Opinion
No. 603798/2007.
2013-02-25
SALT AIRE TRADING LLC, Salt Aire Investment Trust, BLA Investments, LLC, SKJ Investments, LLC, Brian Kelly & Joelle Kelly, Husband & Wife, Plaintiffs, v. ENTERPRISE BANK AND TRUST CORPORATION; Bayerische Hypo–Und Vereinsbank, AG; Bayerische Hypo–Und Vereinsbank, AG–New York Branch; Bayerische Hypo–Und Vereinsbank U.S. Finance, Inc., f/k/a Bayerische Hypo–Und Vereinsbank Structured Finance, Inc., & HVB Risk Management Products, Inc., Defendants.
Malecki Law, for plaintiff. Epstein Becker & Green, P.C., for defendant Enterprise Bank.
Malecki Law, for plaintiff. Epstein Becker & Green, P.C., for defendant Enterprise Bank.
Kasowitz, Benson, Torres & Friedman LLP, for the Bayerische defendants.
SHIRLEY WERNER KORNREICH, J.
Motion sequence numbers 007 and 008 are consolidated for disposition.
This is an action for damages arising out of a fraudulent tax shelter scheme. In motion sequence 007, defendant Enterprise Bank and Trust (Enterprise) moves for summary judgment (CPLR 3212) dismissing the complaint on the ground that it did not materially participate in the scheme. In motion sequence 008, the HVB Defendants
move for summary judgment ( CPLR 3212) dismissing the complaint on the grounds that plaintiffs' damages were not caused by HVB's conduct and that plaintiffs did not reasonably rely on any representations by HVB. Enterprise has also adopted these arguments. Plaintiffs oppose both motions.
The HVB Defendants are Bayerische Hypo-und Vereinsbank AG, Bayerische Hypo-und Vereinsbank AG–New York Branch, Bayerische Hypo-und Vereinsbank U.S. Finance Inc., f/k/a HVB Structured Finance, Inc., and HVB Risk Management Products, Inc. (collectively HVB).
I. Facts
The facts are taken from the parties' Rule 8(A) Joint Statement of Material Facts (JS ¶ __), and the affidavits and other documentary and testimonial evidence submitted on the motions. The background of this action was set forth to some extent in this court's prior orders, including its January 7, 2010 order resolving Enterprise's motion to dismiss (the January 2010 Order) and its September 29, 2010 order resolving HVBs' motion to dismiss (September 2009 Order), familiarity with which is presumed. The facts are undisputed unless otherwise indicated.
This action arises out of plaintiff Brian Kelly's (Kelly) attempt to reduce his 2001 tax liability by participating in a tax shelter known as the Coastal Trading Common Trust Fund III(CTF). The CFT was intended to generate a tax loss that could be claimed as a deduction. However, the deduction was ultimately disallowed by the IRS, and Kelly brought this action to recover the amount of the tax penalties that were imposed upon him and various costs associated with the transaction.
Kelly is an executive of Activision, Inc. (JS ¶ 1). He has an accounting degree from Rutgers University and a law degree from Fordham University (JS ¶ 5), but never took the bar exam (Lerner Aff., Exh 1, Kelly Dep. Tr. [Kelly], 63). In 2001, Kelly received approximately $36 million in income from Activision (Kelly, 85–86). In the spring of that year, Kelly met with Michael N. Schwartz, a principal of Coastal Trading LLC and a promoter of the CTF program (Am. Compl. ¶ 34; JS ¶ 8; Kelly, 370).
At that meeting, Kelly was accompanied by Alan Solarz and Robert Chadwick (JS ¶ 8).
Solarz was a partner at Robinson Silverman Pearce Aronsohn Berman LLP (now Bryan Cave LLP) who had experience as a tax attorney, including advising clients in complex tax strategies (JS ¶¶ 10–11). He represented Kelly as his tax attorney and business advisor both generally and with respect to certain aspects of the CTF Program (JS ¶ 9). Chadwick was Kelly's accountant and is a CPA (JS ¶ 12).
