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SHLOMCHIK v. RICHMOND 103 EQUITIES CO.

December 15, 1986

SEYMOUR SHLOMCHIK, a limited partner in Richmond 103 Equities Co., a New York Limited Partnership, for himself and on behalf of the partnership, Plaintiff,
v.
RICHMOND 103 EQUITIES CO., a New York Limited Partnership, and WILLIAM S. HACK and PEARL H. HACK, individually and as general partners of Richmond 103 Equities Co., a New York Limited Partnership, Defendants


Bernard Newman, Senior Judge, United States Court of International Trade, sitting as a District Court Judge, by designation.


The opinion of the court was delivered by: NEWMAN

OPINION, FINDINGS OF FACT AND CONCLUSIONS OF LAW

BERNARD NEWMAN, Senior Judge, United States Court of International Trade, sitting as a District Court Judge, by designation:

 Introduction

 Dr. Seymour Shlomchik, a limited partner in Richmond 103 Equities Co. ("R 103"), a New York limited partnership, seeks recovery of damages from William S. Hack and his wife, Pearl H. Hack, individually and as general partners of R 103.

 Plaintiff asserts two types of causes of action: (1) derivative claims brought on behalf of R 103 pursuant to New York Partnership law § 115-a; and (2) individual claims brought by plaintiff on his own behalf.

 Specifically, plaintiff's derivative causes of action, as set forth in the first three counts of the complaint, are: (1) failure to properly manage R 103 resulting in waste; (2) breach of fiduciary duty; and (3) common law fraud. The individual causes of action, as set forth in counts V through IX of the complaint, are: (1) failure to make cash flow distributions; (2) common law fraud; and (3) fraud in the purchase or sale of securities in violation of the federal and state securities laws. *fn1" These derivative and individual claims are based essentially on the same set of facts, as follows.

 Facts

 On January 1, 1973 plaintiff and eight other investors entered into an agreement of limited partnership relating to R 103. That agreement provides, inter alia, that "the purpose of the partnership is to acquire the land, buildings and improvements at the premises at 42-72 80th Street, Elmhurst, Queens, New York, and of leasing said premises" (paragraph 3); that the term of the partnership would be from January 1, 1973 to December 31, 2012, unless certain events occurred, i.e., "the divesting by the partnership of all interests it may have in said premises, and of any asset it may receive resulting from a sale, exchange or other disposition of said property" (paragraph 4); that the Hacks would be the general partners (paragraph 5); *fn2" that plaintiff would have a 9.8 percent share of the profits and losses (paragraph 10); *fn3" and that plaintiff's capital contribution to R 103 would be $40,000 to be paid in six installments (paragraph 7). Hence, plaintiff's total contribution to R 103 was $40,000, which amount was paid in full.

 Investment in R 103 was recommended to plaintiff by his attorney, Philip Shiekman of Pennsylvania, who was a close personal friend of Hack, an experienced real estate and tax attorney, and a real estate tax shelter promotor. Sheikman furnished plaintiff the proposed partnership agreement and a proposal prepared by Hack describing the investment in R 103 as "an apartment house with 103 apartments in Elmhurst, Queens, New York" (hereinafter referred to as "the Richmond"). The proposal presented the anticipated cash flow and tax losses per unit to the partners, and also disclosed that acquisition of the Richmond would involve a $2,250,000 wrap-around mortgage and net lease for 25 years. Further, the proposal stated that the performance of the wrap-around mortgagee and net lease tenant would be personally guaranteed by Messrs. Aaron Zeigelman and William Langfan (hereinafter referred to as "Z & L"), Hack's longtime friends and business associates.

 Prior to investing in R 103, plaintiff did not inspect the Richmond, see the neighborhood in which it was located or obtain an appraisal report covering the property. In point of fact, plaintiff had no idea as to the value of the Richmond in 1973; he invested in R 103 primarily as a tax shelter. In 1973, plaintiff was in (at the least) a 50 percent tax bracket and the partnership offered "three for one tax write-offs". Interestingly, plaintiff invested in at least four other tax shelter limited partnerships in which Hack was a general partner and the "moving spirit".

 On or about July 1, 1973, R 103 acquired the Richmond from a Z & L affiliate and gave such affiliate a $2,250,000 wrap-around mortgage, which "wrapped around" the existing first and second underlying mortgages on the property. Further, R 103 entered into a net lease of the Richmond to a corporate entity principally owned by Z & L, which net lease tenant operated the Richmond apartment building. As previously mentioned, Z & L personally guaranteed the performance of the wrap-around mortgagee and the net lease tenant.

 The partners' capital contributions to R 103 were used primarily to pay the interest on the wrap-around mortgage. Under that mortgage, R 103 was credited with the rents from the Richmond, and the wrap-around mortgagee made the payments on the underlying mortgages. The wrap-around mortgagee was also obligated to pay Shawnee Equities (Hack's wholly-owned corporation) commissions for Hack's services to R 103.

 From 1973 to August 26, 1977, plaintiff received from R 103 the cash flow distributions projected in the proposal. Thereafter, plaintiff received no further cash distributions from R 103 except a payment in June 1979 in the amount of $3,307.50. Hack sent the latter payment to plaintiff with an accompanying letter explaining that the payment was actually a "nonrecourse loan" from Hack. Plaintiff did not repay this loan to Hack.

