RICO — Investor’s Claim Arising out of Illegal Tax Shelter Not Barred by PSLRA, but Proximate Cause Lacking Because the Government was the Directly Injured Party and Did, in Fact, Sue
From Rezner v. Bayeriusche Hypo-Und Vereinsbank, AG, 2010 U.S. App. LEXIS 26272 (9th Cir. Dec. 28, 2010):
It is undisputed that John Rezner participated in a financial transaction called Custom Adjustable Rate Debt Structure ("CARDS"), designed to avoid the payment of federal income taxes.*** CARDS loan transactions are designed to generate the appearance of large capital losses for high net worth investors to reduce their tax income liability.
In 2001, to carry out this CARDS scheme, HVB incorporated Pinner Financial Trading, LLC ("Pinner"), in the state of Delaware. HVB entered into a credit agreement with Pinner pursuant to which it loaned Pinner Euros 48,000,000 ("the Pinner loan"). Pinner converted the proceeds of the loan into an interest-bearing certificate of deposit for 85% of the loan, and a Euro-denominated promissory note in the amount of Euros 8,000,000 (or approximately $7,300,000) for the remaining 15%. These were placed in an account with HVB to serve as collateral for the Pinner loan.
Rezner assumed Pinner's obligation to pay HVB for the loan of Euros 48,000,000 in exchange for Rezner taking ownership of the Euro-denominated promissory note that was part of the collateral for the Pinner loan. To gain the right to use Pinner's promissory note, Rezner pledged, as collateral for the Pinner loan, a security interest in a SolomonSmithBarney account that held approximately $11,000,000 in municipal bonds. Rezner then sold his interest in Pinner's promissory note to a third party at its fair market value. The legality of the tax consequences of this CARDS facility was supported by a legal opinion letter from Sidley Austin Brown & Wood LLP ("Sidley Austin"). Both Sidley Austin and LeBoeuf Lamb Greene & MacRae LLP ("LeBoeuf") advised Rezner that the loan on which he was co-obligor with Pinner was a for a 30-year term, but had to be renewed or terminated upon each anniversary by the parties. Upon each renewal, HVB had the sole discretion to increase the interest rate and fees associated with the loan.
Another investment firm called Chenery Associates, who engineered CARDS facilities, was involved in negotiating Rezner's participation in the transactions. Rezner paid a total of over $4,000,000 in fees to participate in the CARDS transactions: $1,692,829 to HVB; $1,320,000 to myCFO; $250,000 to Sidley Austin; $80,000 to LeBoeuf; and $800,000 to Chenery.
On March 18, 2002, the IRS published a notice announcing that they would not allow taxpayers to claim a loss based on transactions structured similarly to CARDS. Rezner subsequently claimed a capital loss of $39,649,866 on his 2001 tax return based upon the fact that he received only $7,300,000 for the sale of the Euro-denominated promissory note, while assuming joint and several liability for the full Euros 48,000,000 Pinner loan. Rezner carried most of the loss to the year 2002, when he sold over $30,000,000 in Yahoo! stock. He claimed no tax liability for that year in part because of the alleged carry-over loss resulting from assuming liability for the Pinner loan.
In August 2002, one year after Rezner entered into his agreement to assume liability for the Pinner loan, HVB raised the fees and interest rate on the loan. It was entitled to do so under its agreement with Pinner. Rezner accepted the increase. On August 13, 2003, HVB unilaterally terminated the loan and demanded immediate repayment of the entire outstanding balance.
In 2005, Rezner was audited by the IRS. The audit resulted in the denial of Rezner's claimed capital loss made in connection with the Pinner loan. He was also ordered to pay approximately $11,000,000 in back taxes and interest. *** On February 13, 2006, HVB admitted to participating in a number of unlawful tax shelter schemes, including the Pinner loan, that were designed to defraud the United States. HVB entered into a Deferred Prosecution Agreement ("DPA") with the United States Attorney for the Southern District of New York. 1 HVB stated in the DPA that "all parties involved [in the illegal tax shelter transactions], including the clients/' borrowers,' knew that the transactions would be unwound in approximately one year in order to generate the phony tax benefits sought by the client participants." ***
Rezner filed a motion for partial summary judgment on February 3, 2009. He argued that HVB's admission that it defrauded the United States in the DPA was sufficient to establish that HVB violated RICO***.
The district court granted summary judgment in favor of Rezner on his RICO and UCL claims. *** The district court rejected HVB's primary reliance on the report of its expert, Alan Dlugash ("the Dlugash Report"), to show that Rezner was aware that the CARDS transactions lacked economic substance. The district court stated that there was "nothing in the Dlugash report that suggest[ed], based on admissible evidence, that [Rezner] was aware that the CARDS facility was an unlawful tax shelter." ***
HVB contends that Rezner's RICO claim was preempted by the PSLRA because "his pledge of municipal bonds [as substitute collateral for the CARDS loan] . . . qualified as the sale of securities under settled precedent" which constituted "a fraud coincid[ing] with the sale of securities" as described in SEC v. Zandford, 535 U.S. 813, 815 (2002). (Appellant's Op. Br. 48.)
