The opinion of the court was delivered by: LEONARD B. SAND
This action arises out of failed tax shelters. Plaintiffs are investors who claim they were defrauded in connection with their purchases of limited partnership interests in one or more of eleven limited partnership tax shelters marketed and managed by defendants. Plaintiffs also claim they were defrauded in connection with their investment in discretionary trading accounts maintained and managed by defendants. Plaintiffs base their suit on alleged violations of the Racketeer Influenced and Corrupt Organizations Act ("RICO"), 18 U.S.C. § 1961 et seq., as well as on claims of state law fraud.
The moving defendants assert, inter alia, that the statutes of limitations have lapsed on the various claims, that the complaint fails to allege facts from which it could be inferred that some of the defendants perpetrated or participated in the alleged acts of fraud, and that plaintiffs have failed to plead fraud with particularity.
The financial transactions at the heart of this action are described in detail in both United States v. Manko, 979 F.2d 900 (2d Cir. 1992), cert. denied, 113 S. Ct. 2993 (1993), and Greenwald v. Manko, 840 F. Supp. 198 (E.D.N.Y. 1993). What plaintiffs essentially allege is that, beginning in or around 1977, defendants embarked on a scheme to induce individual investors to invest in what purported to be two types of tax-advantaged investment vehicles: discretionary trading accounts and limited partnerships. Defendants allegedly represented to potential investors that they, or the limited partnerships to be established by them, would enter into profit-motivated transactions in the field of government-backed securities, and that these transactions, precisely because they would be profit-motivated and carry risk, would generate losses that the investors could successfully claim as loss deductions on their individual tax returns. In making their decisions to invest in the trading accounts and the limited partnerships, plaintiffs maintain that they relied upon representations contained in private placement memoranda issued by defendants to the effect that no security transactions would be entered into unless they had enough economic substance to be capable of producing a pre-tax profit. Amended Complaint, dated May 24, 1993 ("Am. Compl."), PP 55-58.
The fraud in the sale of these tax-deferral investments lay in the fact that defendants allegedly never had any intention of conducting bona fide, profit-driven transactions in the securities markets. Rather, it is alleged that defendants, on their own and through secret oral agreement with a third-party trading entity, orchestrated billions of dollars worth of prearranged and fictitious trades in put options, Treasury Bill straddles, and repurchase agreements. Am. Compl. PP 59, 66, 73. These paper transactions, which, as one court has put it, consisted of "typing, not trading,"
were allegedly rigged from the outset to generate nothing but losses for the trading accounts and the partnerships, which losses were then passed through to the individual investors, who wrongfully (albeit unwittingly) claimed them as deductions on their tax returns. It is further alleged that defendants looted the money that plaintiffs invested in the trading accounts and partnerships by way of the commissions they awarded themselves for their trading account activity; by way of the incentive compensation they paid themselves as managers of the investment vehicles; by way of "fees," disguised as interest expenses, they paid to the third-party trading counterpart of the partnerships; and by way of the wasted operating expenses of the trading accounts and the partnerships. Am. Compl. PP 106-08, 110.
Plaintiffs claim that defendants' pattern of fraudulent misrepresentations and bogus trading activity caused them to lose their investments, to lose any chance of earning profit on their investments, to incur large income tax deficiencies and interest penalties as a result of the IRS's disallowance of their tax deductions, and to incur expenses in defending themselves from the IRS's challenges to their tax filings. Am. Compl. P 105.
A. Statute of Limitations
General Principles. The parties are right in emphasizing to the Court that the statute of limitations for RICO actions is somewhat unique. Agency Holding Corp. v. Malley-Duff & Assocs., Inc., 483 U.S. 143, 97 L. Ed. 2d 121, 107 S. Ct. 2759 (1987), established that a four-year limitations period governs civil RICO claims. Bankers Trust Co. v. Rhoades, 859 F.2d 1096 (2d Cir. 1988), cert. denied, 490 U.S. 1007, 104 L. Ed. 2d 158, 109 S. Ct. 1642 (1989), made clear that the four-year period begins to run not, as in ordinary fraud actions, from the date a plaintiff discovered or should have discovered the "bad acts" causing him injury, but from the date a plaintiff discovers or should have discovered the specific injury itself. 859 F.2d at 1103. "[A] plaintiff may sue for any injury he discovers or should have discovered within four years of the commencement of his suit, regardless when the RICO violation causing such injury occurred." Id. This rule of accrual flows logically from civil RICO's standing criterion, under which only persons "injured in [their] business or property by reason of a violation of section 1962" can bring a civil RICO action. Id. at 1102. "Until such injury occurs, there is no right to sue for damages . . . and until there is a right to sue . . ., a civil RICO action cannot be held to have accrued." Id.
