subcommittee.

Second, the Relator contended that the Defendants violated the New York Rules of Professional Conduct (“NYRPC”), by failing to consult with the client as to the conduct and have the Tax Fraud allegations reviewed by an international tax attorney.  Had the defendants complied with the NYRPC, the Relator alleged, the defendants would have been told the allegations were correct, and paid the tax.[35]

Preliminarily, the Relator must show that the Defendants committed tax fraud in the 1999 transactions.  In his opinion, Professor Avi-Yonah stated  “[t]he Placements were apparently structured in this way to avoid U.S. federal, New York  State and New York City income tax.“

Professor Avi-Yonah also commented on the concern expressed by the New York State Supreme Court in the Willcox I litigation that permitting application of the reverse false claims theory in the context of tax returns would “vitiate” the statute of limitations for such actions.

“The simple answer” explained Professor Avi-Yonah, “is that it would be possible for a relator to take this action, if the relator could bring a claim in negligence.  However, a relator cannot bring a NY FCA act based on allegations of negligence.  Instead, a relator’s claim can be based only on fraud, or the substantial equivalent. Therefore, the claim of ‘vitiation’ is baseless.”

The “vitiation” contention, Professor Avi-Yonah explained, arises from the fact that the statute of limitations of New York City tax claims is three years.  Therefore, to circumvent the statute of limitations, “all a relator would have to do is bring a claim for ten years of negligently false implied claims for refunds.”

However, Professor Avi-Yonah explains “the New York FCA not only requires a scienter greater than negligence, it makes it clear a relator cannot, as a matter of law bring a claim based on negligence.  Further, as there is no statute of limitations for a fraud claim based on a New York City tax return, a New York taxpayer considering what defenses to maintain against claims of fraud must keep indefinitely any evidence to defend against such claims.”

“Therefore,” Professor Avi-Yonah concludes, “the only claim a relator can bring, for fraud or its essential equivalent, within ten years of the false claim. Further, any taxpayer at risk for such an action is equally subject to a direct claim for fraud by New York City.  Finally, the NYFCA expressly bars claims sounding in negligence.  The theory espoused by the Relator in the instant action does nothing to upset New York City’s framework of time limitations on tax actions.”

Apart from the proof of tax fraud, the Willcox II case raises issues of relevance to the Federal FCA. The Escobar ruling set forth a wide range of what was meant to be materiality.  If the Relator can show that New York City would not have paid the refunds at issue had the Defendants disclosed the alleged deficiency, such should satisfy the Escobar standard.

Further, as noted above, the Willcox II  litigation contains several issue of first impression, such as the extent to which Relators can use the NYFCA to address conduct that has taken place beyond the statute of limitations period, whether the automatic withholding of a tax refund satisfies the standard of materiality under Escobar and whether the NYRPC and/or SOX are appropriate standards of “reckless disregard.”

The ability of the Relator to take such action may depend on the strength of the strength of the claims that the Defendants violated the NYCPR and/or SOX.  As for the SOX claims, Vikramaditya S. Khanna, William W. Cook Professor of Law at the University of Michigan commented “the Relator’s Amended Complaint sets forth a picture of a group of banks repeatedly faced with allegations of tax fraud, which would include allegations of tax fraud against New York City.”

Professor Khanna continued, “the Relator alleges he made these allegations in litigation against the Defendants in 2002, that the IRS gave further notice of the alleged Tax Fraud to the defendants in 2006, and that the Relator reiterated the allegations in the Willcox I litigation.”

Further, “the Tax Fraud allegations would probably be considered as material under Sarbanes-Oxley because they are likely to constitute a crime. Further, the fact the same pattern of alleged tax fraud took place in two transactions indicates such activity might have been repeated elsewhere.”

“The City of New York declined to intervene in the lawsuit.  Had the taxes at issue been paid, the City would presumably have intervened to dismiss the case as moot.  As it did not intervene, such indicates that the City taxes apparently are still not paid.  As Professor Avi-Yonah’s opinion depicts a clear picture of apparent tax fraud against, among others, the City of New York, it appears as if the defendants did not take any of the steps required by Sarbanes-Oxley, such as reporting the alleged fraud to the Board of Directors.  Such remedial activity would likely have resulted in payment of the taxes, interest and associated penalties.”

“Therefore, if the Relator’s allegations are correct, the defendants apparently repeatedly failed to comply with the applicable provisions of the Sarbanes-Oxley Act when faced with credible allegations of accounting fraud.”

Further as to the violations of the NYRPC, the applicable standards are very similar to those of SOX.  As note above in footnote 35, an New York in-house lawyer must address a situation where faced with a violation of law that could cause “substantial injury” to a corporation.   This is comparable to the “materiality” standard of SOX.  Further, the in house lawyer must proceed “as is reasonably necessary to protect the best interests of the organization.”  Such is comparable to the SOX requirement that a senior corporate employee make appropriate disclosures to the company’s board of directors and audit committee.

Therefore, it is likely that if the defendants violated SOX in their treatment of the Tax Fraud allegations, the in-house lawyers handling the 2002 litigation, the alleged 2006 interactions with the IRS and the Willcox I allegations, the in-house lawyers handling the cases violated NYRPC 1.13.

