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Qui Tam Troubles, Part 1: An Illinois Informant With No Inside

Posted on June 11, 2014 by Amy Hamilton

This document originally appeared in the April 9, 2014 edition of State Tax Today.

For more than a decade, a Chicago-based class action law firm has been stepping into the role of "whistleblower" and filing hundreds of qui tam tax actions under the Illinois False Claims Act. The private suits filed by the firm -- first as Beeler, Schad & Diamond PC and more recently as Schad, Diamond & Shedden PC -- are driving much of the national discussion about potential abuses of state false claims acts that extend to taxes.

At the root of the matter is the question of who can properly serve as an informant in a whistleblower action.

During an Illinois House Revenue and Finance Committee hearing in July 2012, witnesses testified that Schad Diamond and the firm's lawyers aren't the kind of true insiders that whistleblower laws were meant to encourage. Rather, witnesses from the private and public sectors -- including Illinois Revenue Director Brian Hamer -- described Schad Diamond as a financially motivated third party adept at manipulating the qui tam process to "victimize" businesses that at most made an inadvertent mistake.

Witnesses at the hearing said that by filing nuisance-type suits, the firm exploits the qui tam process and its associated penalties, forcing businesses into settlements for amounts far exceeding any tax owed. They added that the firm -- supposedly an informant already in possession of the requested confidential taxpayer information -- also wants discovery in the cases. Every witness testified to the need for a legislative fix.

Stephen Diamond, the law firm's director and the relator in the firm's qui tam tax actions, did not respond to requests for comment from Tax Analysts. He has also declined requests for comment from in-state publications.

"The cases have clearly interfered with the administration and enforcement of tax law and may have even ultimately cost the state money, though it's impossible to quantify how much," said Mark Dyckman, the Illinois Department of Revenue's deputy general counsel for sales tax litigation.

In an interview with Tax Analysts, Dyckman gave an overview of the state's experience with the two rounds of qui tam tax litigation initiated by Schad Diamond. He said one upshot of the first round of cases was that Illinois lost out on a chance to reach a voluntary collection agreement with a group of remote sellers that already had similar agreements in place in other states.

The next article in this series will look at the new path events are taking in the state and the ways the related issues raised by the litigation are ballooning. The final installment features an interview with an advocate for the use of false claims acts in the state tax arena, as well as an examination of New York's experience implementing its own False Claims Act.


The Whistleblower

According to the National Whistleblowers Center, the federal False Claims Act allows any person or entity with evidence of fraud against federal programs or contracts to sue the wrongdoer on behalf of the government. However, the implication is that the relator generally will be someone from inside the organization being investigated. The center, for example, focuses on protections for employees retaliated against through harassment or job loss as a result of whistleblowing; it also directs Web traffic to a scholarly study published by the Boston University Law Review analyzing the importance of financial incentives for insiders to disclose corporate fraud that the government otherwise would be unable to detect.

Bradley Birkenfeld, the former UBS banker whose information about banks and individuals hiding money in Switzerland helped the IRS collect more than $5 billion in unpaid taxes, is probably the classic and best-known tax whistleblower.

Similarly, the relator in the unclaimed property qui tam action unsealed by the Delaware attorney general on April 11 is a former senior officer of two of the card services companies alleged to have conspired with multiple Delaware gift card defendants to hide hundreds of millions of dollars due to Delaware. The whistleblower -- a former controller and vice president of client relations -- maintained the entities' books and records. He gave the state copies of the card services defendants' marketing materials, contracts, and correspondence with the Delaware defendants, including reports showing the amounts of unredeemed gift card value that the companies failed to report or remit to the state escheator.

In New York, the first state to specifically authorize the application of its false claims act to "claims, records or statements made under the tax law," AG Eric Schneiderman (D) included in his complaint against Sprint Nextel Corp. information provided by a whistleblower about internal analyses, discussions, and presentations by Sprint's state and local tax group that allegedly show that the company concluded that by not paying the proper amount of sales tax to New York, it would position its calling plans as cheaper than competitors' plans.