To say that RICO injury triggers the running of the four-year limitations period does not mean, however, that a plaintiff's discovery of his RICO injury, be it actual or constructive, is a sufficient prerequisite of accrual. Rather, in the wake of Bankers Trust, it is only a necessary prerequisite of accrual. A plaintiff must obviously still have, in addition to knowledge of his injury, actual or constructive knowledge of the "bad acts" causing the injury in order for the limitations period to accrue. Were it otherwise, suit would be foreclosed to injured parties who through no fault of their own had no reason to suspect that their financial setbacks were caused by violations of RICO. Accord Dayton Monetary Assocs. v. Donaldson, Lufkin, & Jenrette Secur. Corp., 1992 U.S. Dist. LEXIS 12283, No. 91-2050, 1992 WL 204374, at *4-*5 (S.D.N.Y. Aug. 11, 1992); Amendolare v. Schenkers Int'l Forwarders, Inc., No. CV-87-3023, 1989 U.S. Dist. LEXIS 17215, at *20 (E.D.N.Y. Dec. 17, 1989); Long Island Lighting Co. v. General Elec. Co., 712 F. Supp. 292, 302 (E.D.N.Y. 1989).
Before proceeding to this two-part inquiry, we would make two additional points. The first is that questions regarding actual or constructive notice of facts that start the running of the limitations period usually depend for their answers on inferences that are drawn from the facts of each particular case and that are similar "to the type of inferences that must be drawn in determining intent and good faith . . . ." Robertson v. Seidman & Seidman, 609 F.2d 583, 591 (2d Cir. 1979). What this means in practice is that per se rules of actual or inquiry notice -- such as a rule that notices of disallowances from the IRS are always enough to put an investor on notice of fraud in the marketing and management of his tax-shelter investment -- are not very helpful. Sometimes IRS disallowance notices will convey the information necessary to provide notice, sometimes they will not -- it all depends on the content of the notice, the nature of the loss, and the nature of the fraud.
The second point relates to the date of the occurrence of one's RICO injury. Bankers Trust held that an injury occurs for statute of limitations purposes only when the damages have become definite and provable, rather than conjectural. "Refusal to award damages as too speculative is equivalent to holding that no cause of action has yet accrued. When damages do become definite, a claim will accrue, and plaintiff will have four years to bring an action for recovery." 859 F.2d at 1106 (citations omitted). Contrary to the suggestions of the defendants, we do not read the recent Second Circuit decision in Long Island Lighting Co. v. Imo, 6 F.3d 876 (2d Cir. 1993), as altering or even refining this decisional rule. In Imo, the plaintiff had constructive knowledge of the fact that it had been sold faulty generators no later than 1977; one of the generators failed in 1983; plaintiff brought suit against the manufacturer of the generators in 1985. The Court of Appeals, relying on Bankers Trust, held that plaintiff's RICO claims were time-barred because plaintiff "should have known in 1977 that [the defendant] had delivered defective Generators . . . [and plaintiff's] injury was not in any sense speculative at that juncture . . . ." 6 F.3d at 887. In our view, this holding stands only for the unremarkable proposition that a party to a commercial venture can be injured not only when his purchase actually fails in the field but also when he learns that he has received something less than what he paid for. The holding does not stand, as defendants suggest, for the proposition that one's injury need not be ascertainable or quantifiable; nor does it stand for the proposition that "injury" is co-extensive with knowledge of "bad acts." We will therefore analyze, the question of when plaintiffs' RICO injuries occurred in this case on the basis of the analysis of Bankers Trust.
