Collateral Estoppel on Economic Substance from Prior Criminal Conviction (12/29/11)

In Princeton Strategic Investment Fund, LLC v. United States, 2011 U.S. Dist. LEXIS 147339 (ND CA 2011) (will post a copy when I get a non-copyrighted copy), the principal issue was whether, in a civil TEFRA partnership case, a partnership was bound by the doctrine of collateral estoppel because of the prior convictions of principals affiliated with the partnership.  The criminal case was the criminal convictions of Messrs. Robert Pfaff, John Larson and R. J. Ruble.  (I  refer to this criminal case as United States v. Pfaff (see prior blog on the Second Circuit's affirmance, here.)  United States v. Pfaff was the remnant of the much larger indictment in United States v. Stein in which 13 of the defendants were dismissed for prosecutorial abuse.  (See United States v. Stein, 541 F.3d 130 (2d Cir. 2008).)  These cases arose from the KPMG related shelters, principally the BLIPS shelters.

Messrs. Pfaff and Larson were principals in the firms controlling the partnership and thus all the decisions regarding the BLIPS transaction.  More importantly, they were convicted of a count of conviction for tax evasion with regard to the partnership and tax losses in question.  So the issue was whether the partnership would be collaterally estopped because of their convictions.

Collateral estoppel is a judicial principal that prevents issues from being relitigated between the same parties or, in some cases, between parties in privity.  The Princeton Strategic Court described the elements of collateral estoppel as follows:

Collateral estoppel may only be invoked by a party when: (1) the party to be bound by the estoppel was either a party to the prior suit or in privity with a party to the prior suit; (2) the issue to be litigated is identical to an issue that was necessarily decided in the prior case; and (3) the prior proceeding ended with a final judgment on the merits.

Applying that test, the Court found that the parties in the Princeton Strategic civil case were bound by collateral estoppel for the following reasons:

1. The Court found that the convicted defendants were sufficiently related to the civil plaintiffs based on a "pre-existing substantive legal relationship."  The Court said (footnotes omitted):

Based on this undisputed evidence, the Court finds that the relationship between Larson, Pfaff, Makov and Petitioners is the type of pre-existing substantive legal relationship giving rise to non-party preclusion. As managers of both Petitioner partnerships, Larson, Pfaff and Makov had a fiduciary duty to Petitioners with regards to their handling of the investments at issue. Petitioners' pleadings make clear that no partner other than Presidio Growth, as controlled by Larson, Pfaff and Makov, would have the legal ability to influence the implementation of the BLIPS transactions. Thus, since those parties already bound by prior judgments (Pfaff, Larson and Makov) were both fiduciaries and partners of Petitioners, and were the only people legally entitled to make decisions about the tax transactions at issue on Petitioners' behalf, the Court finds that they had a sufficient pre-existing substantive relationship with Petitioners to justify the application of non-party preclusion.

2. The Court determined that the issue had been decided in the convictions of Messrs. Larson and Pfaff.  The Court noted that the transaction in issue had been the transaction involved in one of the counts of conviction for tax evasion.  The Court reviewed the jury instructions in United States v. Pfaff which as presented permitted the jury convict only if the jury found the transaction lacked economic substance.  Hence, the conviction meant that the jury had found beyond a reasonable doubt that the transaction lacked economic substance.

3. Finally, of course, the prior litigation did end in a decision on the merits via the convictions.

So, the on the merits of the claimed losses, the civil plaintiffs were shut out.  Further, the Court determined that the jury conviction necessarily encompassed a finding of negligence and shut the civil plaintiffs out on that issue also.

Importantly, however, based on prior Ninth Circuit precedent, the Court gave them a victory on the 40% gross valuation misstatement penalty in Section 6662(h).  Keller v. Comm'r, 556 F.3d 1056, 1059-62 (9th Cir. 2009)..  Basically, as best I understand the Ninth Circuit's reasoning, if the deduction is disallowed by some threshold infirmity -- such as lack of economic substance -- before the issue of valuation misstatement is reached, the valuation misstatement penalty cannot apply.  (Readers should note that there is a split in the circuits on this issue, with the trend, to impose the penalty even if there is such a threshold infirmity, see Fid. Int'l Currency Advisor A Fund, LLC v. United States, 661 F.3d 667, 673 n. 6 (1st Cir. 2011).  (I previously discussed Fid. Int'l Currency here.)

JAT Addendum 12/30/11:  For those wanting to pursue related facets of the collateral estoppel question and its relationship to burden of proof (only hinted at in the Presidio Strategic case because the criminal burden of proof was significantly greater than the civil burden of proof), I attach here the most recent iteration of a discussion from my Federal Tax Crimes book.