Introduction

With New York coming off an $8.5 billion state budget shortfall in 2011,1 it is perhaps no surprise that New York Attorney General Eric Schneiderman has vowed to hold “large-scale tax cheats” accountable.2 What is notable are the means he intends to use. The Attorney General plans to plow new ground by applying New York’s version of the False Claims Act (the New York FCA) to tax fraud.3 The New York FCA is based upon its federal equivalent. But, in 2010, while a New York State Senator, Attorney General Schneiderman pushed through amendments to the New York FCA to explicitly include tax fraud. The result is what Schneiderman calls a “false claims act on steroids.”4 The tax fraud amendment has only recently been put to the test. The use of a false claims theory in the area of tax law is not only unprecedented in New York, it has not been attempted in any other jurisdiction.

The potential recoveries for New York and the corresponding risks to large taxpayers (including corporations) are huge because the statute provides for treble damages when the state can prove it has been defrauded. In the first tax fraud cause brought under the New York FCA, Schneiderman targeted Sprint-Nextel Corporation for alleged underpayments of over $100 million in sales taxes on the company’s flat-rate access charges for wireless calling plans.5 If successful, the case could net the State of New York more than $300 million and become a blueprint for similar tax fraud enforcement actions, both in New York and across the country.

Schneiderman’s actions are emblematic of the broader direction both he and authorities in other jurisdictions have been taking with regard to the enforcement and interpretation of false claims acts. These statutes, both state and federal, were originally designed to punish fraud that specifically victimized the government. However, they have more recently been extended to a myriad of different forms of financial fraud, including cases where the government might not have been an intended (or even foreseen) victim. That is significant because in the age of complex financial instruments, many types of financial fraud can have a government connection, be it through pay-outs by government-backed insurance programs or losses incurred by state pension funds. The attraction of treble damages and the lenient burden of proof available to civil false claims act plaintiffs suggest that the volume of FCA cases will only continue to increase in coming years. That trend has already taken root in the Southern District of New York, where US Attorney Preet Bharara established a Civil Frauds Unit in his office and recently filed FCA lawsuits against mortgage originators for conduct that allegedly contributed to the credit crisis.6

Overview of the New York and Federal False Claims Acts

The Federal False Claims Act (the Federal FCA) is the prototype upon which states have built their FCA regimes. The Federal FCA was originally enacted during the Civil War to combat fraud perpetrated by companies that sold supplies to the Union Army.7 It includes provisions for both criminal and civil liability, holding parties accountable for a variety of forms of conduct that are grounded in fraud and might result in financial loss to the United States. The criminal provision carries up to five years imprisonment and fines of up to $250,000 for any person who “makes or presents . . . any claim upon or against the United States, or any department or agency thereof, knowing such claim to be false, fictitious, or fraudulent.”8 The more widely used provision is the civil component, which imposes liability for a variety of conduct, including “knowingly present[ing] . . . a false or fraudulent claim for payment” and “knowingly mak[ing] . . . a false record or statement material to a false or fraudulent claim.”9

The Federal FCA has been used predominantly in relation to two groups of cases: (1) procurement fraud and (2) healthcare fraud. Procurement fraud refers to those cases where a contractor submits a false or fraudulent claim for payment to the government, and includes cases of bid-rigging, delivery of sub-standard goods contrary to contractual specifications, or not delivering goods while still invoicing the government for them. In the healthcare arena, the Federal FCA has been used to fight a variety of forms of Medicare and Medicaid fraud, including cases involving billing for products or services not delivered, performance of medically unnecessary procedures, and payment of kickbacks to physicians.

Over the years, private use of the civil component of the Federal FCA has grown, largely because it permits whistleblowers to bring so-called “qui tam” actions on behalf of the government and receive a sizeable portion of the recovery (as much as 30 percent, plus expenses, attorneys’ fees, and costs).10 The number of qui tam cases has swelled, increasing in each of the last four years, to more than 638 cases brought in 2011.11 Accompanying that growth has been an uptick in cases brought by prosecutors either in conjunction with a qui tam relator, or independently.

Prosecutors favor use of the FCA for a variety of reasons: First, if the government is successful, the Federal FCA permits treble damages, interest, and civil penalties.12 The damages and penalties often quickly add up given that, for example, each individual invoice submitted by a contractor to the government is considered a claim under the statute. These hefty remedies provide huge incentives for the government to bring FCA cases and create substantial leverage in settlement negotiations. Second, the civil Federal FCA contains a lower burden of proof than criminal fraud cases. Unlike a criminal fraud case which requires proof beyond a reasonable doubt, civil FCA cases are subject to the much less burdensome preponderance of evidence standard, and the “knowledge” standard under the statute is akin to recklessness.13 Third, due to the qui tam provisions, the government can rely on private parties to detect and pursue FCA actions, with the government retaining an option to intervene later in potentially meritorious cases. Under the Federal FCA, the government has 60 days from the date the government is served and a statement of material evidence is submitted, whichever is later, to notify the court whether it will intervene, and that period can be further extended “for good cause.”14