Please see footnotes below. Learn more about the national False Claims Act here. Meet Mr. Androphy and read his biography on this page. Lastly, reach-out to Berg & Androphy if you have questions or concerns about your own potential FCA case and qui tam litigation.

 

Notes

[1] State Finance Law, Art. 13, §§187-194.

[2] 31 U.S.C. §§ 3729-3733.

[3] NYS Tax Law §188 (3), and 31 U.S.C. §3729(b)

[4]  First, the New York FCA allows for three times the damages (two times the damages for voluntary and immediate self-reporting of fraud)

The New York FCA can be used for tax fraud only if the defendant has “net income or sales” of $1 million or more and damages as plead are greater than $350,000. Another difference is that, in contrast to the Federal FCA’s statute of limitations of six years, the New York FCA applies one of ten years, which has been applied retroactively.

[5] Index No 100356/2016.  The formal names of the defendants are: Credit Suisse Securities (USA) LLC, as Successor-In-Interest to Donaldson Lufkin & Jenrette Securities Corporation, Morgan Stanley, JP Morgan Chase & Co., As Successor-In-Interest to Bear Stearns & Co., Inc. And Chase Securities, Inc., and Bank Of America Corporation, As Successor- In-Interest to Merrill Lynch & Co., Inc.     This case is proceeded by State of New York ex rel Thomas C. Willcox v. Credit Suisse Securities (USA) LLC et al, Index No Docket No. 100185/2013, discussed infra., which sought refunds claimed for New York State Taxes.     For the purposes of clarity, the earlier action for the New York State tax will be referred to as Willcox I  and the instant case will be referred to as Willcox II.

[6] For simplicity’s sake, the original pagination of the Amended Complaint, heavily cited herein, has been redacted, and the pagination added by the Clerk’s Office (which appears not just at the bottom of the page, but in the Adobe Reader pagination box) is used.

[7] Amended Complaint (“AC”) at 15-21.

[8] Liquidating claimed that the transactions in question were a violation of New York’s General Obligation Law §5-531(1), which caps at .5% the fees that may be collected by a corporate borrower’s agent for the services of brokering a loan or forbearance); see also, Fischer v. Panasian Communications, 87 NY2d 958 (1996) (“[section] 5-531 [applies to private placement transactions between corporate borrowers and large institutional investors” (id at 960)).   AC at 16.  Liquidating contended that the transactions, while nominally structured as a purchase and resale of notes, were, due to the imposition of the defendants that they were not committed to purchasing the securities until they, at their unilateral discretion, countersigned a particular document, were, in substance, brokered loans and therefore subject to GOL §5-531.  AC at 17-20.

[9][9] AC at 10-12.

[10] Id at 30.

[11] Id at 27.

[12] Id.

[13] Id.

[14] Id.

[15] Id.

[16] Id at 29.

[17] Id at 19-21.

[18] Id at 20.

[19] Id at 18-20.

[20] Id.  Hereinafter the Relator’s efforts in this regard will be referred to as the “IRS Reporting Efforts.”

[21] Id at 23-24.

[22] Id  at 5-6.  Critical to the case is that there is no statute of limitations for New York City civil tax fraud claims.  NYC AC 11-674 (3)(a)(2).  Therefore, a deficiency created by fraud is never extinguished.

[23] Id at 24.

[24] Id at 23-24.

[25] Id at 24.

[26] See Supplemental Appendix to Complaint at 42-49.

[27] Id at 37, citing Escobar, supra at 2001.

[28] Id at 32-34.

[29] New York City Administrative Code, §11-617 “OverPayment,” permits the City to withhold tax refunds in a current year based on the existence of a deficiency in a prior year.

  1. General. The commissioner of finance, within the applicable period of limitations, may credit an overpayment of tax and interest on such overpayment against any liability in respect of any tax imposed by any of the named subchapters of this chapter or on the taxpayer who made the overpayment, and the balance shall be refunded out of the proceeds of the tax

[30] Id  at 32-36.

[31] Id.

[32] Id at 37.

[33] Passed in July 2002, Pub L. No 107-204, 116 Stat. 745, 784 (codified as amended in scattered sections of §§ 11, 18, 28 and 29 U.S.C).

[34]15 U.S.C. §7241(5)(B)

[35] Id at 38. The Relator cited NYRPC 1.2(d) and Comment 13 in support of this contention.  In fact, the more specific provision is NYCPC 1.13 “Organization as a Client”, subsection b, addresses the situation wherein an in house lawyer is faced with a violation of law within the corporation which could cause “substantial injury” to the corporation, and concludes that the lawyer should proceed “as is reasonably necessary to protect the best interests of the organization.”

Further, Rule 1.13 (b)provides options for the in-house lawyer to take, including but not limited to:

“(1) asking reconsideration of the matter;

(2) advising that a separate legal opinion on the matter be sought for presentation to an appropriate authority in the organization; and

(3) referring the matter to higher authority in the organization, including, if warranted by the seriousness of the matter, referral to the highest authority that can act in behalf of the organization as determined by applicable law.”

(emphasis added).