The PSLRA amended RICO to state
Any person injured in his business or property by reason of a violation of [RICO] may sue therefor in any appropriate United States district court . . . , except that no person may rely upon any conduct that would have been actionable as fraud in the purchase or sale of securities to establish a violation of [RICO].
18 U.S.C. § 1964(c). Actions for fraud in the purchase or sale of securities are controlled by section 10(b) of the Securities Exchange Act of 1934. ***
The requirement under section 10(b) that the fraud committed be "in connection with" a securities transaction means "that a certain relationship [must] be established between the fraud and the transaction that resulted in the injury complained of." In re Fin. Corp. of Am. S'holder Litig. ("Financial Corp."), 796 F.2d 1126, 1129-30 (9th Cir. 1986). ***
While a pledge of securities can effect a transfer of "an interest in a security" sufficient to qualify as a "sale" of a security under the Securities Act, Rubin v. United States, 449 U.S. 424, 429 (1981), "'it is not sufficient [merely] to allege that a defendant has committed a proscribed act in a transaction of which the pledge of a security is a part.'" Financial Corp., 796 F.2d at 1130 (quoting Chemical Bank v. Arthur Andersen & Co., 726 F.2d 930, 943 (2d Cir. 1984), cert. denied, 469 U.S. 884 (1984)).
Financial Corp. concerned advice from Arthur Andersen to the plaintiff about how to account for the purchase and sale of various securities. The plaintiff alleged that Andersen's fraudulent accounting advice in connection with the securities caused its loss. We held that the plaintiff had failed to satisfy the "in connection with" requirement because its loss resulted from Arthur Andersen's advice, not the sale of the securities. Id. at 1130-31; see also Chemical Bank, 726 F.2d at 944 & n.24 (holding that a loan procured by fraud that happens to be "collateralized by a pledge of security as to which no misrepresentations were made" does not come within section 10(b) if "but for the pledge it would not").
The connection here between the pledge of securities and the fraud is even more tenuous. There is no allegation that there were any misrepresentations about the value of the securities Rezner pledged. While the CARDS scheme, as implemented in this case, involved the pledge of some municipal bonds, Rezner's alleged loss was not a result of the pledge of these bonds. Rezner's alleged loss resulted from HVB's misrepresentations to the United States regarding the tax treatment of the Pinner loan. In Financial Corp., at least the fraudulent advice directly related to the securities; here, the securities were merely a happenstance cog in the scheme. The fraud bore an insufficient connection to the securities.
HVB argues that Swartz v. KPMG LLP, 476 F.3d 756 (9th Cir. 2007), and Curtis Inv. Co. v. Bayerische Hypo-und Vereinsbank, No. 06-cv-2752, 2007 WL 4564133 (N.D. Ga. Dec. 20, 2007), aff'd, 341 Fed. Appx. 487 (11th Cir. 2009), suggest otherwise. We disagree.
In Swartz, the fraud involved a tax-shelter scheme named BLIPS. The various transactions, called BLIPS, had the effect "to artificially inflate Swartz's basis in the Microsoft stock so he could sell it and claim a capital 'loss' in the amount of the difference between the inflated basis and the value of the stock." *** The sale of the Microsoft stock was the "lynchpin of the BLIPS scheme" and the fraud and security were directly connected. *** Here, the bonds were not the lynchpin of the scheme. Rezner's decision to use bonds had no effect on the fraudulent scheme, which instead concerned the tax treatment of a loan. See Ambassador Hotel Co., Ltd. v. Wei-Chuan Inv., 189 F.3d 1017, 1026 (9th Cir. 1999) ("[T]he fraud in question must relate to the nature of the securities, the risks associated with their purchase or sale, or some other factor with similar connection to the securities themselves.").
In Curtis, which involved similar RICO claims by a different plaintiff against HVB for its sale of the CARDS facility, the district court, in an unpublished opinion, noted in dicta in one sentence that "[i]f the collateral was a promissory note, that note was likely a 'security' within the scope of the PSLRA." *** It did not conduct any further analysis. Without something further, Curtis is not persuasive authority for holding that the PSLRA bars Rezner's RICO claim here. ***
HVB argues that the district court erred in granting summary judgment in favor of Rezner because Rezner has failed to establish that HVB's fraud against the United States caused his injury. ***
Here, Rezner alleges that a third-party, the United States, was directly injured by HVB's fraudulent activity. It was the United States that lost tax revenue as a direct result of HVB's fraud. Rezner's asserted injury only indirectly resulted from HVB's fraudulent activity against the United States. See Holmes, 503 U.S. at 271 (holding that where a fraudulent scheme directly harmed stockbrokers by causing stock prices to plummet, creditors to the stockbrokers could not show proximate causation because their injury was "purely contingent" on the harm to the brokers).
In analyzing proximate causation, one consideration is whether a better suited plaintiff would have an incentive to sue. See Hemi, 130 S. Ct. at 990. Here, the direct victim of HVB's fraudulent conduct — the United States — did in fact sue by entering into a deferred prosecution agreement with HVB. The United States, not Rezner, was best situated to recover for fraud against it. ***
Here, the United States, not Rezner, was the immediate victim of HVB's fraud and better situated to sue HVB. Therefore, we hold that Rezner cannot show proximate causation based on HVB's fraud against the United States and REVERSE the district's court grant of summary judgment on the RICO claim.
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