ORLANDO, Fla. – U.S. Rep. Alan Grayson, known on Capitol Hill for aggressively questioning key players in the nation?s financial crisis, has suffered a ?financial disaster? of his own, he confirmed to Local 6.
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Grayson, D-Orlando, fell victim to a billion-dollar Ponzi scheme operated by Derivium Capital, a South Carolina firm that a federal jury ruled in February defrauded Grayson of $34 million -- an amount equal to more than half of Grayson?s 2008 net worth.
?It was very much like the Bernie Madoff situation,? said Grayson, who?s had Madoff?s Ponzi scheme in his crosshairs from his seat on the House Financial Services Committee.
In February, Grayson?s Washington office issued a press release criticizing Madoff?s ?penthouse arrest,? calling for the swindler to be jailed while awaiting sentencing.
And in video played thousands of times on You Tube, Grayson on Feb. 4 facetiously asked a financial expert who tried in vain to warn regulators about Madoff?s scheme: ?You referred to this several times as a Ponzi scheme. Is that some newfangled thing??
Of course, Grayson knew better: at the exact time he spoke on Capitol Hill, his lawyers were in a South Carolina courtroom arguing he was a victim of just such a scheme.
?What happened to the victims in Madoff is the same thing that happened to me,? Grayson told Local 6 in an interview Monday. ?I lost millions of dollars.?
Scam's Most Frequent Customer
Between 2000 and 2005, Grayson was the most frequent participant in Derivium?s ?90-percent stock-loan? program, transferring about $29 million in stocks to Derivium and promptly receiving 90 percent of it ? about $26 million ? back in cash as ?stock loans,? according to his court filings.
So Grayson spent only about $3 million out of pocket. When you include the nearly $600,000 he received back from stock loan proceeds, his net cash loss is about $2.4 million, according to court records.
But Derivium had promised to pay Grayson profits on his stocks, if they appreciated enough over the three-year loan period to cover the amount of his ?stock loans? plus interest. And Grayson picked some lucrative stocks. His $34 million in damages is based on the profits he should have received on stocks that rose in value ? had Derivium not run out of cash and filed for bankruptcy.
In all, about 800 clients provided about $1 billion in stocks they owned in various companies to Derivium Capital and its associates. The firm claimed their clients did not have to pay capital gains taxes on the transfers of stock.
But the Internal Revenue Service has another opinion, alleging Derivium was an illegal tax evasion scheme used by some of its wealthy clients to evade paying an estimated $235 million in income taxes.
Grayson said he is not one of those clients accused of tax evasion. ?The difference is they broke the law and I didn?t,? he said.
A review of public court documents by Local 6 found no evidence Grayson is accused or suspected of any wrongdoing.
Unlike those Derivium clients who evaded capital gains taxes through their stock loans, Grayson did not hold the vast majority of his stocks long enough to accrue any significant taxable capital gains, according to Grayson, court records and interviews with sources familiar with the case.
?I took these loans in order to make money,? Grayson told Local 6. ?My taxes were reported accurately year after year without any question.? If anything, he said, ?the scheme made my taxes higher rather than lower,? because of losses he incurred.
Fraud, Tax Scheme?Or Both?
In February 2007, Grayson filed a fraud and racketeering lawsuit against Derivium Capital and its associates in federal court in South Carolina. After a nearly month-long trial, on Feb. 26, 2009, a jury returned a $270 million verdict in favor of Grayson, several other former Derivium clients and a bankruptcy trustee. Grayson?s damages were set at $34 million.
?The judge and the jury could not have reached a more favorable conclusion from our point of view. They literally gave us every single penny we asked for,? Grayson said.
The South Carolina jury found Grayson and the others were victims of fraud and racketeering.
At the same time, across the country, the federal government was calling Derivium a tax-fraud scheme.
In a lawsuit filed in San Francisco in September 2007 against Derivium and its associates, the government claims Derivium illegally helped some of its wealthy clients evade nearly $235 million in capital gains taxes.
In a February 2009 hearing, a U.S. Justice Department tax attorney told a federal magistrate he believes all of the 270 Derivium clients audited so far by the IRS were found to have used the loans as an abusive tax shelter. He did not identify in court any of those audited, nor would he comment to Local 6 about the investigation.
But U.S. Magistrate Judge Joseph Spero said during that February hearing, ?Apparently, there?s no conclusion in any of those audits that it was not an abusive tax shelter.?
Grayson said he was not one of those audited, adding the IRS knows ?very well what?s in my tax returns and they know if they did audit me, they?d end up owing me money.?
The IRS is asking the court to rule Derivium and its associates ?interfered? with tax collections through their ?tax-fraud schemes.? It seeks an injunction barring them from organizing, promoting or selling the stock loans and wants the judge to force the defendants to turn over the identities of all their clients. Trial is set to begin in October in San Francisco.
Collecting Damages
Meanwhile, the judge in the South Carolina case is deciding whether to allow February?s racketeering verdict to stand; if it does, damages would be tripled to $810 million ? the largest judgment in South Carolina history, according to the attorney for the bankruptcy trustee. And Grayson?s damages would reach $102 million.