In the meeting with Schwartz, the first of several, Kelly and his advisors hoped and anticipated that the CTF tax shelter could be used to generate a tax loss to offset his 2001 income (Lerner Aff., Exh 2, Solarz Dep. Tr. [Solarz], 48). Schwartz explained the transaction to Kelly and told him that it was intended that he would report the paper losses on his income tax returns to offset income (Kelly, 95–97; Lerner Aff., Exh. 4, Schwartz Dep.Tr. [Schwartz], 47). Kelly understood that a loan of $35 million to him would be required to provide a tax basis for such a loss (Kelly 223–24; Solarz, 223–24; Chadwick 108–09). Kelly knew that he would not suffer an actual loss that would deplete his assets by that amount (Kelly, 171–72).
Kelly also knew that there was a risk that the IRS or state taxing authorities would not allow him to claim the losses from the CTF on his tax returns (JS ¶ 15). He discussed with his advisors the bases on which the IRS could disallow the deduction, including the economic substance doctrine. (Solarz 282–83). To try to avoid IRS penalties, Kelly obtained a legal opinion letter from Sidley Austin Brown & Wood stating a belief that it was “more likely than not” that the IRS would sustain his deduction (Kelly 216–17; Lerner Aff., Ex. 32; Jordan Aff., Exh. AO). Solarz and Chadwick received and reviewed a draft of the opinion letter before Kelly engaged in the transaction (Kelly 216; Solarz 160). Kelly and Solarz also were generally aware of the fee structure of the CTF and the amounts required to be paid by Kelly during the life of the CTF before entering into the transaction (JS ¶ 16).
The structure of the CTT transaction was set forth in a Private Offering Memorandum dated October 16, 2001 (Jordan Aff., Exh. AA [POM] ). The CTF's trust was created by a Plan of Trust dated October 24, 2001, executed by Enterprise (Plan of Trust) (Jordan Aff ., Exh. AC). Kelly created and controlled a number of entities to implement the necessary transactions, specifically, plaintiff SKJ Investments, LLC (SKJ), a single member limited liability company owned by him (JS ¶ 2); plaintiff BLA Investments, LLC (BLA), a single member limited liability company (JS ¶ 3); and plaintiff Salt Aire Trading, LLC (Salt Aire Trading), a partnership in which BLA held a 1% interest and SKJ held a 99% interest (JS ¶ 4). Kelly's wife, plaintiff Joelle Kelly, owned BLA, but had no actual control, understanding or awareness of the entities or various transactions. Rather, she deferred to her husband on all financial matters and signed whatever papers he asked her to without reading them (Jordan Aff., Exh J, Joelle Kelly Dep.Tr. [Joelle], 23–86).
For the purposes of this decision, a summary of the complex mechanics of the CTF “tax straddle” transaction will suffice. Kelly was required to establish a foreign currency trading account to facilitate the execution of currency transactions at Beckenham Trading Company, Inc., under the discretionary trading authority of Deerhurst Management Co. (POM 1). To fund the account, Kelly contributed $5.25 million of his own money to the Coastal Trading CTF (JS ¶ 18). Additionally, he borrowed, indirectly through Braxton Management, Inc., approximately $35 million from HVB which funds were transferred to the CTF by the Kelly entities pursuant to various agreements (Malecki Aff., Exh. AG, AH, BC, BD, BE, BF).
