Antitrust Law Daily Wrap Up, RICO—N.D. Ill.: Unlawful tax shelter lacked sufficient continuity; RICO claims thwarted, (Jul 19, 2016)

By Mark Engstrom, J.D.

A stockholder failed to allege a sufficiently continuous pattern of racketeering in his RICO claims against the purveyors of an allegedly fraudulent tax shelter, the federal district court in Chicago has ruled. Because the defendants perpetrated a single scheme to defraud a single victim who was injured by a single tax planning product with a "natural ending point," the RICO claims lacked the requisite continuity and were dismissed without prejudice (Menzies v. Seyfarth Shaw LLP, July 15, 2016, Blakey, J.).

Steven Menzies, the President and CEO of Applied Underwriters Inc. (AUI)—a financial services company that provided workers’ compensation insurance to small and mid-sized businesses—sued lawyers, bankers, and financial planners who had developed, promoted, sold, and implemented an unlawful tax scheme to shelter his capital gains.

According to Menzies, the defendants sold him a tax-avoidance plan that artificially inflated his tax basis in AUI stock, a maneuver that was designed to diminish or eliminate capital gains on the sale of that stock. Because the IRS considered the maneuver an unlawful tax avoidance plan, Menzies had to pay more than $10.4 million in capital gains taxes, penalties, and interest. Menzies sought the same amount in damages from the defendants for their RICO violations and other unlawful conduct.

The defendants sought dismissal of the RICO claims because Menzies, in their view, failed to adequately allege a RICO enterprise, a pattern of racketeering, the "conduct" of an enterprise under the "operation-management" test, or a RICO conspiracy. The defendants further argued that Menzies’s RICO claims were barred by the Private Securities Litigation Reform Act of 1995 (PSLRA).

Enterprise. Menzies properly alleged a RICO enterprise. According to the court, the allegations in his complaint—and the reasonable inferences that could be drawn therefrom—established a common purpose and the requisite relationships among the associates of the enterprise.

The complaint alleged that the defendants had joined together to enrich themselves and to further the common interests of the group as a whole. In the court’s view, the alleged interactions among the members of the enterprise were more than the typical interactions of normal commercial relationships. In addition, the alleged enterprise exhibited sufficient longevity—at least 31 months or more—to permit its associates to pursue its purposes.

The court could distinguish Menzies’s allegations from "run-of-the-mill" commercial activity because the complaint established a "truly joint enterprise," in which each associate acted in concert with the other associates to pursue a common interest. Significantly, the defendants had planned and worked in concert, and even shared business that was vital to the alleged fraud.

More specifically, the defendants allegedly performed services—such as issuing opinion letters and conducting trust activities—that aided a scheme to generate sustained profits for the enterprise members. Ultimately, the allegations showed a common purpose, relationships among the entities that were associated with the enterprise, and longevity that was sufficient to permit the associates to pursue the enterprise’s purposes.

Pleading requirements. The defendants argued that the federal courts were obligated to strictly construe the pleading requirements for civil RICO claims—to prevent RICO from becoming a federal surrogate for "garden-variety fraud actions" that were properly asserted under state law. The court disagreed.

In the court’s view, a strict-construction rule did not exist for RICO cases in general, or for civil RICO cases in particular, and no judicially-created rule for civil RICO cases could be reconciled with the Supreme Court’s admonition to read the statute’s provisions the same way in criminal and civil contexts. Further, a "strict construction" rule conflicted with Congress’ mandate to liberally construe the RICO statute in light of its broad remedial purposes. To the extent that "garden-variety" fraud met the well-settled elements of a RICO claim, Congress intended RICO to apply to those types of fraud, the court explained.

Continuity. Menzies alleged a closed-ended pattern that involved multiple acts of mail and wire fraud in furtherance of an overall scheme to defraud. Given the quantity of predicate acts that Menzies had alleged, and the duration of those acts over a period of 31 months, the allegations appeared to present a sufficient pattern, at least initially. On further inspection, however, the court concluded that Menzies did not allege the requisite continuity for a pattern of racketeering.