Collecting from the bankrupt firm and other defendants who claim they have little or no assets could prove difficult.
But Grayson has set his eyes on some deep pockets.
His firm, Grayson Consulting, is suing Wachovia Securities, claiming the brokerage ?aided and abetted? Derivium?s scheme, turning a ?blind eye? to the fraud in order to collect $5 million in brokerage fees on the stock trades.
Grayson Consulting paid Derivium?s bankruptcy trustee $25,000 for the right to sue the brokerage and keep up to 90 percent of any judgment it wins after paying its attorney?s costs and expenses. Grayson Consulting is seeking damages ?to punish and set an example of? Wachovia, which has since been acquired by Well Fargo.
As a member of the House Financial Services Committee, Grayson wields some power over the financial institution his consulting firm is suing for punitive damages. For example, he sponsored a bill that in April passed the House limiting ?unreasonable and excessive? compensation to financial industry executives that received federal bailout funds, including Wells Fargo.
But, Grayson noted to Local 6, no one has suggested there?s any conflict of interest ?because there is no conflict of interest ? I have not and will not do anything that singles out a specific bank.?
How It Worked
The ?90-percent stock loan? program was marketed as a way for clients to avoid or defer capital-gains taxes while limiting their losses on their stocks to only 10 percent. And clients were told they could retain much of the profits if the stock increased substantially in value by the end of the loan?s term, usually three years.
It worked like this: Clients turned over stock to Derivium and almost immediately got back 90 percent of its value in cash as a loan. That loan would accrue interest, usually at rates between 9.75 and 11.75 percent a year.
Instead of holding the stock as collateral for the loan, as they claimed they would, Derivium or its associates simply sold it and gave the clients 90 percent of it back as the cash loan.
If, at the end of the loan period, the shares were worth less than what was owed on the loan, including interest, the client could walk away from the loan, keep the 90 percent he received in cash three years earlier and owe nothing ? effectively limiting his stock losses to 10 percent over the three years.
But if, the shares were worth more than the loan balance, the client had three options: pay off the loan, plus interest, and get back his stock at the by-then higher value; collect in cash the difference between the new, higher value of the stock and what was owed on the loan plus interest; or use the stock to renew the loan for another term.
A Fairy Tale
Derivium claimed its founder, Charles Cathcart, had devised a complex hedging formula involving financial derivates that would provide enough profits to pay back the clients if their stocks increased substantially in value.
The problems arose in 2005, when Derivium did not have enough cash to pay the profits its clients earned at the end of the three-year terms.
Grayson, a savvy trial lawyer and experienced investor with undergraduate and law degrees from Harvard College, said he believed the pitch.
Asked how he could fall for such a scam, Grayson answered: ?The jury said nobody could see this coming. Not just me ? nobody ? If (Cathcart) had simply done what he said he was doing, then it wouldn?t have been any problem ? The problem was that he was lying. It?s that simple.?
In May 2001 Grayson visited the firm?s South Carolina office to investigate the operation. ?The place where they were doing what they called this ?dynamic hedging? looked like the cockpit of a spaceship,? Grayson recalled, adding, ?It was very impressive.?
He now says he realizes it was all a ?fairy tale.?
?It was theft, pure and simple,? Grayson said.
The Money Trail
In 92 separate transactions between November 2000 and March 2005, Grayson turned over stock worth $28.7 million to Derivium, according to his lawsuit. Grayson got $25.8 million of it back in cash.
He said he used the cash to make loans to and invest in Latin American businesses.
?There are restrictions on what you can do with borrowed money in the United States. I didn?t have that opportunity to take that money and invest in the United States,? Grayson told Local 6. ?That, of course, is my preference being an American ? So I had no choice but to invest it in foreign countries.?
But first, he said he transferred the cash from the stock loans to the AMG Trust he established in the Cook Islands, a South Pacific government associated with nearby New Zealand.
According to Grayson?s congressional financial disclosure statement last year, his AMG Trust held between $25 million and $50 million in assets, producing dividends and capital gains income of between $1 million and $5 million last year, and more than $5 million the previous year.
Offshore trusts like those in the Cook Islands often attract wealthy people seeking to legally shield their assets from any potential lawsuit judgments, according to experts on wealth protection.
The Cook Islands is also among 34 jurisdictions listed by the IRS as ?probable locations of U.S. tax evasion.?
But Grayson said transferring the cash to the offshore trust had nothing to do with lowering his taxes. ?It didn?t affect my income tax burden at all,? Grayson said. ?Every penny of income to that trust is reported on my personal tax return.?
As with any Ponzi scheme, Derivium?s success depended on attracting cash from new clients so that older ones could be paid off when they demanded any money back. And in 2002, Grayson?s cash was ?currently supporting our business almost singlehandedly,? according to an email between Derivium employees found in the court file. That year Grayson provided Derivium with at least $3.26 million in stock.
But the IRS says this was a Ponzi scheme with a twist ? it helped some of its taxpayer-clients evade capital gains taxes, potentially indefinitely.