The Plan of Trust Enterprise required Enterprise to retain Coastal Trading LLC Series III as an investment advisor to the CTF (Plan of Trust § 5.[1] ). Schedule 1 to the Plan of Trustgranted Deerhurst and Coastal Transactions Series I the authority to determine the CFT's investment strategy (Plan of Trust, p. 20). By letter dated November 15, 2001, Salt Aire directed Enterprise to invest the assets of its investment trust into the CTF (Kelly 427; Jordan Aff., Exh. AK). Pursuant to a Revocable Trust Agreement dated December 3, 2001 (the RTA) (Jordan Aff., Exh. AB), of which Enterprise was designated as trustee, Salt Aire Trading, as grantor, reserved the right to direct Enterprise “concerning designation of investment managers and advisors, the choices of investments and investment strategies, and the use of various investment vehicles” (RTA at p. 5, ¶ N). On December 28, 2001, a $35.2 million loss was allocated to Kelly which reduced his tax liability for that year by approximately $13 million (Lerner Aff., Exhs. 32, p. 6; Exh.47).
In January 2002, the IRS announced an amnesty initiative in its Bulletin 2002–2, allowing participants in certain tax shelters to waive accuracy-related penalties if they promptly disclosed underpayments (Lerner Aff., Exh. 43). Solarz testified that it was very likely that he discussed the initiative with Kelly prior to the deadline (Solarz, 173).
In 2003, the IRS issued Notice 2003–54, announced that it would pursue back taxes and penalties against users of CTF tax straddle shelters (Lerner Aff., Exh. 44). The notice stated:
The Internal Revenue Service and the Treasury Department have become aware of a type of transaction, described below, that is being used by taxpayers for the purpose of generating deductions. This notice alerts taxpayers and their representatives that the claimed tax benefits purportedly generated by these transactions are not allowable for federal income tax purposes.
( Id ). The notice described the targeted transaction as follows:
The transaction involves the use of a common trust fund (CTF) that invests in economically offsetting gain and loss positions in foreign currencies and allocates the gains to one of more tax indifferent parties and the losses to another taxpayer and that an investor (Taxpayer) who desires a tax loss.., invest[s] in the CTF.
In explaining why deductions would be disallowed for such transactions, the notice stated:
The offsetting positions entered into by the CTF did not have any effect on the CTF's net economic position or non-tax objectives and did not serve any non-tax objectives of the CTF or afford it a reasonable prospect for profit. Therefore, the losses purportedly resulting from this transaction are not allowable ... In addition, the Service may also disallow the loss of an individual under § 165(c)(2) by asserting that the loss was not incurred in a transaction undertaken for profit.
( Id ).
In 2004, Kelly was audited; he settled with the IRS in January 2007 (Lerner Aff., Exh. 49). On the settlement election form, he indicated that Notice 2003–54 governed the type of transaction in which he had engaged (Lerner Aff., Exh. 49). He paid $13,369,060 in back taxes, $1,336,906 in penalties, and $2,404,178 in interest (Lerner Aff., Exh. 53).
In February 2006, HVB entered into a Deferred Prosecution Agreement (DPA) with the United States Attorney for the Southern District of New York. HVB agreed to pay approximately $29 million in fees, restitution, and penalties for its involvement in certain tax shelters; including the CTF Program (JS ¶ 19; Lerner Aff., Exh. 50). HVB admitted to “engaging in activity with others including ... clients (defined herein to include the high net worth individuals and the purported entities they created who participated in the transactions to obtain and generate tax losses), all directed toward the implementation of the tax shelters designed to defraud the United States” ( Id., Statement of Admitted Facts ¶ 2). Enterprise was not indicted for its involvement in the CTF Program (JS ¶ 20).
II. Procedural History
Plaintiffs commenced this action in February 2008. By stipulation dated October 3, 2008 (the Stipulation), plaintiffs agreed to limit any amended pleading to claims for conspiracy, fraud, breach of fiduciary duty and breach of contract. Pursuant to the court's directive in the January 2010 Order, plaintiffs filed the Amended Complaint in January 2010.
