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STECHLER v. SIDLEY

April 5, 2005.

JOSEPH STECHLER; GAIL STECHLER; AND STECHLER & CO., INC. F/K/A JOSEPH STECHLER & CO., INC., Plaintiffs,
v.
SIDLEY, AUSTIN BROWN & WOOD, L.L.P.; R.J. RUBLE; THE DIVERSIFIED GROUP INCORPORATED; JAMES HABER; ALPHA CONSULTANTS, INC.; ALPHA CONSULTANTS, L.L.C., IVAN ROSS; IRWIN ROSEN; GRANT THORNTON, L.L.P.; GRANT THORNTON INTERNATIONAL; ISRAEL PRESS, REFCO CAPITAL MARKETS, LTD., and REFCO CAPITAL L.L.C., Defendants.



The opinion of the court was delivered by: SHIRA SCHEINDLIN, District Judge

OPINION AND ORDER

I. INTRODUCTION

  This case arises out of tax and consulting services offered by several legal and financial services firms. Plaintiffs allege a conspiracy among defendants to market, sell and implement a tax shelter — known as the Digital Options Strategy — which defendants knew or should have known would be considered unlawful by the IRS. Plaintiffs allege that defendants violated the Racketeer Influenced and Corrupt Organizations Act, 18 U.S.C. § 1962, and are liable for damages and other relief arising from unjust enrichment, breach of contract, breach of the duty of good faith and fair dealing, breach of fiduciary duty, fraud, negligent misrepresentation, professional malpractice, and civil conspiracy. Jurisdiction is based on the presence of a federal question, pursuant to 28 U.S.C. § 1331. All defendants other than Refco now move to dismiss the complaint.*fn1 In addition, DGI and Brown & Wood move to compel arbitration and stay the proceedings. For the following reasons, the motions to compel arbitration are granted in part and denied in part, and the motions to dismiss are granted with leave to amend.

  II. BACKGROUND A. The Alleged Conspiracy

  The Stechlers allege a complex conspiracy among a number of defendants, the details of which are largely irrelevant to the disposition of the present motions. Only the general outlines of the conspiracy are described here. These facts are drawn from the allegations in the Amended Complaint, and are presumed to be true for the purpose of the motions to dismiss.

  The tax shelter known as the Digital Options Strategy was developed by DGI in the mid-90s.*fn2 DGI sold the Strategy to wealthy individuals who had realized large capital gains. DGI recruited the other defendants to play a variety of roles in marketing and implementing the Strategy.*fn3 Grant Thornton agreed to identify potential purchasers of the Strategy among their clients and to assist DGI in marketing and selling the strategy to those individuals. DGI and Grant Thornton would present the Strategy to potential clients, assuring them that "the Strategy would more than likely pass IRS scrutiny if they were ever audited" — a representation that, the Stechlers allege, defendants knew or should have known was false.*fn4 Grant Thornton also prepared tax returns reflecting the Strategy. Alpha and Refco agreed to assist DGI in implementing the transactions required to execute the Strategy. In addition, DGI recruited Brown & Wood to provide clients with a purportedly independent opinion letter attesting to the propriety of the tax shelter transaction. DGI and the other defendants entered into an arrangement whereby each defendant would receive a certain portion of the fee paid to DGI for the Strategy.

  B. The Digital Options Strategy

  To carry out the Digital Options Strategy, the taxpayer first forms a limited liability company (LLC) and an S corporation.*fn5 Through the LLC, the taxpayer enters into two offsetting Digital Options Contracts with a counterparty. In the first contract (the "Long Option"), the taxpayer purchases a digital option on the Nasdaq 100 Index; in the second (the "Short Option"), the taxpayer sells a digital option on the Index. The cost to the taxpayer of the purchased option is largely offset by the payment made for the sold option. These contracts are matters of private contract between the taxpayer and the counterparty, and are not traded on any recognized exchange. The first contract will result in a payout, of a certain fixed sum*fn6 to the taxpayer if the Reference Price on the Index is at or above a certain Strike Price during a fifteen minute period on a certain date. The second contract will require the client to pay out a roughly equal sum if the Reference Price on the Index is at or above a certain Strike Price — within fractions of a penny of the strike price on the opposing contract — on that date. Because the strike prices are so close, and because the counterparty has the discretion to pick the precise moment during the fifteen minute period when the Reference Price will be determined, the overwhelming likelihood is that either both payments or neither will be made, and the transaction will be close to a wash.

  The taxpayer then contributes his or her interest in the LLC to another LLC, a fund managed by DGI and Alpha. In return, the taxpayer receives an interest in the fund. For tax purposes the taxpayer's interest in the fund has a basis equal to the amount the taxpayer paid for the Long Option. However, according to the promoters of the Strategy, the amount received for and the potential obligation to pay out on the Short Option are ignored for basis purposes because the Short Option is viewed as a contingent liability. The taxpayer then asks to be redeemed from the fund. As payment for the taxpayer's interest in the fund, the taxpayer receives cash and other assets owned by the fund. These assets have (pursuant to the Digital Options Strategy) a basis equal to the taxpayer's artificially inflated basis in his or her interest in the fund. The assets thus acquire an artificially inflated basis, far in excess of their fair market value. The taxpayer then contributes those assets to the taxpayer's S corporation. The S corporation then sells the assets, realizing a large capital loss. This loss is then applied to eliminate or reduce the taxpayer's capital gains, substantially reducing his or her tax liability.