IRS Claims Tax Fraud
The IRS says the ?loans? were actually stock sales and clients should have paid capital gains taxes on any profits they accrued from the time they bought the stock until they turned it over to Derivium. The top capital gains tax rates from 2000 to 2008 were between about 15 percent and 21 percent.
Grayson said in court records he ?treated the stock loan transactions as loans for the purposes of taxation,? just as Derivium?s ?outside accountant? advised their clients. That accountant is among the defendants the IRS is accusing of providing ?false statements? to clients in violation of the tax laws.
The IRS also claims Derivium did not send its clients IRS Form 1099s, which list capital gains and dividends, ?making it less likely that the customer would actually report any income or pay any income tax.?
But Grayson said he did not hold the stocks long enough to accrue any capital gains, because he transferred the stock to Derivium within a week or so of purchasing it. In six early transactions where he was paid a total profit of about $588,000, Grayson said he did report that on his taxes as capital gains.
Grayson Picks Winners
Grayson said he used the Derivium stock loans to get cash to invest in and lend to Latin American businesses. Derivium, he said, offered him a chance to limit his losses on the stock to a maximum of 10 percent, while maintaining the ?upside? potential, if the stock appreciated greatly during the course of the loan.
He said he had one goal: to make money.
And the record shows he does that very well.
The freshman Democrat, a multimillionaire former telecommunications company president, last year reported a net worth of between $30 million and $60 million, making him one the wealthiest members of the U.S. House of Representatives, according to financial disclosure statements.
But, he contends, he?d be $34 million richer, had Derivium not gone under.
That?s how much he was owed on 33 ?stock loan? transactions he entered into between 2002 and 2005, based on the stocks? July 2007 values.
For example in the first quarter of 2003, Grayson gave Derivium 350,000 shares of Continental Airlines stock worth $2.15 million at the time. In exchange, Grayson received 90 percent of it ? $1.93 million ? in cash as a loan with an interest rate of 11.75 percent a year.
By July 2007, those shares of Continental stock had increased in value from $2.15 million to $12.5 million. Even after paying back the ?loan? with interest ? which after three years totaled $2.7 million ? Grayson stood to make a profit of $9.8 million, if Derivium had not run out of money and filed for bankruptcy in 2005.
Some of the stocks Grayson picked increased 300, 500 and 600 percent during the three-year loan periods.
Unclean Hands
The Derivium defendants Grayson sued in South Carolina tried to delve into all 92 ?stock loans? Grayson participated in dating back to November 2000 ? not just the 33 profitable ones that Grayson relied on to set his damages at $34 million.
And, to determine how Grayson treated them in his taxes, they asked the judge to order Grayson to produce his income tax returns.
In a June 2008 hearing, an attorney for one of Derivium?s owners said Grayson had taken some cash profits ?and got that money sent to the Cook Islands ? and I want to see how this shows up on his tax returns. Are all the gains shifted to (the AMG Trust) and the Cook Islands where they do not have to file tax returns??
The attorney also suggested Grayson could have claimed losses on some trades to reduce his taxes, while concealing profits in the Cook Islands to evade capital gains. ?If he is playing fast and short with the IRS, I think that?s relevant in this case,? the attorney argued.
Grayson?s attorney, Alisa Roberts, told the judge there is ?absolutely no evidence or any basis upon which (the defendants) might possibly conclude that Alan Grayson or the AMG Trust committed tax fraud.? Even if there were, she said, any tax evasion by Grayson would be irrelevant to the fraud and racketeering counts facing Derivium.
The attorney for another Derivium owner disagreed, saying the IRS had taken action against ?lots of borrowers, tagging them with multimillion-dollar tax deficiencies for not declaring it as a sale ? (Grayson) may have had some ulterior motives. And he may have had unclean hands. And I think that?s relevant.?
But U.S. District Chief Judge David C. Norton denied access to the tax returns, ruling they were not relevant in the South Carolina case.
Also kept from the jury: the opinions of a defense expert who implied in his deposition that Grayson used the funds in ?an illegal or improper manner,? according to court transcripts. Grayson?s attorney argued successfully that such speculation did not belong in evidence.
?In a trial,? Grayson told Local 6, ?the other side will always try to change the subject, to cast aspersions on you?try to slime you, but good people can see through that. The jury was good and they saw through that.?
Grayson did have to submit in 2008 to four days of depositions, answering questions under oath about his investments and taxes. But a court order consented to by all parties has allowed transcripts of those depositions and other documents in the case to remain confidential.
Outspoken Voice
Grayson, still smarting from his Derivium dealings, vows to remain an outspoken voice in Congress against those who took advantage of taxpayers and others before and during the current recession.
?You know, people are angry. They want to know what happened to their money and if I can help to accomplish that then I think people will feel I?ve done something important,? Grayson said.
Reminded he didn?t know what happened to his own money after he turned his stock over to Derivium, Grayson responded, ?Well, we found out eventually.?
Asked if -- as a congressman who ran, in part, on his success as a businessman -- he was embarrassed or hurt to be victimized, he said, ?No. people lied to me? When someone lies to you, it?s not your fault.?