Settlement Data Reveals Lawyer’s False Claims Freight Train

Oct. 19, 2016, 2:23 PM

Attorney Stephen B. Diamond, regarded by some as Chicago’s “king of qui tam,” and likely the most prolific tax whistle-blower in the country, could be coming to the end of his false claims gravy train, a new analysis by Bloomberg BNA reveals.

Diamond, who has filed at least 911 qui tam actions in Cook County Circuit Court under the Illinois False Claims Act (FCA), has racked up almost $30 million in settlements over 15 years.

While a large portion of the funds belongs to the state of Illinois, Diamond’s share of the proceeds totals $11.6 million.

At the same time, Diamond’s litigation freight train may have hit a bump in the tracks.

Bloomberg BNA’s analysis, drawn from hundreds of previously confidential settlements collected though a Freedom of Information Act request on the Illinois Attorney General’s Office, provides the first clear picture of Diamond’s false claims business model and the financial impact it has had on hundreds of defendants.

The list of defendants is impressive, ranging from the most powerful corporations in the world to hundreds of tiny online retailers. A brief list of Diamond’s targets includes Microsoft Corp., Boeing Co., Fox Broadcasting Co. and Deere & Co., but also WrestlingGear.com Ltd., an Elmhurst, Ill., seller of wrestling shoes and athletic wear (see related story in this issue) and the Infinite Monkey Theorem, a small Denver-based wine seller and one of more than 500 wineries and liquor retailers sued in the last three years.

The Bureau of National Affairs Inc., which publishes Daily Tax Report, was also a defendant in an action brought by Diamond and settled in February 2015.

While the 900-plus cases are filed under the FCA, they all feature legal strategies that accuse defendants of improperly administering provisions of Illinois’ sales and use tax code. A unique quality of the FCA permits a private citizen, acting as a whistle-blower or relator, to sue on behalf of Illinois to correct an alleged fraud. Various iterations of Diamond’s law firms, including Beeler, Schad & Diamond P.C.; Schad, Diamond & Schedden P.C.; and Stephen B. Diamond P.C., are designated as relators in each case.

The device is controversial and has led to many calls for overhauling the law, though practitioners tell Bloomberg BNA that is unlikely to happen.

371 Settlements Net $29.3 Million

Highlights of the settlement data show:

• Diamond and his law firms have negotiated 371 settlements, netting $29.3 million in proceeds and attorneys’ fees for the state and himself; • the amount of unpaid taxes in dispute is estimated by tax practitioners at $6.7 million; • the average settlement paid by defendants totaled $79,089, not including amounts paid for legal representation; • settlements ranged from a high of $6.3 million to as little as $500; • Illinois’ share of the settlements totaled $17.7 million; • the Illinois Attorney General office’s share of the settlements was about $2.9 million; • defendants paid Illinois $45,000 in attorneys’ fees and costs; • Diamond’s share of the settlements totaled $5.7 million; • defendants paid Diamond $5.9 million in attorney’s fees and costs; and • 78 percent of the settlements involved a defendant’s failure to properly apply the sales and use tax on shipping and handling charges on merchandise sold into Illinois.

‘Abusing the Statute.’

Dennis Ventry, a professor of tax policy at the University of California Davis School of Law who has written extensively on whistle-blower statutes, said Diamond’s settlement track record points to a level of success demonstrating he is more than a serial filer of “nuisance claims.”

“If he’s winning 40 percent of these cases, maybe this isn’t as frivolous as we thought,” Ventry said.

“These are still nuisance claims. Diamond is still, to my mind, abusing the statute. The statute, however, is what it is and until it’s changed, he’s not doing anything wrong.”

In an Oct. 3 letter to Bloomberg BNA, Diamond characterized his long history of false claims suits as a significant service to “a state which has enormous tax revenue problems.” He objected to any suggestion that his lawsuits abuse the false claims process.

“The Relator does not establish tax policy, the legislature and the courts do,” Diamond wrote.

Running Out of Steam?

While Bloomberg BNA’s analysis shows that Diamond has successfully used false claims suits for several years, it also shows that the strategy may be running out of steam.

