Securities Litigation Reform Act Barred RICO Claims Against Tax Shelter Scheme

This posting was written by Mark Engstrom, Editor of CCH RICO Business Disputes Guide.

The Private Securities Litigation Reform Act (PSLRA) barred RICO claims against a law firm that allegedly participated in a scheme to promote an illegitimate tax shelter, the U.S. Court of Appeals in New Orleans has ruled.

The scheme required investors to purchase and sell offsetting digital options contracts through limited liability companies (LLCs) that were created solely for that purpose. Each taxpayer would claim a tax basis (in an LLC) that was increased by the cost of the options purchased but was not decreased by the price of the options sold.

The plaintiffs (investors) argued that the PSLRA was inapplicable because the options contracts were not securities; nor were their ownership interests in the LLCs.

Investment Contracts

Ownership interests in the LLCs were “investment contracts” that constituted securities within the meaning of the securities laws, the court concluded. In SEC v. W.J. Howey Co. (328 U.S. 293), the U.S. 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 . . . “

The investors argued that their profits were not derived “solely” from the efforts of others because they had retained control of the LLCs. However, economic reality governed over form, and the investors’ control was merely theoretical.

The investors, for example, did not allege that they had exercised any managerial authority over the LLCs. Rather, the LLCs—according to the terms of the investment contracts—were directed and managed by various consulting and brokerage entities for the purpose of implementing the tax scheme.

“Passive” Investors

In addition, the investors had expressly alleged that they did not know that the digital options transactions had little or no true economic substance. The investors 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.

Their ownership interests in the LLCs were therefore investment contracts that constituted securities, according to the court.

The decision, Affco Investments 2001 LLC v. Proskauer Rose, L.L.P., will appear at CCH RICO Business Disputes Guide ¶11,941.