Notice of Injury. As noted above, plaintiffs claim to have suffered three types of injury from defendants' fraud: liability to federal, state and/or local tax authorities; expenses incurred in defending themselves against challenges to their tax filings; and the depletion of the financial base of the tax-shelter investments themselves.
As regards the first alleged injury, defendants have submitted evidence showing that as early as 1985 the IRS was examining the books of the limited partnerships and finding grounds to challenge the declarations of income and losses contained in them. See Exh. D to the Affidavit of Jon Edelman, dated November 27, 1992 ("Edelman Aff."). Defendants have also submitted evidence showing that as early as 1985, the IRS had preliminarily decided to disallow certain income and expense items reported by the partners in connection with one of the limited partnerships, see Exh. J to the Edelman Aff., and a general partnership that served as the agent of the limited partnerships in trades with third parties, see id.; that by 1986 the IRS had audited and determined to disallow certain reported items on the books of an additional partnership, see Exh. H to the Edelman Aff.; that by 1986 New York State had begun to issue deficiency notices to seven of the limited partnerships, Exh. F to the Edelman Aff.; that the IRS's pattern of audit and disallowance of partnership income and expense items continued into 1987 and 1988, see Exhs. K, L to the Edelman Aff.; Exh. B to the Affidavit of Barry Lyman, dated September 29, 1994; and finally, that by late December 1987, the IRS and counsel for all of the partners of all of the limited partnerships had worked out a global settlement, the terms of which fixed the allowable losses and reportable gains for all of the partnerships and the way in which interest penalties would be calculated, Exh. F to the Affidavit of Allan Lazaroff, dated January 28, 1994 ("Lazaroff Aff."), at 26-27, 48-50; Transcript of Trial Proceedings, United States v. Manko, 979 F.2d 900 ("Manko Trial Transcript"), at 5189-90 (testimony of Barbara Kaplan). Through a letter from counsel to the IRS dated January 15, 1988, roughly two hundred partners expressed their intention to accept the terms of this settlement. Exh. M to the Edelman Aff; Exh. F to the Lazaroff Aff. at 43. On February 25, 1988, counsel for the partners and the IRS informed the tax court that a settlement had been reached. Exh. F to the Lazaroff Aff. at 50.
All of this evidence indicates that plaintiffs' tax-related injuries occurred prior to February 8, 1989, and that plaintiffs knew of their extent. The very disallowances of which plaintiffs complain were made by the IRS over the course of the years 1985-88, and agreement on the formula by which the partners' tax deficiencies would be computed was reached by the end of 1987. A number of partners accepted the terms of the agreement in January 1988. By January 1988, then, all of the partners -- plaintiffs included -- knew that they had incurred tax related expenses of a provable amount. And it was the partners' obligation to pay those expenses, not the actual payment as such, that counted as an economic injury for purposes of the accrual of RICO's statute of limitations. See Bankers Trust, 859 F.2d at 1105 (RICO plaintiff suffers injury as to each expense when he becomes obligated to pay that expense, not at some later date when he actually makes payment).
Plaintiffs do not dispute that the IRS began to scrutinize and disallow items on their tax returns well before February 8, 1989. They argue, however, that their tax-related injuries did not materialize until sometime after February 8, 1989 because the global settlement agreement with the IRS was not finalized until December 1989, when certain issues pertaining to its implementation were resolved, and because it was only after December 1989 that individual partners signed binding closing agreements with the IRS.
Plaintiffs add that the IRS would not issue final notices of disallowance to any of the partners during the pendency of the criminal investigation and prosecution of two of the ringleaders of the tax shelter investment scheme, Bernhard Manko and Jon Edelman. Affidavit of Alan J. Dlugash, dated December 29, 1993 ("Dlugash Aff."), P 24. Manko and Edelman were indicted for tax fraud on February 8, 1989 and convicted on February 4, 1991.
