A law firm that gave assurances on a tax avoidance scheme that employed digital securities options was not liable for securities fraud, ruled a Fifth Circuit panel, since without direct attribution to the firm’s role in the tax scheme, any taxpayer-investor reliance on the firm’s participation in the scheme was too indirect for liability. The panel said that a secondary actor cannot be held liable in a private securities fraud action for deceptive conduct not attributed to it before an investor decides to invest. (AFFCO Investments 2001 LLC v. Proskauer Rose LLP, CA-5, No. 09-20734, Oct. 27, 2010).
The Fifth Circuit panel distinguished its ruling that explicit attribution is required to show reliance under Rule 10b-5 from an earlier Fourth Circuit ruling that an investor can plead fraud-on-the-market reliance by alleging facts from which a court could plausibly infer that investors would have known that the defendant was responsible for the statement at the time it was made even if the statement on its face is not directly attributed to the defendant. Janus Capital Group v. First Derivatives Traders. The distinguishing factor, said the panel, is that the Fourth Circuit was dealing with fraud on the market and this tax scheme case is not that. The Fifth Circuit was concerned about whether the Fourth Circuit’s standard comports with the Supreme Court’s stated goals of certainty and predictability in securities law. This question may soon be answered because the Supreme Court has agreed to review the Fourth Circuit’s opinion in Janus, with oral argument set for December.
The scheme before the Fifth Circuit was a variation on a tax avoidance strategy that was heavily marketed and promoted by the financial planning and management industry in the late 1990s The IRS’s subsequent disallowance of these strategies resulted in a number of lawsuits against their developers and promoters.
This particular scheme involved a sophisticated income tax avoidance strategy in which taxpayers attempted to claim tax losses through a mechanism of offsetting digital options. Through a limited liability company (LLC) created solely for the purpose, a taxpayer would use a brokerage firm as a counterparty 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 company that was increased by the cost of the purchased options, but not reduced by the price received for the options sold. When the company later suffered a “loss” (for example, by selling its options for their low fair-market value), taxpayers would claim a share of that “loss” calculated according to their increased tax basis. Digital options are option contracts in which the purchaser of the option wagers that the price of an underlying security will be above or below a certain “strike price” at a particular point in time.
The accounting firm solicited the law firm for participation in the 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, the accounting firm promised to provide independent opinions from “several major national law firms” that had analyzed and approved the tax strategy On the strength of the accounting firm’s assurances, including the promise of opinions from unnamed law firms, investors agreed to participate in the scheme. The IRS later investigated investors for participation in an abusive tax shelter, and they were required to pay millions of dollars in back taxes, interest, and penalties.
As a threshold issue, the panel ruled that the taxpayers’ ownership interests in the LLCs constituted investments contracts and therefore were securities within the meaning of the federal securities laws. The tax avoidance scheme met the Supreme Court’s Howey test of an investment of money in a scheme functioning as a common enterprise with the expectation that profits will be derived solely from the efforts of individuals other than the investors. Tax benefits may constitute an expectation of profits under the test, said the panel. Further, while the taxpayer-investors may have had theoretical control over the situation, they did not exercise any managerial authority over the LLCs. Rather, under the terms of the investment contracts, the LLCs were to be managed by various investment consulting and brokerage entities for the purpose of implementing the tax scheme.
Absent attribution at time of investment decision making, the law firm recruited to give assurances on the tax avoidance strategy could not be liable under Rule 10b-5. While the investors’ allegations painted a clear picture of the law firm’s intimate involvement in the tax scheme, there was no assertion that they had knowledge of the firm’s role prior to their actual investment in the tax scheme. They do not allege that they ever saw or heard any of the firm’s work product before making their decision, nor do they allege that the promoters specifically identified the firm as one of the “major national law firms” that had vetted and cleared the tax scheme or that had agreed to provide opinions supporting the same.
Indeed, the law firm’s explicit involvement in the scheme, two tax opinions regarding the IRS reporting requirements, were rendered well after the purchase of the digital options and the creation of the taxpayers’ interests in the LLCs. Since the investors do not allege that they knew of the firm’s role in the tax scheme during the relevant time period when they were making their investment decisions, they failed to show reliance on the firm.
Knowing the identity of the speaker is essential to show reliance, reasoned the panel, because a word of assurance is only as good as its giver. Clients engage name-brand law firms at premium prices because of the security that comes from the general reputations of such firms for giving sound advice, or for winning trials. Specific attribution to a reputable source also induces reliance because of the ability to hold such a party responsible should things go awry.