Schad Diamond, by contrast, purports to conduct its own investigations into the sales and use tax practices of online retailers by buying items over the Internet. When a retailer fails to collect tax -- on the purchases in the first round of cases, and on a portion of shipping and handling charges in the second -- Schad Diamond files a qui tam action. In those actions, Schad Diamond alleges that the retailers have committed fraud by knowingly failing to collect tax. The firm is able to file the whistleblower actions based on its knowledge as the consumer in the transactions.


'Perverse Incentives'

"It seems to me that the purpose of these suits isn't to get at the correct amount of tax," said Jordan Goodman, a partner in the Chicago office of Horwood Marcus & Berk Chartered. "It's for the awards given to the relator. The relator is making a lot of money off this."

Goodman talks often about the steep combined penalties and potential payouts in state false claims acts, which create what he calls "perverse incentives" that can lead to parasitic lawsuits. First, the relator in an Illinois whistleblower action is entitled to at least 25 percent of any proceeds recovered by the government -- regardless of whether that money is recovered through litigation or in a settlement.

Second, while the treble damages for back taxes under false claims acts naturally attract the most attention, Goodman said the civil penalty -- generally $5,000 to $10,000 per false claim under the federal law and $5,500 to $11,000 per false claim under the Illinois statute -- can be just as oppressive, depending on what counts as a false claim. If each monthly sales tax return is a false claim carrying a $10,000 penalty, and 12 returns are filed in one year, that's a $120,000 penalty. If every failure to collect taxes on shipping and handling is a false claim, and the business averages 10 sales into the state per month for 120 false claims, that's a $1.2 million penalty for the year, which can turn into $12 million for the 10-year period covered by the false claims act.

Businesses in these suits also are potentially on the hook for attorney fees. According to practitioners, Schad Diamond is seeking maximum fees for filing the same complaint repeatedly, with only the name of the business being sued changed.

"I have a client with approximately $100 of tax due over a 10-year period," Goodman said. "The relator wanted in the mid-to-high five figures to pay for their attorney fees for filing the suit. The relator got 50 times more than what was owed in tax. My client was forced to pay because to litigate on the merits is an expensive proposition."

Dyckman said the DOR is sympathetic to targeted businesses that have hired reputable law firms and are paying large sums just to try to get dismissals of the cases. That has generated a number of settlements in the shipping and handling cases, in which businesses paid double the amount of potential tax owed plus fees because hiring a quality law firm to defend them would cost more than their exposure, Dyckman said.

"The problem is, that's created a moral hazard," Dyckman said. The settlements encourage the relator to file actions against big companies for small sums to get two times the tax and fees from businesses that just want to make the cases go away, he said.

How much Schad Diamond received in those settlements is unclear. But a December 10, 2012, column in Crain's Chicago Business followed up on the Revenue and Finance Committee's hearing that year. Under the headline "State Blows the Whistle on This Whistleblower," the columnist quoted Rep. Michael Zalewski (D) as saying Schad Diamond isn't going after businesses that are willfully avoiding taxes, but is only interested in collecting damages and attorney fees.

"I'd imagine it amounts to millions," Zalewski told the publication.


Round 1

In the first round of cases, which started in 2002, Beeler, Schad & Diamond targeted out-of-state businesses that didn't collect Illinois use tax on purchases made over the Internet. According to Dyckman, 104 nexus qui tam cases were filed in the state over an eight-year period.

Goodman and other advisers with Horwood Marcus & Berk wrote in a 2013 report for the Journal of Multistate Taxation and Incentives that tax professionals in the state immediately recognized two glaring problems with the actions: In most cases, there was no violation of the false claims act, as a remote seller's decision not to collect use tax could not have constituted the retailer "knowingly" avoiding its obligation to collect the tax. Also, according to the authors, many of the complaints were based on public disclosures, such that the relator could not have been the original source of information regarding the "violations" in the cases. In other cases, in-state affiliates already had been audited by the DOR.

The retailers in these cases not only didn't hide their allegedly fraudulent tax practice, but they publicly took the position that they didn't have nexus with Illinois under the U.S. Supreme Court's decision in Quill Corp. v. North Dakota and thus weren't required to collect tax on their sales into the state.

Illinois wasn't the only state targeted in that first round of cases: Schad Diamond brought the same kind of nexus qui tam actions in Nevada and Tennessee. AGs in those states intervened early on, winning dismissals of the suits on the grounds that the actions were inconsistent with the states' obligation to enforce and interpret the tax law.

