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Let's say you're
sitting on a block of stock with a huge gain in it. Wouldn't
you be tempted by this offer? You can (a) have your cake, (b)
eat it, too, and (c) not pay taxes until later.
Just such an offer was made by a firm
called Derivium Capital LLC. Several hundred wealthy investors
grabbed it. Now many wish they hadn't.
The Derivium deal called for the
customer to get a loan equal to 90% of the value of his
shares. If the stock went up, he could get it back by repaying
the loan, with interest. If the stock went down, he could walk
away and owe nothing. And, supposedly, the initial loan was
not a sale and thus not taxable.
Now Derivium, which did $1 billion in
loans, is in bankruptcy and under investigation by the
Internal Revenue Service. Some clients could face back tax
bills and others could lose millions in stock gains in a
mystery that includes a former Citibank executive, companies
in Ireland and the Isle of Man and Britain's former honorary
consul to Liechtenstein.
It's beginning to look like it
may have been a very sophisticated Ponzi scheme," worries
Alan M. Grayson, a lawyer and former president of
long-distance provider IDT. He figures the shares he used as
collateral for Derivium loans are now worth $12 million more
than his loan balances. But Derivium reports it has no stock
and no money in the bank.
In June an arbitrator ruled that
Derivium owes Fair Oaks, Calif. real estate developer Don
Hancock $47 million. Former Amazon.com marketing exec Mary
Morouse got a $15 million judgment against Derivium. Legg
Mason Executive Vice President Robert G. Sabelhaus is owed a
net $8 million in stock, an arbitrator ruled. The family of
William C. Newton, a former executive at Capital Research
& Management, the giant mutual fund operator, alleges in
two suits that they have been defrauded; the family looks to
be out $12 million.
At the center of the mess is Charles
D. Cathcart, a 65-year-old economist whose résumé and/or Web
site includes the following: a University of Virginia Ph.D., a
stint at the Central Intelligence Agency and service as a
derivatives pioneer at Citicorp. Cathcart set up First
Security Capital in Charleston, S.C. in 1998 and during the
tech boom renamed it Derivium.
Clients who turned over their shares
couldn't reclaim them during the course of their loans (many
of which were for three years), but they didn't have to ante
up interest--it was simply added to the loan balance. At the
end of the term, if the stock was worth less than the balance,
the borrower could forfeit it and walk away. If it was worth
more, a borrower could pay off the loan and get the stock
back, roll over the loan into a larger one or ask the stock be
sold and take profits.
Borrowers generally didn't report any
income until the stock was forfeited or sold. (Some might not
have reported income even then, since Derivium didn't send
1099s.) The IRS and California tax authorities assert that the
loans were really sales, in part because now investors can't
get their stock back.
So what was Cathcart's hedging
secret? In a deposition he gave last year to California
regulators, he said he controlled the risk of a slide in the
stock price by immediately selling the stock. As for the
upside, he said he gave the offshore lenders backing the loans
advice on strategies they could pursue, but had no
"specific knowledge" of what hedges actually took
place. In fact, some borrowers say they didn't learn
until
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2002 that Derivium
was using an offshore lender--first an Irish company and, from
2000 on, Bancroft Ventures Ltd., on the Isle of Man.
Let's say you're sitting on a block of stock with a huge gain in it.
Wouldn't you be tempted by this offer? You can (a) have your
cake, (b) eat it, too, and (c) not pay taxes until later.
Just such an offer was made by a firm
called Derivium Capital LLC. Several hundred wealthy investors
grabbed it. Now many wish they hadn't.
The Derivium deal called for the
customer to get a loan equal to 90% of the value of his
shares. If the stock went up, he could get it back by repaying
the loan, with interest. If the stock went down, he could walk
away and owe nothing. And, supposedly, the initial loan was
not a sale and thus not taxable.
Now Derivium, which did $1 billion in
loans, is in bankruptcy and under investigation by the
Internal Revenue Service. Some clients could face back tax
bills and others could lose millions in stock gains in a
mystery that includes a former Citibank executive, companies
in Ireland and the Isle of Man and Britain's former honorary
consul to Liechtenstein.
It's beginning to look like it
may have been a very sophisticated Ponzi scheme," worries
Alan M. Grayson, a lawyer and former president of
long-distance provider IDT. He figures the shares he used as
collateral for Derivium loans are now worth $12 million more
than his loan balances. But Derivium reports it has no stock
and no money in the bank.
In June an arbitrator ruled that
Derivium owes Fair Oaks, Calif. real estate developer Don
Hancock $47 million. Former Amazon.com marketing exec Mary
Morouse got a $15 million judgment against Derivium. Legg
Mason Executive Vice President Robert G. Sabelhaus is owed a
net $8 million in stock, an arbitrator ruled. The family of
William C. Newton, a former executive at Capital Research
& Management, the giant mutual fund operator, alleges in
two suits that they have been defrauded; the family looks to
be out $12 million.
At the center of the mess is Charles
D. Cathcart, a 65-year-old economist whose résumé and/or Web
site includes the following: a University of Virginia Ph.D., a
stint at the Central Intelligence Agency and service as a
derivatives pioneer at Citicorp. Cathcart set up First
Security Capital in Charleston, S.C. in 1998 and during the
tech boom renamed it Derivium.
Clients who turned over their shares
couldn't reclaim them during the course of their loans (many
of which were for three years), but they didn't have to ante
up interest--it was simply added to the loan balance. At the
end of the term, if the stock was worth less than the balance,
the borrower could forfeit it and walk away. If it was worth
more, a borrower could pay off the loan and get the stock
back, roll over the loan into a larger one or ask the stock be
sold and take profits.
Borrowers generally didn't report any
income until the stock was forfeited or sold. (Some might not
have reported income even then, since Derivium didn't send
1099s.) The IRS and California tax authorities assert that the
loans were really sales, in part because now investors can't
get their stock back.
So what was Cathcart's hedging
secret? In a deposition he gave last year to California
regulators, he said he controlled the risk of a slide in the
stock price by immediately selling the stock. As for the
upside, he said he gave the offshore lenders backing the loans
advice on strategies they could pursue, but had no
"specific knowledge" of what hedges actually took
place. In fact, some borrowers say they didn't learn until
2002 that Derivium was using an offshore lender--first an
Irish company and, from 2000 on, Bancroft Ventures Ltd., on
the Isle of Man.
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