Diamond’s false claims onslaught peaked in 2012, when he settled 124 cases, netting almost $6 million for himself and the state. Three good years followed, with 36 settlements totaling $3.5 million in 2013, 54 settlements totaling $4.3 million in 2014, and 102 settlements totaling $2.4 million in 2015.

But Diamond’s batting average fell precipitously in 2016 due to the dismissal of more than 300 of his cases at the attorney general’s urging, as well as legal defeats in a small number of cases that went to trial. Diamond’s business model also suffered a blow in April when the Illinois Department of Revenue (DOR) issued regulations clarifying the taxability of shipping and handling charges—a crucial tax administration question featured in more than 500 of the lawsuits.

As a result, the first nine months of 2016 yielded only 12 settlements totaling $208,566.

Diamond, however, scored an October surprise with a $6.6 million settlement against Cowabunga Enterprises Inc., a defunct subsidiary of the personal computer companies Gateway Inc. and Acer Inc. Diamond’s law firm confirmed that the Cowabunga settlement, the largest in the firm’s 15 years of FCA actions, was an outlier with no similar deals on the horizon.

Still, business organizations and practitioners defending corporate taxpayers expressed doubts about a long-term batting slump for Diamond.

“There is no case and no legislation that says Steve Diamond cannot keep doing what he’s doing as long as he finds another issue,” said Michael Wynne, a partner with Reed Smith LLP in Chicago and counsel to dozens of defendants sued by Diamond.

“Nothing has really changed. This all just means there is a next issue ripe for Steve Diamond to find and sue.”

Diamond signaled he isn’t ready to abandon the FCA, saying he has filed an unspecified number of additional cases “under seal.” The FCA requires details of a relator’s claim to remain confidential until the attorney general decides whether to intervene.

29 State False Claims Laws

According to the Taxpayers Against Fraud Education Fund, Illinois is one of 29 states to administer a false claims statute. Within that group, Delaware, Florida, Illinois, Indiana, Nevada, New Hampshire, New York, Rhode Island and Washington permit actions targeting tax code frauds.

False claims or qui tam actions permit the relator or whistle-blower to step into the shoes of the state to sue persons or entities who knowingly perpetrate fraud against the state. The classic whistle-blower is an insider holding specific knowledge of misconduct, but the law also permits actions by third parties witnessing improper conduct harming the state.

The FCA incentivizes relators to come forward, permitting them to share in any proceeds resulting from their lawsuits.

Those proceeds can be substantial. The FCA permits civil penalties of between $5,500 and $11,000, plus three times the damages sustained by the state due to the misconduct. The relator’s portion of the award ranges between 15 percent and 30 percent of the total. Whistle-blowers are also entitled to litigation costs, expenses and reasonable attorneys’ fees.

Settlements reached under the FCA are poured into a settlement fund. One-sixth of the funds are forwarded to the Office of the Attorney General, and another one-sixth goes to the state police for law enforcement purposes. The relator’s share is also removed from the fund, and any remaining dollars are distributed to Illinois’ General Revenue Fund.

Nexus Cases

A spokesman for Illinois Attorney General Lisa Madigan (D) pointed to five tranches of litigation engineered by Diamond over 15 years.

Diamond’s FCA pattern began in 2001 with actions targeting out-of-state retailers that failed to collect and remit use taxes on internet-based transactions to Illinois customers. The “nexus cases” continued for several years during a period of confusion about retailers’ duties with regard to electronic-commerce transactions.

Diamond went on to file 111 nexus lawsuits over eight years.

His first, and second-largest, settlement came at the end of 2003 in a case against Viking Office Products Inc. and Office Depot Inc., netting $1,069,734 for the state and $310,567 for himself.

Similar success came in 2006 in a settlement with KB Toys Inc., bringing $624,000 to the state and $156,000 to Diamond.

Peggy Mathy Diamond, Diamond’s wife, scored a huge success in 2011 with a settlement against Polo Ralph Lauren Corp. that earned $588,000 for the state and $372,000 for herself and the Diamond law firm.

Later that year, she succeeded in an action against Burberry Ltd., with a $386,903 settlement for the state and $396,243 for herself and the Diamond law firm.

