You don't want to get the government mad at you -- even a local government. I once wrote an article critical of New York City's tax department. Two months later, I was summoned to a three-year audit. At the time the city was auditing only about one New Yorker a day -- out of 8 million -- but it was probably just coincidence they chose me.*
Imagine how much worse it must be to get a really big government mad at you -- like the U.S. Government, in the person of former U.S. Attorney Rudolph Giuliani. That's what money manager James Sutton ("Jay") Regan, 47, seems to have done. His firm, Princeton/Newport Partners, was charged with making a series of bogus trades in 1984 and '85 to claim tax losses. The trades were shams, argued the Government, because though Princeton/Newport really did sell securities in which it really did have losses, the firm didn't really sell them because it had an unwritten deal to buy them back later at about the same price.
For this, Regan and five others were charged with racketeering and effectively put out of business even before the trial began. Last week he was sentenced to six months in prison and fined $325,000, on top of more than $5 million in legal fees he'd incurred.
In a world where one man who clearly violates the tax law gets elected mayor of New York while another gets put out of business and sentenced to jail, it's worth a few moments to try to discern what's going on.
Regan would argue that he didn't violate the tax law. (A former IRS commissioner was prepared to testify to much the same thing, but the jury was not allowed to hear this because the judge accepted the Government's argument that his views might blur the issue.) Regan's trades were part of a hedging strategy under which you buy and sell related securities at the same time. You lose on one and gain on the other, but if you've done the math right, you'll usually lose a little less than you gain. Yippee! But you've got to keep your transaction costs low and, of course, not get caught with a taxable gain on one half of the hedge without realizing your loss on the other half. It was to avoid that hitch, basically, that Princeton/Newport entered into understandings with Drexel Burnham Lambert and other firms to make these tax sales. "Look," Regan's traders said in essence, "you're not going to have any risk because we're going to buy these things back once we've satisfied the tax-loss requirements, so just charge us a small commission and some interest for your trouble -- O.K.?" "O.K.," said Drexel.
Sounds pretty innocent, though one might wonder why, if it's legal, Drexel and others haven't offered this appealing tax-loss service more widely.
The Government argued that Regan and Princeton/Newport did violate the tax law, but -- worse -- tried to disguise what they did by breaking up their repurchases into odd amounts at varying prices. What perhaps got Regan into the hottest water, though -- and it's kind of scary the Government might work this way -- is that he refused to provide damning evidence against Drexel and others: "Cooperate and we'll go easy on you. Stonewall us and we'll kill you." We've seen it on TV a thousand times.