By contrast, the Illinois AG intervened as a plaintiff in some of Schad Diamond's nexus qui tam actions.

At the least, that was a move that practitioners cite as an example of a state's support for using a false claims act to enforce the government's preferred reading of an unclear area of tax law. (Prior coverage.)


The State's Perspective

"When those [cases] first came in, the department had some mixed feelings on it," Dyckman said. The DOR has always been concerned that the false claims act as applied to tax has the potential to interfere with the department's ability to administer and enforce the tax law, he said, adding, "We think we should have pretty much exclusive jurisdiction over it and not have outside parties in the middle of that."

However, Dyckman said that with the nexus cases, there also was a belief among tax officials that there might be substantial amounts of money at stake. The cases also posed a possible opportunity for the Illinois tax system to bring in out-of-state companies that weren't already registered and filing, he said.

Another important aspect of the cases to keep in mind is that no one wants to be seen as being against real whistleblowers, Dyckman said. While that is generally true everywhere, he said, the public in Illinois might be especially sensitive to the need for whistleblowers and rooting out corruption, given the history of Chicago and the state's politics. When the nexus whistleblower cases started, then-Gov. George Ryan was in hot water over the illegal sale of government licenses, contracts, and leases by state employees during his tenure as secretary of state. Ryan, who completed his federal prison sentence in 2013, was succeeded by former Gov. Rod Blagojevich, who in March 2012 began serving his own federal prison sentence after being convicted on charges of corruption.

But in an amicus brief filed in Illinois litigation in 2005, the Council On State Taxation called it "unbelievable" that a company could be subject to the false claims act's punitive damages for following Quill. COST also warned that the state's actions could spur the firm to file additional lawsuits, giving it "the ability to legally extort money and drive up litigation costs (already exceeding the tax that many of the Defendants 'failed' to collect) from retailers pending resolution of unwarranted lawsuits."

According to practitioners, businesses settled most of the nexus qui tam actions. Of those cases that went to litigation, practitioners continue to point to one appellate court decision that affirms a trial court's dismissal of Diamond as a party in two of the qui tam nexus suits.

In State of Illinois ex rel. Beeler, Schad and Diamond PC v. Target Corp., a consolidated appeal, the state argued that Diamond couldn't qualify as an original source because he wasn't an insider with potential access to information unavailable to the general public. The state also argued that while Diamond, by making purchases online, could have gathered direct knowledge of whether the retailers collected tax, his knowledge was not independent from information that was already publicly available.

The state submitted into evidence several news articles about congressional hearings on the remote sales tax nexus issue. Diamond said in an affidavit that he personally had neither seen nor read those specific articles. The Illinois appellate court said the trial court was correct in finding that Diamond was not the original source and affirmed the trial court's order dismissing Diamond as a party to the suits at issue.

The court never got to the nexus questions. According to practitioners, a client can be trapped in years of qui tam procedural morass without ever getting to possible defenses based on the merits of the case.

While Schad Diamond was found not to be an original source in those consolidated cases, each case stands on its own, according to practitioners with clients dealing with qui tam litigation. This means that in every new qui tam action filed, the respondent must jump through the same hoops to have the case dismissed. The Illinois courts and the Office of the Attorney General are generally protective of qui tam actions, providing the relator with great leeway.


Second Thoughts

Dyckman said that during the course of the nexus qui tam actions, the DOR and Office of the Attorney General came to believe that most of the suits fell into one of two categories: Either they had no merit, or they were rooted in an affiliate nexus legal theory so cutting edge that even if it turned out that the defendant owed taxes, there would have been a serious question whether the retailer's failure to collect could have risen to the level of a knowing false claim.

"The standard for false claims act cases theoretically should be fraud, or material misrepresentation, or gross negligence rather than just merely, 'You didn't pay the correct amount of tax,'" Dyckman said.

The federal False Claims Act requires that the person or entity that is the subject of a qui tam action knowingly act in deliberate ignorance or in reckless disregard of the truth when making the false claim. In 1986 Congress amended the federal law so that there no longer has to be a showing of specific intent to defraud the government for federal False Claims Act liability to attach. But the federal False Claims Act specifically bars qui tam actions for alleged income tax violations; at the federal level, there is a separate whistleblower reward program administered by the IRS.