The Amended Complaint sets forth ten causes of action. The first claim is for fraud against HVB and Enterprise, alleging that they conspired to induce plaintiffs into a sham transaction, and the second claim charges those defendants with aiding and abetting the fraud. The third claim alleges fraudulent concealment against them. The fourth claim asserts that HVB and Enterprise violated various sections of the Exchange Act. The fifth claim charges them with breach of fiduciary duty, and the sixth claim with aiding and abetting that breach. The seventh claim seeks rescission on the ground that the various transactional documents are void or voidable. The eighth claim alleges that HVB breached the loan agreements. The ninth claim asserts that Enterprise breached the POM and the Plan of Trust. The tenth claims alleges that HVB and Enterprise breached the covenant of good faith and fair dealing. The prayer for relief seeks “Kelly's initial loss on investment totaling over $1,922,214; (b) Loan origination fees totaling $350,000; (c) IRS penalties totaling $1,336,906; (d) attorney and accounting fees related to the CTF transaction; (e) lost profits; (f) plus interest, attorney fees and costs according to proof.”
By stipulation dated May 26, 2010, plaintiffs voluntarily dismissed the fourth and tenth claims for relief as against Enterprise (Jordan, Exh. AQ). In the September 2010 order, this court granted HVB dismissal as to the fourth, seventh and tenth causes of action, finding that they were barred by the Stipulation. The court upheld the remaining claims. As to the fraud-based causes of action, the court held that “the amended complaint does alleged, in voluminous detail, that HVB knowingly and intentionally made misrepresentations to plaintiffs, who relied on them to their detriment and damage ... HVB, in the [DPA] ... admitted to the exact scheme to defraud on which the amended complaint is based-the design, marketing and implementation of CTF” (September 2010 Order, at 11).
In sustaining the claims for breach of fiduciary duty, the court found that plaintiffs had sufficiently pled that HVB had “superior knowledge of material information about the CTF program and plaintiffs' investments that was purposefully withheld from plaintiffs, having discretionary control over plaintiffs' investments, transactions and trades, as well as involvement in and control over Common Trust Fund tax shelter transactions ... the allegations further establish ... either explicitly or by inference, that plaintiffs and other investors reposed confidence in [HVB and the other defendants] and reasonably relied on [their] superior expertise or knowledge” (September 2010 Order, at 13) (internal quotations and citations omitted). As to the contract claims, the court held that “HVB breached specific obligations, such as funding the promised loan and providing accurate accounts statements ... and damages, such as payment of fees for services not actually performed” (September 2010 Order, at 14). Following discovery, HVB and Enterprise made the instant motions for summary judgment.
III. Discussion
The summary judgment motions are granted. The expanded record establishes, at a minimum, that by virtue of their own complicity in the tax shelter scheme, plaintiffs could not have reasonably relied on any alleged misrepresentations by defendants. Furthermore, plaintiffs cannot demonstrate that defendants' conduct was the cause of the damages related to the disallowance of their deduction.
The facts here are essentially indistinguishable from those in Shalam v. KPMG, 89 AD3d 155 (1st Dept 2011), wherein the plaintiff paid to participate in a “Bond Linked Issue Premium Structure” (BLIPS) tax shelter to avoid paying capital gains on approximately $50 million in income. As here, after the IRS disallowed his deduction, the plaintiff negotiated a settlement to pay additional federal taxes and interest, Shalam, 89 AD3d 156–57. Plaintiff then sued HVB, allegeing that it, along with others, “created, orchestrated and operated” a scheme which misled him into believing that the tax shelter was legal. In dismissing plaintiff's fraud claims, the First Department held:
While the complexities of the BLIPS structure may have limited plaintiff's understanding of it, and while some information about BLIPS may have been unavailable to participants absent extraordinary efforts, nevertheless, plaintiff understood enough to know that BLIPS was a scheme to create artificial losses and that the IRS, if it investigated, might very well disallow deduction of those losses. Plaintiff was presented with information sufficient to cause him to doubt the propriety of the BLIPS scheme for tax avoidance purposes, and willfully blinded himself to that information by failing to ask questions, pay attention to details, or read the documents he signed. Thus, he cannot demonstrate reasonable reliance.
Shalam, 89 AD3d 159.