Second, the fact that problems relating to the implementation of the global settlement agreement remained outstanding until December 1989 does not mean that plaintiffs' tax-related injuries had yet to occur. Only one of the two implementation problems identified by plaintiffs would arguably have had an impact on the amount of a given partner's tax liability, namely, the question of whether the IRS would allow the partners to net the interest due on refunds owed to them against the interest on their deficiencies. Whatever the sum of money that hung in the balance as a result of this implementation issue,
it did not render plaintiffs' injuries incalculable. Bankers Trust does not say that a potential plaintiff must be able to calculate his loss down to the last penny before his RICO injury can be said to exist; all that is required is that the injury not be "speculative." 859 F.2d at 1106. As a result of the December 1987 accord with the IRS, plaintiffs' injuries were ascertainable; indeed, they had in hand an agreed-upon formula for calculating their tax arrears. The only question remaining was how to minimize their losses by getting the IRS to exercise its discretion and give them a "good deal" on the mechanics of their deficiency payments.
Third, plaintiffs' claim that the IRS refused to enter into definitive settlements with the partners until the prosecutions of Manko and Edelman had run their course is belied by the fact that at least one of the partners signed a closing agreement with the IRS in June 1989, well before the trial and convictions of these two men. See Danzer Aff. P 5. The claim is also at odds with the concession plaintiffs made at oral argument that, for purposes of these motions, they were put on notice of their fraud claims on February 8, 1989, the day the Manko/Edelman indictment came down. See Transcript of Oral Argument, dated January 26, 1995, at 35.
We conclude that plaintiffs' tax-related injuries occurred prior to February 8, 1989, and that plaintiffs had actual knowledge of those injuries prior to that date.
We reach the same conclusion with regard to the two other types of claimed injury. Plaintiffs clearly incurred expenses in defending their interests from challenge by the tax authorities prior to February 8, 1989. Any expenses incurred after February 8, 1989 would amount only to further damages, not to a new, independent injury. See Bankers Trust, 859 F.2d at 1103 ("Where the plaintiff has already suffered injury and will continue to suffer that same injury in the future, an award of past and future damages may be entirely appropriate, subject of course to the normal standards governing such awards.") (emphasis in original). The losses associated with the depletion of the money invested in the trading accounts and limited partnerships and the lost opportunity to earn a profit occurred, according to the Amended Complaint, every time defendants paid themselves trading commissions and incentive compensation, every time they paid bogus fees to the third-party trading counterpart of the investment partnerships, and every time the operating expenses of the trading accounts and partnerships were wasted on the bogus trading activity. Because plaintiffs maintained their investments in the trading accounts only until 1981, Am. Compl. P 3, and because plaintiffs do not allege any trading on the part of the limited partnerships beyond 1983, see Am. Compl. P 76, the injuries to the integrity and profitability of their investments must be deemed to have occurred no later than the end of 1983. Plaintiffs have not alleged when they first learned of these losses, and there is nothing in the summary judgment record to counter defendants' contention that they learned of them at or around the same time they learned of the disallowances and their deficiency liabilities. It may be concluded, then, that plaintiffs had notice of this third type of injury prior to February 8, 1989.
Having determined as a matter of law that plaintiffs had notice of each of their injuries prior to February 8, 1989, we next consider when they first had notice of the alleged fraud.
Notice of Fraud. Defendants argue that plaintiffs had actual notice, or at the very least inquiry notice, of the alleged fraud well before February 8, 1989.
In particular, defendants point to a series of communications from the management of the partnerships to the limited partners over the course of the 1980's, which they claim unequivocally conveyed to the partners the probability that they were being defrauded. Plaintiffs claim that the earliest possible date they learned of the fraud was February 8, 1989, the day the Manko/Edelman indictment came down.
It is clear that tax shelters can be risky ventures for reasons wholly unrelated to fraud. As Judge Stanton pointed out in Dayton Monetary Assocs., 1992 U.S. Dist. LEXIS 12283, 1992 WL 204374, at *4, "there are many reasons, other than fraud on the part of [a tax shelter's] managers and trading partners, for an investment in a tax shelter limited partnership to become worthless and for its associated tax deductions to be disallowed by the IRS." One common reason, litigated in case after case before the tax courts, is that the tax authorities simply disagree with the taxpayer that a given transaction falls within the meaning of one of the tax code's terms of art, such as "income" or "loss." This potential for disagreement over the merits of a given transaction for tax purposes arises out of the so-called "sham-in-substance" doctrine, which requires courts and the tax authorities
to look beyond the form of a transaction and to determine whether its substance is of such a nature that expenses or losses incurred in connection with it are deductible under an applicable section of the Internal Revenue Code. If a transaction's form complies with the Code's requirements for deductibility, but the transaction lacks the . . . economic substance that form represents, then expenses or losses incurred in connection with the transaction are not deductible.