Madigan’s spokesman said 58 of the 111 nexus cases eventually settled and 48 were dismissed. A handful of the cases are pending.

Shipping and Handling Cases

The Illinois Supreme Court opened a fertile field for a second tranche of suits in 2009 in a case called Kean v. Wal-Mart Stores, Inc., 235 Ill.2d 351 (2009). The court held that delivery charges for products purchased over the internet and shipped to Illinois customers must be taxed when an “inseparable link” exists between the sale and delivery of the merchandise.

The ruling received limited attention among retailers, and the DOR failed to adjust its regulations and audit protocols, which had held that tax on shipping and handling charges shouldn’t be assessed in cases where the charges are separately negotiated and stated on invoices, and such charges are equal to the retailer’s actual shipping cost.

The resulting regulatory gap spurred Diamond to file 451 shipping and handling actions in a few years. Court documents reveal that Diamond and his law firm purchased hundreds of products each year from hundreds of online retailers simply to determine if the seller would impose tax on the shipping and handling charges. Sellers who failed to apply the tax were slapped with false claims lawsuits.

The actions were particularly frustrating to defendants, who had received rulings from the DOR approving their tax treatment of shipping and handling charges. Others were stunned to become defendants after surviving DOR audits without any comment on the issue.

According to Madigan’s office, the shipping and handling juggernaut netted 291 settlements and 147 dismissals. Five cases went to trial, and eight remain pending.

Wine and Liquor Cases

Three additional tranches of litigation have developed since 2011 and operate as variants on the shipping and handling cases.

Diamond has filed 202 actions against out-of-state liquor retailers, claiming the companies defrauded the state by failing to collect and remit sales and liquor gallonage taxes on their sales into Illinois.

In a departure from their previous posture, Madigan’s attorneys directly intervened in these lawsuits, calling for dismissal based on lack of merit. The state argued the defendant liquor companies lacked “substantial nexus with Illinois” and couldn’t be compelled to collect and remit sales taxes.

Similarly, assistant attorneys general argued the defendants aren’t required to remit liquor gallonage taxes under the liquor control statute because sales of distilled spirits, wine and beer by nonmanufacturers is illegal in Illinois.

On May 23, Cook County Circuit Court Judge James Snyder agreed, dismissing the entire block of cases before the court.

$120 Million Left on Table

Diamond initially objected, but ultimately declined to appeal the dismissals. Diamond told Bloomberg BNA his lawsuits could have recovered $120 million for the state if the actions hadn’t been dismissed.

A similar result occurred a few months earlier in a fourth tranche of 114 cases involving unlicensed out-of-state wineries.

Here again, attorneys for Madigan argued the defendants weren’t licensed to sell alcohol into the state and thus had no tax collection duties in Illinois.

Snyder dismissed the entire group of winery cases in an order dated Dec. 17, 2015.

A final tranche of 33 cases involving licensed out-of-state wineries has netted mixed results for Diamond. Fourteen of the cases have been settled, but 17 have been dismissed. Two cases remain pending.

DOR Frustration

There is no shortage of people frustrated with Diamond’s litigation strategies and interventions on behalf of the state.

Mark Dyckman, general counsel for the state revenue department, said the FCA is a potent tool for uncovering tax fraud, and many earnest whistle-blowers have brought big-impact tax compliance cases to the DOR. But Dyckman said Diamond’s false claims model “interferes with the department’s authority to administer and enforce the tax laws.”

Dyckman told Bloomberg BNA that Diamond’s relentless focus on minor tax issues second-guesses broader agency objectives, interferes with the trajectory of audits and frequently derails the department’s ability to wisely use limited resources. In some cases, Dyckman said Diamond has obstructed the DOR’s ability to settle compliance problems, carrying real revenue consequences to the state.

By way of example, Dyckman pointed to a series of negotiations the DOR conducted with a team of attorneys representing more than two dozen retailers attempting to make good on their tax obligations during the early years of e-commerce transactions. The deal would have held the retailers harmless for some past compliance failures, but compelled them to collect and remit the proper taxes going forward.

Ultimately, Dyckman said, the DOR wasn’t free to complete the negotiations because some of the retailers became targets of actions filed by Diamond.