  C. The Stechlers' Involvement in the Strategy

  During the latter part of 2000, Mr. Stechler's company had large capital gains from the sale of certain stock holdings.*fn7 After realizing these gains, the Stechlers met with their long-term accountant, Israel Press of Grant Thornton, to discuss the implications of the capital gains and develop a tax plan.*fn8 Press scheduled meetings with James Haber of DGI to discuss tax shelters, including the Digital Options Strategy.*fn9 During the course of these meetings, Press and Haber represented that the Strategy would pass muster with the IRS, and that Brown & Wood would provide an independent evaluation of the strategy.*fn10

  In November 2000, the Stechlers agreed to engage in the Strategy, and paid DGI $750,000 to implement the Strategy.*fn11 The Stechlers formed JXS Trading LLC ("JXS Trading") for the purpose of carrying out the Strategy.*fn12 The Stechlers entered into an operating agreement with DGI (the "JXS Operating Agreement").*fn13 Under the JXS Operating Agreement, Mr. Stechler became the sole member of JXS Trading, and DGI became its manager. The Agreement establishes their "rights and obligations . . . in connection with forming and operating" JXS Trading.*fn14 The Agreement contains an arbitration clause.*fn15

  On November 9, 2000, the Stechlers entered into two Digital Options Contracts with Refco.*fn16 The Stechlers paid $25,000,000 for a Long Option and received $24,500,000 for the Short Option. The Long Option provided that, if the Reference Price of the Nasdaq 100 Index on January 19, 2001 between 9:30 and 9:45 a.m. exceeded the strike price of $3,716.84, Refco would pay the Stechlers $140,230,051. The Short Option provided that, if the Reference Price at that time exceeded the strike price of $3,716.87, the Stechlers would pay Refco $138,430,056.

  DGI and Alpha formed AD Equity Fund 2000 LLC ("the Fund") on November 3, 2000.*fn17 In the process of forming the Fund, DGI and Alpha signed another operating agreement, the "Fund Operating Agreement."*fn18 On November 15, 2000, the Stechlers contributed their interest in JXS Trading to the Fund in exchange for an 87.72% interest in the Fund.*fn19 On joining the Fund, Mr. Stechler also signed the Fund Operating Agreement.*fn20 The Fund Operating Agreement contained an arbitration provision.*fn21 On the same day, Mr. Stechler signed a Contribution Agreement with the Fund, memorializing the contribution of the Stechlers' interest in JXS Trading to the Fund.*fn22 The Contribution Agreement does not contain an arbitration clause. However, the Contribution Agreement is subject to the terms and conditions of the JXS Operating Agreement and the Fund Operating Agreement.*fn23

  The Stechlers resigned from the Fund on December 20, 2000.*fn24 In redemption of their interest in the Fund, the Stechlers received a distribution with a fair market value of $31,249, consisting of $2,179 in cash and $29,070 in marketable securities.*fn25 On the same day, the Stechlers contributed the cash and securities to Joseph Stechler & Co., Inc., an S corporation.*fn26 Joseph Stechler & Co. subsequently sold those assets for their fair market value.*fn27

  In February 2001, the Stechlers received the promised opinion letter from Brown & Wood, attesting to the validity of the Digital Options Strategy.*fn28 In July 2001, they filed their tax return for 2000, including the artificial losses generated by the Digital Options Strategy.*fn29 Grant Thornton prepared the Stechlers' 2000 tax return.*fn30

  In December 2000, before the Stechlers engaged in the Digital Option Strategy, the IRS began an investigation into the Strategy and similar shelters, serving DGI with a request for a list of clients who had engaged in such shelters.*fn31 This was not disclosed to the Stechlers.*fn32 In 2001, the IRS offered an amnesty program for individuals who had participated in the Strategy and similar shelters.*fn33 In March 2002, Brown & Wood informed the Stechlers of the amnesty program, and advised them to contact their accountants to determine whether they should participate in the program.*fn34 The Stechlers contacted Grant Thornton, who advised them not to participate.*fn35

  On January 23, 2003, DGI informed the Stechlers by letter of the IRS' investigation of the Digital Options Strategy, and advised them to obtain counsel experienced in tax matters.*fn36 On June 19, 2003, the IRS notified the Stechlers that their 2000 tax return had been selected for examination.*fn37 The Stechlers retained new counsel.*fn38 The Stechlers have settled with the IRS, agreeing to pay back taxes, interest and a 10% penalty, and losing ...


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