Imagine having the rights to make actual sponges in the image of SpongeBob SquarePants. That was the enviable position of a company called Spongetech.
Spongetech's reported sales rocketed and its stock price along with it. In 2009 Mark Fidelman wrote
This appears to be a very good stock. $60m in annualized sales, strong growth, and a lot of advertising. Well the last item bugs me. They appear to be spending way too much money on advertising which is hurting their profitability. I recognize the need for recognition, but the profit motive is best for investors.
I'll keep an eye on the stock, but it appears to be a very good buy at 0.15.
The advertising raised a bit of concern in other areas. Forbes contributor Allen Adamson in a piece about who was marketing at the US Open wrote.
On the other hand, a brand that seems out of place in this expensive, cluttered marketing arena is SpongeTech, manufacturer of revolutionary sponges. Don’t get me wrong. I’m all for cleanliness, but giving out sponges at a tennis event strikes me as a little off the mark, unless of course the brand stands for good, clean fun.
As it turned out much of Spongetech's sales weren't, you know, sales where the company ships stuff and gets money for it. The sales number was more like what you would call "a figure". SpongeTech was a pump and dump, but according to Roddy Boyd, a really special one.
SpongeTech was no ordinary pump-and-dump penny-stock scheme; it was, to play off Churchill’s famous definition of Russia, a fraud wrapped in a stock-market rig inside a money-laundering conspiracy.
Among the victims were Robert and Penny Greenberger who lost $569,220.
Capital Loss?
The tax problem with a big capital loss like that is that you can only use it against capital gains. Well, you can use $3,000 per year against ordinary income, a number that has not changed in a really long time. So if the Greenbergrers were patient they would be able to burn through it in less than two centuries. They were in more of a hurry, though, so in 2012 they amended their 2010 return to claim a refund of $177,102 by claiming the loss as a theft loss.
Up Close And Personal
Up Close And Personal
Robert Greenberger's involvement with Spongetech had gone significantly beyond that of an ordinary investor.
Greenberger heard the rumors that Spongetech was a scam, but he believed they were false. Even as allegations of fraud began to percolate, Furth and Moskowitz both defended Spongetech when they spoke with Greenberger. When Greenberger asked Moskowitz about Spongetech's delayed SEC filings, Moskowitz blamed the company's accountants and assured him that the filings were coming. Greenberger believed these reassurances, and went so far as to repeat them by posting comments on internet message boards defending the company against accusations that its executives were committing fraud.
Greenberger's closeness to Spongetech continued through its bankruptcy. Around the time Spongetech filed for bankruptcy, Greenberger finally received the financial statements that Spongetech had been delinquent in filing with the SEC. Greenberger had sent a letter to Spongetech in April 2010 demanding to inspect the company's books and records, including its draft SEC filings.
Thus the principals in Spongetech were up close and personal in their deception of Mr. Greenberger.
Not Up Close Enough
Still the Court needed to look at Ohio law as to whether what happened to the Greenegergers constituted theft. And they came up short. They had bought the Spongetech stock in the open market. Even though there is a good statistical likelihood that some of the fraudsters were on the other side of the transaction, the transaction was with the impersonal market.
Due to the lack of direct connection between wrongdoer and victim, the theft-loss deduction is generally not allowed in cases where the value of shares bought on the open market declines due to fraud. In a leading case, Paine v. Commissioner of Internal Revenue, the Tax Court held that a plaintiff who bought shares in a company on the open market could not claim a theft-loss deduction because the corporate officers who issued fraudulent financial records did not specifically target any one individual or sell the stock—they simply published the misleading information, and let market forces drive up the price of the stock.70 The officers, therefore, had not “criminally appropriat[ed]” the plaintiff's property.
The Greenbergers also tried an estoppel argument maintaining that since the Department of Justice had notified them that they might be victims of a crime, that the government could not now argue that they were not theft victims. That just didn't work because Ohio law requires a privity between the thief and the victim.
There is probably not much of a tax planning point here since nobody plans to get defrauded. The fraud story is a really good one, though. I can't rate it that highly since the basis was simply inflating sales, but I do think they should get some extra credit for including an animated character.
Other Coverage
Forbes contributor Timothy Todd also covered this case - District Court Denies Theft Loss Deduction For Worthless Stock. Professor Todd is new to forbes.com and he has already written quite a few pieces that seem to be very strong technically. You should go over and bid him welcome.
Jay Freireich also has something on the technical aspects of the case.
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