Commercial Litigation and Arbitration

RICO — PSLRA Bar — Investment in LLC as Part of Tax-Avoidance Strategy = “Investment Contract” Triggering PSLRA Bar

From Affco Invest. 2001 LLC v. Proskauer Rose LLP, 2010 U.S. App. LEXIS 22105 (5th Cir. Oct. 27, 2010):

This case involves a sophisticated income tax avoidance strategy in which taxpayers attempted to claim tax losses through a mechanism of offsetting digital options.

[Footnote 1] Digital options are option contracts in which the purchaser of the option wagers that the price of an underlying commodity, currency, or security will be above or below a certain "strike price" at a particular point in time. A correct wager, or a "win," results in the payout of a predetermined amount, while an incorrect wager, or a "loss," results in the forfeiture of the cost of the option.

Through a limited liability company ("LLC") created solely for the purpose, a taxpayer would use a brokerage firm as a counter-party to buy and sell nearly identical options at approximately the same prices. Having thus hedged against any true losses, the taxpayer would claim a tax basis in the LLC that was increased by the cost of the purchased options, but not reduced by the price received for the options sold. When the LLC later suffered a "loss" (for example, by selling its options for their low fair-market value), the taxpayer would claim a share of that "loss" calculated according to his increased tax basis. ***

According to the amended complaint, the accounting firm of KPMG, LLP ("KPMG") targeted and solicited Plaintiffs for participation in such a tax scheme, representing the scheme to be a legitimate investment vehicle as well as a legitimate tax shelter through which taxpayers could offset some or all of their income. As part of their marketing strategy, KPMG promised to provide independent opinions from "several major national law firms" that had analyzed and approved the tax strategy. Plaintiffs allege that the law firm of Proskauer Rose, L.L.P. ("Proskauer") worked with KPMG and other defendants behind the scenes to prepare, in advance, model opinions supporting the validity of the tax scheme. ***

RICO provides a private right of action for persons harmed by a pattern of racketeering activity. 18 U.S.C. §§ 1962, 1964(c). However, Congress limited this right by amending RICO in 1995, as part of the PSLRA, to bar civil RICO claims based on "any conduct that would have been actionable as fraud in the purchase or sale of securities." 18 U.S.C. § 1964(c). *** Because we find that Plaintiffs' ownership interests in the LLCs constituted "investments contracts," and therefore were "securities" within the meaning of the federal securities laws, we affirm the district court without reaching the question of whether the digital options that Plaintiffs bought and sold also were securities.

Both the 1933 and 1934 Acts broadly define the term "security" to include, among other things, an "investment contract." See 15 U.S.C. § 77b(a)(1); 15 U.S.C. § 78c(a)(10). In SEC v. W. J. Howey, Co., the Supreme Court defined an investment contract as "a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party . . . ." 328 U.S. 293, 298-99, 66 S. Ct. 1100, 90 L. Ed. 1244 (1946). The Howey test thus contains three elements: (1) an investment of money; (2) in a scheme functioning as a common enterprise; (3) with the expectation that profits will be derived solely from the efforts of individuals other than the investors. SEC v. Koscot Interplanetary, Inc., 497 F.2d 473, 477 (5th Cir. 1974) (citations omitted); accord Williamson v. Tucker, 645 F.2d 404, 417-18 (5th Cir. 1981) (citing Koscot, 497 F.2d 473). With respect to Plaintiffs' interests in the LLCs, the only issue raised on appeal is whether the profits — here, the tax benefits — were to come solely from the efforts of those other than Plaintiffs.

[Footnote 4] Tax benefits may constitute an expectation of "profits" under the Howey test. See Long v. Shultz Cattle Co., 881 F.2d 129, 132-33 n.2 (5th Cir.1989) (citations omitted).

We are not without guidance in deciding this question. In SEC v. Koscot Interplanetary, Inc., we examined a pyramid promotion scheme involving the sale of cosmetics. Notwithstanding the efforts of the individual investors, who actually sold the products and recruited new investors, we found the scheme to be an investment contract because the promoters of the scheme retained immediate control over the essential managerial conduct of the enterprise, and because the investors' realization of profits was inextricably tied to the success of the promotional scheme. 497 F.2d at 485. In so doing, we held that the proper standard for analyzing the third prong of the Howey test is "whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise." Id. at 483 (quoting and adopting the standard explicated by the Ninth Circuit in SEC v. Glenn W. Turner Enters., Inc., 474 F.2d 476, 482 (9th Cir. 1973)) (internal quotation marks omitted).

Our decision not to literally construe the "solely from the efforts of others" test is consistent with the Supreme Court's emphasis on the principle that "economic reality is to govern over form." See Williamson, 645 F.2d at 418 (citations omitted). ***

We applied this standard in Long v. Shultz Cattle Co., 881 F.2d 129 (5th Cir. 1989), where we examined a cattle-feeding consulting agreement designed to achieve advantageous tax write-offs for investors. Although the investors had the formal authority to make such management decisions as the purchase of cattle, the choice of a feed yard, and when and to whom to sell, they were not cattlemen and did not have the wherewithal to manage a cattle-feeding business. They therefore relied solely upon the advice and managerial efforts of a third party in "authorizing" all such decisions.... Given the economic reality of the situation, we held that the expected profits came solely from the efforts of others.

Plaintiffs' ownership interests in the LLCs are similar to the consulting agreements held to be investment contracts in Long. The original complaint describes the formation, funding, and trading activities of four LLCs: three single-member LLCs, capitalized by three separate named Plaintiffs, and a fourth LLC that was capitalized in part by a fourth Plaintiff, an investment entity, which in turn was largely owned by other named Plaintiffs. Plaintiffs argue that, based on these facts, they retained control over the LLCs.

However, Plaintiffs' control was theoretical rather than actual. Plaintiffs do not plead that they exercised any managerial authority over the LLCs; rather, the original complaint states that, under the terms of the investment contracts, the LLCs were to be "under the direction of," and "managed by," various investment consulting and brokerage entities for the purpose of implementing the tax scheme. As expressly pled in the original complaint, Plaintiffs were unaware that the underlying digital options transactions had little or no true economic substance. Plaintiffs thus portrayed themselves as passive investors who depended — both in reality and according to their investment contracts — upon the efforts of others for their profits. The district court did not err in assuming these facts to be true, as it must under Rule 12(b)(6), and dismissing the RICO claim as barred by the PSLRA on the face of the pleadings.

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