 After cash flow distributions ceased, plaintiff made periodic inquiries of Hack by letter and telephone during a 5-year period from 1977 to 1982 concerning the reasons why distributions had not been made and seeking to elicit information as to the financial affairs of the partnership. Hack failed to reply to many of plaintiff's inquiries. In response to one inquiry, however, Hack explained to plaintiff that R 103 was having cash flow difficulties and that cash flow could not be distributed to the partners until it was received. Plaintiff demanded to know why, if R 103 was having cash flow problems, Hack was not legally pursuing the net lessee and Z & L, the guarantors. Additionally, upon being informed by Hack that the net lessee had defaulted under the lease, plaintiff demanded that Hack declare the net lessee in default, take the property back, and operate the Richmond as a landlord or property manager. Moreover, after cash flow distributions ceased, plaintiff repeatedly demanded to examine R 103's books and records, but Hack did not make them available to plaintiff until 1982.

 Hack's testimony establishes, without contradiction, that in 1975 the New York real estate market was depressed, Z & L had seriously overextended themselves in their real estate investments and were losing properties through foreclosure. In a word, the Z & L financial empire was on the verge of collapsing. *fn4"

 Hack discussed enforcement of their guarantee with Z & L who threatened Hack with their bankruptcy. At the trial, Hack explained it was his firm conviction that the pursuit of legal proceedings against Z & L upon their personal guarantees would have resulted in their bankruptcy and ultimately the foreclosure of the wrap-around mortgage on the Richmond. Hack informed plaintiff that, as a practical matter, R 103 had nothing to gain by pursuing either the net lessee or the guarantors since such action would precipitate foreclosure of the wrap-around mortgage, which from a tax standpoint, would be disastrous to the limited partners.

 According to Hack's testimony, in 1976 the Richmond could not have been sold at a price sufficient to pay off the wrap-around mortgage, and by foreclosure, R 103 would not only have lost the Richmond, but the limited partners would also have suffered serious tax recapture of both capital gains and ordinary income at least equal to the total amount of the deductions theretofore taken by them of approximately $1,000,000. Hack stressed he strongly believed that foreclosure of the mortgage and severe adverse tax consequences would have resulted by pursuing Z & L on their guarantee by legal process.

 Significantly, in April 1976, without the knowledge or consent of the limited partners and in furtherance of his plan to preserve the tax shelter benefits of the partnership, Hack arranged for the "tax-free exchange" of the Richmond for a substitute property, a 37.6 percent interest in an apartment complex in Yonkers known as Glenwood Gardens. The remaining 62.4 percent interest in Glenwood Gardens was acquired by four other real estate limited partnership tax shelters in which Hack was the general partner. Hack utilized five wrap-around mortgages totaling $5,980,000, each mortgage being in the amount of the percentage interest held by each of the five limited partnerships acquiring an interest in Glenwood Gardens. Hack testified convincingly that his only motivation for consummating the exchange of the Richmond for Glenwood Gardens was to avoid the imminent foreclosure of the wrap-around mortgage on the Richmond, and the consequential tax recapture which would have adversely impacted all the limited partners.

 Hack's modus operandi for the 1976 tax-free exchange was: a third party purchased Glenwood Gardens at the same closing in which Glenwood would then be exchanged for the Richmond. The third party would then dispose of the Richmond. Thus, through the use of a third party, Hack was able to "exchange" the Richmond for Glenwood Gardens and hopefully obviate a tax liability that would have been incurred by directly selling the Richmond and directly purchasing Glenwood Gardens.

 The danger to R 103 of the third party exchange was that the partnership might be deemed by the Internal Revenue Service to be a "seller" of the Richmond and a "buyer" of Glenwood Gardens. According to Hack, an experienced tax attorney, he determined to minimize this risk by avoiding any communications with the limited partners disclosing the exchange of properties thus reducing the potential for scrutiny of the transaction by the Internal Revenue Service.

 A total of eight properties involving eight limited partnerships and approximately eighty limited partners were affected by the 1976 third party exchange. In order to effectuate the third party tax-free exchange, Hack advanced $200,000 of his personal funds which were used by the "third party" to purchase Glenwood Gardens. The $200,000 advance was repaid to Hack.

 The 1976 exchange involved the payment by Z & L (through their affiliate Mari Corp.) to R 103 of $225,000. After an initial down payment on the $225,000, Mari Corp. executed a note and mortgage in the amount of $168,750 for the balance due R 103. Hack returned the note and mortgage to Z & L after being paid only $89,242.74 (half the amount due), and relinquished payment of the balance. Also involved in the 1976 exchange of properties was a release given by Hack to Z & L from their guarantee of the wrap-around mortgage and net lease of the Richmond.

 The record also shows that Hack, through his wholly-owned corporation Shawnee Equities, received payments totaling $114,090.14 during 1976 and 1977 for effecting the Glenwood Gardens transaction.

 From 1973 through and including 1976, plaintiff received tax deductions totaling $71,981, which closely approximated the amount of tax losses per unit projected in the proposal. From 1977 through and including 1983, plaintiff received tax deductions totaling $52,605, which were $12,601 more than originally projected in the R 103 proposal.

 In March 1982 and after numerous demands by plaintiff, Hack for the first time made available to plaintiff and his attorney certain books and records, including tax returns of R 103. Plaintiff learned from these records of the earlier 1976 exchange and that the partnership no longer owned the ...


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