Significantly, all of the predicate acts were conducted in furtherance of a single scheme to defraud a single victim who was injured by a single tax planning product. In addition, the predicate activity included just two substantive crimes—mail and wire fraud—that were committed during the execution of a single tax avoidance plan for the disposition of a single person’s stock holdings. The court acknowledged that the defendants had staged their complex tax plan over length of time, but nevertheless found that the totality of the circumstances revealed a single "dishonest undertaking" for the purpose of evaluating a pattern of racketeering.

The large number of mail and wire fraud acts did not, by itself, establish a threat of continued criminal activity, and the fact that the alleged pattern had occurred over a lengthy period of time did not alter the court’s conclusion regarding continuity.

The court acknowledged that the Seventh Circuit did not employ a bright-line rule for determining an acceptable length of time for closed-ended periods of continuity. Nevertheless, it did not hesitate to find that, in appropriate cases such as this one, closed periods of "several months to several years" could be insufficiently substantial to satisfy RICO’s continuity requirement. In this case, the "natural and commonsense" result was to find a lack of continuity.

Threat of continuing activity. Because Menzies was the only victim of the defendants’ "clear and terminable" goal, he failed to allege a threat of continuing criminal activity. According to the court, the "natural ending point" for the alleged pattern had exhausted the threat of repetition.

Significantly, the complaint stated that, by June of 2005, the defendants had "completed all necessary transactions in furtherance of the Tax Shelters, and pursuant to the Defendants’ Conspiracy were paid substantial fees and expenses from Menzies." Thus, on the complaint’s own terms, the alleged pattern did not project into the future, either from the character of the enterprise or the regular manner in which the enterprise allegedly conducted its business. By setting forth a single scheme to defraud just Menzies, the complaint failed to establish a threat of continuity.

Because Menzies failed to properly allege either continuity or the threat of continuity, his RICO claims were dismissed without prejudice. Menzies could file an amended complaint that re-alleged those claims, but only if the amendment was consistent with his obligations under Rule 11 of the Federal Rules of Civil Procedure.

RICO conspiracy, operation-management test. According to the court, the maintenance of a RICO conspiracy claim did not require the "operation or management" of a RICO enterprise by the alleged conspirators as long as the conspirators "knowingly agree[d] to perform services" that facilitated the activities of those who were operating or managing the enterprise. For that reason, the defendants could not be held liable for RICO violations unless they had: (1) exercised some direction over the named enterprise or helped to operate it or (2) knowingly conspired to facilitate the activities of someone who was a manager or operator of the enterprise.

In the court’s view, Menzies satisfied the requisite test. As either a principal offender or as an aider and abettor, each defendant had personally operated, or otherwise exerted control over, the affairs of the alleged enterprise. Their participation included the planning and commission of the predicate activities and the active concealment of their prior relationships as part of the fraudulent scheme.

The asserted conduct included: (1) luring the plaintiff into a bogus tax shelter plan; (2) referring business to other violators by convincing the plaintiff to hire co-conspirators; (3) participating in telephone conversations, without the plaintiff, to plan the scheme; (4) structuring the legal instrumentalities of the scheme; (5) defrauding the plaintiff and supporting the appearance of the scheme’s legitimacy with false statements and opinion letters; and (6) controlling the instrumentalities of the scheme through active service as a trustee for the relevant assets and legal instrumentalities that were used to injure the plaintiff.

Those allegations were sufficient, the court explained, because the class of potential violators included "lower-rung participants" who were under the direction of upper management (or other participants who were associated with the enterprise and exerted control over its affairs). Ultimately, the defendants’ alleged misconduct was more than a "tangential involvement" in the affairs of the enterprise.

Conspiracy elements. Given the fatal absence of continuity, or its threat, in the underlying RICO claim, the conspiracy count could not proceed. It, too, was dismissed without prejudice.

The court concluded, however, that the RICO claims were not barred by the Private Securities Litigation Reform Act.

The case is No. 15 C 3403.

Attorneys: Daniel Aaron Dorfman (Harris Winick Harris LLP) for Steven Menzies. Matthew J. Gehringer (Perkins Coie LLP) for Seyfarth Shaw LLP.

Companies: Seyfarth Shaw LLP

Cases: RICO IllinoisNews