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November 3, 1986

EDWARD J. BRADY and BRADY & TARPEY, P.C., Defendants

The opinion of the court was delivered by: SAND


Plaintiff Eugene duPont III commenced this action against Edward J. Brady and Brady & Tarpey, P.C., alleging violations of the federal securities laws, 15 U.S.C. § 78j(b) (1982); 17 C.F.R. § 240.10b-5 (1986), and New York's Martin Act, N. Y. Gen. Bus. Law § 352-c (McKinney 1984), as well as common law fraud and attorney malpractice. DuPont claims that Brady and Brady's law firm defrauded their client, duPont, by concealing a conflict of interest and misrepresenting supposed tax benefits in connection with duPont's investment in the Kenona Coal Program. After a bench trial, the following constitutes our findings of fact and conclusion of law that plaintiff has failed to sustain the burden of proof with respect to any of the four counts.


 The following facts are not in dispute in this litigation. Defendant Brady, a resident of New York, at all times relevant to this action, has been a shareholder of, and lawyer associated with defendant Brady & Tarpey, P.C. ("B & T"), a New York corporation. Brady was plaintiff duPont's personal lawyer from 1956 to 1980, rendering services which included advice as to tax matters. DuPont is a resident of Florida. Over the course of their relationship, duPont, aided by Brady, purchased a variety of investments, several of which he used as tax shelters.

 In late 1979, Brady and B & T advised duPont that in their opinion, an investment in the Kenona Coal Program would provide duPont with a valid federal tax deduction. DuPont purchased three limited partnership units in Kenona for a total of $75,000 and in addition made an optional capital contribution to Kenona of $225,000. B & T received commissions from the Kenona promoters with respect to this sale (fifteen percent of $75,000), as well as legal fees for Brady's services. DuPont claimed a $300,000 deduction in his 1979 federal income tax return for his investment in Kenona.

 Kenona never engaged in coal mining, and duPont's investment in Kenona is worthless. In June 1983, several individuals were convicted of securities fraud and other crimes in connection with the offering of interests in coal mining ventures, including Kenona. In April 1985, the Internal Revenue Service (IRS) disallowed duPont's $300,000 deduction, claiming a deficiency of $191,645. In April 1986, duPont and the IRS stipulated that the deficiency in respect of 1979 was $140,513.


 The evidence establishes that in the course of Brady's twenty-five year representation of duPont, Brady handled a variety of legal matters for duPont and served as trustee on a number of trusts established by duPont. During this time, duPont frequently sought investments which were motivated primarily by the tax savings they could provide and apprised Brady of several such investments himself. In fact, one of Brady's main functions for duPont was to analyze duPont's tax planning schemes.

 For instance, Brady testified without contradiction that duPont presented Brady with, inter alia, proposals converting two safaris that duPont took with his wife into charitable deductions, and the concept of building a 40-acre lake behind his home, which by way of a joint venture, duPont converted into a tax loss. Other comparable tax schemes that duPont brought to Brady on duPont's own behalf involved shielding income behind farm investments, real estate, and a partnership that duPont created to write a book about his brother. Moreover, in response to duPont's requests, Brady would advise duPont on the availability of tax shelter investments, which prior to 1979, resulted in duPont's investment in two limited partnerships. These investments provided duPont with tax deductions over a period of years.

 In late 1979, during a meeting in which duPont was present, duPont's investment advisors at the Southern National Bank in Houston informed Brady that duPont had a potential tax exposure in excess of his ability to pay. Brady advised duPont that this tax exposure required him to shelter at least $300,000 worth of income, and that a tax shelter investment of that magnitude should be found. Although the evidence conflicts as to whether Brady mentioned the Kenona Coal Program specifically as a possible investment at this meeting, it appears that Brady did indicate that he "thought" a tax shelter investment "would be deductible." DuPont asked no further question about the potential investment at this meeting or at any other time.

 Pursuant to this meeting, Brady asked Daniel Gaven, an attorney in Brady's firm, to investigate the availability of a tax shelter for duPont. B & T were then dealing with a number of tax shelter promoters, some of whom provided fees or commissions to B & T upon investment by B & T clients. Gaven and Brady found two potential investments for duPont, both of which would have provided B & T with a commission. They determined that of the two, the Kenona Coal Program -- a carbon copy of other coal programs that B & T had already reviewed -- would be better suited to plaintiff's financial needs.

 According to the Kenona Program's private placement memoranda, investors, who became Kenona's limited partners, could obtain under the existing law deductions of up to four times the amount of their cash investments, if the investors furnished recourse notes for the balance. The tax shelter was made up of two elements. First, the recourse notes were to fund an "optional capital contribution" to an "insurance reserve fund" designed to protect Kenona's general partner against accident claims to the extent they exceeded the highest coal mining accident judgment ever recorded. The investor would be required to pay on the recourse note only in the remote event that a tort judgment against the partnership actually exceeded this amount, thus requiring use of the insurance reserve fund. At any time prior to use of this fund, investors could voluntarily withdraw their optional, non-cash capital contributions. However, while an investor's optional capital contribution remained in the insurance reserve fund, the combination of this capital contribution and the cash contribution totaled the investor's basis in the program.

 The second element of the shelter provided the vehicle -- a minimum annual royalty payment -- by which an investor sustained a deductible loss for the tax year 1979 up to the amount of his basis in the investment. The program contemplated a deduction in 1979 for a full year of minimum annual royalties even though operations were not to begin until November 1979. Since the partnership had no income in the short year 1979, the minimum royalty payment (financed primarily out of nonrecourse notes that the partnership would pay only if the mine produced coal) generated a loss.

 Kenona's private placement memoranda contained a favorable tax opinion prepared by Mirrer, Lerner & Ryan, P.C. (the Mirrer firm). However, plaintiff's expert witness at trial testified, and the Court finds, that based on the law as it existed in 1979, no reasonable and experienced tax lawyer could have issued a favorable opinion on either the deductibility of the optional capital contribution (based on the "at risk" rule) or the annual minimum royalty (because it would be paid only if there was actual production from the mine).

 The evidence produced at trial demonstrates that Gaven investigated Kenona and several other identical coal programs by reviewing the private placement memoranda and by conducting a limited review of the pertinent legal authority. He also spoke with Raymond Mirrer (the author of Kenona's tax opinion) and Michael Donoghue (who was involved with the promotion of Kenona) regarding the deductibility of an investment in the tax shelters. Gaven's investigation of Mirrer's credentials was limited to ascertaining that he was listed in the Martindale Hubbell directory. Based on his discussion with Mirrer, Gaven believed and reported to Brady that while the ...

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