Federal Judge Permanently Enjoins HedgeLender From Promoting Its Stock-Loan Arrangement Which Allegedly Assisted Customers Evade Nearly 30 Million in Income Taxes

Jun 23, 2011   
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On June 14, 2011, a Virginia federal judge granted a permanent injunction barring HedgeLender, LLC (“HedgeLender”) from promoting a stock-loan tax scheme that allowed owners of appreciated stock to obtain cash without paying capital gains tax through the use of purported income.

In 1999, Daniel Stafford started an unincorporated entity named the “SAS” group in Reston, Virginia. He incorporated the entity in 2001 in Delaware as HedgeLender Corporation and maintained its principal place of business in Reston, VA. In August 2001, HedgeLender entered into a joint venture agreement to design, produce, sell, and deliver no-margin call, no-contingent-liability stock loan products. HedgeLender coordinated all marketing efforts and advertised the transactions to customers outside the insurance industry.

Specifically, HedgeLender advertised HedgeLoans as a means for consumers to transfer their securities to certain lenders as collateral for a loan against the value of those securities. Specifically, they advertised the loans as “non-recourse, non-callable loans for up to 90% of the value of a customer’s securities.” The customers then transferred the securities to a specific as collateral for the loan. HedgeLender promotions also stated that capital gains from the HedgeLoans were not income, but tax free loan proceeds. Other marketing tactics included:

  • A term of two to seven years;
  • An above-market interest rate;
  • Any dividends issued on the securities during the loan were credited against the accrued interest;
  • Prepayment of the principal and interest was prohibited during the term of the loan; and
  • The customer can receive the full value of his securities at maturity if he repaid the balance of the loan, regardless of how much the securities had appreciated.

Once a customer entered into a HedgeLoan transaction, HedgeLender gave the customer a Master Loan Agreement (“MLA”). The customer would then be told to transfer his securities to a lender, which essentially also transferred the securities legal title. HedgeLender, however, told customers that they still had “beneficial ownership” of the securities for the term of the transaction. HedgeLender also told customers that once the securities were transferred, the lender would enter into “hedges” with the customers’ securities. According to the MLA, the lender had no responsibility to transfer the loan proceeds to a customer until it hedged the securities.

As discussed by the Court,

The defendant [was] aware that the “hedge” [was] actually a sale of the customers’ securities in the open market. Because the lender [sold] the securities, they are not collateral for a loan. Regardless, the lender in the joint venture with the defendant sends statements to the customers that describe the value of the customer’s collateral securities, the amount of accrued, and any dividends received on the securities. But, because the securities are sold, no dividends are issued on them and no interest is accrued. The lender also does not issue IRS form 1099 to customers or to the IRS when it sells the securities.

United States v. HedgeLender LLC, No. 10-cv-01054-TSE-IDD, (E. Dist. Va. 2011).

In 2007, several customers whose loans matured chose to repay the loans; the lender, however, did not have enough funds to buy back the securities or return the cash equivalent to the customers. The lender, thus, defaulted on its obligations under the MLA. Consequently by 2008, more than $268 million in securities and more than 350 customers had transacted in the scheme.

After conducting audits of some HedgeLoans customers, the IRS has determined that the HedgeLoan schemes have helped customers to evade taxes and hindered the Agency’s efforts to administer federal tax laws. Furthermore, between 2001 and 2008, Defendant’s promotion of HedgeLoans caused more than $268 million in taxable sales of securities for more than 350 customers. The IRS has determined that the average amount of under-reported income for HedgeLender customers has resulted in an average deficiency of $85,641 in income tax owed per customer. As a result, the Agency estimates a total loss in income tax in the amount of as much as $30 million.

Id. As discussed above, the Court deemed HedgeLoans a tax shelter within the meaning of IRC §6700. As further discussed by the Court:

Since the Defendant promoted the HedgeLoans transactions as “loans,” which has tax implications for customers, then the transactions have some connection to taxes and are a “plan or arrangement” within the meaning of IRC §6700.

When considering whether injunctive relief was appropriate under IRC §§7402(a) and 7408, the Court considered the following:

  1. The gravity of harm caused by the offense;
  2. The extend of the defendants participation and his degree of scientor;
  3. The isolated or recurrent nature of the infraction and the likelihood that the defendants customary business activities might again involve him in such transactions;
  4. The defendants recognition of his own culpability; and
  5. The sincerity of his assurances against future violations.

With regard to HedgeLender, the Court found that permanent injunctive relief was appropriate after weighing the above factors.

Specifically, Defendant has promoted and marketed HedgeLoans, and as a result, hundreds of customers have engaged in transactions. Through audits of some HedgeLoans customers, the IRS has determined that these customers have failed to report income, which on average, results in $85,641 in income tax deficiency per customer. In total, the IRS estimates that it has lost income in the approximate amount of $30 million in unpaid taxes involving all HedgeLoans customers. In addition, the Agency will have to utilize significant resources to continue audits of HedgeLoans customers. This is a significant harm to society because it promotes noncompliance with federal tax laws and is a great cost to the public.

Id. (emphasis added).

The attorneys at Fuerst Ittleman, PL have extensive experience with the complex regulatory provisions governing the reporting of transactions including the tax treatment of loans as well as the sale of securities. You can contact an attorney by emailing us at contact@fidjlaw.com.