In reaching this conclusion, the Appellate Division found that “the information that plaintiff acknowledged possessing at the time, along with information contained in documents in his possession, conclusively establish that he knew or should have known that he was participating in a scheme of doubtful legality,” Shalam, 89 AD3d 157. In particular, the court noted that “plaintiff acknowledged that he understood that BLIPS was not an investment, but strictly a tax avoidance strategy, an artificial transaction to create paper losses against which he could offset his capital gains so as to avoid paying taxes on those gains” Shalam, 89 AD3d 157–58. The court further observed that “[m]uch paperwork was generated, including loan documents that required his signature and that reflected purported loans that were not actually made ... [f]rom these documents plaintiff either knew or should have known that an appearance of investment was being created to give the structure the appearance of legitimacy,” Id.
In Shalam, the plaintiff, as here, argued that a DPA that HVB had executed in connection with the tax shelter precluded dismissal of his fraud claims. In rejecting this argument, the First Department stated:
The “Deferred Prosecution Agreement” in which HVB admitted to participating in fraudulent tax shelters designed to defraud the United States is of no avail to plaintiff. While it certainly establishes that HVB used BLIPS to perpetrate frauds on the IRS, earning enormous fees from participants such as plaintiff in the process, HVB's admissions do not serve to demonstrate that plaintiff was an unwitting victim of the fraud.
Shalam, 89 AD3d 157. Finally, the court held that the plaintiff could not invoke an opinion letter he had received as proof of his reasonable reliance:
Plaintiff's testimony also makes clear that he understood that the official opinion letter with which he was provided was not a true assessment of the legality of the tax shelter. The letter stated that it was more likely than not that claimed losses from BLIPS would be allowed, and all parties, including plaintiff, understood that its purpose was to protect participants from incurring any penalties in the event that the BLIPS' true construct was uncovered by the IRS. As this Court has had occasion to observe, opinion letters that state that the IRS will “more likely thannot” accept a tax shelter “put[ ] an ordinary person on notice that the odds in favor of legality could be as slim as 51% to 49%” ( see Gaslow v. QA Invs. LLC, 36 AD3d 286, 291, 825 N.Y.S.2d 187 [1st Dept.2006] ). Where the odds in favor of legality are virtually equivalent to the odds in favor of illegality, even a taxpayer with less business experience than plaintiff will apprehend the substantial risk that his tax avoidance strategy will not pass muster with the IRS.
Shalam, 89 AD3d 158.
In view of this precedent, the fraud claims against HVB and Enterprise cannot survive on the record as it has developed. Kelly, a successful corporate executive with a legal education, certainly “knew or should have known that he was participating in a scheme of doubtful legality,” Shalam, 89 AD3d 157. He recognized from the outset that the objective of the CTF was to create losses to offset his substantial 2001 income, not to profit from foreign currency trading. He employed experienced tax and accounting professionals to work with the CTF promoters to achieve his tax-avoidance goal. As in Shalam, the DPA that HVB entered into does not confer “unwitting victim” status upon Kelly, where the evidence establishes that he was an active participant in formulating the terms of the shelter. Similarly, his reliance on the opinion letter assuring him that IRS approval was “more likely thannot” fails for the reasons stated in Shalam.
Absent evidence of reliance, plaintiffs' alleged proof of defendants' attempts to mislead them regarding the nature, control or duration of the loan transaction, to conceal the mechanics of the shelter, or defendants' alleged failure to provide them with adequate accounting information and documentation, is irrelevant. All that matters is that plaintiffs had sufficient information and knowledge to cause them to doubt the propriety of the CTF scheme. Plaintiffs harbored those doubts from the inception of their involvement with defendants' tax shelter.