Of course, there is always the possibility that the tax authorities will challenge a reported item, not because they dispute the taxpayer's characterization of the underlying transaction for tax purposes, but because the transaction itself is not what the taxpayer represents it to be. It is one thing, for example, for the IRS to say that an "option straddle transaction," involving prerogatives to buy and sell commodities, was not sufficiently profit-motivated to merit the claimed tax treatment. It is another thing for the IRS to say that the claimed sales and purchases of commodities cannot be recognized because they never in fact occurred. Things being other than what they are claimed to be is not a matter of differing interpretations; it is the essence of fraud.
The IRS has announced its intention to increase its emphasis on tax shelter partnership audits. Partnerships engaging in spread or straddle transactions are of particular interest to the IRS.
The IRS has indicated to the Managing Partners that it is examining the 1978 tax returns of two partnerships with which the Managing Partners are affiliated as general partners or consultants. . . . Prospective investors should note that the business activities of the two entities being examined by the IRS are substantially similar to the proposed business activities of the Partnership.
Exh. 9 to the Affidavit of Claude M. Tusk, dated October 29, 1993, at 38. The question is not whether the limited partners knew of the risk that the trading activity in which they had invested would fail to achieve the tax advantages they hoped for; they did know or are presumed to have known this. Rather, the question is whether the limited partners knew of the risk that the trading activity itself would not occur as promised by the promoters and managers of the limited partnerships. We do not believe that we can say, as a matter of law, that they were so apprised.
In March 1984, the management of the partnerships notified all of the limited partners that the IRS was questioning the substance of certain transactions similar to the ones engaged in by the partnerships. Exh. C to the Edelman Aff. The notification suggested that the threat to the tax positions of the partnerships arose as a result of rapid changes in the tax laws and tax regulations and the interpretation given them by the IRS. Id. In June 1985, the management of the partnerships notified all of the limited partners that the IRS had proposed adjustments to the partnerships' tax returns. Exh. D to the Edelman Aff. The notification stated that the proposed adjustments were based primarily on Fox v. Commissioner, 82 T.C. 1001, 1023 (1984), a tax court opinion holding that a deferral scheme involving options transactions was insufficiently motivated by a desire for economic profit to generate recognizable losses. There was no allegation in Fox that the transactions at issue did not occur as claimed; the opinion even conceded that all but one of the transactions had some potential for profit after commissions. Id. at 1021.
In our view, neither one of these correspondences to the partners need be read as communicating circumstances suggesting the probability of fraud. They more readily suggest IRS concern with the tax treatment to be accorded trades which were in fact transacted than challenges to trades which fraudulently never took place.
In April 1986, all of the limited partners received a status report from Saltzman & Holloran, a law firm that had been retained by the management of the partnerships to defend the partnerships against the IRS's inquiries. Saltzman & Holloran advised that the IRS's basis for disallowing losses on certain option transactions, and interest expenses on certain repo transactions, was that the transactions had not been engaged in primarily for profit within the meaning of the Internal Revenue Code. In a passage strongly relied upon by defendants, Saltzman & Holloran then advised the partners that
the other stated ground for disallowance of both the options and repo transactions is the allegation that the transactions did not occur as claimed, had no economic substance and were prearranged. . . . We will demonstrate from the books and records of the partnerships that the transactions occurred as claimed and that they were not prearranged or economically irrational. The partnerships purchased and sold government securities and entered into repo transactions with independent third parties . . . .
Defendants argue that the status reports from Saltzman & Holloran, coupled with the Summary Reports issued by the IRS and relayed to the limited partners, put plaintiffs on notice of the fraud. And they have a point: these reports depict the partnerships' transactions as not merely preconceived or prearranged with an eye to tax advantages, but as fictitious. They depict "shams-in-fact" -- "typing" not "trading" -- and ...