Finally, amendments to the Federal FCA passed in 2009 expanded the statute’s reach. The Federal FCA is no longer limited to claims made directly to the government for funds to which the government has title. Now, the statute also applies to fraudulent claims presented “to a contractor, grantee, or other recipient, if the money or property is to be spent or used on the Government’s behalf or to advance a Government program or interest” and the government provides or will reimburse any portion of the requested funds.15 The plain language of the Federal FCA can now, for example, reach a subcontractor on a large scale construction project who invoices the general contractor and never directly presents an invoice or claim to the government. All that is required under the amended statute is that the subcontractor “knowingly presents” the fraudulent invoice to the general contractor for reimbursement from federal funds.16 Given these low hurdles, the federal government has recovered at least $3 billion through FCA prosecutions and settlements in each of the past two fiscal years.17

Following the federal government’s lead, many states have enacted their own civil false claims statutes. In 2007, New York passed its statute, which largely tracks the language of the pre-2009 Federal FCA. The statute imposes liability for knowingly presenting false or fraudulent claims for payment/approval and making or using false records or statements material to a false or fraudulent claim.18 Like the Federal FCA, treble damages are available, recklessness is sufficient to satisfy the “knowledge” requirement, and whistleblowers are entitled to a portion of the recovery.19

In 2010, amendments were passed to further enhance the appeal of the New York FCA to state prosecutors and private plaintiffs alike. For private plaintiffs, the amendments relaxed the pleading requirements. Private plaintiffs need no longer allege fraud with particularity. A complaint will be sufficient “if the facts alleged in the complaint, if ultimately proven true, would provide a reasonable indication of one or more violations . . . and if the allegations in the pleading provide adequate notice of the specific nature of the alleged misconduct.”20 The amended statute also extends the statute of limitations for New York FCA actions to 10 years; previously it had been six years, or three years if the government had actual or constructive knowledge of the violation.21

Perhaps most notably, unlike the Federal FCA which specifically excludes false claims, records, and statements made pursuant to the Internal Revenue Code, the New York amendments were the first in the country to expand the false claims statute to include tax fraud.22 New York’s FCA now extends liability for all civil FCA offenses to individuals and businesses with more than $1 million in net income or sales if the damages resulting from their improper tax filings amount to at least $350,000.23 Again, under the civil provisions of the New York FCA, the state may prove “knowledge” by a showing of recklessness and need only do so by a preponderance of the evidence. This sweeping provision and low burden of proof provides the New York Attorney General with an attractive tool to recoup large sums of money from “large-scale tax cheats.”

The New Frontier?

Given his involvement as a state senator in passing the New York FCA’s amendments, it is not surprising that Attorney General Schneiderman has sought to take advantage of the opportunities afforded by it. Early in his tenure as Attorney General, Schneiderman created the “Taxpayer Protection Bureau” to investigate those individuals and entities that defraud government pension funds, over-bill the state, and engage in tax fraud.24 The Bureau’s stated mission is to investigate and prosecute fraud cases using the New York FCA, thereby subjecting violators to “the highest civil penalties of any New York statute.”25 Schneiderman has encouraged “any lawmaker who is serious about cracking down on corporate tax cheats [] to follow [New York’s] example,”26 and further emphasized his commitment to aggressively prosecute large-scale fraud through the FCA. That commitment has not been limited to the tax arena, rather Schneiderman has sought to apply the FCA to other fraud in the financial services industry. Recent Federal and New York FCA cases include those regarding foreign currency exchange trading fraud and alleged improprieties related to mortgage origination and insurance (discussed below).

The New York FCA’s First Tax Fraud Case: New York v. Sprint-Nextel Corp.

In its inaugural FCA tax case, New York sued Sprint-Nextel for alleged underpayment of New York sales tax on mobile calling plans that provide 450-minutes of call time in exchange for a fixed monthly charge of $39.99 per month.27 According to the state, since 2002, New York tax law has required mobile phone companies to collect and pay sales taxes on the full amount of their monthly access charges for all calling plans.28 The Attorney General’s suit alleges that Sprint- Nextel failed to collect and pay more than $100 million in taxes in an effort to gain a competitive advantage in the marketplace.29 The Attorney General accuses Sprint- Nextel of both under-collecting and underpaying millions in New York state and local taxes.30

Although this case sends a clear message that the Attorney General plans to make use of the FCA as a tax enforcement tool, it also raises several questions regarding the future of the New York FCA. First, at this early stage of the litigation, it is unclear whether the state’s case against Sprint-Nextel will end up being a model for future enforcement actions. Sprint-Nextel has vigorously denied the claims, arguing that the charges are baseless because New York’s tax law expressly exempts interstate voice services from sales tax and Sprint paid tax on the intrastate portion of its flat-rate plans.31 Second, ex post facto issues could, at least in the short term, limit the effectiveness of the New York FCA when applied to tax years ending before the 2010 amendment. In Sprint-Nextel, the state seeks damages for conduct as far back as 2005, five years before the New York FCA was extended to tax cases.32