‘It Makes No Sense.’

Rob Karr, president of the Illinois Retail Merchants Association, said Diamond’s interventions hamper retailers’ efforts to properly comply with the state revenue code. He pointed to the years of confusion over the proper method for computing taxes on shipping and handling charges.

“This violates the fundamental principles of the tax system where you have one administrator, one interpreter of the tax code in the Illinois Department of Revenue, and you have retailers following the regulations and interpretations of the department,” Karr said. “But now they are being sued and financially punished for following the law. It makes no sense.”

Karr added that part of the genius of Diamond’s business model, particularly in the shipping and handling context, is the nuisance value of the claims. By targeting a low-dollar problem and pressuring defendants to respond quickly, Karr said Diamond forces his targets to abandon viable defenses and settle.

“He has found this sweet spot where he tries to incent the defendant to settle due to the way the finances look to the company,” Karr said. “They ultimately realize they could spend $100,000 or more litigating, or they could settle for $20,000 or $25,000.”

Tax Fairness?

Defense attorney Wynne, and former DOR general counsel, faulted Diamond on tax fairness grounds, accusing him of turning innocent tax infractions into expensive trips to court.

By way of example, Wynne pointed to a typical Diamond-driven qui tam where the taxpayer might be forced to admit a $3,000 shipping and handling tax deficiency. Assuming the taxpayer wishes to settle quickly, the deficiency could quickly turn into a $15,000 settlement when treble damages and penalties are assessed. Diamond’s fees and costs add another $7,000 to $10,000 to the taxpayer’s bill. The taxpayer then pays a similar amount for representation by defense counsel.

By the time the smoke has cleared, Wynne said the taxpayer has shelled out almost $30,000 to take care of a $3,000 infraction.

“If the Department of Revenue had gotten to those people instead of Diamond, those people would have paid the tax, they probably would have paid no penalties because of the lack of clarity between the Kean case and the regulations, and there would have been some interest,” Wynne said. “Instead, they paid through the nose for the same violations that on audit would have been almost nothing.”

After examining the data collected by Bloomberg BNA, Wynne estimated that the unpaid taxes in dispute in the 371 settled cases likely totaled no more than $4.1 million. The dispute involving Cowabunga/Gateway adds more than $2.5 million to that pot.

Attorney General Maligned

The business community has also been critical of Illinois Attorney General Lisa Madigan (D) for letting Diamond pursue actions against hundreds of taxpayers. They point to long periods in which Madigan declined to intervene in Diamond-initiated cases and ignored taxpayers’ pleas for relief.

“One of the assumptions of the taxpayer community is the people he is suing are getting poorly treated in part because the Attorney General’s office enjoys bringing that money into the state,” said Carol Portman, president of the Taxpayers’

Federation of Illinois. “They don’t care about getting to the right answer, they care about looking good and bringing in money. I hope that’s not right, but I’ve heard it a lot.”

Madigan’s spokesperson Eileen Boyce disagreed, pointing to recent efforts to cut the case volume in Cook County Circuit Court.

“Attorney General Madigan has been able to diminish these cases significantly in recent years as the legal theories evolved, leaving only about a dozen pending out of more than 900,” Boyce told Bloomberg BNA.

Diamond Rebuts Criticisms

Diamond vigorously objects to criticism that his litigation interferes with the state’s tax collection and administration duties.

Diamond said his actions have sought to enforce two core principles of Illinois’ sales and use tax code: the collection of taxes by out-of-state sellers with substantial nexus in the state, and the collection of taxes on shipping and handling charges as established under the Kean decision.

In addition, Diamond stressed that his actions have had a “significant prophylactic effect,” forcing retailers on a prospective basis to make good on their duties under the tax code. He noted that several of the early cases brought no settlement dollars to the state, but generated millions of dollars in revenue as major retailers, including Target Corp. and Wal-Mart Stores Inc., commenced their compliance duties.

“Similarly, although the State intervened in Relator’s lawsuit against Amazon that was filed in 2003, the State dismissed the lawsuit in 2014 at the same time Amazon agreed to establish a warehouse in Illinois and collect taxes on all sales,” Diamond wrote.