At least two issues arise when a state models its false claims act after the federal law. First, in most of the 29 states that have adopted false claims acts, the expansion of the false claims statutes to sales and use taxes and other state-administered taxes is unintentional. What typically happens is that states will incorporate federal False Claims Act language into their own statutes; thus, most states explicitly exclude qui tam actions for income taxes but are silent on other taxes not enumerated in the federal statute. The Illinois Chamber of Commerce considers that a loophole in the state's own false claims act that is being taken advantage of by a financially motivated third party.

Second, while the federal False Claims Act does not extend to taxes, the federal definitions of what constitutes a knowing violation of the law are being incorporated into state false claims act that extend to taxes. That means Illinois, like many other states, provides that there doesn't have to be a showing of specific intent to defraud the government for false claims act liability to attach to a tax claim. According to the Illinois Chamber of Commerce, many state courts interpret that to mean the relator in a qui tam tax action only has to establish that the taxpayer's position is incorrect. Goodman said requiring that there be actual fraud or intent to defraud the government could cut down on some of the more frivolous lawsuits.

Whatever their merits, case-by-case efforts to enforce sales tax collection from online vendors may also have been undercutting efforts to address the issue more holistically.

Dyckman said that when the suits started in 2002, a group of remote sellers represented by an attorney in Atlanta was reaching out to states to enter into prospective sales and use tax collection agreements on the condition that the state wouldn't look back and litigate previous audit periods. Dyckman said the group claimed at the time to have already entered into those collection agreements with more than 20 states.

"That program got cut off at the knees because a number of the potential remote sellers were in the whistleblower cases," Dyckman said, adding that it's impossible to quantify how much tax revenue Illinois lost in the years it took to dismiss or settle those nexus qui tam actions.

Dyckman added that had the group and the state reached a collection agreement in 2002, there's a real possibility that remote sellers whose cases were still under seal at that time would have started collecting and remitting taxes to Illinois in 2003, yet would have still been trapped in years of qui tam litigation.


Latest Cases

Just as the nexus qui tam cases started to dwindle, the Illinois Supreme Court in 2009 decided Kean v. Wal-Mart Stores Inc., ruling that in some situations, a portion of the shipping charges connected with online orders are subject to sales tax.

Diamond "threw himself into the breach" and essentially went on an online shopping spree, Dyckman said. When a retailer didn't tax shipping and handling charges, Schad Diamond filed a qui tam action.

However, the underlying issue itself is hardly straightforward: 86 Ill. Adm. Code section 130.415 provides that there is no tax on shipping charges because they are separately negotiated and contracted for when they are separately stated. But the Illinois Supreme Court held that in some circumstances, a charge for shipping associated with an online sale is taxable because it is inseparable from the underlying transaction for the purchase of tangible personal property. The court did not invalidate the DOR regulation, which is still in effect.

Schad Diamond has filed actions alleging fraud in cases in which the retailer has followed the state's published guidance. In other cases, the retailer's tax treatment of the portion of shipping and handling charges has been approved by the Illinois DOR under audit. On top of that, Schad Diamond has argued that retailers should apply Chicago's local tax rate to the charges rather than using the state's place-of-origin test.

Dyckman said 266 such shipping and handling qui tam actions have been filed over the past four years. Some ancillary suits have been filed by law firms other than Schad Diamond, and some tax relators have come forward without attorneys representing them, Dyckman said.

The qui tam process can work in the field of taxation for true whistleblowers, Dyckman said, providing two examples in which a person from inside a business came forward as a sales and use tax relator. One of the cases resulted in an agreed audit with penalties and interest, he said, while the second led to a partial re-audit and a settlement under which the state collected the taxes due. In both cases, the whistleblowers received compensation, he said.

But a single relator is responsible for 99 percent of the qui tam tax litigation in Illinois, Dyckman said. In expressing frustration with the suits, he said a typical remote seller in one of the cases can be collecting and remitting $2 million in use tax to Illinois on its Internet sales, but the relator will argue that the business is knowingly committing fraud by failing to collect an additional $12,000 in tax on a portion of the shipping and handling charges.

"In those particular instances it's almost impossible to believe that there's fraud or material misrepresentation or reckless disregard for the law going on," Dyckman said.