Plaintiffs' knowledge of the purpose of the CTF scheme also precludes a finding that defendants' conduct was the proximate cause of their damages, with respect to the fraud claim or the remaining causes of action. Plaintiffs were disallowed the deduction not because of how HVB handled the loan or Enterprise maintained the trust, but because plaintiffs' own objectives were primarily tax-driven. Under I.R.C. § 165(c)(2), individuals are allowed a deduction from taxable income only for “losses incurred in any transaction entered into for profit.” What matters is the individual's “primary motive” for entering into the transaction. Nathel v. C.I.R., 615 F3d 83, 94 (2d Cir.2010). “Losses resulting from sham transactions ... are not deductible ... A transaction is a sham if it is fictitious or if it has no business purpose or economic effect other than the creation of tax deductions .” DeMartino v. C.I.R., 862 F.2d 400, 406 (2d Cir1988); Ferguson v. C.I.R., 29 F3d 98 (2d Cir1994). “A pointlessly complex transaction with a tax-indifferent counterparty that insulates the taxpayer from meaningful economic risk of loss or potential for gain cries out for substance over form treatment.” Altria Group, Inc. v. U.S., 658 F3d 276 (2d Cir2011)(internal quotations and citations omitted). The taxpayer's belief that the transaction is legal is irrelevant—“rather, the issue is whether [the individual's] investment decisions were profit-driven or tax-driven.” Leslie v. C.I.R., 146 F3d 643 (9th Cir1998).
As set forth in IRS Notice 2003–54, the “investing” in which plaintiffs engaged “did not have any effect on the CTF's net economic position or non-tax objectives and did not serve any non-tax objectives of the CTF or afford it a reasonable prospect for profit.” Kelly conceded that his motive in entering the transaction was to offset his sizeable income. He knew that the objective was to generate a proportionate loss to eliminate his 2001 tax liability, not to profit through currency trading, and that the purpose of the HVB loan was to facilitate a paper loss without risking his own assets.
The failure of the shelter and the resulting penalties were the consequences of Kelly's undisputed tax objectives, not defendants' failure to honor their fiduciary or contractual duties. A plaintiff's mere identification of various alleged breaches, without a showing of how the damages flowed from them, is insufficient. See Frydman & Co. v. Credit Suisse First Boston Corp., 1 AD3d 274, 275 (1st Dept 2003) (summary judgment appropriate where “plaintiffs failed to raise any triable issues of fact with regard to defendants' demonstration that the alleged contractual and tortious breaches were not the proximate cause of plaintiffs' failure to acquire the target corporation”); Laub v. Faessel, 297 A.D.2d 28 (1st Dept 2002); Aldridge v. Brodman, 100 AD3d 1537 (4th Dept 2012). Hence, plaintiffs are not entitled to the return of the loan origination fee, attorney's fees and other expenses that they voluntarily paid in furtherance of their attempt to avoid taxes by participation in the shelter.Furthermore, plaintiffs could have avoided the tax penalties altogether by availing themselves of the amnesty initiative offered in IRS Bulletin 2002–2, something they chose not to do.
Finally, the breach of fiduciary duty claims fail for the additional reason that the record negates the existence of such a relationship between the parties. Given plaintiffs' independent assessment of the CTF transaction, it cannot “reasonably be concluded that” [plaintiffs] repose[d] a high level of confidence and reliance in [defendants], who thereby exercise[d] control and dominance over [plaintiffs].”
RNK Capital LLC v. Natsource LLC, 76 AD3d 840 1st Dept 2010) (internal quotations and citations omitted). Morever, “that defendants may have had superior knowledge of the particular type of investment products involved does not, without more, create a fiduciary relationship ... especially given that plaintiffs themselves are highly sophisticated business entities.” Id. As noted above, plaintiffs' understanding of the shelter was sufficient in all material respects, and no information that was allegedly concealed from them could have blinded them to its obvious and palpable risks. Accordingly, it is
ORDERED, that defendants' motion for summary judgment is granted, and it is further
ORDERED, that the complaint is dismissed with costs and disbursements to defendants as taxed by the Clerk of the Court upon the submission of an appropriate bill of costs; and it is further
ORDERED that the Clerk is directed to enter judgment accordingly.