Further, the frequency with which New York’s FCA will be used in tax cases remains unknown. Since the New York FCA’s expansion in 2010, the Sprint-Nextel case, in which New York intervened in April 2012, is still the only tax case New York has brought. The Sprint-Nextel case is also based on the violation of one industry-specific tax provision, N.Y. Tax Law § 1105, which only applies to “receipts from every sale of mobile telecommunication services provided by a home service provider.”33 It remains to be seen whether the Attorney General plans to use the statute to pursue a broader range of tax violations. The Attorney General has recently launched an FCA investigation into whether partners at private-equity firms have inappropriately accounted for “carried interest” earnings as capital gains rather than ordinary income to delay or avoid taxes. It remains unclear whether that investigation will result in a lawsuit.34 Regardless, given the New York FCA’s low burden of proof, severe penalties, and the New York Attorney General’s stated commitment to the statute’s enforcement, particularly during lean budget years, large-scale tax payers are well advised to heed the Attorney General’s warning and pay attention to the risks of any “aggressive” tax strategies that may trigger liability.

Application of False Claims Acts to Financial Services Cases

Both the federal government and New York have further extended their FCAs beyond the prototypical procurement and healthcare cases to cases involving the financial services industry. Thus far, cases have been primarily limited to two aspects of the financial services industry: foreign currency exchange trading and mortgage origination and insurance.

Trading Fraud

In October 2011, the New York Attorney General sued BNY Mellon under New York’s False Claims Act and the Martin Act, alleging that the bank defrauded clients in foreign currency exchange transactions.35 The federal government brought a factually similar suit, although instead of the FCA, it relied on the Civil Fraud Injunction Statute and the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA).36 BNY Mellon was accused of making the following misstatements in its representations to investors:

  • That the bank offered the “best rate of the day” or the “best execution”
  • That it priced transactions “at levels generally reflecting the interbank market” or the “market rate”
  • That clients would receive the “same attention and competitive pricing”
  • That trades would be executed “free of charge”
  • That the conversion process was based on the “current foreign exchange rate input”37

New York’s hook for applying the FCA — a statute that only applies to fraud against the government — is based on the allegation that state pension funds are among the victims of BNY Mellon’s misstatements.38 That theory stands in sharp contrast to the prototypical procurement case alleging false claims act violations where a business, for example, submits a false or fraudulent invoice for payment directly to the government. BNY Mellon is aggressively fighting the case, and similar FCA suits brought against it in other states have been dismissed for failure to plead that a claim was actually made to the government.39 The New York FCA suit against BNY Mellon is still active.

Fraud in Mortgage Origination and Insurance

The Federal FCA has also found its way into lawsuits regarding losses incurred by the government in connection with the credit crisis. These lawsuits generally relate to alleged misstatements by lenders or others who made certifications to the US Department of Housing and Urban Development (HUD). In order to obtain Fair Housing Act (FHA) mortgage insurance, certain representations and annual certifications must be made to HUD to ensure that FHA loans are given to eligible borrowers and that the companies acting on HUD’s behalf are adhering to FHA rules.40

In United States ex rel. Belli v. Allied Home Mortgage Capital Corp., a case seeking hundreds of millions of dollars for insurance claims paid by HUD, the government contends that, as a HUD-approved loan correspondent and lender, Allied Home Mortgage made misstatements in its certifications to HUD. Allied, which once billed itself as one of the nation’s largest privately held mortgage lenders, originated HUDinsured mortgage loans and was required to seek HUD approval for each office from which it originated FHA loans. It was also required to certify that it maintained a quality control program that reviewed loans that went into early payment default and that it complied with HUD requirements.41 According to US Attorney Bharara, those certifications were false and, in fact, Allied had unapproved “shadow” satellite offices that operated under little oversight, obtained multiple HUD IDs for its offices based on fraudulent information, and falsely certified that none of its employees had been convicted of a crime.42

Allied is interesting in that many of the allegedly fraudulent certifications — such as certifications that no employees have been convicted of a crime — on their face bear only a tenuous causal link to the actual default of individual mortgages.43 However, if the false certifications to HUD are sufficient to subject Allied to liability, the repercussions could be massive. According to the US Attorney, the FHA has paid insurance claims totaling $834 million for mortgages originated and fraudulently certified by Allied and more loans are currently in default, which could result in additional insurance claims paid by HUD for as much as $363 million.44

Since Allied, similar cases have been brought against lenders and others for allegedly misleading governmental entities about the quality of mortgages that later defaulted and there are reasons to suspect additional cases may be filed.

Going Forward

It is unlikely that the expansion of the FCA will stop with tax, foreign exchange currency trading, or mortgage fraud. By premising liability on false certifications to regulatory bodies, prosecutors have opened the door for even broader application of false claims statutes. Given the advantages of such statutes, they will likely not only walk through that door, but prop it open and invite others to follow them. It remains to be seen where legislatures, prosecutors, and courts will draw the line. For now, however, it appears that the frontiers of the federal and state false claims acts will continue to expand beyond the traditional realms of procurement fraud and health care. The only questions are how fast and how far?