Whistle-Blowers Become Investment Option for Hedge Funds

Whistle-Blowers Become Investment Option for Hedge Funds
By DAVID KOCIENIEWSKI
Copyright by Bloomberg News
Published: May 19, 2010
http://www.nytimes.com/2010/05/20/business/20whistleblower.html?th&emc=th


Hedge funds have found a new market to invest in: whistle-blowers.

Bradley Birkenfeld, now in prison, contends he should be awarded millions for helping the I.R.S. identify tax evaders abroad.

Informants who turn in tax cheats have to wait years to get their share of any reward from the I.R.S.’s recently expanded whistle-blower program. So hedge funds, private equity groups and other big investors are offering an alternative. They are essentially agreeing to buy a percentage of those future payouts in exchange for a smaller amount upfront to the whistle-blowers.

The surging size of the potential awards is driving all the interest. Three years ago, the I.R.S. began offering bigger rewards — 15 percent to 30 percent of whatever money the government recovered — in a move that has turbocharged the agency’s whistle-blower program.

Where it once handled only a trickle of tips, often involving relatively small amounts of unpaid taxes, I.R.S. offices now receive a torrent of big money claims. Accountants and company employees have taken to trooping in bearing computer records and boxes of documents to back up their claims of underpayment by big companies.

In what is believed to be the first of these structured tax payouts, an I.R.S. informant who reported that an overseas multinational corporation had underpaid its taxes by billions of dollars received $4 million last month from a private equity firm. In exchange, the firm will receive a portion of the award the informant expects to collect eventually.

The whistle-blower’s lawyer, Eric R. Havian, declined to name his client or provide specifics of the deal, such as how much more than $4 million the investor expects to get. But he said the informant needed money to cover living expenses because he had had trouble finding work since filing his claim.

“The investors take a big bite out of the awards because they could get nothing if the I.R.S. decides not to pay,” said Mr. Havian, a partner in Phillips & Cohen, a firm in Washington specializing in whistle-blower cases.

“And for the whistle-blowers, the amount of the potential award is so astronomical — tens of millions, hundreds of millions of dollars — that they have to ask themselves, ‘How many times over do you have to be rich?’ and ‘Would I be better off with the guarantee of some money now?’ ”

Determining the value of a whistle-blower complaint is a risky endeavor for the investors. Confidentiality rules forbid I.R.S. officials from discussing the status of an investigation even with the whistle-blower, so investors are left to gauge the strength, and potential payoff, of any claim by reviewing the documentation provided by the informant and his lawyer.

I.R.S. officials acknowledge that they have discussed such agreements with whistle-blower lawyers, but the agency does not keep track of how many may have been executed.

Among the lawyers, hedge funds and investors who may provide the financing for class-action lawsuits and whistle-blower cases against government contractors, the reinvigorated I.R.S. program has attracted attention.

Even Credit Suisse, the big Swiss bank, which has been criticized by the United States and other governments for allowing tax evaders to use its private accounts to hide assets, has explored the possibility of investing in a whistle-blower’s award, according to lawyers involved in the negotiations. A Credit Suisse spokesman, however, said the bank had not made any deal and was no longer interested in one.

David Desser, whose capital management firm specializes in litigation finance, said the market was likely to expand once the I.R.S. awarded its first whistle-blower a check under the expanded program, which is expected later this year.

“As soon as the I.R.S. begins paying whistle-blowers, more people will realize that this is a whole new class of assets to be monetized,” Mr. Desser said. “It will be limited in size, because only a percentage of whistle-blowers will have incentive to sell. But for investors there is potential here for outsized returns.”

While the market in whistle-blower futures is in its infancy, investors have been requesting as much as 65 percent of any award an informant receives, according to lawyers negotiating possible deals. In the more established field of litigation finance, investors who underwrite the cost of a lawsuit get 5 percent to 50 percent of any legal settlement or jury award.

Although the I.R.S. has long accepted tips from informants, until recently it seemed reluctant to investigate their complaints or reward them. For the five years ended in 2008, the I.R.S. received about 80 whistle-blower complaints a year, and recovered an average of $155 million a year from tips in previous years, paying an average of $14 million annually in awards.

Since sweetening its awards, the whistle-blower’s office has been receiving more than 500 tips a year, involving far larger amounts. In the five years through fiscal 2008, tips from informants led to 20 cases in which the I.R.S. had been underpaid by at least $2 million. Now the I.R.S. receives 40 or 50 such tips a month, about 10 percent claiming fraud of $100 million or more.

It is too early to gauge whether the program will deliver on the promise that it might recover billions each year, but the preliminary results are promising: an audit by the Treasury Department found that in 2008 alone, whistle-blowers had reported $65 billion in unpaid taxes.

Law firms have been aggressively marketing themselves by setting up whistle-blower blogs and seminars, financing taxpayer antifraud groups, firing off press releases to trumpet big claims, and holding whistle-blower boot camps to train lawyers.

Some accountants and tax lawyers warn that the lure of big money awards could taint the process, even encouraging false accusations from unscrupulous business rivals, or disgruntled employees looking to cash in.

Donald L. Korb, former chief counsel of the I.R.S., said he considered it “unseemly” for the government to encourage citizens to become bounty hunters by informing on their co-workers, employers and neighbors.

During his tenure at the I.R.S., Mr. Korb said he had tried to set up a sophisticated set of procedures to vet complaints because he feared that misuse of the program might bring new complaints about overzealousness by I.R.S. auditors. “I think it’s a bad precedent,” said Mr. Korb, now a partner at the law firm Sullivan & Cromwell. “It’s a disaster waiting to happen.”

But I.R.S. investigators say that the whistle-blower’s office will carefully screen cases to prevent abuse and that the program already precludes monetary awards for people involved in planning or initiating the tax fraud they report.

Those restrictions will be tested in the case of Bradley C. Birkenfeld, the whistle-blower who helped pierce the secrecy of the Swiss banking system.

Mr. Birkenfeld’s tip helped the government win a $780 million settlement from UBS, another big Swiss bank, and could lead to billions more because he helped the I.R.S. find thousands of Americans with offshore accounts.

But Mr. Birkenfeld also withheld information from investigators about his actions to help a client evade taxes, and is now serving a 40-month sentence. Dean A. Zerbe, who represents Mr. Birkenfeld, said the I.R.S. risked undermining the program if it reneged on paying an award.

“He came forward and helped them recover more tax money than anyone else in history,” said Mr. Zerbe, who helped write the new whistle-blower rules four years ago, while working for the Senate Finance Committee. “And if people see that he went to jail and didn’t get the kind of award the I.R.S. has been promising, why would anyone ever come forward again?”

A recent round of “program changes” by the I.R.S. announced that informants are entitled only to a portion of the money directly paid to the government. If a tip simply leads to the denial of a refund — or if the unpaid taxes are used to offset other losses — the whistle-blower comes up empty.

Erika Kelton, a whistle-blower lawyer who testified before the Senate when the rules were being amended, predicted the limits would be struck down “either in tax court or in Congress.”