Pump and Dump Scheme Did Not Equate to Theft, So Loss on Shares was Capital Rather Than Ordinary

In the case of Greenberger, et al v. Commissioner, 115 AFTR2d ¶2015-844, US DC ND Ohio, No. 1:14-cv-01041 the issue is not whether the taxpayers had incurred a deductible loss—the IRS agreed that was so.  Rather the question was the nature of the loss.

Specifically the issue was whether the loss represented a theft loss (deductible as an ordinary loss under IRC §165 or was rather a capital loss that could only offset other capital gains or be slowly absorbed against $3,000 of other income each year.

The taxpayers in this case had bought stock in a small company which, it would turn out, would come under SEC scrutiny for a claimed “pump and dump” scheme.  The officers of the company had released information regarding substantial sales that, as it turned out, simply did not exist. 

After releasing the information, these officers and others “in the know” were able to dump shares they had obtained for very low cost in the company into the market and obtain a much higher price.  Of course, those shares were actually purchased by others in the market who later suffered a complete loss of their investment when the SEC opened up an investigation and eventually halted trading in the company in question, which also filed for bankruptcy.

The taxpayers in this case were part of that latter group.  A former friend of theirs, a financial and investment adviser, had recommended that they buy the stock.  It turns out this adviser was one of the largest shareholders of this company and, the taxpayers allege, was “in” in the scheme, helping to build up demand for the shares (and thus drive up the price) to enable the dumping of shares by the insiders.

However the former friend actually appeared to not be fully in on the scheme.  He lost $15 million when the company went under.

Mr. Greenberger bought several thousand dollars worth of stock in the enterprise, trading it via his own brokerage account.  He did not acquire any of the stock directly from the company and he himself made money on some trades of the stock during the (unknown to him) “pump” phase.

Mr. Greenberger continued to believe in the company even as the rumors of “cooked books” began to swirl, even loaning the company $20,000 for debtor in possession financing immediately after the bankruptcy.  He also ended up acquiring additional shares as the price continued to tumble downward.

When the dust settled, he ended up with a loss of $569,200.  He claimed this loss as a theft loss on his tax returns, which the IRS disallowed, holding it had to be treated as a loss on worthless securities.

For an item to be treated as a theft for federal income tax purposes, it must qualify as a theft under the applicable local law (Ohio in this case). 

The court determined that to meet this test two things must be shown:

·       First, that certain wrongdoers acted with the specific intent to deprive the taxpayers of their property and

·       Second, that the taxpayers transferred their property to these wrongdoers

In this case the taxpayer’s major problem is the second prong of this test—their property was not transferred to the wrong-doers (the management of the company) but rather to general investors in an open market. 

The taxpayers did actually have contact with the CEO of the company during this process and he did try to mislead them about the Company’s financial affairs.  But, unlike the taxpayers in certain other cases cited by the Court (McComb v. Commissioner and Vietzke v. Commissioner) they had not acquired the shares from the company after such contact.  And while the investor in the case of Adkins v. United States had bought the shares in the open market, the Court in that case found he had demonstrated that he purchased from entities controlled by the wrong-doer.

The Court found:

The Greenbergers bought their Spongetech shares on the open market, without any knowledge of who was on the other side of the transaction. This is little different than any other corporate fraud, where the executives profit from pumping up the price of their own shares to the detriment of the unsuspecting public. Granted, it is very possible that at least some of the shares the Greenbergers bought came from the fraud perpetrators, given that the number of Spongetech shares illegally distributed by the fraudsters (about 2.5 billion) far exceeds the number of legitimately issued and outstanding shares (about 700 million). But this is ultimately immaterial, as the purchase of these shares was done in the open market on the OTC Bulletin Board, rather than being purchased directly from Spongetech or its executives.

Just as importantly, Plaintiffs have also not shown that Moskowitz or any other Spongetech executive targeted Greenberger with the specific intent to take his money. Greenberger talked to Moskowitz on the phone a few dozen times from 2008 to 2010. During these conversations, Moskowitz appears to have merely repeated the same lies about the company's sales Moskowitz was spreading in publicly available (though fraudulent) releases. Moskowitz also reassured Greenberger that the company was going to hire new accountants to remedy its delay in its SEC filings. But Plaintiffs have not alleged, nor presented any evidence, that Moskowitz ever encouraged Robert Greenberger to buy Spongetech stock.

Thus, while the taxpayers may have lost money due to bad faith actions, they had not had the funds stolen as that term is defined under state law.  Rather their loss was simply that of an investor who made a bad investment—and, therefore, a capital loss.