Diamond also disputed criticism that his patterns of litigation could be characterized as “abusive” when the Illinois attorney general can seek dismissals.

“Under the False Claims Act the State has the power to dismiss any claim filed by the Relator,” he wrote. “The State has never asserted that the lawsuits filed by the Relator were abusive of the false claims process.”

Complement to Tax Enforcement

While the University of California’s Ventry questions Diamond’s tactics, he agreed that Chicago’s king of qui tam has likely pushed Illinois to more vigorously enforce its tax statutes.

“We don’t know if the revenue department ever would have gotten around to collecting these taxes,” Ventry said. “So I look at this as a compliment to traditional tax enforcement, especially in a world where the tax officials and tax agencies are woefully underfunded.”

Some in the business community are expressing hope that Diamond’s storm of FCA actions has run its course. The dismissals of 114 out-of-state winery cases in December 2015 and 202 out-of-state liquor retailer cases in May created a significant gap in Diamond’s litigation pipeline and demonstrated a new willingness by Madigan to intervene.

Regulatory Fix

Most significantly, the DOR amended its regulations under Ill. Admin. Code tit. 86 Sections 130.415 and 130.410 with regard to shipping and handling effective April 1. The regulations clarify when “transportation and delivery charges” are considered part of gross receipts subject to the sales and use tax code.

Dyckman said the regulations incorporate the precedent established in Kean, finding that delivery charges on products purchased electronically and shipped to Illinois consumers are subject to tax when “an inseparable link” exists between the sale and the delivery of the merchandise. The regulations provide guidance on the inseparable link principle through a series of examples.

In addition, the regulations offer a safe harbor in cases where the seller offers the purchaser the option to pick up the property and charges the same price for the property regardless of whether it is delivered or picked up. The regulations specify that shipping and handling charges aren’t subject to taxation.

Dyckman said the adjustments would have a chilling effect on Diamond’s ability to file shipping and handling cases.

Retailers “know what the rules are and they can plan accordingly,” Dyckman said. “It probably has the effect of not totally eliminating, but reducing the amount of shipping and handling cases down to the point where it wouldn’t be a good business model anymore.”

Defend Instead of Settle

The defense bar also points to losses in two important Diamond cases this summer, raising expectations that defendants, armed with the right fact patterns, will choose to defend themselves instead of settle.

Cook County Circuit Court Judge Thomas Mulroy on Aug. 30 rejected an action brought against Australia-based Treasury Wine Estates Americas Co., one of the world’s largest makers and distributors of wine.

After a bench trial, Mulroy found that Diamond had failed to prove Treasury Wine had “acted knowingly or with reckless disregard” when it declined to collect Illinois use tax on shipping and handling charges between 2008 and 2015. Mulroy agreed that Illinois’ tax regulations were unclear in the aftermath of the Kean decision and found Treasury Wine had presented evidence showing it acted responsibly during this period of confusion.

On Aug. 1, an Illinois appeals court panel tossed a whistle-blower action against National Business Furniture LLC, finding that the e-commerce retailer hadn’t engaged in “gross negligence-plus” when it failed to collect use tax on shipping charges for internet and catalog sales made to in-state customers.

The court agreed with Diamond that Wisconsin-based NBF failed to understand its obligations to collect Illinois’ use tax on shipping charges and remit those funds to the state. However, the appeals court also found that NBF’s conduct didn’t constitute reckless disregard for any obligations due to the state.

Statutory Change?

Despite the regulatory changes and courtroom losses, many in the business community insist Diamond won’t dial down his false claims fury without statutory changes.

Portman said Illinois needs to amend the FCA to minimize opportunities for potentially abusive whistle-blower actions, something the Illinois General Assembly has been reluctant to do.

“Part of me hopes that because these cases are drying up due to the Attorney General kicking them out, the courts shutting them down, and the legal provisions tightening up, maybe the political resistance to change will diminish,” Portman said. “I mean, the pot at the end of the rainbow is going away.”

She added, “but that might be naive.”

To contact the reporter on this story: Michael J. Bologna in Chicago at mbologna@bna.com

To contact the editor responsible for this story: Ryan C. Tuck at rtuck@bna.com

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